ECONOMICS Economics is the social science that analyzes the production, distribution, and consumption of goods and services.

It can also be said as the study of what constitutes rational human behaviour in the endeavour to fulfil needs and wants.

BASICS OF ECONOMICS Concept of Scarcity Scarcity refers to the tension between our limited resources and our unlimited wants and needs. For an individual, resources include time, money and skill. For a country, limited resources include natural resources, capital, labour force and technology. So, because of scarcity, people and economies must make decisions over how to allocate their resources. Economics, in turn, aims to study why we make these decisions and how we allocate our resources most efficiently. Macroeconomics Macroeconomics looks at the total output of a nation and the way the nation allocates its limited resources of land, labour and capital in an attempt to maximize production levels and promote trade and growth for future generations. (The branch of economics that studies the overall working of a national economy) Microeconomics Microeconomics looks into similar issues, but on the level of the individual people and firms within the economy. It tends to be more scientific in its approach, and studies the parts that make up the whole economy. Analyzing certain aspects of human behaviour, microeconomics shows us how individuals and firms respond to changes in price and why they demand what they do at particular price levels. (The branch of economics that studies the economy of consumers, households or individual firms)

Production Possibility Frontier (PPF) In the field of macroeconomics, the production possibility frontier (PPF) represents the point at which an economy is most efficiently producing its goods and services and, therefore, allocating its resources in the best way possible. If the economy is not producing the quantities indicated by the PPF, resources are being managed inefficiently and the production of society will dwindle. The production possibility frontier shows there are limits to production, so an economy, to achieve efficiency, must decide what combination of goods and services can be produced.

Keep in mind that A, B, and C all represents the most efficient allocation of resources for the economy; the nation must decide how to achieve the PPF and which combination to use. If more wine is in demand, the cost of increasing its output is proportional to the cost of decreasing cotton production. Point X means that the country's resources are not being used efficiently or, more specifically, that the country is not producing enough cotton or wine given the potential of its resources. Point Y, as we mentioned above, represents an output level that is currently unreachable by this economy. However, if there were changes in technology while the level of land, labour and capital remained the same, the time required to pick cotton and grapes would be reduced. Output would increase, and the PPF would be pushed outwards. A new curve, on which Y would appear, would represent the new efficient allocation of resources.

When the PPF shifts outwards, we know there is growth in an economy. Alternatively, when the PPF shifts inwards it indicates that the economy is shrinking as a result of a decline in its most efficient allocation of resources and optimal production capability. A shrinking economy could be a result of a decrease in supplies or a deficiency in technology. An economy can be producing on the PPF curve only in theory. In reality, economies constantly struggle to reach an optimal production capacity. And because scarcity forces an economy to forgo one choice for another, the slope of the PPF will always be negative; if production of product A increases then production of product B will have to decrease accordingly. Opportunity Cost Opportunity cost is the value of what is foregone in order to have something else. This value is unique for each individual. You may, for instance, forgo ice cream in order to have an extra helping of mashed potatoes. For you, the mashed potatoes have a greater value than dessert. But you can always change your mind in the future because there may be some instances when the mashed potatoes are just not as attractive as the ice cream. The opportunity cost of an individual's decisions, therefore, is determined by his or her needs, wants, time and resources (income). This is important to the PPF because a country will decide how to best allocate its resources according to its opportunity cost. Therefore, the previous wine/cotton example shows that if the country chooses to produce more wine than cotton, the opportunity cost is equivalent to the cost of giving up the required cotton production.

Remember that opportunity cost is different for each individual and nation. Thus, what is valued more than something else will vary among people and countries when decisions are made about how to allocate resources. Demand and Supply Demand refers to how much (quantity) of a product or service is desired by buyers. The quantity demanded is the amount of a product people are willing to buy at a certain price; the relationship between price and quantity demanded is known as the demand relationship. Supply represents how much the market can offer. The quantity supplied refers to the amount of a certain good producers are willing to supply when receiving a certain price. The correlation between price and how much of a good or service is supplied to the market is known as the supply relationship. Price, therefore, is a reflection of supply and demand. Law of Demand The law of demand states that, if all other factors remain equal, the higher the price of a good, the less people will demand that good. In other words, the higher the price, the lower the quantity demanded. The amount of a good that buyers purchase at a higher price is less because as the price of a good goes up, so does the opportunity cost of buying that good. As a result, people will naturally avoid buying a product that will force them to forgo the consumption of something else they value more. The chart below shows that the curve is a downward slope.

A, B and C are points on the demand curve. Each point on the curve reflects a direct correlation between quantity demanded (Q) and price (P). So, at point A, the quantity demanded will be Q1 and the price will be P1, and so on. The demand relationship curve illustrates the negative relationship between price and quantity demanded. The higher the price of a good the lower the quantity demanded (A), and the lower the price, the more the good will be in demand (C). Law of Supply Like the law of demand, the law of supply demonstrates the quantities that will be sold at a certain price. But unlike the law of demand, the supply relationship shows an upward slope. This means that the higher the price, the higher the quantity supplied. Producers supply more at a higher price because selling a higher quantity at higher price increases revenue.

A, B and C are points on the supply curve. Each point on the curve reflects a direct correlation between quantities supplied (Q) and price (P). At point B, the quantity supplied will be Q2 and the price will be P2, and so on. Time and Supply Unlike the demand relationship, however, the supply relationship is a factor of time. Time is important to supply because suppliers must, but cannot always, react quickly to a change in demand or price. So it is important to try and determine whether a price change that is caused by demand will be temporary or permanent.

Let's say there's a sudden increase in the demand and price for umbrellas in an unexpected rainy season; suppliers may simply accommodate demand by using their production equipment more intensively. If, however, there is a climate change, and the population will need umbrellas year-round, the change in demand and price will be expected to be long term; suppliers will have to change their equipment and production facilities in order to meet the long-term levels of demand. Supply and Demand Relationship Lets turn to an example to show how supply and demand affect price. Imagine that a special edition CD of your favourite band is released for $20. Because the record company's previous analysis showed that consumers will not demand CDs at a price higher than $20, only ten CDs were released because the opportunity cost is too high for suppliers to produce more. If, however, the ten CDs are demanded by 20 people, the price will subsequently rise because, according to the demand relationship, as demand increases, so does the price. Consequently, the rise in price should prompt more CDs to be supplied as the supply relationship shows that the higher the price, the higher the quantity supplied. If, however, there are 30 CDs produced and demand is still at 20, the price will not be pushed up because the supply more than accommodates demand. In fact after the 20 consumers have been satisfied with their CD purchases, the price of the leftover CDs may drop as CD producers attempt to sell the remaining ten CDs. The lower price will then make the CD more available to people who had previously decided that the opportunity cost of buying the CD at $20 was too high. Equilibrium When supply and demand are equal (i.e. when the supply function and demand function intersect) the economy is said to be at equilibrium. At this point, the allocation of goods is at its most efficient because the amount of goods being supplied is exactly the same as the amount of goods being demanded. Thus, everyone (individuals, firms, or countries) is satisfied with the current economic condition. At the given price, suppliers are selling all the goods that they have produced and consumers are getting all the goods that they are demanding.

As you can see on the chart, equilibrium occurs at the intersection of the demand and supply curve, which indicates no allocative inefficiency. At this point, the price of the goods will be P* and the quantity will be Q*. These figures are referred to as equilibrium price and quantity. In the real market place equilibrium can only ever be reached in theory, so the prices of goods and services are constantly changing in relation to fluctuations in demand and supply. Disequilibrium Excess Supply: If price is set too high, excess supply will be created within the economy, and there will be allocative inefficiency.

Excess Demand: Excess demand is created when price is set below the equilibrium price. Because the price is so low, too many consumers want the good while producers are not making enough of it.

Movements & Shifts

Movements: Like a movement along the demand curve, a movement along the supply curve means that the supply relationship remains consistent. Therefore, a movement along the supply curve will occur when the price of the good changes and the quantity supplied changes in accordance to the original supply relationship. In other words, a movement occurs when a change in quantity supply is caused only by a change in price, and vice versa.

Shifts: A shift in a demand or supply curve occurs when a goods quantity demanded or supplied changes even though price remains the same. For instance, if the price for a bottle of beer were $2 and the quantity of beer demanded increased from Q1 to Q2 then there would be a shift in the demand for beer. Shifts in the demand curve imply that the original demand relationship has changed, meaning that quantity demand is affected by a factor other than price. A shift in the demand relationship would occur if, for instance, beer were all of a sudden the only type of alcohol available for consumption. Conversely, if the price for a bottle of beer were $2 and the quantity supplied decreased from Q2 to Q1, then there would be a shift in the supply of beer. Like a shift in the demand curve, a shift in the supply curve implies that the original supply relationship has changed, meaning that quantity supplied is affected by a factor other than price. A shift in the supply curve would occur, if, for instance, a natural disaster caused a mass shortage of hops: beer manufacturers would therefore be forced to supply less beer for the same price. Elasticity The degree to which a demand or supply curve reacts to a change in price is the curve's elasticity. Elasticity varies among products because some products may be more essential to the consumer. Products that are necessities are more insensitive to price changes because consumers would continue buying these products despite price increases. Conversely, a price increase of a good or service that is considered less of a necessity will deter more consumers because the opportunity cost of buying the product will become too high.

A good or service is considered to be highly elastic if a slight change in price leads to a sharp change in the quantity demanded or supplied. Usually these kinds of products are readily available in the market and a person may not necessarily need them in his or her daily life. On the other hand, an inelastic good or service is one in which changes in price witness only modest changes in the quantity demanded or supplied, if any at all. These goods tend to be things that are more of a necessity to the consumer in his or her daily life. Elasticity = (% change in quantity / % change in price) If elasticity is greater than or equal to one, the curve is considered to be elastic. If it is less than one, the curve is said to be inelastic.

A. Factors affecting Demand Elasticity 1. The availability of substitutes - This is probably the most important factor influencing the elasticity of a good or service. In general, the more substitutes, the more elastic the

demand will be. For example, if the price of a cup of coffee went up by $0.25, consumers could replace their morning caffeine with a cup of tea. This means that coffee is an elastic good because a raise in price will cause a large decrease in demand as consumers start buying more tea instead of coffee. However, if the price of caffeine were to go up as a whole, we would probably see little change in the consumption of coffee or tea because there are few substitutes for caffeine. Most people are not willing to give up their morning cup of caffeine no matter what the price. We would, therefore, say that caffeine is an inelastic product because of its lack of substitutes. Thus, while a product within an industry is elastic due to the availability of substitutes, the industry itself tends to be inelastic. Usually, unique goods such as diamonds are inelastic because they have few - if any - substitutes. 2. Amount of income available to spend on the good - This factor affecting demand elasticity refers to the total a person can spend on a particular good or service. Thus, if the price of a can of Coke goes up from $0.50 to $1 and income stays the same, the income that is available to spend on Coke, which is $2, is now enough for only two rather than four cans of Coke. In other words, the consumer is forced to reduce his or her demand of Coke. Thus if there is an increase in price and no change in the amount of income available to spend on the good, there will be an elastic reaction in demand: demand will be sensitive to a change in price if there is no change in income. 3. Time - The third influential factor is time. If the price of cigarettes goes up $2 per pack, a smoker, with very little available substitutes, will most likely continue buying his or her daily cigarettes. This means that tobacco is inelastic because the change in the quantity demand will have been minor with a change in price. However, if that smoker finds that he or she cannot afford to spend the extra $2 per day and begins to kick the habit over a period of time, the price elasticity of cigarettes for that consumer becomes elastic in the long run. B. Income Elasticity of Demand In the second factor outlined above, we saw that if price increases while income stays the same, demand will decrease. It follows, then, that if there is an increase in income, demand tends to increase as well. The degree to which an increase in income will cause

an increase in demand is called income elasticity of demand, which can be expressed in the following equation:

If EDy is greater than one, demand for the item is considered to have a high income elasticity. If however EDy is less than one, demand is considered to be income inelastic. Luxury items usually have higher income elasticity because when people have a higher income, they don't have to forfeit as much to buy these luxury items. Let's look at an example of a luxury good: air travel. Bob has just received a $10,000 increase in his salary, giving him a total of $80,000 per annum. With this higher purchasing power, he decides that he can now afford air travel twice a year instead of his previous once a year. With the following equation we can calculate income demand elasticity:

Income elasticity of demand for Bobs air travel is seven - highly elastic. With some goods and services, we may actually notice a decrease in demand as income increases. These are considered goods and services of inferior quality that will be dropped by a consumer who receives a salary increase. An example may be the increase in the demand of DVDs as opposed to video cassettes, which are generally considered to be of lower quality. Products for which the demand decreases as income increases have an income elasticity of less than zero. Products that witness no change in demand despite a change in income usually have an income elasticity of zero - these goods and services are considered necessities.

Concept of Utility Underlying the laws of demand and supply is the concept of utility, which represents the advantage or fulfilment a person receives from consuming a good or service. Utility, then, explains how individuals and economies aim to gain optimal satisfaction in dealing with scarcity. Utility is an abstract concept rather than a concrete, observable quantity. The units to which we assign an amount of utility, therefore, are arbitrary, representing a relative value. Total utility is the aggregate sum of satisfaction or benefit that an individual gains from consuming a given amount of goods or services in an economy. The amount of a person's total utility corresponds to the person's level of consumption. Usually, the more the person consumes, the larger his or her total utility will be. Marginal utility is the additional satisfaction, or amount of utility, gained from each extra unit of consumption. Although total utility usually increases as more of a good is consumed, marginal utility usually decreases with each additional increase in the consumption of a good. This decrease demonstrates the law of diminishing marginal utility. Because there is a certain threshold of satisfaction, the consumer will no longer receive the same pleasure from consumption once that threshold is crossed. In other words, total utility will increase at a slower pace as an individual increases the quantity consumed. Take, for example, a chocolate bar. Let's say that after eating one chocolate bar your sweet tooth has been satisfied. Your marginal utility (and total utility) after eating one chocolate bar will be quite high. But if you eat more chocolate bars, the pleasure of each additional chocolate bar will be less than the pleasure you received from eating the one before - probably because you are starting to feel full or you have had too many sweets for one day.

This table shows that total utility will increase at a much slower rate as marginal utility diminishes with each additional bar. Notice how the first chocolate bar gives a total utility

of 70 but the next three chocolate bars together increase total utility by only 18 additional units. The law of diminishing marginal utility helps economists understand the law of demand and the negative sloping demand curve. The less of something you have, the more satisfaction you gain from each additional unit you consume; the marginal utility you gain from that product is therefore higher, giving you a higher willingness to pay more for it. Prices are lower at a higher quantity demanded because your additional satisfaction diminishes as you demand more. In order to determine what a consumer's utility and total utility are, economists turn to consumer demand theory, which studies consumer behaviour and satisfaction. Economists assume the consumer is rational and will thus maximize his or her total utility by purchasing a combination of different products rather than more of one particular product. Thus, instead of spending all of your money on three chocolate bars, which has a total utility of 85, you should instead purchase the one chocolate bar, which has a utility of 70, and perhaps a glass of milk, which has a utility of 50. This combination will give you a maximized total utility of 120 but at the same cost as the three chocolate bars. Monopoly, Oligopoly and Perfect Competition Economists assume that there are a number of different buyers and sellers in the marketplace. This means that we have competition in the market, which allows price to change in response to changes in supply and demand. Furthermore, for almost every product there are substitutes, so if one product becomes too expensive, a buyer can choose a cheaper substitute instead. In a market with many buyers and sellers, both the consumer and the supplier have equal ability to influence price. In some industries, there are no substitutes and there is no competition. In a market that has only one or few suppliers of a good or service, the producer(s) can control price, meaning that a consumer does not have choice, cannot maximize his or her total utility and has have very little influence over the price of goods. A monopoly is a market structure in which there is only one producer/seller for a product. In other words, the single business is the industry. Entry into such a market is restricted due to high costs or other impediments, which may be economic, social or political. For

instance, a government can create a monopoly over an industry that it wants to control, such as electricity. Another reason for the barriers against entry into a monopolistic industry is that oftentimes, one entity has the exclusive rights to a natural resource. For example, in Saudi Arabia the government has sole control over the oil industry. A monopoly may also form when a company has a copyright or patent that prevents others from entering the market. Pfizer, for instance, had a patent on Viagra. In an oligopoly, there are only a few firms that make up an industry. This select group of firms has control over the price and, like a monopoly; an oligopoly has high barriers to entry. The products that the oligopolistic firms produce are often nearly identical and, therefore, the companies, which are competing for market share, are interdependent as a result of market forces. Assume, for example, that an economy needs only 100 widgets. Company X produces 50 widgets and its competitor, Company Y, produces the other 50. The prices of the two brands will be interdependent and, therefore, similar. So, if Company X starts selling the widgets at a lower price, it will get a greater market share, thereby forcing Company Y to lower its prices as well. There are two extreme forms of market structure: monopoly and, its opposite, perfect competition. Perfect competition is characterized by many buyers and sellers, many products that are similar in nature and, as a result, many substitutes. Perfect competition means there are few, if any, barriers to entry for new companies, and prices are determined by supply and demand. Thus, producers in a perfectly competitive market are subject to the prices determined by the market and do not have any leverage. For example, in a perfectly competitive market, should a single firm decide to increase its selling price of a good, the consumers can just turn to the nearest competitor for a better price, causing any firm that increases its prices to lose market share and profits. Marginal Propensity to Consume (MPC) In economics, the marginal propensity to consume (MPC) is an empirical metric that quantifies induced consumption, the concept that the increase in personal consumer spending (consumption) occurs with an increase in disposable income (income after taxes and transfers). The proportion of the disposable income which individuals desire to spend on consumption is known as propensity to consume. MPC is the proportion of additional income that an individual desires to consume. For example, if a household earns one extra dollar of disposable income, and the marginal propensity to consume is

0.65, then of that dollar, the household will spend 65 cents and save 35 cents. Obviously, the household cannot spend more than the extra dollar. Mathematically, the function curve. function is expressed as the derivative of the consumption , i.e., the instantaneous slope of the -

with respect to disposable income

or, approximately,

where

is the change in consumption, and

is the change in disposable

income that produced the consumption.

MPC and nature of country The MPC is higher in the case of poor than in case of rich people. The greater a persons income, the more of her or his basic human needs will have already been met, and the greater his or her tendency to save in order to provide for future will be. The marginal propensity to save of the richer classes is greater than that of the poorer classes. If, at any time, it is desired to increase aggregate consumption, then the purchasing power should be transferred from the richer classes (with low propensity to consume) to the poorer classes (with a higher propensity to consume). Likewise, if it is desired to reduce community consumption, the purchasing power must be taken away from the poorer classes by taxing consumption. The marginal propensity to consume is higher in a poor country and lower in the case of rich country. The reason is same as stated above. In the case of rich country, most of the basic needs of the people have already been satisfied, and all the additional increments of income are saved, resulting in a higher marginal propensity to save but in a lower marginal propensity to consume. In a poor country, on the other hand, most of the basic needs of the people remain unsatisfied so that additional increments of income go to increase consumption, resulting in a higher marginal propensity to consume and a lower marginal propensity to save. This is the reason MPC is higher in the underdeveloped countries of Asia and Africa, and lower in developed countries such as the United States, the United Kingdom, Singapore and Germany.

Average Propensity to Consume Average propensity to consume (APC) is the percentage of income spent (or percentage of income people desired to spend). To find the percentage of income spent,

one needs to divide consumption by income, or Sometimes, disposable income is used as the

. denominator instead,

so

where C is the amount spent, Y is pre-tax income, and T is taxes.

Marginal Propensity to Save (MPS) The marginal propensity to save (MPS) refers to the increase in saving (non-purchase of current goods and services) that results from an increase in income i.e. The marginal propensity to save might be defined as the proportion of each additional dollar of household income that is used for saving. It is also used as an alternative term for the slope of the saving line. For example, if a household earns one extra dollar, and the marginal propensity to save is 0.35, then of that dollar, the household will spend 65 cents and save 35 cents. It can also go the other way, referring to the decrease in saving that result from a decrease in income. MPS can be calculated as the change in savings divided by the change in income.

Or mathematically, the marginal propensity to save (MPS) function is expressed as the derivative of the savings (S) function with respect to disposable income (Y).

Where, dS=Change in Savings and dY =Change in income. (MPS + MPC = 1)

Average Propensity to Save The average propensity to save (APS), also known as the savings ratio, is an economics term that refers to the proportion of income which is saved, usually expressed for household savings as a percentage of total household disposable income. The ratio differs considerably over time and between countries. The savings ratio can be affected by (for example): the proportion of older people, as they have less motivation and capability to save; the rate of inflation, as expectations of rising prices can encourage people to spend now rather than later (monetary base/mass depreciation). APC and APS are complement of each other. (APC + APS = 1)

MACROECONOMICS Macroeconomics (from the Greek prefix makro- meaning "large" and economics) is a branch of economics dealing with the performance, structure, behaviour, and decisionmaking of an economy as a whole, rather than individual markets. This includes national, regional, and global economies. Macroeconomists study aggregated indicators such as GDP, unemployment rates, and price indices to understand how the whole economy functions. Macroeconomists develop models that explain the relationship between such factors as national income, output, consumption, unemployment, inflation, savings, investment, international trade and international finance. Macroeconomic models and their forecasts are used by both governments and large corporations to assist in the development and evaluation of economic policy and business strategy. Business Cycle The term business cycle (or economic cycle) refers to economy-wide fluctuations in production, trade and economic activity in general over several months or years in an economy organized on free-enterprise principles.

The business cycle is the upward and downward movements of levels of GDP (gross domestic product) and refers to the period of expansions and contractions in the level of economic activities (business fluctuations) around its long-term growth trend. These fluctuations occur around a long-term growth trend, and typically involve shifts over time between periods of relatively rapid economic growth (an expansion or boom), and periods of relative stagnation or decline (a contraction or recession). Business cycles are usually measured by considering the growth rate of real gross domestic product. Despite being termed cycles, these fluctuations in economic activity can prove unpredictable. Inflation Inflation is defined as a sustained increase in the general level of prices for goods and services. It is measured as an annual percentage increase. For example, if we say that the current inflation is 8 percent, it means the general price level has increased by 8 percent over the last one year. There are several variations on inflation: Deflation is when the general level of prices is falling. This is the opposite of inflation. Hyperinflation is unusually rapid inflation. In extreme cases, this can lead to the breakdown of a nation's monetary system. One of the most notable examples 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 during the 1970s, when a bad economy was combined with OPEC raising oil prices. Theories of Inflation Demand Pull Inflation Aggregate demand pull inflation occurs when the aggregate demand for output is in excess of maximum feasible or potential or full-employment output (at the going price level). Since the level of output is taken as a given data, the excess demand is

supposed to be generated by the factors influencing only the demand side of the commodities market. Demand-pull inflation simply means that aggregate demand has been pulled above what the economy is capable of producing in the short run. Cost- Push Inflation Cost push inflation occurs due to an increase in the cost of production. In contrast to the demand-pull inflation, the cost-push inflation emphasizes increases in some important component or the other cost as the true source of inflation. It works through some important cost components in the production process such as wages or materials cost. Note that according to this theory, the upward push in costs is independent of the demand conditions of the concerned market; for example, wages could rise because of trade union activities rather than shortage of labour. The second important aspect to note is that the higher cost is passed on to the consumers in terms of higher prices and are not absorbed by the producers. Measuring Inflation What do we mean by general price level and why do we use general price levels to measure inflation? Supposing an economy produces 1000 goods. During a given year, the price of these goods may have changed by different percentages; some may have risen by 5 %, some by 7 %, some by 20 % and there may even be some goods, whose prices may have actually fallen. No single commodity will give us correct picture of the general price increase in the economy. So, we must create a price index by taking into account either all the commodities in the economy or a basket of sufficiently large number of commodities that broadly represent the economy. Generally, the latter (that is, a given basket of commodities) is chosen to create a price index. The purpose of a price index is to quantify the overall increase or decrease in prices of several commodities through a single number. The price index is measured at regular intervals and changes in price index are an indicator of the average price movement of a fixed basket of goods and services (that represent the entire economy). The Inflation at any given time is measured by computing the percentage changes in the price index at that point of time over the index prevailing one year previously. To measure the rate of inflation, the following formula is used: Rate of Inflation in year X: [(Px Px-1) / (Px-1)] * 100

Where: Px is the price index for the year X. Px-1 is the price index of the preceding year. The wholesale price index and the wholesale price inflation in India during 1993/94 to 2009/10 are given below.

An important point to note from the Table 2.1. is that while the price level increased consistently over the period (indicated by a consistent increase in index), the inflation rate fluctuated; that is rose in some years and fell in other years. This is so, because inflation is the rate of price increase, which can fluctuate both ways even when prices continually increase. Wholesale Price Index (WPI) (also called as Producers Price Index - PPI) WPI is the index of prices prevailing in the wholesale market. The concept of wholesale price adopted in practice represents the quoted price of bulk transaction generally at primary stage. For example, the price pertaining to bulk transaction of agricultural commodities may be farm harvest prices, or prices at the village mandi / market. Similarly, for manufactured goods, the wholesale prices are ex- factory gate level or exmine level. In India, wholesale price index is calculated by the Government on monthly

and yearly basis. What you see in Table 2.1 is the yearly wholesale price index and yearly wholesale inflation. The wholesale price index and wholesale price inflation are keenly watched by the observers of the economy and policy makers. The wholesale price inflation is also called the headline inflation. Please note that it is only since November 2009 that the WPI has begun to be announced on a monthly basis; earlier, it used to be on a weekly basis. The switch to monthly inflation from weekly inflation was made to ensure that the policy makers are not misled by the week-to-week fluctuations in inflation to make policy prescriptions. The WPI is compiled by the Office of Economic Advisor to the Ministry of Commerce and Industry of the Government of India. There are three major groups in Indias wholesale price index: 1) Primary Articles 2) Fuel, Power, Lights & Lubricants and 3) Manufacturing Items. (See Box) Note that the indexes of the three major groups and each of the subgroups under them are publicly available. So, it is possible for us to calculate not only general inflation, but also the inflation rate of a particular group (such as primary articles) or sub-group (such as leather and leather products). The commodity basket for the computation of WPI consists of 435 commodities, of which 98 are under primary articles, 19 under Fuel, Power, Light and Lubricants and 318 under manufactured products. (From the headline inflation if the effect of changes in prices of food and energy (petroleum etc), which are prone to volatile price movements, are removed, what we get is called Core inflation. The concept of core inflation rate was introduced by Robert J. Gordon in 1975.

Meaning of WPI for Investors The biggest attribute of the WPI in the eyes of investors is its ability to predict the CPI. The theory is that most cost increases that are experienced by retailers will be passed on to customers, which the CPI could later validate. Because the CPI is the actual inflation indicator out there, investors will look to get a sneak preview by looking at the WPI figures. Consumer Price Index (CPI) Consumer Price Index is the index of prices prevailing in the retail market. CPI is more relevant to the consumer, since it measures changes in retail prices. The Consumer Price Index represents the basket of essential commodities purchased by the average consumer food, fuel, lighting, housing, clothing, articles etc. Inflation measured by using CPI is called consumer price inflation. There are three measures of CPI, which track the cost of living of three different categories of consumersindustrial workers (IW), agricultural labourers (AL) and rural labourers (RL). Each category has its own basket of commodities that represent the consumption pattern of the respective consumer groups. Not only does the basket of commodities differ, but also the weights

assigned to the same commodity may be different under different CPI series. For example, food gets a weight of only 48 percent under CPI-IW, but 73 percent under CPIAL. Among the three, CPI-IW is most popular. In the organized sector, CPI IW is used as the cost of living index. Consumer Price Index is measured on a monthly basis in India. All the three series of CPI are compiled by Labour Bureau of the Labour Ministry of the Government of India. While wholesale price inflation is more popular in India, the Consumer Price Index is a popular measure in developed nations like USA, UK. Meaning for Investors The CPI is probably the single most important economic indicator available, if for no other reason than because it's very final. Many other indicators derive most of their value from the predictive ability of the CPI, so when this release arrives, many questions will be answered in the markets. This report will often move equity and fixed-income markets, both the day of the release and on an ongoing basis. It may even set a new course in the markets for upcoming months. Comparison of WPI and CPI While each of the measures has its advantages as well as weaknesses, the selected measure of inflation should broadly capture the interplay of effective demand and supply forces in the economy at frequent intervals. This will be facilitated if the price indices have a high periodicity of release, and it is in this sense that WPI is superior to CPI. WPI's coverage of commodities is also high. While services do not come under the ambit of WPI, the coverage of non-agricultural products is better in WPI than CPI, making WPI less volatile to relative price changes as against the CPI. The coverage of tradable items, essentially manufactured products (weight = 57.06 per cent) is higher in the case of WPI whereas the coverage of non-tradables like services pertaining to education, medical care and recreation are more in the case of CPI-IW. The weekly periodicity of WPI with a lag of a fortnight often coincides with the release of banking and money supply data on 14 day basis. Impact of Inflation on Macroeconomic Variables Exchange Rate: Persistently higher inflation in a country (say Country A) relative to the inflation in another country (say Country B) generally leads to depreciation of a currency in country A. Depreciation of the currency of country A means decrease in the value of

the currency of country A relative to the currencies of country B. In other words, if country A persistently experiences higher inflation than country B, in exchange for the same number of units of Currency A, the residents of country A will get fewer units of currency B than before. Exports and Imports: As stated in the preceding paragraph, relatively higher inflation in a country leads to the depreciation of its currency vis--vis that of the country with lower inflation. If the two countries happen to be trading partners, then the commodities produced by the higher inflation country will lose some of their price competitiveness and hence will experience lesser exports to the country with lower inflation. A currency depreciation resulting from relatively higher inflation leads not only to lower exports but also to higher imports. Interest Rates: When the price level rises, each unit of currency can buy fewer goods and services than before, implying a reduction in the purchasing power of the currency. So, people with surplus funds demand higher interest rates, as they want to protect the returns of their investment against the adverse impact of higher inflation. As a result, with rising inflation, interest rates tend to rise. The opposite happens when inflation declines. Also interest rates are increased to reduce the flow of money in the economy thus reducing demand and controlling inflation. Unemployment: There is an inverse relationship between the rate of unemployment and the rate of inflation in an economy. It has been observed that there is a stable short run trade-off between unemployment and inflation. This inverse relationship between unemployment and inflation is called the Phillips Curve (see below).

As shown in the above graph, when an economy is witnessing higher growth rates, unless it is a case of stagflation, it typically accompanies a higher rate of inflation as well. However, the surging growth in total output also creates more job opportunities and hence, reduces the overall unemployment level in the economy. On the flip side, if the headline inflation breaches the comfort level of the respective economy, then suitable fiscal and monetary measures follow to douse the surging inflationary pressure. In such a scenario, a reduction in the inflation level also pushes up the unemployment level in the economy. Controlling Inflation There are broadly two ways of controlling inflation in an economy Monetary measures and fiscal measures. The most important and commonly used method to control inflation is monetary policy of the Central Bank. Most central banks use high interest rates as the traditional way to fight or prevent inflation. Monetary measures used to control inflation include (i) bank rate policy (ii) cash reserve ratio and (iii) open market operations. Besides these monetary policy steps, the fiscal measures to control inflation include taxation, government expenditure and public borrowings. The government can also take some protectionist measures (such as banning the export of essential items such as pulses, cereals and oils to support the domestic consumption, encourage imports by lowering duties on import items etc.).

National Income Accounting The most common measure used to estimate the size of an economy is called the Gross Domestic Product or GDP. GDP is a comprehensive measure of a countrys overall economic output. GDP is defined as the market value of all final goods and services produced within an economy in a given period of time, usually in a financial year. When GDP calculations are done using current prices, it is called nominal GDP. To measure how fast a countrys economy is growing, the rate of growth of real GDP is used. Annual rate of growth of real GDP is calculated using the following formula:

So, unless otherwise mentioned, the economic growth of a country means growth of its real GDP. Real implies adjusted for inflation. If it is not adjusted for price level, then it is nominal. When GDP figures are adjusted for depreciation, the resultant measure is called Net Domestic Product or NDP. Therefore, NDP is: NDP = GDP- depreciation of capital stock Methods of Measuring National Income 1) Expenditure Approach

Y = C + I + G + (X-M) The national income accounts divide GDP into four broad categories of spending: Consumption (C) Investment (I) Government spending (G) Net Exports (X-M)

The right hand side of the above equation actually shows the aggregate demand generated for the goods and services of the economy. 2) Income Approach GDP can be measured from the income side as well. The income approach measures economic activity by adding all the incomes received by all the producers of output. This includes wages received by workers and profits received by the owners of the firms. To be more specific, there can be five types of income: Compensation of employees: This is the income of workers, including selfemployed workers, and includes salaries, wages, pensions etc. Proprietors income: These are the profits of partnerships and solely owned businesses, like a family restaurant. Rental income of persons: Income earned by individuals who own land or structures that they rent to others. Corporate profits: Corporate profits are the profits earned by the corporations and represent the remainder of corporate revenue after wages, rents, interest payments and other costs. Net interest: Net interest is the interest earned by individuals from business and foreign sources GDP measurement based on income or expenditure should result in the same GDP figures. Therefore, GDP sometimes is also called the total income of the economy.

Fiscal Policy Fiscal policy is the use of government revenue collection (taxation) and expenditure (spending) to influence the economy. The two main instruments of fiscal policy are changes in the level and composition of taxation and government spending in various sectors. These changes can affect the following macroeconomic variables in an economy: Aggregate demand and the level of economic activity; The distribution of income; The pattern of resource allocation within the government sector and relative to the private sector. The three main stances of fiscal policy are: Neutral fiscal policy is usually undertaken when an economy is in equilibrium. Government spending is fully funded by tax revenue and overall the budget outcome has a neutral effect on the level of economic activity. Expansionary fiscal policy involves government spending exceeding tax revenue, and is usually undertaken during recessions. Contractionary fiscal policy occurs when government spending is lower than tax revenue, and is usually undertaken to pay down government debt. However, these definitions can be misleading because, even with no changes in spending or tax laws at all, cyclic fluctuations of the economy cause cyclic fluctuations of tax revenues and of some types of government spending, altering the deficit situation; these are not considered to be policy changes. Therefore, for purposes of the above definitions, "government spending" and "tax revenue" are normally replaced by "cyclically adjusted government spending" and "cyclically adjusted tax revenue". Thus, for example, a government budget that is balanced over the course of the business cycle is considered to represent a neutral fiscal policy stance. Methods of funding Governments spend money on a wide variety of things, from the military and police to services like education and healthcare, as well as transfer payments such as welfare benefits. This expenditure can be funded in a number of different ways:

1. Taxation 2. Seigniorage, the benefit from printing money 3. Borrowing money from the population or from abroad 4. Consumption of fiscal reserves 5. Sale of fixed assets (e.g., land) Below described are the sources of Government Expenditure and Revenue: Government Revenue: Government Receipts = Revenue Receipts + Capital Receipts Revenue receipts consist of: Taxes (Direct and Indirect Taxes) Non-Tax Revenue (Administrative receipts, net contribution from PSU including railways, posts, currency and mint and other revenues) Capital receipts consist of: Revenue arising from selling some of Government assets (non-debt capital) Borrowings from external and internal sources (debt capital)

Government Expenditure: All revenue received and loans raised by the Government are credited to the Consolidated Fund of India and all expenditure of the Government is incurred from this fund. Money can be spent through this fund only after getting approval from the Parliament. The Consolidated Fund has further been divided into Revenue and Capital divisions. Revenue Expenditure It involves routine government expenditure, which does not create any asset for the government. Revenue expenditure is incurred by the government for the normal running of government departments and various services (salaries and pensions of government employees, subsidy payments for food fertilizers etc)

Capital Expenditure Capital expenditure can be defined as an expenditure which leads to addition of material assets for the economy. Capital expenditure does not include operating expenditure. Examples of capital expenditure are building infrastructure projects like roads and ports, buying land, making buildings, purchase of machinery and equipment etc. Plan and Non-Plan Expenditures Since the country follows a plan based model of an economy, the total expenditure of the government is divided under plan and non-plan expenditures. The plan expenditure is directly related to expenditure on schemes and programmes budgeted in the governments plans. The non-plan expenditure is the expenditure incurred on establishment and maintenance activities. Non-plan capital expenditure mainly includes defence, loans to public enterprises, loans to States, Union Territories and foreign governments. On the other hand, non-plan revenue expenditure includes expenses on interest payments, subsidies (mainly on food and fertilizers), wage and salary payments to government employees, grants to governments of States and Union Territories, pensions, police services, economic services in various sectors, other general services such as tax collection, social services, and grants to foreign governments. In India, revenue expenditure tends to be much higher than capital expenditures under both plan and non-plan heads. Low capital expenditure can be a problem for a country like India because it suffers from weak infrastructure such as road, electricity, water etc. Low investment in these areas can impede the pace of economic growth. Deficit Indicators Revenue Deficit: Revenue Deficit refers to the excess of revenue expenditure over revenue receipts. In other words, Revenue Deficit (RD) = Revenue Expenditure (RE) Revenue Receipts (RR)

Gross Fiscal Deficit is the excess of total expenditure over the sum total of revenue receipts and recovery of loans. This indicates the total borrowing requirements of government from all sources. In other words, Fiscal Deficit (FD) = {Total Expenditure (Revenue receipts + recovery of loans)} Net fiscal deficit is the gross fiscal deficit less net lending of the Central Government. Primary deficit is measured by deducting interest payments from gross fiscal deficit.

Financing of persistent fiscal deficit creates another set of problems for policymakers. If the government uses domestic debt to finance the fiscal deficit, the debt obligation of the government increases. Also, debt service requirements increase. This may lead to a situation where a major part of the revenue earned by the government is spent on debt service requirements. This will limit the ability of the government to develop capital stock and physical infrastructure for the economy which is crucial to enhance and sustain a high level of economic growth. As high fiscal deficit can lead to a number of problems including debt sustainability, inflation (under certain circumstances) and crowding-out, the government of India has been trying to maintain fiscal prudence by containing fiscal deficit level. Toward this end, in 2003, the government enacted the Fiscal Responsibility and Budget Management Act (FRBMA) for medium-term management of the fiscal deficit. The FRBMA imposes some constraints on the expenditure pattern of the government. It requires that the government to reduce the revenue deficit gradually, so that it eventually disappears and also to reduce the fiscal deficit gradually to a level

below 3 percent of GDP within a specified period. However, government has failed to achieve these targets, particularly in the last couple of years because of fiscal stimulus packages that it introduced to tackle the economic slump. Impact of Fiscal Policy on Financial Markets The most direct impact of fiscal policies on the financial market is through taxation. The government can try to change the tax rates; it can impose new taxes or abolish existing ones or can use measures to broaden the tax base. In each of these cases, it will affect the income and consumption pattern of a large number of people. Depending upon the tax measure, it will have a positive or a negative impact on the financial market. For example, if personal income tax rate is lowered then it is likely to increase the disposable income of people and can have a positive impact on the financial markets through an enhanced level of financial savings. On the other hand, introduction of a long-term capital gains tax may have the adverse impact on the market.

MONETARY POLICY Monetary policy is the process by which monetary authority of a country, generally a central bank controls the supply of money in the economy by exercising its control over interest rates in order to maintain price stability and achieve high economic growth. Components of Money Supply in India The Reserve Bank of India (RBI) publishes 4 measures of monetary aggregates in India. These measures define money based on progressive liquidity or spendability. a) M1 = currency held by the public (currency notes and coins) + Demand deposits with the banking system (on current and saving bank accounts) + Other demand deposits with RBI. b) M2 = M1 + saving deposits with Post office savings banks. c) M3 = M1 + time deposits with the banking system.

d) M4 = M3 + total deposits with the post office savings organization (excluding National Savings Certificates). M1 represents the most liquid form of money among the four money stock measures adopted by RBI. As we proceed from M1 to M4, the liquidity gets reduced. In other words, M4 possesses the lowest liquidity among all these measures. The importance of all these four money stock measures varies from the point of view of monetary policy. Objectives of Monetary Policy 1. Growth with Stability: Traditionally, RBIs monetary policy was focused on controlling inflation through contraction of money supply and credit. This resulted in poor growth performance. Thus, RBI has now adopted the policy of Growth with Stability. This means sufficient credit will be available for growing needs of different sectors of economy and at the same time, inflation will be controlled with in a certain limit.

2. Regulation, Supervision and Development of Financial Stability: (Financial stability means the ability of the economy to absorb shocks and maintain confidence in financial system.)

3. Promoting Priority Sector: Priority sector includes agriculture, export and small scale enterprises and weaker section of population. RBI with the help of banks provides timely and adequately credit at affordable cost of weaker sections and low income groups.

4. Generation of Employment: Monetary policy helps in employment generation by influencing the rate of investment and allocation of investment among various economic activities of different labour Intensities.

5. External Stability: With the growth of imports and exports Indias linkages with global economy are getting stronger. Earlier, RBI controlled foreign exchange market by determining exchange rate. Now, RBI has only indirect control over external stability through

the mechanism of managed Flexibility, where it influences exchange rate by buying and selling foreign currencies in open market.

6. Encouraging Savings and Investments: RBI by offering attractive interest rates encourages savings in the economy. A high rate of saving promotes investment. Thus the monetary management by influencing rates of interest can influence saving mobilization in the country.

7. Redistribution of Income and Wealth: By control of inflation and deployment of credit to weaker sectors of society the monetary policy may redistribute income and wealth favouring to weaker sections.

8. Regulation of NBFIs: Non Banking Financial Institutions (NBFIs), like UTI, IDBI, IFCI plays an important role in deployment of credit and mobilization of savings. RBI does not have any direct control on the functioning of such institutions. However it can indirectly affects the policies and functions of NBFIs through its monetary policy. Types of Monetary Policies

(India is using Multiple Indicator Approach explained later) Monetary Policy of the RBI A) General Quantitative Credit Control Methods Quantitative credit controls are used to maintain proper quantity of credit and money supply in market. Some of the important general credit control methods are:-

1.

Bank Rate Policy:-

Bank rate is the rate at which the Central bank lends money to the commercial banks for their liquidity requirements. Bank rate is also called discount rate. In other words bank rate is the rate at which the central bank rediscounts eligible papers (like approved securities, bills of exchange, commercial papers etc) held by commercial banks. Bank rate is important because it is the pace setter to other market rates of interest. Bank rates have been changed several times by RBI to control inflation and recession. 2. Open market operations:-

It refers to buying and selling of government securities in open market in order to expand or contract the amount of money in the banking system. This technique is superior to bank rate policy. Purchases inject money into the banking system while sale of securities do the opposite. During last two decades the RBI has been undertaking switch operations. These involve the purchase of one loan against the sale of another or, vice-versa. This policy aims at preventing unrestricted increase in liquidity. 3. Cash Reserve Ratio (CRR)

The Cash Reserve Ratio (CRR) is an effective instrument of credit control. Under the RBl Act of, l934 every commercial bank has to keep certain minimum cash reserves with RBI. The RBI is empowered to vary the CRR between 3% and 15%. A high CRR reduces the cash for lending and a low CRR increases the cash for lending. 4. Statutory Liquidity Ratio (SLR)

Under SLR, the government has imposed an obligation on the banks to maintain a certain ratio to its total deposits with RBI in the form of liquid assets like cash, gold and other securities. The RBI has power to fix SLR in the range of 25% and 40%. 5. Repo and Reverse Repo Rates

In determining interest rate trends, the repo and reverse repo rates are becoming important. Repo means Sale and Repurchase Agreement. Repo is a swap deal involving the immediate Sale of Securities and simultaneous purchase of those securities at a future date, at a predetermined price. Repo rate helps commercial banks to acquire funds from RBI by selling securities and also agreeing to repurchase at a later date.

Reverse repo rate is the rate that banks get from RBI for parking their short term excess funds with RBI. Repo and reverse repo operations are used by RBI in its Liquidity Adjustment Facility. RBI contracts credit by increasing the repo and reverse repo rates and by decreasing them it expands credit. B) Selective / Qualitative Credit Control Methods Under Selective Credit Control, credit is provided to selected borrowers for selected purpose, depending upon the use to which the controls try to regulate the quality of credit - the direction towards the credit flows. The Selective Controls are:1. Ceiling on Credit

The Ceiling on level of credit restricts the lending capacity of a bank to grant advances against certain controlled securities. 2. Margin Requirements

A loan is sanctioned against Collateral Security. Margin means that proportion of the value of security against which loan is not given. Margin against a particular security is reduced or increased in order to encourage or to discourage the flow of credit to a particular sector. It varies from 20% to 80%. For agricultural commodities it is as high as 75%. Higher the margin lesser will be the loan sanctioned. 3. Discriminatory Interest Rate (DIR) Through DIR, RBI makes credit flow to certain priority or weaker sectors by charging concessional rates of interest. RBI issues supplementary instructions regarding granting of additional credit against sensitive commodities, issue of guarantees, making advances etc. 4. Directives

The RBI issues directives to banks regarding advances. Directives are regarding the purpose for which loans may or may not be given.

5.

Direct Action

It is too severe and is therefore rarely followed. It may involve refusal by RBI to rediscount bills or cancellation of license, if the bank has failed to comply with the directives of RBI. 6. Moral Suasion

Under Moral Suasion, RBI issues periodical letters to bank to exercise control over credit in general or advances against particular commodities. Periodic discussions are held with authorities of commercial banks in this respect. Key Policy Rates (as of 28 June 2013) Bank Rate: 8.25% Repo Rate: 7.25% Reverse Repo Rate: 6.25% Base Rate: 9.7% - 10.25% Term Deposit Rate: 7.5% - 9% RBIs Measures for Short-term Liquidity Management 1. Repo I Reverse Repo Marginal Standing Facility Rate: 8.25% CRR: 4% SLR: 23% Savings Deposit Rate: 4%

To improve short term liquidity management, RBl introduced repos in December 1992. Repo is Sale and Repurchase Agreement. It is a swap deal involving the immediate Sale of Securities and simultaneously purchase of those securities at a future date, at a predetermined price. Such deals take place between RBI and banks. Due to lack of demand repos auctions were discontinued in March 1995, they were resumed again in 1997. Reverse repo rate is the rate that banks get from RBI for parking their short term excess funds with RBI.

2.

Interim Liquidity Adjustment Facility (ILAF)

To develop short term money market Narasimham Committee 1998 recommended LAF. Accordingly in 1999 RBI introduced ILAF. It (ILAF) provided a mechanism for liquidity management through a combination of repos, export credit refinance and collateralised lending facilities supported by Open Market Operations. 3. Liquidity Adjustment Facility (LAF)

RBI introduced-full-fledged LAF which has been revised further. Under LAF, Reverse repo auctions and Repo auctions are conducted on daily basis. In India, the emergence of LAF was a single biggest factor which helped RBI to manage short term liquidity and maintain interest rate stability. In 2009-10, liquidity absorption through reverse repo reached its peak on 4th September 2009 at Rs. 1,68,215 crore. 4. Sterilization

Sterilization means re-cycling of foreign capital inflows to prevent appreciation of domestic currency and to check the inflationary impact of such capital. Sterilization is carried out through open market operations. But Sterilization can also leads to some problems. Thus RBI also uses a variety of other measures to manage interest rates. 5. Market Stabilization Scheme (MSS):-

Till 2003-04 the impact of large capital inflows was managed through day-to-day LAF and OMO. In the process, the government securities available with RBI declined, as they were being used for absorbing excess liquidity. In order to handle these issues, RBI signed a Memorandum of Understanding (MOU) with Government for issuance of Treasury Bills and dated government securities under Market Stabilization Scheme (MSS). These Bills and Securities are used to absorb excess liquidity from market and: maintain stability in foreign exchange market. Changes in RBIs Monetary Policy 1) Multiple Indicator Approach

Upto late 1990s, RBI used the Monetary targeting approach to its monetary policy. Monetary targeting refers to a monetary policy strategy aimed at maintaining price

stability by focusing on changes in growth of money supply. After 1991 reforms this approach became difficult to follow. So RBI adopted Multiple indicator Approach in which it looks at a variety of economic indicators and monitor their impact on inflation and economic growth. 2) Selective Methods Being Phased Out

With rapid progress in financial markets, the selective methods of credit control are being slowly phased out. Quantitative methods are becoming more important. 3) Reduction in Reserve Requirements

In post-reform period the CRR and SLR have been progressively lowered. This has been done as a part of financial sector reforms. As a result, more bank funds have been released for lending. This has led to the growth of economy. 4) Deregulation of Administered Interest Rate System

Earlier lending rate of banks was determined by RBI. Since 1990s this system has changed and lending rates are determined by commercial banks on the basis of market forces. 5) Delinking Of Monetary Policy from Budget Deficit

In1994 government phased out the use of adhoc treasury Bills. These bills were used by government to borrow from RBI to finance fiscal deficit. With phasing out of Bills, RBI would no longer lend to government to meet fiscal deficit. 6) Liquidity Adjustment Facility (LAF)

LAF allows banks to borrow money through repurchase agreement LAF was introduced by RBI during June, 2000, in phases. The funds under LAF are used by banks to meet day-to-day mismatches in liquidity. 7) Provision of Micro Finance

By linking the banking system with Self Help Groups, RBI has introduced the scheme of micro finance for rural poor. Along with NABARD, RBI is promoting various other microfinance institutions.

8)

External Sector

With globalisation large amount of foreign capital is attracted. To provide stability in financial markets, RBI uses sterilization and LAF to absorb the excess liquidity that comes in with huge inflow of foreign capital. 9) Expectation as a Channel of Monetary Transmission

Traditionally, there were four key channels of monetary policy transmission: Interest rate, credit availability, asset prices and exchange rate channels. Interest rate is the most dominant transmission channel as any change in monetary policy has immediate effect on it. In the recent years fifth channel, expectation has been added. Future expectations about asset prices, general price and Income levels influence the four traditional channels. Achievements and Failures of Monetary Policy Achievements: 1. Short- term Liquidity Management 2. Financial Stability 3. Financial Inclusion 4. Adaptability (Shifting monetary policy to multiple indicator approach) 5. Increase in Growth (GDP growth rate) 6. Increase in Bank Deposits 7. Competition among Banks Failures: 1. Huge Budgetary Deficits:

RBI makes every possible attempt to control inflation and to balance money supply in the market. However Central Government's huge budgetary deficits have made monetary policy ineffective. Huge budgetary deficits have resulted in excessive monetary growth.

2.

Coverage of Only Commercial Banks:

Instruments of monetary policy cover only commercial banks so inflationary pressures caused by banking finance can be controlled by RBI, but in India, inflation also results from deficit financing and scarcity of goods on which RBI may not have any control. 3. Problem of Management of Banks and Financial Institutions:

The monetary policy can succeed to control inflation and to bring overall development only when the management of banks and financial institutions are efficient and dedicated. Many officials of banks and financial institutions are corrupt and inefficient which leads to financial scams in this way overall economy is affected. 4. Unorganised Money Market:

Presence of unorganised sector of money market is one of the main obstacle in effective working of the monetary policy. As RBI has no power over the unorganised sector of money market, its monetary policy becomes less effective. 5. Less Accountability:

At present time, the goals of monetary policy in India are not set out in specific terms and there is insufficient freedom in the use of instruments. In such a setting, accountability tends to be weak as there is lack of clarity in the responsibility of governments and RBI. 6. Black Money:

There is a growing presence of black money in the economy. Black money falls beyond the purview of banking control of RBI. It means large proposition of total money Supply in a country remains outside the purview of RBI's monetary management. 7. Increase Volatility:

The integration of domestic and foreign exchange markets could lead to increased volatility in the domestic market as the impact of exogenous factors could be transmitted to domestic market. The widening of foreign exchange market and development of rupee - foreign exchange swap would reduce risks and volatility.

8.

Lack of Transparency:

According to S. S. Tarapore, the monetary policy formulation, in its present form in India, cannot be continued indefinitely. For a more effective policy, it would be necessary to have greater transparency in the policy formulation and transmission process and the RBI would need to be clearly demarcated. International Trade Mercantilism is an economic theory, thought to be a form of economic nationalism, that holds that the prosperity of a nation is dependent upon its supply of capital and that capital is represented by bullion (gold, silver, and trade value) held by the state, which is best increased through a positive balance of trade with other nations. The Mercantilists of 16th to 18th Century believed that international trade leads to a situation, where the country with positive trade balance improves its national wealth at the expense of the country which is running a trade deficit. It was believed that a country can promote its self-interest by discouraging imports and encouraging exports to increase its wealth. This position essentially called for a protectionist trade policy. Not surprisingly, tariffs and quotas were used to restrict imports and subsidies were used to boost exports to cause a favourable trade balance. However, Adam Smith and David Ricardo challenged this perception and showed that international trade can be beneficial for all the countries. They showed that trade is not a zero sum game (that is, one countrys gain from trade is equal to its trading partners loss) and that free trade increases the global wealth. Specialization and Comparative Advantage An economy can focus on producing all of the goods and services it needs to function, but this may lead to an inefficient allocation of resources and hinder future growth. By using specialization, a country can concentrate on the production of one thing that it can do best, rather than dividing up its resources. For example, let's look at a hypothetical world that has only two countries (Country A and Country B) and two products (cars and cotton). Each country can make cars and/or cotton. Now suppose that Country A has very little fertile land and an abundance of steel

for car production. Country B, on the other hand, has an abundance of fertile land but very little steel. If Country A were to try to produce both cars and cotton, it would need to divide up its resources. Because it requires a lot of effort to produce cotton by irrigating the land, Country A would have to sacrifice producing cars. The opportunity cost of producing both cars and cotton is high for Country A, which will have to give up a lot of capital in order to produce both. Similarly, for Country B, the opportunity cost of producing both products is high because the effort required to produce cars is greater than that of producing cotton. Each country can produce one of the products more efficiently (at a lower cost) than the other. Country A, which has an abundance of steel, would need to give up more cars than Country B would to produce the same amount of cotton. Country B would need to give up more cotton than Country A to produce the same amount of cars. Therefore, County A has a comparative advantage over Country B in the production of cars, and Country B has a comparative advantage over Country A in the production of cotton. Now let's say that both countries (A and B) specialize in producing the goods with which they have a comparative advantage. If they trade the goods that they produce for other goods in which they don't have a comparative advantage, both countries will be able to enjoy both products at a lower opportunity cost. Furthermore, each country will be exchanging the best product it can make for another good or service that is the best that the other country can produce. Specialization and trade also works when several different countries are involved. For example, if Country C specializes in the production of corn, it can trade its corn for cars from Country A and cotton from Country B. Determining how countries exchange goods produced by a comparative advantage ("the best for the best") is the backbone of international trade theory. This method of exchange is considered an optimal allocation of resources, whereby economies, in theory, will no longer be lacking anything that they need. Like opportunity cost, specialization and comparative advantage also apply to the way in which individuals interact within an economy.

Absolute Advantage Sometimes a country or an individual can produce more than another country, even though countries both have the same amount of inputs. For example, Country A may have a technological advantage that, with the same amount of inputs (arable land, steel, labour), enables the country to manufacture more of both cars and cotton than Country B. A country that can produce more of both goods is said to have an absolute advantage. Better quality resources can give a country an absolute advantage as can a higher level of education and overall technological advancement. It is not possible, however, for a country to have a comparative advantage in everything that it produces, so it will always be able to benefit from trade. Transfers are gifts or payments which are not in return for any economic activity. In case of India, transfers comprise primarily remittances from Indians working overseas. Net factor income means income paid to Indians from overseas sources which can be earnings on investment i.e. income (rent, profits, dividends), royalties and interest. On the debit side, it will be similar types of income that foreigners get from India. Balance of Payments (BoP) Balance of payments (BoP) is a summary statement in which all the transactions of the residents of a nation with the residents of all other nations are recorded during a particular period of time, typically a calendar year. Thus, BoP is a much wider term in its coverage as compared to balance of trade. An important purpose of measuring the balance of payments is to inform the government regarding the international position of the nation and to help it in its formulation of monetary, fiscal and trade policies. International transactions are classified as credits or debits. Credit transactions involve the receipt of payments from foreigners and are entered with a positive sign in the BoP statement. The export of goods and services, unilateral transfers from foreigners and capital inflows are credits as they involve the receipt of payments from foreigners. On the other hand, debit transactions involve the making of payments to foreigners and entered with a negative sign. Import of goods and services, unilateral transfers to foreigners and capital outflows are debits as they involve payments to foreigners.

Classification of BoP Accounts Current Account The Current Account records the transactions in merchandise and invisibles with the rest of the world. Merchandise covers exports and imports of all movable goods, where the ownership of goods changes from residents to non-residents and vice versa. Invisibles, as stated earlier, has three components: trade in services, transfer payments and factor incomes. Thus, Current Account captures the effect of trade link between the economy and rest of the world.

The current account of a country is in surplus if receipts from exports of goods and services and from transfers and factor incomes exceed payments on account of imports of goods and services, transfers and factor incomes, the country is said to have a current account surplus. On the other hand, if payments on this account exceed receipts from trade in goods and services and transfer payments, the country is said to have a current account deficit. Capital Account The capital account records purchases and sales of assets, such as stocks, bonds and land. In other words, the capital account shows all the inflows and outflows of capital. Capital account transactions reflect net change in the national ownership of assets. For example, when foreign investors acquire shares listed in India from Indian shareholders, it results in a change in the ownership of those shares by the Indian nationals. This represents a capital account transaction. Capital account tracks the movement of funds for investments and loans into and out of a country. Some of the components of capital account are foreign direct investment (FDI), foreign portfolio investment (FPI) and external commercial borrowing (ECB).

Note that a country may incur a deficit of a surplus in both (i) the current account transactions and (ii) capital account transactions. The overall Balance of Payments for a country in a given year is the sum of the surplus/ deficits of current and capital accounts. A surplus in one account can offset the deficit in the other. Foreign Direct Investment (FDI) The International Monetary Fund (IMF) defines FDI as an investment made to acquire lasting interest in enterprises operating outside of the economy of the investor. In other words, FDI comprises activities that are controlled and organized by firms (or groups of firms) outside of the nation in which they are headquartered and where their principal decision makers are located. In the context of the manufacturing sector, FDI is conventionally thought of in terms of branch plant or subsidiary company operations that are controlled by parent companies based in another country. The most important characteristic of FDI, which distinguishes it from foreign portfolio investment, is that it is undertaken with the intention of exercising control over an enterprise. FDI can be of two broad types, viz. (a) Greenfield investments and (b) through merger and acquisition activities. Greenfield investment is defined as the establishment of a completely new operation in a foreign country. Greenfield FDI refers to investment projects that entail the establishment of new production facilities such as offices, buildings, plants and factories. In Greenfield Investment, the investor uses the capital flows to purchase fixed assets, materials, goods and services, and to hire workers for production in the host country. Greenfield FDI thus directly adds to production capacity in the host country and, other things remaining the same, contributes to capital formation and employment generation in the host country. Secondly, FDI can also be through Merger and Acquisitions with existing firms in the destination country (FDI through M&A). Such cross-border M&As involve the partial or full takeover or the merging of capital, assets and liabilities of existing enterprises in a country by a firm from other countries. The target company that is being sold and acquired is affected by a change in owners of the company. There is no immediate augmentation or reduction in the amount of capital invested in the target enterprise at the time of the acquisition. If for example, an Indian company is acquired by an US company, capital would flow into India from the USA to the owners of the company, but not to the company itself. So, there is no immediate addition to the productive capacity.

However, there can be efficiency gains in the medium term through transfer of technology, better management, better market access etc. Foreign Portfolio Investment (FPI) Foreigners investment in a countrys capital market is known as foreign portfolio investment. The basic difference between FDI and FPI is that in case of FDI, the investor acquires lasting interest in the company where it has invested. But in case of FPI, the investor does not have any managerial representation in the board of directors of the company. In other words, foreign direct investors have the management of the firms under their control; but this is not the case for foreign portfolio investors. Registered foreign investors are called as the Foreign Institutional Investors (FIIs). Along with FIIs, Non-Resident Indians (NRIs) are also eligible to purchase shares and convertible debentures under the Portfolio Investment Scheme. FIIs include Asset Management Companies, Pension Funds, Mutual Funds, Investment Trusts as Nominee Companies, Incorporated/Institutional Portfolio Managers or their Power of Attorney holders, University Funds, Endowment Foundations, Charitable Trusts and Charitable Societies. FIIs are also allowed to invest on behalf of their sub-account. A sub account of an FII is generally the underlying fund on whose behalf the FIIs invests. The following entities are eligible to be registered as sub-accounts, viz. partnership firms, private company, public company, pension fund, investment trust, and individuals. A similar but more complex system is investment by FIIs through the Participatory Notes (PN) route. Participatory notes (PNs) are instruments used by foreign investors not registered with the Indian regulators for taking an exposure in the domestic market. PNs are like contract notes and are issued by FIIs registered in India to their overseas clients who may not be eligible to invest in the Indian stock markets. There have been some controversies about the use of PNs by FIIs. Concerns have been expressed that undesirable elements may have been investing money in India through this route and accordingly certain restrictions have been imposed. Indian companies are also allowed to raise equity capital in the international market through the Global Depository Receipt (GDR) and American Depository Receipt (ADR) route. Let us understand how this works. To raise capital through public issues, a

company has to be listed and traded on various stock exchanges. Thus, companies in India issue shares which are traded on Indian stock exchanges (such as National Stock Exchange). These shares are sometimes also listed and traded on foreign stock exchanges like NYSE (New York Stock Exchange) or NASDAQ (National Association of Securities Dealers Automated Quotation), if the intention to raise capital abroad. But to list on a foreign stock exchange, the company has to comply with the policies of those stock exchanges, which are much more stringent than the policies of the exchanges in India. This is especially so for the exchanges in the USA and Europe. This deters these companies from listing on foreign stock exchanges directly. But many companies get listed on these stock exchanges indirectly using ADRs and GDRs. How does this work? The company deposits a large number of its shares with a bank located in the country where it wants to list indirectly. The bank issues receipts against these shares, each receipt having a fixed number of shares as an underlying (usually 2 or 4). These receipts are then sold to the people of this foreign country. This is how the company raises capital abroad. These receipts are listed on the stock exchanges. They behave exactly like regular stocks and their prices fluctuate depending on their demand and supply, and depending on the fundamentals of the underlying company. These receipts, which are traded like ordinary stocks, are called Depository Receipts. Each receipt amounts to a claim on the predefined number of shares of that company. The issuing bank acts as a depository for these shares that is, it stores the shares on behalf of the receipt holders. Both ADR and GDR are depository receipts, and represent a claim on the underlying shares. The only difference is the location where they are traded. If the depository receipt is traded in the United States of America (USA), it is called an American Depository Receipt, or an ADR. If the depository receipt is traded in a country other than USA, it is called a Global Depository Receipt, or a GDR. This allows retail investors of other countries to invest in shares of Indian companies. Exchange Rate Calculation: If the price of a basket of goods in India is P, the price of the same basket of goods in USA is P*, then the exchange rate e (expressed in terms of INR per dollar), should be determined by the following equation: e.P*= P or e = P/P*

Foreign Exchange Reserves If the overall balance (sum of CA and KA) is positive it means that a country is receiving net positive payments from abroad. The excess foreign exchange that is flowing in the country means that there is an upward pressure on INR. In other words, given the excess supply of foreign exchange in comparison to demand, the INR would tend to appreciate. If the RBI does not want INR to appreciate, then it should buy the excess dollars (which are the result of positive overall balance in India) from the foreign exchange market. To keep the value of INR within a narrow band, it is actively intervening in the foreign exchange market and mopping up excess supply of dollars. This has kept the value of INR in check and has allowed RBI to amass huge amount of foreign exchange reserves.

Foreign exchange reserves play a number of important roles for the economy. According to Y.V. Reddy, former governor of Reserve Bank of India, high amount of foreign exchange reserve is necessary for: maintaining confidence in monetary and exchange rate policies, enhancing capacity to intervene in foreign exchange markets, limiting external vulnerability by maintaining foreign currency liquidity to absorb shocks during times of crisis including national disasters or emergencies; providing confidence to the markets especially international credit rating agencies that external obligations can always be met, thus reducing the overall costs at

which foreign exchange resources are available to all the market participants, and incidentally adding to the comfort of the market participants, by demonstrating the backing of domestic currency by external assets. However, amassing huge foreign exchange reserves also creates some other macroeconomic management problems for the economy. In a scenario, when there is a positive capital account balance and if such balance exceeds the foreign exchange requirements to finance the current account deficit, as in the case of India then there is an excess supply of foreign exchange (say dollars) as compared to demand. As a result, the Indian rupee would tend to appreciate. If this happens for a sustained period of time, the Indian exports would lose their competitiveness. To counter this problem, the central bank of the country has the option to check the appreciation of the domestic currency by buying up some foreign currency (say US dollar) in the Indian foreign exchange market. However by doing that, the central bank may lose control over the money supply, because the RBI buys the foreign currency in the market in exchange for Indian rupees. As a result, the supply of Indian rupees (money supply) increases. Sometimes, this increase in money supply may lead to a money supply growth that exceeds the RBIs desired money supply growth. Thus the RBI faces conflicting objectives. If in the situation of excessive capital inflows, it intervenes by purchasing excess dollars, it can maintain the competitiveness of Indian exports, but may lose control over money supply. On the other hand, if in such a situation, it does not intervene, it would have greater control over money supply, but the competitiveness of Indian exports would go down. There are a couple of alternatives to deal with these conflicts. First, the central bank can moderate some of the pressure on the rupee to appreciate by encouraging private investment overseas by Indian businessmen or by allowing foreigners to borrow from the local market. This way the excess supply of dollars can be reduced without any need for RBI intervention. The second alternative is to sterilize the capital inflows, which is elaborated below. Sterilization of Capital Flows During a sustained period of net capital inflow, when the central bank buys foreign exchange from the market in exchange for rupees to keep the nominal exchange rate of

the domestic currency from appreciating, it creates excess supply of rupees (relative to demand) in the market. Subsequently, the central bank mops up the excess supply of rupees by selling government securities in open market operations. When the central bank sells government bonds in the market, it implies that economic agents (like commercial banks, financial institutions, retail investors etc.) are buying these papers by paying money to RBI from the existing supply of money. This reduces money supply in the economy. This whole exercise of mopping up excess supply of rupees from the market is called sterilization of capital flows. Sterilization can keep the growth in money supply under control, thereby avoiding the undesirable expansionary effects on money supply of capital inflows. Intervention in the foreign exchange market followed by sterilization allows the monetary authority (RBI) to build foreign exchange reserves (that will help to withstand future shocks, and provide comfort and confidence to market participants), while keeping the money supply growth under control. However, there are some problems with sterilization. In a theoretical world with completely free capital flows, sterilization is self defeating. In theory, capital is attracted to a country A, if the risk adjusted rate of interest in country A is higher than the same in the home country of the capital. If a central bank sterilizes the capital flow by selling securities, it will have to offer attractive interest rates for those papers to attract buyers. This will push up the rate of interest in country A and it will attract more capital inflow. Therefore, the sterilization process will exacerbate the problem of excess liquidity that it tried to tackle. However, in a practical world, capital inflows depend on a host of other factors apart from risk-adjusted rate of interest. Therefore, in real life, many central banks of the world, including RBI, have partially managed to sterilize the effects of excessive capital inflow. The second problem is more pertinent. There are certain fiscal costs associated with sterilization. This is because during sterilization, the central bank is essentially selling government securities to mop up excess liquidity. The government would have to pay interest to those who come to acquire government securities due to the sterilization process. This is called the fiscal cost of sterilization. According to RBI estimates, the interest cost of sterilization to the Government and the RBI in 2005-06 is reported to be in the broad range of Rs. 4,000 crores.

ECONOMIC INDICATORS An Economic indicator is a statistic about an economic activity. Economic indicators allow analysis of economic performance and predictions of future performance. One application of economic indicators is the study of business cycles. Economic indicators include various indices, earnings reports, and economic summaries. Classification of Indicators A) By Timing Economic indicators can be classified into three categories according to their usual timing in relation to the business cycle: leading indicators, lagging indicators, and coincident indicators. Leading Indicators Leading indicators are indicators that usually change before the economy as a whole changes. They are therefore useful as short-term predictors of the economy. Stock market returns are a leading indicator: the stock market usually begins to decline before the economy as a whole declines and usually begins to improve before the general economy begins to recover from a slump. Other leading indicators include the index of consumer expectations, building permits, and the money supply. List of Leading Indicators for Indian Economy: The following is an exhaustive list of likely candidates for series which can be considered as leading indicators of the Indian economy: Trends in Gross Domestic Product (GDP): Contribution of Agriculture, Industry and Services Purchasing Power Parity (PPP) Index Fiscal Deficit Trends in Inflation Rate Interest Rates Credit Off-take Balance of Payment

Foreign Exchange Reserves Crude Oil Rates Foreign Direct Investment (FDI) and Foreign Institutional Investment (FII) Trends Rain fall Index Sensex Exchange Rate Savings/GDP Ratio Human Development Index Electric Power Generation

Lagging Indicators Lagging indicators are indicators that usually change after the economy as a whole does. Typically the lag is a few quarters of a year. The unemployment rate is a lagging indicator: employment tends to increase two or three quarters after an upturn in the general economy. Coincident Indicators Coincident indicators change at approximately the same time as the whole economy, thereby providing information about the current state of the economy. There are many coincident economic indicators, such as Gross Domestic Product, industrial production, personal income and retail sales. A coincident index may be used to identify, after the fact, the dates of peaks and troughs in the business cycle. Generally used indicators are GDP, IIP, WPI & CPI Inflation, Interest Rates and Exchange Rates. B) By Direction There are also three terms that describe an economic indicator's direction relative to the direction of the general economy:

Procyclical indicators They move in the same direction as the general economy: they increase when the economy is doing well; decrease when it is doing badly. Gross domestic product (GDP) is a procyclic indicator. Countercyclical indicators They move in the opposite direction to the general economy. The unemployment rate is countercyclic - it rises when the economy is deteriorating. Acyclical indicators These are those with little or no correlation to the business cycle - they may rise or fall when the general economy is doing well, and may rise or fall when it is not doing well.

Also read budget 2013-14

Factors affecting Rupee Movement As we know that Forex market for Indian currency is highly volatile where one cannot forecast exchange rate easily, there is a mechanism which works behind the determination of exchange rate. One of the most important factors, which affect exchange rate, is demand and supply of domestic and foreign currency. There are some other factors also, which are having major impact on the exchange rate determination. After studying research reports on relationship between Rupee and Dollar of last four years we identified some factors, which have been segregated under four heads. These are: 1. Market Situations 2. Economic Factors 3. Other Factors Market Situations: 1) Importing Petroleum In India, there are big Public Sectors Units (PSUs) like ONGC, GAIL; IOC etc. all the foreign related transactions of these PSUs are settled through the State Bank of India. E.g. India is importing Petroleum from the other countries so payment is made through State Bank of India in the foreign currency. When State Bank of India (SBI) sells and buys the foreign currency then there will be noticeable movement in the rupee. If the SBI is going for purchasing the Dollar then Rupee will be depreciated against Dollar and vice versa. (90% of the Forex market is between the inter-bank transactions)

2) FII Inflows and Outflows Foreign Institutional Investors (FIIs) inflow and outf low of the currency is having the major impact on the currency. E.g. U.S. based company is investing their money through the Stock markets BSE or NSE so her inflows of the Dollars is increasing and when it is selling out their investments through these Stock markets then outflows of the Dollars are increasing. However if the FIIs inflowing the capital in the country then there will be the supply of the foreign currency increases and Demand for the Rupee will increases and that will resulted appreciation in the rupee and vice versa.

3) Transactions of Importers and Exporters Importer and Exporters trading is also affecting to the rupee. Like if an Indian exported material to U.S. so he will get his payments in Dollars and that will increase the supply of Dollars and increase of demand of rupee and that will appreciate the rupee and vice versa.

4) Managed Float system As we know that in India there is a floating rate system. In India Central Bank (RBI) is always intervene in the trade for smoothen the market. And this RBI can achieve by selling foreign exchange and buying domestic currency. Thus, demand for domestic currency which, coupled with supply of foreign exchange, will maintain the price foreign currency at the desired level. Interventions can be defined as buying or selling of foreign currency by the central bank of a country with a view to maintaining the price of a given currency against another currency. US Dollar is the currency of intervention in India. Economic Factors: Internal Factors 1) Inflation Over short-term foreign investors see inflation as a temporary problem and still invest in the domestic economy but if inflation becomes a prolonged one, it leads to overall worsening of economic prospects and capital outflows and eventual depreciation of the currency.

Purchasing Power Parity Theory

PPP -> Purchasing Power Rate Rh -> Rate of inflation in Home country

Rf -> Rate of Inflation in foreign country Example:

2) Interest Rate Differentials

Interest Rate Parity Theory

If -> Interest rate in foreign country Ih -> Interest Rate in home country Example:

3) Current Account Deficit (CAD)

Increase in imports without proportionate increase in exports has been leading to the increase in CAD. Increase in imports is mainly due to increase in demand for gold and oil.

Effects of CAD are: Currency Depreciation Inflation Reduction of Credit Rating affecting foreign investment (leading to outflow of currency) Steps taken by the Government to Curb CAD Decreasing imports. Levying higher taxes and import duties to discourage gold imports was one such step. Controlling and suppressing demand by tightening monetary policy.

Promoting foreign investments to participate in productive activity of the country. The recent impetus on Foreign Direct Investments (FDIs) in various sectors is to this effect.

Increasing growth by taking steps giving economic stimulus. Promoting national savings to fund investment. Schemes like the Rajiv Gandhi Equity Savings Scheme (RGESS) and the recently implemented Inflation Indexed Bonds (IIBs) are some such steps by the govt. to encourage savings and wean away investors from gold thus reducing burden of gold imports.

Increasing exports from the country. Non-resident Indian remittances to home country.

4) Weak GDP growth Tightening monetary measures and a weak global economic outlook has had an impact on Indias growth. External Factors 1) Global Economic Situation Recovering of US economy (which is indicated by increase in no. of jobs and changing monetary policy of the FED FED will reduce the QE stimulus) as well as a weak economic outlook in the EURO region has lead to rise in dollars value.

2) International Crude Oil Prices A war-like situation in Middle-east (US putting pressure on Iran) as well instability in Egypt has lead to an increase in Crude Oil Prices internationally. Other Factors 1) Bureaucracy Slow-decision making, red-tapes, vague policies etc has been impacting the countrys growth thus indirectly impacting the currency movement.

2) Political Instability It can lead to possibility of delayed implementation of policies thus again impacting the countrys growth

3) Emergency situations like WAR with neighbouring countries. Examples: In the year 1998, when Government of India did Pokhran Nuclear Test at that time rupee has been depreciated around 85 paise in day and 125 paise in seven days. Her main fear was that U.S., Australia and other countries have stop to sanctions the loans. So this type of event will have major impact on the market. And due to this the decision procedure of the trader also varies. In the year 2000, India has faced Kargil war, which is also affected to the market. By this war the defense expenditures are raised and due to that there will be increase in the fiscal deficit. And become obstacle in the growth of the economy. So this type of event has impact on the Forex market. IMPACT of RUPEE Depreciation Positive Effects for: NRIs, Exporters

Negative Effects for: Importers, Foreign Currency borrowers Foreign Travel Foreign Education+

What is the difference between the current account convertibility and capital account convertibility? Currency convertibility means the freedom to convert one currency into other internationally accepted currencies, wherein the exporters and importers where allowed a free conversion of rupee. But still none was allowed to purchase any assets abroad. Capital Account Convertibility means that rupee can now be freely convertible into any foreign currencies for acquisition of assets like shares, properties and assets abroad. Further, the banks can accept deposits in any currency.

So if a foreigner buys a building in India, and after 5 yrs its selling price rises so sells it at five times the cost he collected, now he has rupees in hand, can he easily convert these rupees into say 'yen' easily? Considering that exchange rate is better in terms of INR-JPY, the foreigner would want to convert the currency into yen and this can be done if complete capital a/c convertibility takes place. Remittance to foreign countries from India is restricted by RBI. For import of machines you are remitting abroad means it is capital account convertibility. If you remit money to your son or relative living abroad means current account convertibility. For India: The govt has allowed De-Jure (by law) Current Account Convertibility but not De-Facto (in reality) convertibility. What it means is that current account convertibility is only in the name. While there are no limits placed on current account convertibility for import and export purposes, there are logical limits imposed on convertibility for other reasons like personal travel, business travel, medical treatment, Studies, Maintenance, etc. Convertibility on Capital Account, also called full float of rupee, is still far way off. Even though Tarapore Committee had recommended Capital Account Convertibility, Govt and RBI are treading a cautious approach. The repercussions of Capital Account Convertibility can be disastrous if things go wrong. The world learnt it through East Asian Economic Crisis in 1997. Booming Economies suddenly collapsed in a matter of days. Once Capital Account convertibility is allowed, everyone is allowed a free hand to invest in and dis-invest from the country as much as and whenever he wants. At the first sign of trouble, investors rush to dis-invest and the cascading effect on economy is crippling. Currently, there are caps on how much one can invest abroad or how much can a foreign company invest in which company/sector. In addition, before investing, companies have to register themselves. There are caps on ECB as well.

South East Asian Financial Crisis (1997): (a) Countries had adopted complete convertibility on Current as well as Capital account. This made flight of capital very easy. There was no way to control outward flight of capital at the time of crisis. (b) They adopted Fixed Peg system against dollar. There was massive influx of foreign currency through hot investments, foreign currency loans by banks, etc. This money was invested in assets like real estate and stocks. There was massive rise in asset prices and an asset bubble was created. (c) There was massive current account deficit. Imports far exceeded exports. (d) High inflation rates due to increased money supply. Inflation was not reflected in exchange rate; firstly, due to Fixed Peg system and secondly, due to govts reluctance to revise the rate downwards which would have affected investors sentiments. Speculators suddenly realized that due to overvalued currencies, it was beneficial to convert local currency into dollars and they went for it hammer and tongs. Due to relatively small size of economies (a few tens of billion dollars each), in three trading sessions, Forex reserves became nil.