Economy part 5

8/22/2019 Economy part 5

1/13

Macroeconomic Problems and Measures to counter them Fin.Wiz

Inflation

Inflation is defined as a sustained increase in the general level of prices for goodsand services. It is measured as an annual percentage increase. As inflation rises,every dollar you own buys a smaller percentage of a good or service.

The value of a currency does not stay constant when there is inflation. The valueof a currency is observed in terms of purchasing power, which is the real, tangiblegoods that money can buy. When inflation goes up, there is a decline in the

purchasing power of money. For example, if the inflation rate is 2% annually,then theoretically a Rs.1 pack of gum will cost Rs.1.02 in a year. After inflation,your Rupee can't buy the same goods it could beforehand.

There are several variations on inflation:

Deflation is when the general level of prices is falling. This is the oppositeof inflation.

Hyperinflation is unusually rapid inflation. In extreme cases, this can leadto the breakdown of a nation's monetary system. One of the most notableexamples of hyperinflation occurred in Germany in 1923, when prices rose

2,500% in one month! Stagflation is the combination of high unemployment and economic

stagnation with inflation. This happened in industrialized countries duringthe 1970s, when a bad economy was combined with OPEC raising oil

prices.

Causes of Inflation

Economists wake up in the morning hoping for a chance to debate the causes ofinflation. There is no one cause that's universally agreed upon, but at least two

theories are generally accepted:

Demand-Pull Inflation - This theory can be summarized as "too muchmoney chasing too few goods". In other words, if demand is growingfaster than supply, prices will increase. This usually occurs in growingeconomies.

Cost-Push Inflation - When companies' costs go up, they need to increaseprices to maintain their profit margins. Increased costs can include things

such as wages, taxes, or increased costs of imports. Built-in inflation is induced by adaptive expectations, and is often linked to

the "price/wage spiral". It involves workers trying to keep their wages upwith prices (above the rate of inflation), and firms passing these higher

labor costs on to their customers as higher prices, leading to a 'viciouscircle'. Built-in inflation reflects events in the past, and so might be seenas hangover inflation.

Costs of Inflation

Almost everyone thinks inflation is evil, but it isn't necessarily so. Inflation affectsdifferent people in different ways. It also depends on whether inflation isanticipated or unanticipated. If the inflation rate corresponds to what the majorityof people are expecting (anticipated inflation), then we can compensate and the

cost isn't high. For example, banks can vary their interest rates and workers can

negotiate contracts that include automatic wage hikes as the price level goes up.


2/13

Problems arise when there is unanticipated inflation:

Creditors lose and debtors gain if the lender does not anticipate inflationcorrectly. For those who borrow, this is similar to getting an interest-freeloan.

Uncertainty about what will happen next makes corporations andconsumers less likely to spend. This hurts economic output in the long run.

People living off a fixed-income, such as retirees, see a decline in theirpurchasing power and, consequently, their standard of living.

The entire economy must absorb repricing costs ("menu costs") as pricelists, labels, menus and more have to be updated.

If the inflation rate is greater than that of other countries, domesticproducts become less competitive.

People like to complain about prices going up, but they often ignore the fact thatwages should be rising as well. The question shouldn't be whether inflation is

rising, but whether it's rising at a quicker pace than your wages.

Finally, inflation is a sign that an economy is growing. In some situations, littleinflation (or even deflation) can be just as bad as high inflation. The lack of

inflation may be an indication that the economy is weakening. As you can see, it'snot so easy to label inflation as either good or bad - it depends on the overalleconomy as well as your personal situation.

The stock and bond markets are very sensitive to its changes because wheninflation rises, purchasing power is eroded. The ensuing drop in consumerspending has a negative effect on stock and bond prices. The rate of inflationtends to increase during economic expansions and decrease during recessions.Inflation tends to be moderate during expansions, and high inflation rates tend tohasten the transition from peak to recession. Deflation is rare and occurs only

during recessions.

Deflation

Deflation is a general decline in prices, often caused by a reduction in the supplyof money or credit. Deflation can also be caused by a decrease in government,

personal or investment spending. The opposite of inflation, deflation has the sideeffect of increased unemployment since there is a lower level of demand in the

economy, which can lead to an economic depression.

Declining prices, if they persist, generally create a vicious spiral of negatives such

as falling profits, closing factories, shrinking employment and incomes, andincreasing defaults on loans by companies and individuals. To counter deflation,the Reserve Bank of India (RBI) can use monetary policy to increase the money

supply and deliberately induce rising prices, causing inflation. Rising pricesprovide an essential lubricant for any sustained recovery because businessesincrease profits and take some of the depressive pressures off wages and debtorsof every kind.

This is the opposite of inflation, which is characterized by rising prices (do notconfuse deflation with disinflation, which is simply a slowing of inflation). To manyeconomists, deflation is more serious than inflation because deflation is moredifficult to control. Deflationary periods can be either short or long, relativelyspeaking. Japan, for example, had a period of deflation lasting decades starting inthe early 1990's. The Japanese government lowered interest rates to try andstimulate inflation, to no avail. Zero interest rate policy was ended in July of 2006.

Equity prices begin to decline as people sell off their investments, which are nolonger offering good returns, and bonds temporarily become more attractive.


3/13

Hyperinflation

Extremely rapid or out of control inflation. There is no precise numerical definitionto hyperinflation. Hyperinflation is a situation where the price increases are so outof control that the concept of inflation is meaningless. When associated with

depressions, hyperinflation often occurs when there is a large increase in themoney supply not supported by gross domestic product (GDP) growth, resultingin an imbalance in the supply and demand for the money. Left unchecked thiscauses prices to increase, as the currency loses its value.

When associated with wars, hyperinflation often occurs when there is a loss ofconfidence in a currency's ability to maintain its value in the aftermath. Because

of this, sellers demand a risk premium to accept the currency, and they do this byraising their prices.One of the most famous examples of hyperinflation occurredin Germany between January 1922 and November 1923. By some estimates, theaverage price level increased by a factor of 20 billion, doubling every 28 hours.

Stagflation

This is a condition of slow economic growth and relatively high unemployment - a

time of stagnation - accompanied by a rise in prices, or inflation.

Stagflation occurs when the economy isn't growing but prices are, which is not a

good situation for a country to be in. This happened to a great extent during the1970s, when world oil prices rose dramatically, fuelling sharp inflation indeveloped countries. For these countries, including the U.S., stagnation increasedthe inflationary effects.

Recession

A significant decline in activity across the economy, lasting longer than a fewmonths. It is visible in industrial production, employment, real income and

wholesale-retail trade. The technical indicator of a recession is two consecutivequarters of negative economic growth as measured by a country's gross domestic

product (GDP). Recession is a normal (albeit unpleasant) part of the businesscycle; however, one-time crisis events can often trigger the onset of a recession.The global recession of 2008-2009 brought a great amount of attention to therisky investment strategies used by many large financial institutions, along with

the truly global nature of the financial system. As a result of such a wide-spreadglobal recession, the economies of virtually all the world's developed anddeveloping nations suffered extreme set-backs and numerous government

policies were implemented to help prevent a similar future financial crisis.A recession generally lasts from six to 18 months, and interest rates usually fallin during these months to stimulate the economy by offering cheap rates at which

to borrow money.

What causes a Recession?

Many factors contribute to an economy's fall into a recession, but the major causeis inflation. Inflation refers to a general rise in the prices of goods and servicesover a period of time. The higher the rate of inflation, the smaller the percentageof goods and services that can be purchased with the same amount of money.Inflation can happen for reasons as varied as increased production costs, higherenergy costs and national debt.

In an inflationary environment, people tend to cut out leisure spending, reduce

overall spending and begin to save more. But as individuals and businessescurtail expenditures in an effort to trim costs, this causes GDP to decline.Unemployment rates rise because companies lay off workers to cut costs. It isthese combined factors that cause the economy to fall into a recession.


4/13

How do we measure Inflation? LowHighRisingDeclining

Measuring inflation is a difficult problem for government statisticians. To do this,a number of goods that are representative of the economy are put together intowhat is referred to as a "market basket." The cost of this basket is then compared

over time. This results in a price index, which is the cost of the market baskettoday as a percentage of the cost of that identical basket in the starting year.http://www.unescap.org/stat/meet/keyindic/india_cpi_wpi.pdf

Wholesale Price Index (WPI) - The Wholesale Price Index or WPI is "theprice of a representative basket of wholesale goods". Some countries use

the changes in this index to measure inflation in their economies, inparticular India The Indian WPI figure was earlier released weekly onevery Thursday and influenced stock and fixed price markets. The IndianWPI is now updated on a monthly basis. The Wholesale Price Indexfocuses on the price of goods traded between corporations, rather thangoods bought by consumers, which is measured by the Consumer PriceIndex(CPI). The purpose of the WPI is to monitor price movements that

reflect supply and demand in industry, manufacturing and construction.

This helps in analyzing both macroeconomic and microeconomic conditions.In India; Inflation is based on Wholesale Price Index, all India CPI is beingreleased since January 2011 and it will take some time in stabilizing.

Monetary policy has also been continuing to target WPI for its pricestability objective. In view of above, it has been decided to consider WPIfor inflation protection.

Consumer Price Index (CPI) - A measure that examines the weightedaverage of prices of a basket of consumer goods and services, such astransportation, food and medical care. The CPI is calculated by taking

price changes for each item in the predetermined basket of goods andaveraging them; the goods are weighted according to their importance.

Changes in CPI are used to assess price changes associated with the costof living. The CPI is a statistical estimate constructed using the prices of asample of representative items whose prices are collected periodically.Sub-indexes and sub-sub-indexes are computed for different categoriesand sub-categories of goods and services, being combined to produce the

overall index with weights reflecting their shares in the total of theconsumer expenditures covered by the index. It is one of several priceindices calculated by most national statistical agencies. The annual

percentage change in a CPI is used as a measure of inflation. A CPI can be

used to index (i.e., adjust for the effect of inflation) the real value ofwages, salaries, pensions, for regulating prices and for deflating monetarymagnitudes to show changes in real values. In most countries, the CPI is,

along with the population census and the USA National Income andProduct Accounts, one of the most closely watched national economicstatistics. It is sometimes referred to as "headline inflation."

Producer Price Indexes (PPI) - A family of indexes that measure theaverage change over time in selling prices by domestic producers of goodsand services. PPIs measure price change from the perspective of the seller.


5/13

How Governments Influence Markets The way Out

In the 1920s, very few people would have identified the government as the majorplayer in the markets. Today, very few people would doubt that statement. Here,we will look at how the government affects the markets and influences business

in ways that often have unexpected consequences.

Fiscal Policy (Explained in Detail Later) Monetary Policy (Explained in Detail Later) Currency Inflation - Governments are the only entities that can legally

create their respective currencies. When they can get away with it,governments always want to inflate the currency. Why? Because it

provides a short-term economic boost as companies charge more for theirproducts and it also reduces the value of the government bonds issued inthe inflated currency and owned by investors.

Inflated money feels good for awhile, especially for investors who see

corporate profits and share prices shooting up, but the long-term impact is

an erosion of value across the board. Savings are worth less, punishingsavers and bond buyers. For debtors, this is good news because they nowhave to pay less value to retire their debts - again, hurting the people who

bought bank bonds based off those debts. This makes borrowing moreattractive, but interest rates soon shoot up to take away that attraction.

Bailouts -After the financial crisis from 2008-2010, it is no secret thatthe U.S. government is willing to bailout industries that have gottenthemselves into problems. Truth be told, this fact was known even beforethe crisis. The savings and loan crisis of 1989 was eerily similar to the

bank bailout of 2008, but the government even has a history of savingnon-financial companies like Chrysler (1980), Penn Central Railroad (1970)

and Lockheed (1971 Bailouts can skew the market by changing the rulesto allow poorly run companies to survive. Often, these bailouts can hurtshareholders of the rescued company and/or the company's lenders. Innormal market conditions, these firms would go out of business and seetheir assets sold to more efficient firms in order to pay creditors and - if

possible - shareholders. Fortunately, the government only uses its abilityto protect the most systemically important industries like banks, insurers,airlines and car manufacturers.

Subsidies and Tariffs - Subsidies andtariffs are essentially the samething from the perspective of the taxpayer. In the case of a subsidy, thegovernment taxes the general public and gives the money to a chosen

industry/individuals to make it more profitable/economical. In the case ofa tariff, the government applies taxes to certain products to make themmore expensive, allowing the suppliers to charge more for their product.Both of these actions have a direct impact on the market.

Government support of an industry is a powerful incentive for banks andother financial institution to give those industries favorable terms. This

preferential treatment from government and financing means that morecapital and resources will be spent in that industry, even if theonly comparative advantage it has is government support. This resourcedrain affects other, more globally competitive industries that now have to

work harder to gain access to capital. This effect can be more pronounced

when the government acts as the main client for certain industries, leadingto the well-known examples of over-charging contractors and chronicallydelayed projects.


6/13

Regulations and Corporate Tax - The business world rarely complains

about bailouts and preferential treatment to certain industries, perhapsbecause they all harbor a secret hope of getting some. When it comes toregulations and tax, however, they howl - and not unjustly. Whatsubsidies and tariffs can give to an industry in the form of a comparative

advantage, regulation and tax can take away from many more.

As the regulations increaser, smaller providers get squeezed out by theeconomies of scale the larger companies enjoy. The end result is highly-

regulated industry with a few large companies that are necessarilyintertwined with the government.

High taxes on corporate profits have a different effect in that theydiscourage companies from coming into the industry. Just asstates/sectors with low taxes can lure away companies from theirneighbours/counterparts, States/Sectors that are taxed less will tend to

attract any corporations that are mobile. Worse yet, the companies thatcan't move end up paying the higher tax and are at a competitivedisadvantage in business as well as for attracting investor capital.


7/13

Fiscal Policy The Punches

When the economy begins to suffer from serious recession or inflation,Government will almost always intervene to try to improve the situation. Theirinterventions may or not be good economicsoften they're not!but you can

hardly blame the politicians for trying. Nobody wants to go down in history likeHerbert Hoover, the president who became a widely hated figure for failing to usethe government aggressively enough to try to end the Great Depression.

Politicians hoping to improve economic conditions have two main tools at theirdisposal. Fortunately for them (and thus for the rest of us), the basic principlesbehind them are pretty simple. The core thinking is that inflation and recession

are opposites of one another. During periods of recession there is not enoughmoney circulating in the economy. During periods of inflation, there is too much.So the answer to these problems is to either put money in or take money out ofthe economy.

At this point, economists begin to disagree over who should do the putting in ortaking out, and which means should be used to do so. Some favor fiscal policy

adjusting taxes and government spending. But most prefer monetary policy

adjusting interest rates and reserve requirements, and buying or selling bonds.

Fiscal policy is set by the Finance Minister and passed by the Parliament; they

create the tax system and they decide how the government should spend itsmoney each year. The basic premises behind much of contemporary fiscal policywere introduced by British economist John Maynard Keynes during the Great

Depression. Keynes argued, contrary to conventional thinking, that the marketand the economy could not regulate itself. During periods of recession,consumers hold on to their money rather than spending it. Businesses weresimilarly afraid to expand operations and hire more workers. Therefore, the

government needed to jump-start the economy by injecting some money into it.The tools for doing so were tax rates and government spending. By lowering

taxes people had money to spend; they could buy cars and appliances, or converttheir garage into a game room. All of this put people to work stimulating evenmore spending and job growth. By increasing government spending, thegovernment put money directly into the economy. Building a dam, extendingunemployment benefits, or hiring more teachers also put money into circulation

and, according to Keynesian fiscal theory, stimulated economic growth.

Keynes argued that during periods of recession aggregate demand (AD)thetotal demand of consumers, businesses, and government at various price levels

needed to be stimulated through government action. Through tax cuts andincreased government spending, aggregate demand (AD1) would be increased(AD2).


8/13

Of course, it gets more complicated than this. For starters, policymakers nowdebate whose taxes should be cut during periods of recession. TraditionalKeynesian fiscal policy emphasizes putting money into the hands of middle and

lower-class consumers, thereby stimulating the demand side of the economy.Others argue that more permanent growth is achieved by cutting business andcorporate taxes, and by reducing capital gains taxes and personal income taxrates for wealthier taxpayers. According to these supply-side theorists, the

money saved through these sorts of tax cuts will be reinvested in new businessesand large-scale expansion, thus generating more jobs.

Regardless of whose taxes you cut, however, this course of action may lead togovernment budget deficits - that is, government spending may exceedgovernment income. In response, some argue that short-term deficits areacceptable since once the economy starts to grow, tax revenues will increase.

Others argue that deficits saddle future generations with debt and lead to highinterest rates, crippling future growth.

Examples include changing tax rates, increasing Social Security paymentsand increasing or decreasing government spending.

Based on the theories of English economist John Maynard Keynes. Fiscal policy seeks to stimulate demand and output in periods of business

decline by increasing government expenditures and cutting taxes as ameans of increasing disposable income. The process is reversed to correctfor overexpansion.

Fiscal Policy Options

To Fight Recession:

Reduce taxes Increase government spending

To Fight Inflation:

Increase taxes Reduce government spending

Why It Matters Today

This one's easy: looked at the news lately?

Just about everybody wants us to get out of this recession, to restore robusteconomic growth. But what's the best way to do that? Keep the government outof things and let the economy run its course? Or take deliberate government

actions to stimulate the economy?If you want some kind of stimulus, should itcome in the form of tax cuts (and if so, for whom)? Or should it take the form ofincreased government spending?

Some Side Effects

Just like monetary policy, fiscal policy can be used to influence both expansionand contraction of GDP as a measure of economic growth. When the government

is exercising its powers by lowering taxes and increasing their expenditures, theyare practicing expansionary fiscal policy. While on the surface, expansionaryefforts may seem to lead to only positive effects by stimulating the economy,there is a domino effect that is much broader reaching. When the government is

spending at a pace faster than tax revenues can be collected, the governmentcan accumulate excess debt as it issues interest bearing bonds to finance thespending, thus leading to an increase in the national debt.


9/13

When the government increases the amount of debt it issues during expansionaryfiscal policy, issuing bonds in the open market will end up competing with the

private sector that may also need to issue bonds at the same time. This effect,known as crowding out, can raise rates indirectly because of the increasedcompetition for borrowed funds. Even if the stimulus created by the increased

government spending has some initial short-term positive effects, a portion ofthis economic expansion could be mitigated by the drag caused by higher interestexpenses for borrowers, including the government.

Another indirect effect of fiscal policy often overlooked, is the potential for foreigninvestors to bid up the currency in their efforts to invest in the now higheryielding bonds trading in the open market. While a stronger home currency

sounds positive on the surface, depending on the magnitude of the change inrates, it can actually make domestic goods more expensive to export and foreignmade goods cheaper to import. Since most consumers tend to use price as adetermining factor in their purchasing practices, a shift to buying more foreign

goods and a slowing demand for domestic products could lead to a temporarytrade imbalance. These are all possible scenarios that have to be considered andanticipated. There is no way to predict which outcome will emerge and by howmuch, because there are so many other moving targets, market influences,

natural disasters, wars and any other large scale event that can move markets.

Fiscal policy measures also suffer from a natural lag, or the delay in time from

when they are determined to be needed, and the time their measures passthrough congress and ultimately the president. From a forecasting perspective, ina perfect world where economists have a 100% accuracy rating for predicting thefuture, fiscal measures could be summoned up as needed. Unfortunately, giventhe inherent unpredictability and dynamics of the economy, most economists runinto challenges in accurately predicting short-term economic changes.


10/13

Monetary Policy The Kicks

Overview

Monetary policy rests on the relationship between the rates of interest in an

economy, that is the price at which money can be borrowed, and the total supplyof money. Monetary policy uses a variety of tools to control one or both of these,to influence outcomes like economic growth, inflation, exchange rates with othercurrencies and unemployment. Where currency is under a monopoly of issuance,or where there is a regulated system of issuing currency through banks which aretied to a central bank, the monetary authority has the ability to alter the moneysupply and thus influence the interest rate (in order to achieve policy goals). The

beginning of monetary policy as such comes from the late 19th century, where itwas used to maintain the gold standard.

Monetary policy is referred to as either being an expansionary policy, or acontractionary policy, where an expansionary policy increases the total supply ofmoney or decreases the interest rate in the economy, and a contractionary policydecreases the total money supply or raises the interest rate. Expansionary policy

is traditionally used to combat unemployment in a recession by lowering interest

rates, while contractionary policy involves raising interest rates in order tocombat inflation. Monetary policy should be contrasted with fiscal policy, whichrefers to government borrowing, spending and taxation

Furthermore, monetary policies are described as follows: accommodative, if theinterest rate set by the central monetary authority is intended to create economic

growth; neutral, if it is intended neither to create growth nor combat inflation; ortight if intended to reduce inflation.

There are several monetary policy tools available to achieve these ends:

increasing interest rates by fiat; reducing the monetary base; and increasingreserve requirements. All have the effect of contracting the money supply; and, if

reversed, expand the money supply. Within almost all modern nations, specialinstitutions (such as the Reserve Bank of India, the Bank of England, theEuropean Central Bank, the Federal Reserve System in the United States, theBank of Japan or Nippon Gink, the Bank of Canada or the Reserve Bank of

Australia) exist which have the task of executing the monetary policy and often

independently of the executive. In general, these institutions are called centralbanks and often have other responsibilities such as supervising the smoothoperation of the financial system.

The primary tool of monetary policy is open market operations. This entailsmanaging the quantity of money in circulation through the buying and selling ofvarious credit instruments, foreign currencies or commodities. All of these

purchases or sales result in more or less base currency entering or leavingmarket circulation.

Usually, the short term goal of open market operations is to achieve a specific

short term interest rate target. In other instances, monetary policy might insteadentail the targeting of a specific exchange rate relative to some foreign currencyor else relative to gold. For example, in the case of the USA the Federal Reserve

targets the federal funds rate, the rate at which member banks lend to oneanother overnight; however, the monetary policy of China is to target theexchange rate between the Chinese renminbi and a basket of foreign currencies.


11/13

The Indian Scenario Lets just try another one

Monetary Policy can also be used to ignite or slow the economy and is controlledby the Reserve Bank of India(RBI) with the ultimate goal of creating an easymoney environment. Early Keynesians did not believe that monetary policy had

any long-lasting effects on the economy because

1) since banks have a choice to lend out the excess reserves they have on handfrom lower interest rates, they may just choose not to lend and

2) Keynesians also believe that consumer demand for goods and services maynot be related to the cost of capital to obtain theses goods.

At different times in the economic cycle, this may or may not be true, butmonetary policy has proven to have some influence and impact on the economyand equity and fixed income markets.RBI carries some powerful tools in itsarsenal and is very active with all these.

A. Direct Instruments

Cash Reserve Ratio (CRR): The share of net demand and time liabilitiesthat banks must maintain as cash balance with the Reserve Bank.

Statutory Liquidity Ratio (SLR): The share of net demand and timeliabilities that banks must maintain in safe and liquid assets, such asgovernment securities, cash and gold.

Refinance facilities: Sector-specific refinance facilities (e.g., againstlending to export sector) provided to banks.

B. Indirect Instruments

Liquidity Adjustment Facility (LAF): Consists of daily infusion orabsorption of liquidity on a repurchase basis, through repo (liquidityinjection) and reverse repo (liquidity absorption) auction operations, usinggovernment securities as collateral.

Repo/Reverse Repo Rate: These rates under the Liquidity AdjustmentFacility (LAF) determine the corridor for short-term money market interestrates. In turn, this is expected to trigger movement in other segments ofthe financial market and the real economy.

Open Market Operations (OMO): Outright sales/purchases of govt.securities, in addition to LAF, as a tool to determine the level of liquidity

over the medium term.

Marginal Standing Facility (MSF): was instituted under whichscheduled commercial banks can borrow over night at their discretion up

to one per cent of their respective NDTL at some basis points above therepo rate to provide a safety valve against unanticipated liquidity shocks.

Bank Rate: It is the rate at which the Reserve Bank is ready to buy orrediscount bills of exchange or other commercial papers. It also signals themedium-term stance of monetary policy.

Market Stabilisation Scheme (MSS): This instrument for monetarymanagement was introduced in 2004. Liquidity of a more enduring naturearising from large capital flows is absorbed through sale of short-datedgovernment securities and treasury bills. The mobilised cash is held in aseparate government account with the Reserve Bank.


12/13

The most commonly used tool is their open market operations, which the RBI isactive in on a daily basis. They purchases and sell government securities in theopen market which can increase or decrease reserves with banks while

influencing the supply of money whether they are buying or selling bonds. RBIcan also change the reserve requirements at banks thus directly increasing ordecreasing the supply of money. RBI can also make changes in the Repo ratewhich is the tool that is constantly receiving attention, forecasts, speculation and

the world often awaits the announcements as if any change would have animmediate impact on the economy.

Interest Rates The Barometer

http://pagalguy.com/forums/chit-chat/simplified-economics-and-finance-

discussion-forum-for-t-102917/p-17020306/

Typically, when the supply of money increases, interest rates fall. And when the

supply of money tightens, interest rates increase. So, the RBI actions discussedearlier have an impact on the following:

Consumer spending Interest rates on newly issued bonds Market prices of existing bonds: when interest rates rise, the prices of

bonds with lower coupon rates decrease, and vice versa

RBI actions can also indirectly impact stocks:

When monetary policy expands credit, lower interest rates make bondsless appealing as investments, and stocks more appealing.

From the corporate perspective, company earnings may rise because oflower interest expense, which may cause the market price of the stock torise.

Of course, when the opposite occurs and monetary policy tightens credit, interestrates will rise, earnings will decrease, and the market price of the stock is likely todecrease as well. As interest rates rise, bonds become more attractive to

investors.

Fiscal vs. Monetary

The battle has been hotly debated for decades and the answer is both. Forexample, to a Keynesian promoting fiscal policy over a long period (25 years) of

time, the economy will go through multiple economic cycles. At the end of thosecycles, the hard assets like infrastructure such as buildings, bridges, roads andother long-life assets, will still be standing and most likely be the result of sometype of fiscal intervention. Over that same 25 years, the RBI may haveintervened hundreds of times using their tools and maybe only had success intheir goals some of the time. On the other hand, using just one method may notbe the best idea, because of the lag in fiscal policy as it filters into the economy.Monetary policy has shown its effectiveness in slowing down an economy that is

heating up at a faster than desired pace (inflationary fears), but it has not hadthe same magnitude of change affect when it comes to quickly inducing aneconomy to expand as money is eased, so its success is muted.


13/13

The Bottom Line

Governments may be the most terrifying figures in the financial world. With asingle regulation, subsidy or switch of the printing press, they can sendshockwaves around the world and destroy companies and whole industries. For

this reason, Fisher, Price and many other famous investors considered legislativerisk as a huge factor when evaluating stocks. A great investment can turn out tobe not that great when the government it operates under is taken intoconsideration. Though each side of the policy spectrum has its differences, the

Policymakers have sought a solution in the middle ground, combining aspects ofboth policies in solving economic problems. The Fed may be more recognized, astheir efforts are well publicized and their decisions can move global equity and

bond markets drastically, but the use of fiscal policy lives on. While there willalways be a lag in its effects, fiscal policy seems to have greater effects over long

periods of time and monetary policy has proven to have some short termsuccess.

P.S. -After reading this tutorial, you should have some insight into inflation andits effects. For starters, you now know that inflation isn't intrinsically good or bad.

Like so many things in life, the impact of inflation depends on your personalsituation.

Some points to remember: Inflation is a sustained increase in the general level of prices for goods and

services. When inflation goes up, there is a decline in the purchasing power of

money.

Variations on inflation include deflation, hyperinflation and stagflation. Two theories as to the cause of inflation are demand-pull

inflation and cost-push inflation. When there is unanticipated inflation, creditors lose, people on a fixed-

income lose, "menu costs" go up, uncertainty reduces spending andexporters aren't as competitive.

Lack of inflation (or deflation) is not necessarily a good thing. Inflation is measured with a price index. The two main groups of price indexes that measure inflation are

the Consumer Price Index and the Wholesale Price Indexes.

Interest rates are decided in the by the Central Bank. Inflation plays alarge role in the RBI's decisions regarding interest rates.

In the long term, stocks are good protection against inflation. Inflation is a serious problem for fixed income investors. It's important to

understand the difference between nominal interest rates and real interestrates.

Inflation-indexed securities offer protection against inflation but offer lowreturns. RBI had an Inflation-indexed Bond (IIB) issue in June.

References:

1. www.rbi.org.in2. www.Investopedia.com3. www.wikipedia.com

Economy part 5

Documents