The study of exchange

A social science
Contrasted with natural sciences
Physics
Chemistry

Methodology different from that of natural sciences

A theoretical science
Uses deductive reasoning to identify the Laws of Economics The Laws of Economics are not falsifiable by experimentation

Microeconomics
Macroeconomics

Price Theory
Production Theory Money Intervention in the Free Market

Economics of the Free Market of Voluntary Exchange Economics of violent intervention in the Free Market

Voluntary exchange
Violent Exchange

The set of all the people who exchange goods with each other

A market where all exchanges are voluntary

A market where all exchanges are free of violence

Direct exchange Also known as barter

Indirect exchange Advanced state known as a money economy

Autistic Exchange
Interpersonal Exchange

The theoretical explanation of the formation of prices in the market The basic concepts it deals with

Price Demand and Quantity Demanded Supply and Quantity Supplied Market Clearing Price Equilibrium Price The process of equilibriation

Continuing markets
Money, Indirect Exchange and Money Prices Determination of Money Prices Interrelationships between prices of different goods

Defined for direct and indirect exchange

The ratio of the quantities of the goods exchanged Example 4 bags of wheat for 2 bags of rice
Price of rice 2 bags of wheat Price of wheat bag of rice

Desire + Ability to pay

Pay => Offer quantity asked of other good Two aspects of Demand
Quantity demanded Price

Quantity of good that current possessors are ready to offer at the prevailing price Two aspects of supply
Quantity Supplied Price

Table/Array of quantity demanded/supplied at various hypothetical prices Fundamentally worked out at the level of each individual
Added across all individuals to get market demand and supply schedules

At lower prices, quantity demanded remains the same or increases

At higher prices, quantity supplied remains the same or increases

At sufficiently low prices quantity demanded would be greater than quantity supplied
As price rises, quantity demanded drops off and that supplied rises At sufficiently high prices, quantity supplied would become greater than that demanded At some price, quantity demanded = quantity supplied

The price at which quantity demanded = quantity supplied

At Market Clearing Price, market is in Equilibrium Any attempt to deviate from market clearing price will force movement back to the market clearing price
Hence called an equilibrium

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Supply Demand

Price

Quantity Demanded/Supplied

15

20

25

30

Individual preference for different goods

Called value

A ranking scale
Helps us explain what an individuals demand supply behaviour would be at any hypothetical price Helps develop demand-supply schedules

Man acts
Action is purposeful behaviour Action requires preference Preference + Purposeful behaviour => Rationality Action => An object of action

Reverse Valuation
What makes it possible Subjective nature of value

Ends - What man seeks to satisfy by action

Means That on which action is directed Goods Interchangeable units of a means

Preference for ends => Preference for means

Rationality => Appraisement of usefulness of means towards satisfying ends Called Utility

A subjective appraisement
An ordinal number

Supply of a good allocated from most to least valued ends First unit allocated to most valued ends
Last unit allocated to least valued ends

Marginal Utility - Utility of the marginal unit of a supply of a good

Rank of a good on the value scale determined by its Marginal Utility Greater MU => Higher on value scale
Lower MU => Lower on value scale

MU The factor that determines behaviour in exchange

Greater supply => Marginal unit allocated to less valued end Lower supply => Marginal unit allocated to more valued end
Hence, marginal unit of smaller supply has greater utility that that of larger supply Hence, MU falls as supply increases

Various extraneous factors can cause changes in value scales Reflected in changes in demand and supply and hence in price and quantity exchanged at equilibrium

103 102 101 100 99 98 97 96 95 94 93 92 91 90 89 88 87 86 85 84 83 82 81 80 79 78 77 76 0 5 10

Supply Demand Demand + Demand -

15

20

25

30

35

103 102 101 100 99 98 97 96 95 94 93 92 91 90 89 88 87 86 85 84 83 82 81 80 79 78 77 76 0 5 10

Supply Demand Supply + Supply -

15

20

25

30

35

The double coincidence of wants

The problem of indivisible goods The problem of estimation and production The problem of economic calculation Insurmountable problems

A
Has Wheat Wants Sugar

Wheat Butter

P
Has Butter Wants Wheat

Butter

Sugar

B
Has Sugar Wants Butter

A good accepted solely to be further exchanged for another good

Most marketable commodity emerges as generally accepted medium of exchange Called money
Used to be many commodities

Most resilient Gold and Silver

Everything exchanged for money, not other goods All exchange ratios involve money
Every good has a money price

Identical to determination of goods prices of a good Money units placed on value scales
Money subject to Law of Diminishing MU

Rice vs Wheat Substitute goods

Golf clubs and Golf balls Complementary goods Demand and supply schedules of a good are affected by changes in demand supply schedules of substitutes and complementary goods

To explain..

Prices of factors of production Quantities applied of different factors of production

Factors that affect production and its organisation

Consumers goods
Producers goods

A process of transforming producers goods into consumers goods for consumption

Scarce means applied in production to be eventually transformed into consumers goods

3 categories
Land Labour Capital goods

Iron ore mining

Transportation of ore

Smelting in blast furnace

Purification of pig iron

Modifying properties
Shaping Using as the body of a car

Saving Forsaking of consumption now in favour of consumption later Production requires prior saving

Production takes time

Consumers good not available during process of production There is waiting to consume inevitable

Present goods Goods ready for consumption now

Future goods Goods available for consumption only in the future All consumers goods are present goods

All producers goods and factors of production are future goods

Money is a present good

Capitalists advance present goods in exchange for future goods Take over the mantle of waiting to consume
Rewarded for waiting in the form of interest income Also called price spread in a process of production

60 oz gold

Start of Production

63 oz gold

End of Production

Money advanced at start of production = 60 Money earned from sale of consumers good = 63 Interest Income = 3

The difference between payouts to factors at the start and income received from sale Expressed as a %
5% in our example

Money is the perfect non-specific good

Can move out of and into any line or process of production Greater price spread in 1 line will induce movement of money capital
out of low price spread line => price spread Into high price spread line => price spread

At equilibrium, price spread is equal in all processes

Equal Price Spread at equilibrium called Pure Rate of Interest Different from market rate of interest or contractual rate of interest

The market where present goods are exchanged for future goods The production system
The consumer loans market

Valuation of present vs future goods leads to individual time market schedules Further leads to aggregate time market schedules
Determination of rate of interest

The price of a unit service of a factor of production Equal to price of whole factor for non-durable factors

Future rentals discounted

Totaling up discounted future rental stream = Capitalisation Number obtained called Capital Value

Car rental = Rs. 3,000 per day

Life of car = 1500 days Rate of interest = (12/365)% per day Price of car = Rs. 3000*[1-1/(1+12/36500)1500] 12/36500 = Rs. 35,50,000/- (approx.)

Discounted present value of contribution to revenue attributable to marginal unit of factor at equilibrium
Will be equal across all lines of production

A Snapshot of Macroeconomics

Multiple schools of economic thought

Do not agree on many things
Not even on what Economics is and how it should

be studied

Differ vastly in their assumptions and hence in their conclusions Offer vastly different policy prescriptions
64

Microeconomics deals with specific segments of the economy Macroeconomics in contrast deals with the Economy as a whole

65

The working of an economy

What is/influences Economic Growth?

Evaluating the health of an economy

Macroeconomic Indicators Economic Growth,

Money Supply, Inflation, Prices, Unemployment

Business Cycle Theory

Understanding causes and cures for

Recessions/Depressions
66

Classical/ Neo-Classical

Prices and wages are flexible Markets carry out their functions efficiently The supply side of the economy is very important Changes in the demand side of the economy have only temporary effects on the economy No role for the Government to play - Laissez-Faire

Alfred Marshall, Adam Smith, David Ricardo

Failed to predict/correct the Great Depression of 1929 Early 1970s- New Classical School
67

Keynesian/Neo-Keynesian

Prices and wages are not flexible Markets are not efficient The demand side of the economy is very important Government has a major role to play - Fiscal Policy

John Maynard Keynes, Paul Samuelson, Mankiw, Joan Robinson Early 1980s Neo-Keynesian School (Paul Krugman) Neither School has come up with fully satisfactory explanations of the working of an economy
68

Austrian A heterodox school

Originated from the Classical School Free market is fundamental and efficient All prices are best determined by the market Money is endogenous to a free market No role for the Government to play - Laissez-Faire Rejects the centrality of Mathematics in Economic Theory

Carl Menger, Bohm Bawerk, Frederic Bastiat, Ludwig von Mises, Friedrich Hayek, Murray Rothbard
Comprehensive explanation of causes and cures of the Business Cycle (1974 Nobel in Economics)
69

Total income earned by all individuals in a nation Used as a measure of economic activity
GDP

GNP = GDP + income from abroad

NDP / NNP = GDP / GNP - depreciation

GDP-PPP = GDP based on Purchasing Power Parity

PCI = Per capita GDP

Gross income earned by producers in a nation

Includes income earned from outside sources
Ex: MNC in India is incl. In GDP
Ex: Indian in the Gulf is not included in GDP

Estimated through income or expenditure

One mans expenditure is another mans income The Keynesian Circular Flow Model

Y=C+I+G+XM
C - Personal consumption I - Gross private domestic investment G - Government purchases (X-M) - Net Exports

75

Y=C+I
Enter the Keynesian Consumption Function C = a + bY = bY (assuming a = 0 for simplicity) Y = bY + I => Y (1-b) = I Y = I / (1-b) 1/(1-b) The Keynesian Investment Multiplier

Let a process have 1o machines with life of 10 years

Assume 1 machine replaced every year

Normal demand for capital equipment 1

Let demand for consumers good go up 20%

Machines required goes up from 1 to 3 200%

20% increase in demand for consumers good leads to 200% increase in demand for capital goods

These are usually advanced as justification for various policies The truth both these concepts are fallacies

Parallel economy/Shadow economy

Barter Transactions Double Counting Quality of Data/ Estimates Household Production

79

Measures spending, not saving

Which is the true measure of prosperity? Masks the pernicious influence of debt High (Debt/GDP) ratio PIIGS, UK, USA

Includes government spending

Masks distress in the real economy Justifies Expansionary fiscal and monetary policy Various government interventions in the economy
80

Why include only spending on durable capital goods in I?

Why not include all spending on capital goods durable and non-durable? If you exclude spending on non-durable capital goods, is it really gross? Does it tell us anything at all about the economy?

What is well-being?
Is it objectively measurable or is it a subjective assessment?

Total number of units of the money commodity in circulation Multiple measures exist M0, M1, M2, M3.
What is the true measure?

Determinants of money supply today Government, Central Banks, Banking System

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Is greater Money Supply better for the economy?

Neo-Keynesian and Neo-Classical schools say Yes Austrian School says No

Neo-Keynesian and Neo-Classical schools dominate today

Prevalence of expansionary monetary policy

Austrian School blames expansionary monetary policy for the Business Cycle
84

Classical Definition Steady increase in the supply of money Current Definition Steady increase in price levels

Increase in money supply without an increase in the demand for money causes the steady rise in prices
It can also prevent prices from falling or cause them to fall less than they otherwise would In any case, it distorts the structure of prices

Purchasing power of money What 1 unit of money can get Price of bar of Snickers = Rs. 30
Re. 1 can get 1/30 of a bar of Snickers

1/30 of a bar of Snickers = PPM

Purchasing Power = Price

Price = Purchasing power

Purchasing Power of Money = 1/Price Y-axis = Price of money = 1/P
P= Price of commodities money chases P may be the Composite Price Level of a basket of

commodities

Aggregate of individual money balances

Cash and demand deposits

Determined by short and medium term requirement of money PPM high Less money enough

PPM low

More money required

Downward sloping demand curve with Y-axis = Reciprocal of prices of goods

1/P
1/Pe

Demand

Money Supply
1/P

1/Pe
1/Pe

1/P

Perceived Excess Money

Perceived Money Shortage

1/P
1/Pe 1/Pe

1/P 1/P

1/Pe

Perceived Money Shortage

Perceived Excess Money

Money Supply Price of Money Price Level Money Supply Price of Money Price Level
Increase in money supply pushes prices upwards

Varies across schools

Neo-Keynesian and Neo-Classical Schools
Rely on price indices to measure inflation Believe moderate level of inflation is good

Austrian School

Rejects price indices as a measure of inflation Money supply the proper measure All inflation is undesirable wealth redistribution Enriches rich at the expense of the poor
93

Consumer Price Index

Annual percentage change in the cost of acquiring a fixed basket of goods and services
Measures the purchasing power of consumers Today

vs. Yesterday Basis for Dearness Allowance 4 types- Working class, Agricultural labourers, Industrial workers, Rural labourers Food-60% ;Clothing-8% ;Fuel-6% ;Housing-8% ;Misc18%
94

Wholesale price index WPI

Used to measure change in average price level of goods traded in wholesale market
435 commodities data tracked Captures price movements in a comprehensive

way Widely used in Business, Industry, Government Food-22% ; Mfcg. Goods-64% ;Fuel 14%
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A fall in the general price level or a contraction of credit and available money Neo-Keynesian and Neo-Classical Schools see deflation as a problem
Austrian School sees deflation as the natural condition of a free market
Improvements in productivity have to lead to

falling prices
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Neo-Keynesian Theory
Demand-Pull Cost-Push Structural / Built-In

Neo-Classical/Monetary Theory
Increase in supply of money Decrease in demand for money

Austrian
Government Expansionary fiscal policy Central Banks Expansionary monetary policy Banking System Credit expansion
97

Neo-Keynesian/Neo-Classical/Monetary Theory

Aims to balance inflation and growth Fiscal and tax policy Central Bank open market operations Credit expansion/contraction by Central Bank/banking system

Austrian
Sustained inflation impossible in a free market Repeal of legal tender laws; abolition of fiat money Return to sound, market determined money
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Government uses its revenue and expenditure programs to produce desired effects on
National income Production Economy

Used as a balancing device

Two elements of Fiscal Policy

Taxation Public Expenditure
100

Level of taxation
Structure of taxation Control of govt. expenditure Subsidies and price controls Export/ Import Restrictions

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Mobilization of resources
Acceleration of economic growth

Minimization of the inequalities of income and wealth Increasing employment opportunities

Price stability
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The deliberate effort by the Central Bank to influence economic activity by variations in the money supply, in availability of credit or in the interest rates consistent with specific national objectives
Goals of Monetary Policy

Price stability Exchange stability Full employment and maximum output High rate of growth Balance of Payment Equilibrium Income Stabilization
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Issue of bank notes of all denominations

Regulates money supply Facilitates inter bank transactions Lender of last resort to banks Controls FOREX operations

CRR (Cash Reserve Ratio) Portion of deposits (as cash) which banks have to keep/maintain with the RBI. SLR (Statutory Liquidity Ratio)Portion of their deposits banks are required to invest in government securities Stated purposes of CRR & SLR:
Ensuring that a portion of bank deposits is totally risk-

free Enabling the Central Bank to control liquidity in the system, and thus inflation

105

Understanding how Monetary Policy works

Cash

Assets 1,000,000

Liabilities
500,000 500,000 1,000,000

Total

Equity Debt 1,000,000 Total

Loan to A to buy product of B

IOU from A (asset) Money issued by crediting Bs demand deposit (liability)

Money available for lending = $1,000,000

Assets IOUs 1,000,000 Cash 1,000,000

Liabilities

Total

Deposits Equity Debt 2,000,000 Total

1,000,000 500,000 500,000 2,000,000

Money issued 100% backed by Cash

Non-inflationary
Money supply prior to bank formation -

$1,000,000 Money supply with bank in operation $1,000,000

Reserve Ratio = (Cash/Demand Deposits)

Fixed by Central Bank
We shall assume 10%

Only $100,000 of $1,000,000 required as reserve

$ 900,000 is free cash available to be loaned out

XYZ lends $ 900,000 to C to buy something from D

Takes an additional IOU from C Credits Demand Deposit in Bs name with $ 900,000

Total money in demand deposits - $1,900,000

Where did the extra $900,000 come from?

Out of thin air?

Only $90,000 of $900,000 required as reserve

$ 810,000 is free cash available to be loaned out

Infinite iterations possible

Money created in each step = 0.9*Money created in previous step Total money created = sum of all demand deposits = 1,000,000/(1-0.9) = $ 10,000,000 New money comes out of thin air

Assets
IOUs Cash 10,000,000 1,000,000

Liabilities

Deposits Equity Debt Total 11,000,000 Total

10,000,000 500,000 500,000 11,000,000

Bankers Bank
Banks expected to place their cash reserves with Central Bank Authorised to provide additional reserves to banks
Make loans pyramiding on reserves A Reserve Ratio of their own 0.35 for Fed

Engage in Open Market Operations

Assume Central Bank Reserve Ratio = 1:0.35 Assets Liabilities

29,000,000
1,000,000 1,900,000 Deposits 29,000,000

IOUs
Cash at C.B. C.B. Credit

IOU to C.B
Equity Debt Total 30,900,000 Total

1,900,000
500,000 500,000 30,900,000

Buys $300 billion of existing government bonds

Method - issuing cheques on itself

$300 billion to Banks reserves

Central Bank gives credit of $570 billion
At the click of a button

Banking system creates deposits upto $8.7 Trillion

Bond sales Money supply ?

First buy $(30/2.9) billion bonds Net effect No decrease in money supply

Repo Rate
Repo Repurchase Discount rate used by RBI to repurchase Government

Securities

Reverse Repo Rate

Reverse Repo Reverse Repurchase Buying securities from the Central Bank with the

commitment to sell them back at a future date with interest The interest rate used is Reverse Repo Rate

Used to augment cash reserves of Commercial Banks

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Freedom to convert one currency into other internationally accepted currencies Two forms
Current account convertibility Capital account convertibility

120

Current account convertibility - Freedom to buy or sell foreign exchange for

Trade in products, services and for banking/credit for the

same Interest on loans Moderate remittances for family living expenses

Capital account convertibility - Home currency can be freely converted into foreign currencies for acquisition of capital assets abroad
E.g. An Indian buying stocks on NYSE E.g. Buying a steel plant in the UK

The rupee is currently not freely convertible on the capital account

121

Balance of Payments ( BoP)

A snapshot of cross-border economic

transactions Relative difference between inflow and outflow of goods, services and capital claims & liabilities between a country and its trading partners BoP= (Exports + Inflows)- (Imports + Outflows)

1991 Crisis
122

Provide facilities for the buying and selling of financial claims and services
Classified as Primary and Secondary Also classified as Money and Capital Stock Markets
BSE, NSE SEBI

Forex Markets
124

Issued at the time of collecting funds from investors

Holder gets partial ownership of company Face/Par Value Issue price of 1 share on books accounts of the company Market Capitalisation (M-Cap) Value of the company if one were to buy it out totally Market Value of shares Market Capitalisation/No. of shares

Dividends Profit partially or fully distributed

Capital appreciation Increase in the price per share

Share price depends on

Expectation of future cash flows Perception of risk of the business

Every new bit of information can change the expectation of future earnings and the perception of risk

Owned by a group of stock brokers

Anyone can become a member by paying membership

charges Non-members may trade only through a broker

Big stock exchanges of India BSE, NSE Major Stock Indices of Indian markets
BSE Sensex 30 shares NSE Nifty 50 shares

A financial contract whose values are derived from the value of an underlying asset
Stocks Commodities Currencies Mortgages

Types of derivatives (common ones)

Futures & Options Contracts to buy or sell something at a future date;

price agreed upon today Swaps Two counterparties agree to exchange 2 streams of cash flows (called the legs of the swap) Index funds Collective investment scheme that aims to replicate movements of an index of a specific financial market

Hedging
Risk mitigating devices Limit your losses
Example - Export and import companies Time gap between delivery of goods and encashment Currency fluctuations can hit profits

Also used in areas like petroleum, agricultural

commodities, metals

Speculating
Extra leverage in betting on future price movements

Arbitraging
Take advantage of price discrepancies across markets

Total dollar denominated value of all foreign currency available with the central bank (RBI) Sources of foreign exchange
Borrowings (Private & Govt) FDI/FII inflows Export Earnings NRI Remittances

Uses of Foreign Exchange

Imports
FDI/FII Outflows Repatriation of profits by companies based outside India Loan repayments

Assets, held by monetary authorities, that make international trade possible

Foreign Exchange Reserves include three items
Gold SDRs Foreign currency assets

Denominated in internationally accepted currency

Currently the USD
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Number of units of 1 currency to be given to get 1 unit of another currency

Floating exchange rate system
Since the abandonment of the Gold Standard by the UK

(1931) and the USA (1971) Fixed exchange rate under earlier Gold Standard

Fixing rates
Day-to-day rates Demand vs Supply of respective

currencies Long-term trends Relative rate of monetary inflation

133

Other factors influencing rates

Central Bank operations in forex markets

Why Central Banks intervene

Weak currency makes exports competitive Strong currency makes imports cheaper

Unintended consequences of intervention

China Pegged exchange rate Undervaluing

Renminbi High domestic inflation US Strong dollar Loss of competitiveness in manufacturing Fall in exports + Rise in imports
134

Day-to-day - supply-demand equation Long-term Economic Fundamentals Easy understanding

Let it cost Rs. x to buy a basket of goods in India
Let it cost $ y to buy the same basket of goods in India x/y is said to be the exchange rate of the dollar with

respect to the rupee You get $y for Rs. x if you try to buy dollars

Quality of life with a given amount of money

Easy understanding
Let it cost Rs. x to buy a basket of goods in India
Let it cost $ y to buy the same basket of goods in the US x/y is said to be the PPP of the rupee with respect to the

dollar Currently, it is around 10

Market for long term loans

Govt. securities Corporate securities

Govt. securities
Aimed at bridging fiscal deficit and financing

public sector projects Major holders are RBI, commercial banks, insurance cos. etc.; captive market for govt. securities

Corporate securities
Aimed at mobilizing long term funds for a corporate

to finance capital expenditures, new projects, acquisitions etc. Banks also issue long term bonds

Equities market consists of primary and secondary markets Equity shares traded through stock exchanges by brokers in an online environment
BSE and NSE the two largest stock exchanges in India

Market in short term securities, loans, gold and FOREX

Mainly commercial banks are involved

Inter-bank call money market, short term money management

Basic objectives
To even out short term surpluses and deficits To provide easy access to short term money to meet

commercial requirements