Karvy Classroom

Effect of an increase in interest rate on investments
Effect of an increase in inflation on an economy
Effect of an increase in money supply on an economy
Effect of an increase in fiscal deficit on an economy
Effect of changes in Cash Reserve Ratio (CRR) & statutory liquidity ratio (SLR) on an economy
Effect of an increase in current account deficit on an economy?
Effect of fiscal policy on an economy
Role does monetary policy in an economy
Relationship between fiscal & monetary policy
Reason for currency fluctuations
Depreciation of a currency : good or bad
Importance of money market in an economy
Difference between real & nominal GDP
Inflation targeting & interest rate targeting?

Interest rates & investments

Interest rates & the bond prices are inversely related to each other. When interest rates move up, it causes the bond prices to fall & vice – versa. Say for example, you have a bond, which is yielding 10% now. Suddenly, the interest rates in the economy move up to 11%. Now your bond is giving fewer yields than the market return. Obviously it price is going to fall in such a case. Reverse is the case when interest rates fall, the bond price will move up because it is giving more returns than the market return. So movements in interest rates have serious implications for individual investments.

Inflation and economy

• Inflation effects the economy on three sides. One, it is directly linked to interest rates. The interest rates prevailing in an economy at any point of time are nominal interest rates, i.e., real interest rates plus a premium for expected inflation. Due to inflation, there is a decrease in purchasing power of every rupee earned on account of interest in the future, therefore the interest rates must include a premium for expected inflation. In the long run, other things being equal, interest rates rise one for one with rise in inflation.
  
  Two, it effects the exchange rate. The exchange rates between the currencies of two countries depend upon the level of inflation prevailing in the two countries. According to Purchasing Power Parity principle, the change in the value of one currency vis – a – vis another, is approximately equal to the inflation differential of the two countries. So the inflation levels provide an indication of the movement of currencies against each other.
  
  Three, there is also an inverse inflation between inflation & economic growth. Other things being equal, economic growth is equal to the difference between money supply growth & inflation.

Money supply and the economy

• Money supply also effects the economy on three sides. One, money supply is used to control the inflation in an economy. On the demand side, whenever money supply in the economy increases, consumer-spending increases immediately in the economy because of increased money in the system. But supply can’t vary in the short – term, so there is a temporary mismatch of demand & supply in the economy which exerts an upward pressure on inflation. This argument assumes that demand drives supply, which is generally the case. On the supply side, due to an increase in demand, supply can only be increased by capacity additions. This causes the cost of production to rise & that is reflected in inflation.
  
  Two, money supply also has a direct relationship with the growth of an economy. Until an economy reaches full – employment level, the economy growth is the difference between money supply growth rate & the inflation, other things being equal. When an economy reaches full employment level, the growth in money supply is set off by a growth in inflation, other things being equal. This happens because output can’t rise after full employment & therefore inflation increases one for one with the money supply.
  
  Three, money supply also has a relationship with interest rates. One variable can be used to control the other. Both can’t be controlled simultaneously. If the RBI wants to peg the interest rate at a certain level, it has to supply whatever money is demanded at that level of interest rate. If it wants to fix the money supply at a certain level, the demand & supply of money will determine the interest rates. Usually it is easier for RBI to control the interest rates through its open market operations (OMO). So, the money supply is allowed to vary but RBI controls it by playing around with interest rates through its OMO.

Fiscal deficit and economy

• Fiscal deficit is difference between the receipts & expenditure of the government. An increase in fiscal deficit means that the government is not able to meet its expenditure out of its receipts. Primarily, it has to go to RBI to get the money required. RBI can either issue new notes, which will increase the money supply in the system (the vices of increase in money supply have been discussed above) or it can raise the required amount from the market by issuing new T – bills & G – secs. Issuing these intruments will suck out the liquidity from the system & it will put unnecessary pressure on the interest rates. So, on both counts, the increase in fiscal deficit causes the interest rates to rise in an economy. Also, it will crowd out the private investment from the economy.

Cash Reserve Ratio (CRR) & statutory liquidity ratio (SLR) and an economy

• CRR is the percentage of its total deposits a bank has to keep with RBI in cash or near cash assets & SLR is the percentage of its total deposits a bank has to keep in approved securities. The purpose of CRR & SLR is to keep a bank liquid at any point of time. When banks have to keep low CRR or SLR, it increases the money available for credit in the system. This eases the pressure on interest rates & interest rates move down. Also when money is available & that too at lower interest rates, it is given on credit to the industrial sector which pushes the economic growth.

Current account deficit and economy

• Current account balance is the difference between exports & imports of the country, added to it is net earnings from invisibles. When a country is running a current account deficit, it implies that the domestic savings are sufficient enough to fund domestic investment. The deficit has to come from capital account surplus, i.e., more foreign capital inflows. This trend makes an economy vulnerable to a crisis, if the foreign investment is of short – term in nature because it can be taken away at any point of time & can have a run on a country’s currency. The South East Asian crisis is a classic example of this.

Fiscal policy and economy

• Fiscal policy is an instrument in the hands of government for reallocation of resources according to nation’s priority, redistribution, promotion of private savings & investments & the maintenance of stability. An expansionary fiscal policy means more investment spending on part of government. This increases the interest rates in the economy because government resort to borrowings to finance the expenditure. When interest rates rise, they cause private investment to fall. This phenomenon is called "Crowding out of private investment". A contractionary fiscal policy means less expenditure by government, which hampers the economic growth of a country. So the government has to strike a balance between growth prospects & crowding out.

Monetary policy and economy

• It refers to a regulatory policy whereby the monetary authority of a country maintains its control over the money supply for the realization of general economic objectives. It involves manipulation of money supply, the level & structure of interest rates & other conditions effecting the level of credit. The central bank signals the market about the availability of credit & interest rates through this policy. The RBI fixes the bank rate in this policy which forms the basis of the structure of interest rates & the CRR & SLR, which determines the availability of credit & the level of money supply in the economy. So it plays a very important role in the development of a economy.

Relationship between fiscal & monetary policy

• Both the policies are so interdependent on each other that fiscal policies pursued by the government determine the general directions of monetary policy, & depending upon the monetary control exercised in the monetary policy, the fiscal policies have to be devised. In Indian economy, the monetary policy is brought into play only to correct the adverse effects of fiscal policy. The RBI has no say in determining the level of deficit financing of central government. When deficit financing increases, the RBI has to resort to tight monetary policy to curb the rise in liquidity & inflationary conditions in the country. So the CRR & SLR is raised. Its only recently, when there was so much of debate going on to make RBI more autonomous, that the RBI has got some say in deficit financing. That’s why we are witnessing cuts in CRR. So both the policies have to work in tandem to realize the economic objectives.

Currency fluctuations

• Currency mainly fluctuates because of three reasons. First is inflation. Theoretically, the rate of change in exchange rate is equal to the difference in inflation rates prevailing in the 2 countries. So, whenever, inflation in one country moves, say increases relative to other country, its currency falls down. Two, when the current account balance of country is running in deficit. This means that the importers of the country will demand more of foreign currency to pay for their imports. The demand supply mismatch will cause the currency to fall. Third is speculation. When big players speculate in a particular currency, the currency moves accordingly.

Depreciation of a currency : good or bad

• Depreciation of a currency effects an economy in two ways, which are in a way counter to each other. On the one hand, it makes the exports of a country more competitive, thereby increasing them. On the other hand, it decreases the value of a currency relative to other currencies, thereby decreasing the importance of that currency. So, the policy makers have to strike a balance between the two.

Importance of money market in an economy

• Money market forms the basis of term structure of interest rates. Money market includes call money market, market for sovereign securities & other instruments of short – term nature like commercial paper. The interest rates follow a general principle, as the term to maturity increases, the interest rates also increases because current consumption is always preferred to future consumption. So one has to pay premium for longer maturity. The call money market forms the basis for short – term interest rates. Any institution who wants to lend overnight can place its funds in this market. The rates for sovereign securities are slightly above call rates because their term to maturity is high. Like that, the interest rates are determined according to the interaction of demand of & supply for funds according to their maturity. Money market forms the basis for the yield curve.

Difference between real & nominal GDP

• Nominal GDP measures the value of output in a particular period at the prices of that period or in current rupees.  Nominal GDP changes from year to year because of two reasons.  One, there is a change in the physical output of goods & services & two, the market prices of goods & services produced also change.  Real GDP measures the changes in physical output in the economy between different time periods by valuing all goods produced in the two periods at some base year's prices, or in constant rupees.  It means that the today's output of goods & services will be multiplied by base year's prices to get the real GDP of current period.  In other words, real GDP is nothing but nominal GDP adjusted for inflation.

Inflation targeting & interest rate targeting

• A sustained increase in money supply in the economy will, in the long run, lead to an equal increase in the inflation & in the short run, it will lead to a decrease in interest rates, but in the long run, the real interest rates will come down to the same level because of an equal increase in inflation.  So there is always a trade off that the monetary authority of a country has to make between the two things.  If it allows money supply to grow to keep interest rates down, it is called interest rate targeting & if it keeps money supply in check to keep inflation under control, it is called inflation targeting.  The RBI, right now, is targeting inflation because if it is able to keep inflation in check, the interest rates will be automatically come in check as the nominal interest rate is equal to real interest plus inflation & real interest rates remain constant in the long run.  Interest rates change because of changes in inflation.