Economics from first principle
Introduction
In the bustling world of economics, where policies and decisions sway markets and livelihoods, lies a complex interplay of factors that shape our financial landscape. From government actions to global trade dynamics, every move holds the potential to ripple through the stock market, impact companies, and touch the lives of individuals. In this interconnected realm, understanding how fiscal policy, monetary policy, and external account management influence stock markets, companies, and individuals is not just insightful but essential for navigating the economic currents.
In this article I've broken down the complexities of economics, showing how policies shape our financial landscape. From fiscal policy to monetary policy and external account management, I've explained how they impact stock markets, companies, and individuals. Keep an eye out for the next article, where I'll dive even deeper into economics with the help of informative graphs.
How RBI manages inflation?
Through monetary policy
RBI increase or decrease interest rate to manage inflation
Inflation is a critical economic indicator that impacts the purchasing power of consumers, the profitability of businesses, and the stability of the overall economy. In India, the Reserve Bank of India (RBI) plays a pivotal role in managing inflation through its monetary policy tools. This guide explores how RBI manages inflation and the various instruments it employs to achieve this objective.
Understanding Monetary Policy: Monetary policy refers to the actions taken by the central bank to regulate the money supply and interest rates in the economy. By influencing the cost and availability of credit, monetary policy aims to achieve macroeconomic objectives such as price stability, full employment, and economic growth. In the context of inflation management, RBI uses monetary policy tools to control the rate at which prices of goods and services rise over time.
Key Monetary Policy Tools:
Cash Reserve Ratio (CRR):
CRR is the percentage of deposits that banks are required to maintain with the central bank (RBI) in the form of reserves.
By adjusting the CRR, RBI can control the liquidity in the banking system. A higher CRR reduces the amount of funds available for lending, thereby curbing inflationary pressures.
Statutory Liquidity Ratio (SLR):
SLR mandates banks to maintain a certain proportion of their deposits in the form of liquid assets such as government securities.
Similar to CRR, adjusting SLR affects the liquidity position of banks and influences their ability to lend. Higher SLR requirements reduce excess liquidity in the system, mitigating inflationary tendencies.
Repo Rate:
The repo rate is the rate at which RBI lends short-term funds to commercial banks against government securities.
By increasing the repo rate, RBI makes borrowing more expensive for banks, encouraging them to lend less and reduce the money supply. This helps in controlling inflation.
Reverse Repo Rate:
Reverse repo rate is the rate at which RBI borrows funds from commercial banks.
When RBI raises the reverse repo rate, it incentivizes banks to park more funds with the central bank, reducing the money supply in the economy and containing inflation.
Marginal Standing Facility (MSF):
MSF is a window for banks to borrow funds from RBI in case of emergency or liquidity shortages.
By adjusting the MSF rate, RBI influences short-term interest rates in the economy, which in turn affects borrowing and spending behavior, impacting inflation dynamics.
Managing Inflation through Monetary Policy: RBI's primary objective in managing inflation is to maintain price stability while fostering sustainable economic growth. Depending on the prevailing inflationary pressures, RBI adopts various combinations of monetary policy tools to achieve its inflation target, which is typically set around 4% with a tolerance range.
During periods of high inflation, RBI may increase CRR, SLR, repo rate, or MSF rate to tighten monetary conditions, reduce demand, and moderate price levels.
Conversely, in times of low inflation or economic slowdown, RBI may lower these rates to stimulate borrowing, investment, and consumption, thereby supporting economic activity.
Reserve Ratios and Liquidity:
Liquidity, simply put, is the lifeblood of any economy – it's the availability of money circulating within the financial system. Central banks, like the Reserve Bank of India (RBI), closely monitor liquidity levels and employ tools such as reserve ratios to manage it effectively.
When reserve rates are increased, it translates to a reduction in the liquidity available in the banking system. This happens because banks are required to hold a larger portion of their deposits as reserves with the central bank. Consequently, they have less cash available for lending and investment activities.
At the core of banking operations lies the fundamental principle of borrowing and lending. Banks operate by accepting deposits from customers (borrowing) and extending loans and credit facilities (lending). However, when reserve rates are hiked, banks find themselves with tighter liquidity conditions. With a larger portion of their funds locked up in reserves, they have less capital to extend loans and credit to businesses and individuals.
The consequence of reduced liquidity is far-reaching. As banks become more conservative in their lending practices due to diminished liquidity, the overall money supply in the economy decreases. Over time, this reduction in the money supply acts as a counterbalance to inflationary pressures, ultimately working towards stabilizing or even lowering prevailing inflation levels.
Repo and Reverse Repo:
REPO: In the intricate web of financial transactions, the repo rate stands as a vital cog. Banks often find themselves in need of short-term funds to meet their immediate obligations, and the avenue through which they procure these funds from the central bank is known as the repo market. The rate at which the RBI provides these funds to banks is aptly termed the repo rate.
When the RBI opts to increase the repo rate, it effectively raises the cost of borrowing for banks. With higher interest payments owed to the central bank, banks face a dilemma – how do they cushion themselves against this increased expense?
The solution often lies in the realm of interest rates that banks charge on loans extended to their customers. To offset the elevated cost of borrowing from the RBI, banks are inclined to raise the interest rates on the loans they provide to consumers and businesses alike. This translates into higher borrowing costs for individuals seeking loans for various purposes such as purchasing cars or homes.
Consequently, an uptick in the repo rate can trigger a ripple effect across the economy, leading to higher borrowing costs for consumers and potentially dampening overall economic activity. This nuanced interplay between monetary policy tools and the broader economy underscores the intricate dance central banks must choreograph to steer the economy towards stability and growth.
GDP: Understanding Economic Performance
Nominal GDP:
Nominal GDP, often referred to as GDP at current prices, represents the total value of goods and services produced within a country's borders without adjusting for inflation.
Real GDP:
Real GDP is nominal GDP adjusted for inflation. It reflects the true economic output by accounting for changes in price levels over time. Real GDP is also known as GDP at constant prices, with the base year typically set to provide a benchmark for comparison. In India, the base year for calculating real GDP is 2011-12.
Understanding GDP:
Gross Domestic Product (GDP) serves as a comprehensive measure of a country's economic activity within a specific timeframe. It encompasses the total value of goods and services produced across various sectors of the economy.
To illustrate, imagine a scenario on an island with a single manufacturer producing 100 units of a product annually, each sold at ₹10. In this case, the island's GDP would amount to ₹1000, reflecting the total economic value generated.
GDP encapsulates the collective output of all economic sectors over a defined period. A robust GDP signifies a thriving economy with significant production and consumption levels.
Inflation's Impact on GDP:
Inflation, the rise in the general price level of goods and services, has a substantial influence on economic activity, particularly on GDP. As inflation escalates, consumer spending tends to decline, prompting individuals to seek cost-effective alternatives.
Reduced consumer spending directly impacts GDP by diminishing consumption levels, subsequently curbing production. Consequently, inflationary pressures can impede economic growth, reflecting a negative correlation between inflation and GDP.
The relationship between inflation and GDP is especially pronounced in extreme economic conditions. High inflation rates can erode purchasing power and instill uncertainty, leading to decreased economic output. Conversely, stagnant or declining GDP growth, often associated with deflationary pressures, poses its own set of challenges to economic stability.
Sectoral Contributions to Indian GDP:
In India, GDP is propelled by three primary sectors:
Agriculture (20%)
Industry (29%), comprising:
Manufacturing
Construction
Electricity
Gas
Water
Services (51%), including:
Finance & Real Estate
Trade
Transport & Hotels
Public Administration
Defence
Indicators Influencing GDP Projections:
To gauge economic performance, several key indicators are analyzed:
Agriculture Sector:
Monsoon patterns
Sowing trends
Industrial Growth:
Index of Industrial Production (IIP)
Purchase Managers Index (PMI)
Services Sector:
Services PMI
Domestic air passenger traffic
GDP serves as a vital yardstick for assessing economic health, reflecting the aggregate output of an economy. Understanding the nuances of GDP dynamics, alongside its relationship with inflation and sectoral contributions, provides valuable insights into economic trends and policymaking. By monitoring key indicators and fostering sectoral growth, policymakers strive to ensure sustained economic prosperity and stability.
Fiscal Policy: Managing Government Finances
Fiscal policy refers to the government's strategy for managing its income and expenditure to achieve desired economic outcomes. By carefully allocating resources and influencing economic activity, fiscal policy plays a crucial role in shaping the overall economic landscape.
Understanding Government Revenue and Expenditure:
Cash Inflows:
Borrowings and Other Liabilities (36%)
Corporation Tax (13%)
Income Tax (14%)
Customs (3%)
Union Excise Duties (8%)
Goods and Services Tax (15%)
Non-Tax Revenue (6%)
Non-Debt Capital Receipts (5%)
Cash Outflows:
Centrally Sponsored Schemes (9%)
Central Sector Schemes (13%)
Interest Payments (20%)
Defence (8%)
Subsidies (9%)
Finance Commission and Other Transfers (10%)
States' Share of Taxes and Duties (16%)
Pensions (5%)
Other Expenditure (10%)
Assessing Economic Health Through Fiscal Policy:
The performance of fiscal policy is often evaluated based on key indicators such as government revenue sources and expenditure patterns. For instance, the robustness of Goods and Services Tax (GST) collections serves as a barometer of economic activity, indicating the vibrancy of businesses and consumer spending.
When government expenditure exceeds its income, resulting in a fiscal deficit, it raises concerns about financial sustainability. However, strategic spending on critical sectors can stimulate economic growth and foster prosperity.
Leveraging Infrastructure Spending for Economic Growth:
Investments in infrastructure play a pivotal role in enhancing economic productivity and stimulating growth. Studies suggest that every rupee spent by the government on public infrastructure yields a multiplier effect, generating additional economic value.
Expansive fiscal policies that prioritize infrastructure development are often associated with positive outcomes for the economy. Such policies not only bolster growth but also instill confidence in investors and stakeholders, contributing to overall economic resilience.
The Impact on Financial Markets:
The adoption of expansionary fiscal policies typically corresponds with increased government spending on infrastructure projects. This influx of funds into the economy tends to buoy investor sentiment and stimulate demand, resulting in favorable conditions for the stock market.
Fiscal policy serves as a potent tool for governments to steer economic activity and foster sustainable growth. By judiciously managing revenues and expenditures, policymakers can mitigate economic challenges, promote investment, and enhance the overall well-being of society. Understanding the intricacies of fiscal policy empowers stakeholders to navigate the economic landscape with foresight and adaptability, ultimately contributing to shared prosperity and progress.
The External Account: Balancing Trade and Currency Flows
Composition of Current Account:
The current account of a nation reflects its transactions with the rest of the world, encompassing both exports and imports of goods and services. This account is a crucial component of the external account, offering insights into a country's economic health and its interactions with the global economy.
Export: When goods and services are sold to foreign entities, foreign currency flows into the country, contributing to export earnings.
Import: Conversely, imports entail the purchase of goods and services from abroad, resulting in foreign currency outflows from the country.
Managing Foreign Currency Flows:
Efficient management of foreign currency inflows and outflows is imperative for maintaining stability in the external account. A significant portion of these transactions is accounted for by the trade in goods, with certain commodities holding particular importance.
Crude Oil: India's largest import bill is attributed to crude oil, making it a critical determinant of the country's trade balance. The fluctuation in global oil prices directly impacts India's import expenditure and, consequently, its trade deficit.
Impact on Economic Dynamics:
The interplay between imports and exports, particularly concerning essential commodities like crude oil, can have far-reaching implications for the economy.
Trade Deficit: When the import bill, especially for essential commodities like crude oil, surpasses export earnings, it leads to a trade deficit. This imbalance in trade contributes to economic challenges, including currency depreciation and inflationary pressures.
Fuel Price and Inflation: The escalation of fuel prices, driven by increased import costs, has a cascading effect on the economy. Higher fuel costs raise transportation expenses, which, in turn, affect the prices of essential goods, leading to food inflation and exerting strain on household budgets.
Addressing Challenges:
Addressing the challenges stemming from trade imbalances and external dependencies requires a multifaceted approach.
Diversification of Exports: Encouraging the diversification of export products and markets can reduce reliance on a few sectors and mitigate the impact of external shocks.
Energy Security: Investing in alternative energy sources and enhancing domestic production capabilities can bolster energy security and reduce dependence on imported oil.
The management of the external account is integral to ensuring economic stability and sustainable growth. By monitoring trade dynamics, addressing structural imbalances, and implementing prudent policies, nations can navigate the complexities of global trade and safeguard their economic interests. A strategic approach to managing trade relationships and minimizing external vulnerabilities is essential for fostering resilience and prosperity in an increasingly interconnected world.
Conclusion:
In summary, monetary policy in India has both macroeconomic and microeconomic effects. At the macro level, it influences overall economic growth, inflation, and exchange rates. At the micro level, it affects the decisions of individuals and businesses regarding borrowing, saving, investments, and spending. The RBI's monetary policy decisions have a broad impact on the Indian economy, shaping its overall direction and influencing the financial choices of individuals and entities.