BASICS OF ECONOMY

KT SESSION
ECONOMY…

. . . The word economy comes from a

Greek word for “one who manages a
household.”
SCARCITY…

. . . means that society has limited

resources and therefore cannot
produce all the goods and services
people wish to have.
ECONOMISTS STUDY…

How people make decisions.

How people interact with each other.

The forces and trends that affect the economy

as a whole.
Microeconomics and Macroeconomics

 Microeconomics focuses on the individual

parts of the economy.
 How households and firms make decisions and
how they interact in specific markets
 Macroeconomics looks at the economy as a
whole.
 How the markets, as a whole, interact at the
national level.
Economic Models

 Economists use models to simplify reality in order to

improve our understanding of the world.

 As simplifications of reality, models need assumptions.

Market Types or Structures

• Perfect Markets
• Monopoly
• Monopolistic Competition
• Oligopoly
Demand Curve
Price of
Ice-Cream
Cone
$3.00

2.50

2.00

1.50

1.00

0.50

Quantity of Ice-
0 1 2 3 4 5 6 7 8 9 10 11 12 Cream Cones
Why does the Demand Curve Slope
Downward?

• Law of Demand
– Inverse relationship between price and quantity.
• Law of Diminishing Marginal Utility.
– Utility is the extra satisfaction that one receives
from consuming a product.
– Marginal means extra.
– Diminishing means decreasing.
Market Demand

Market demand refers to the sum of all individual

demands for a particular good or service.

Graphically, individual demand curves are summed

horizontally to obtain the market demand curve.
Two Simple Rules for Movements vs. Shifts

• Rule One
– When an independent variable changes and that
variable does not appear on the graph, the curve
on the graph will shift.
• Rule Two
– When an independent variable changes and does
appear on the graph, a movement along the
existing curve will occur. The curve will not shift.
Change in Quantity Demanded vs
Change in Demand

Change in Quantity Demanded

 Movement along the demand curve.
 Caused by a change in the price of
the product.
Changes in Quantity Demanded
Price of
Cigarettes
per Pack
A tax that raises the
price of cigarettes
C results in a movement
$4.00
along the demand
curve.

2.00 A

D1
0 12 20 Number of Cigarettes Smoked per Day
Change in Quantity Demanded vs
Change in Demand

Change in Demand
 A shiftin the demand curve, either
to the left or right.
 Caused by a change in a
determinant other than the price.
Determinants of Demand

Market price
Consumer income
Prices of related goods
Tastes
Expectations
What are some examples?
Consumer Income
Normal Good
Price of
Ice-Cream
Cone
$3.00 An increase
2.50 in income...
Increase
2.00 in demand

1.50

1.00

0.50 D2
D1
Quantity of Ice-Cream Cones
0 1 2 3 4 5 6 7 8 9 10 11 12
Consumer Income
Inferior Good
Price of
Ice-Cream
Cone
$3.00

2.50 An decrease
2.00
in income...
Decrease
1.50 in demand
1.00

0.50
D2 D1
Quantity of Ice-Cream Cones
0 1 2 3 4 5 6 7 8 9 10 11 12
Supply Curve
Price of
Ice-Cream
Cone
$3.00

2.50

2.00

1.50

1.00

0.50

Quantity of Ice-Cream Cones

0 1 2 3 4 5 6 7 8 9 10 11 12
Law of Supply

The law of supply states that there is a

direct (positive) relationship between
price and quantity supplied.

Quantity supplied is the amount of a

good that sellers are willing and able
to sell.
Change in Quantity Supplied
Price of
Ice-Cream
Cone
S
C
$3.00 A rise in the price
of ice cream cones
results in a
movement along
the supply curve.
A
1.00

Quantity of Ice-Cream Cones

0 1 5
Market Supply

Market supply refers to the sum of all individual

supplies for all sellers of a particular good or service.
Graphically, individual supply curves are summed
horizontally to obtain the market supply curve.
Determinants of Supply

Market price
Input prices
Technology
Expectations
Number of producers
What are some examples?
Change in Supply
Price of S3
Ice-Cream
Cone
S1 S2
Decrease in
Supply

Increase in
Supply

Quantity of Ice-Cream Cones

0
Equilibrium of Supply and Demand
Price of
Ice-Cream
Cone
Supply
$3.00

2.50 Equilibrium

2.00

1.50

1.00

0.50 Demand
Quantity of Ice-Cream Cones
0 1 2 3 4 5 6 7 8 9 10 11 12
Excess Supply
Price of
Ice-Cream
Cone
Supply
$3.00 Surplus

2.50

2.00

1.50

1.00

0.50 Demand
Quantity of Ice-Cream Cones
0 1 2 3 4 5 6 7 8 9 10 11 12
Excess Demand

Price of
Ice-Cream
Cone

Supply

$2.00
$1.50

Shortage Demand

0 1 2 3 4 5 6 7 8 9 10 11 12 13 Quantity of
Ice-Cream Cones
Three Steps To Analyzing Changes in
Equilibrium

Decide whether the event shifts the supply or

demand curve (or both).
Decide whether the curve(s) shift(s) to the left
or to the right.
Examine how the shift affects equilibrium
price and quantity.
How an Increase in Demand Affects the
Equilibrium
Price of 1. Hot weather increases
Ice-Cream the demand for ice cream...
Cone

Supply

$2.50 New equilibrium

2.00
2. ...resulting Initial
in a higher equilibrium
price...
D2

D1
0 7 10 Quantity of
3. ...and a higher Ice-Cream Cones
quantity sold.
How a Decrease in Supply Affects the
Equilibrium
Price of
Ice-Cream 1. An earthquake reduces
Cone the supply of ice cream...
S2
S1

New
$2.50 equilibrium

2.00 Initial equilibrium

2. ...resulting
in a higher
price...
Demand

0 1 2 3 4 7 8 9 10 11 12 13 Quantity of
3. ...and a lower Ice-Cream Cones
quantity sold.
Prices of Related Goods
Substitutes & Complements

When a fall in the price of one good reduces the

demand for another good, the two goods are called
substitutes.
When a fall in the price of one good increases the
demand for another good, the two goods are called
complements.
Gross Domestic Product

 Grossdomestic product (GDP) is a measure of the

income and expenditures of an economy.

 Itis the total market value of all final goods and services
produced within a country in a given period of time.

 How much is the current GDP?

The Measurement of GDP

GDP is:
the market value

of all final goods and services

produced within a country

in a given period of time.

The Circular-Flow Diagram
Revenue Spending
Market for
Goods
Goods & Goods &
Services sold and Services
Services
bought

Firms Households

Inputs for Labor, land,

production Market for and capital
Factors
Wages, rent, of Production Income
and profit
What Is Counted and Not Counted in GDP?

GDP includes all items produced in the economy and sold legally
in markets.
GDP excludes services that are produced and consumed at home
and that never enter the marketplace.
Caring labor, the work that is normally produced by women.

Because GDP does not count it, it diminishes its importance.

GDP also excludes black market items, such as illegal drugs.

Other Measures of Income

 Gross National Product (GNP)

 Net National Product (NNP)

 National Income

 Personal Income

 Disposable Personal Income

The Components of GDP

GDP (Y ) is the sum of the following:

 Consumption (C)
 Investment (I)
 Government Purchases (G)
 Net Exports (NX)

Y = C + I + G + NX
Measuring Economic Growth

We use real GDP to calculate the economic growth rate.

The economic growth rate is the percentage change in the
quantity of goods and services produced from one year to
the next.
We measure economic growth so we can make:
 Economic welfare comparisons
 International welfare comparisons
 Business cycle forecasts
Real versus Nominal GDP

 NominalGDP values the production of

goods and services at current prices.

 Real
GDP values the production of
goods and services at constant prices.
Real GDP and the Price Level

 We use the GDP Deflator to take the air out of Nominal GDP.
The Consumer Price Index

 The consumer price index (CPI) is a measure of the

overall cost of the goods and services bought by a typical
consumer.
 It is used to monitor changes in the cost of living over
time.
The CPI is an accurate measure of the
selected goods that make up the typical
bundle, but it is not a perfect measure
of the cost of living.
The Inflation Rate

The inflation rate is calculated as follows:

CPI in Year 2 - CPI in Year 1

Inflation Rate in Year2   100
CPI in Year 1
GDP Deflator

The GDP deflator is calculated as follows:

Nominal GDP
GDP deflator =  100
Real GDP
Real and Nominal Interest Rates

 The nominal interest rate is the interest rate not corrected

for inflation.
 It is the interest rate that a bank pays.
 The real interest rate is the nominal interest rate that is
corrected for inflation.

Real interest rate = (Nominal interest rate – Inflation rate)

Investment from Abroad

Investment from abroad takes several forms:

Foreign Direct Investment
 Capital investment owned and operated by a foreign entity.

Foreign Portfolio Investment

 Investments financed with foreign money operated by
domestic residents or foreign investors
Three Functions of Money

Money has three functions in

the economy:
 Medium of exchange
 Unit of account

 Store of value
Money in the Indian Economy

 Currency is the paper bills and coins in the hands

of the public.
 Demand deposits are balances in bank accounts
that depositors can access on demand by writing a
check.
Reserve Bank Of India (RBI)

 The Reserve Bank Of India (RBI) serves as the

nation’s central bank.
It is designed to oversee the banking system.

It regulates the quantity of money in the economy.

Three Primary Functions RBI

 Regulates banks to ensure they follow laws intended to

promote safe and sound banking practices.
 Acts as a banker’s bank, making loans to banks and as
a lender of last resort.
 Conducts monetary policy by controlling the money
supply.
RBI’s Tools of Monetary Control

RBI has three tools in its monetary toolbox:

Open-market operations
Changing the reserve requirement

Changing the discount rate

Banks and The Money Supply

 Reserves are deposits that banks have received but have not
loaned out.
 In a fractional reserve banking system, banks hold a fraction
of the money deposited as reserves and lend out the rest.
 When a bank makes a loan from its reserves, the money
supply increases
Money Creation

 The money supply is affected by the amount deposited in

banks and the amount that banks loan.
Deposits into a bank are recorded as both assets and
liabilities.
The fraction of total deposits that a bank has to keep as
reserves is called the reserve ratio.
Loans become an asset to the bank.
The Money Multiplier

The money multiplier is the reciprocal of the reserve

ratio:
M = 1/R

With a reserve requirement, R = 20% or 1/5,

The multiplier is 5.
Money Supply, Money Demand, and
Monetary Equilibrium

 Themoney supply is a policy variable that is

controlled by RBI.
 Through instruments such as open-market operations, the
RBI directly controls the quantity of money supplied.
Money Supply, Money Demand, and
Monetary Equilibrium

Money demand has several determinants,

including interest rates and the average level of
prices in the economy.
Money Supply, Money Demand, and
Monetary Equilibrium

In the long run, the overall level of prices adjusts to the

level at which the demand for money equals the supply.
Money Supply, Money Demand, and
the Equilibrium Price Level

Value of Price
Money (1/P) Money supply
Level (P)
(High) 1 1 (Low)

3/4 1.33
value of money

price level
Equilibrium
1/2 2
Equilibrium

1/4 4
Money
demand
(Low) 0 (High)
Quantity fixed Quantity of
by the Fed Money
The Effects of Monetary Injection

Value of Price
Money (1/P) MS1 MS2
Level (P)
(High) 1 1. An increase 1 (Low)
in the money
supply...
3/4 1.33

A
1/2 2

B
1/4 4
Money
demand
(Low) 0 (High)
M1 M2 Quantity of
Money
Velocity and the Quantity Equation

The velocity of money refers to the speed at

which the typical dollar bill travels around
the economy from wallet to wallet.
Velocity and the Quantity Equation

V = (P x Y)/M
Where: V = velocity
P = the price level
Y = the quantity of output
M = the quantity of money
Velocity and the Quantity Equation

 Thequantity equation shows that an increase in the

quantity of money in an economy must be reflected in
one of three other variables:
 the price level must rise,
 the quantity of output must rise, or

 the velocity of money must fall.

Nominal Exchange Rates

 The nominal exchange rate is the rate at which a

person can trade the currency of one country for
the currency of another.
Nominal Exchange Rates

If a dollar buys more foreign currency, there is an

appreciation of the dollar.
If it buys less there is a depreciation of the dollar.
How Do Changes in Exchange Rates
Affect People?

 Businesses  Tourists
 Appreciation of the  Appreciation of the
INR will hurt Indian INR will help Indian
tourists by increasing
exports and thus
their purchasing
Indian business. power.
 Depreciation of the  Depreciation of the
INR will help Indian INR will hurt Indian
exports and thus tourists by decreasing
Indian businesses. their purchasing
power.
Aggregate Demand

 Many factors influence aggregate demand besides monetary and

fiscal policy.
 In particular, desired spending by households and business
firms determines the overall demand for goods and services.
 When desired spending changes, AD shifts.
 Monetary and Fiscal policy are used to offset those shifts in AD.
How Monetary Policy Influences
Aggregate Demand

For the Indian economy, the most important reason

for the downward slope of the aggregate-demand
curve is the interest-rate effect.
Money Demand

 Theopportunity cost of holding money is the interest that

could be earned on interest-earning assets.

 An increase in the interest rate raises the opportunity cost

of holding money.

 As a result, the quantity of money demanded is reduced.

Equilibrium in the Money Market

 According to the theory of liquidity preference:

 The interest rate adjusts to balance the supply and demand
for money.
 There is one interest rate, called the equilibrium interest rate,
at which the quantity of money demanded equals the quantity
of money supplied.
 The price level is stuck at some level.
Equilibrium in the Money Market...

Interest
Rate
Money
supply

r1
Equilibrium
interest rate

r2
Money
demand

0 M 1d Quantity fixed M 2d Quantity of

by the Fed Money
Changes in the Money Supply

 The RBI can shift the aggregate demand curve when it

changes monetary policy.
 An increase in the money supply shifts the money supply
curve to the right.
 Without a change in the money demand curve, the interest
rate falls.
 Falling interest rates increase the quantity of goods and
services demanded.
A Monetary Injection...
(a) The Money Market (b) The Aggregate-Demand Curve

Interest Money MS2 Price 3. …which

Rate supply, Level increases the
MS1 quantity of goods
1. When and services
the RBI demanded at a
increases
the money given price level.
supply… P
r1

r2 AD2

Aggregate
demand, AD1
0 Quantity 0 Y1 Y2 Quantity
2. …the equilibrium of Money of Output
interest rate falls…
Changes in the Money Supply

 When RBI increases the money supply, it lowers the interest

rate and increases the quantity of goods and services demanded
at any given price level, shifting aggregate-demand to the right.

 When RBI contracts the money supply, it raises the interest

rate and reduces the quantity of goods and services demanded
at any given price level, shifting aggregate-demand to the left.
How Fiscal Policy Influences
Aggregate Demand

Fiscal policy refers to the government’s choices regarding the overall

level of government purchases or taxes.
Fiscal policy influences saving, investment, and growth in the long
run.
In the short run, fiscal policy primarily affects the aggregate demand.
Fiscal policy can be used to alter government purchases or to change
taxes.
Changes in Government Purchases

There are two macroeconomic effects

from the change in government
purchases:
The multiplier effect
The crowding-out effect
The Multiplier Effect

 Government purchases are said to have a multiplier

effect on aggregate demand.
 Each rupee spent by the government can raise the
aggregate demand for goods and services by more than
a rupee.
The Multiplier Effect...
Price
Level 2. …but the multiplier effect can amplify
the shift in aggregate demand.

$20 billion

AD3
1. An increase in government
AD2
purchases of $20 billion
initially increases aggregate Aggregate demand, AD1
demand by $20 billion…
0 Quantity
of Output
A Formula for the Spending Multiplier

 The formula for the multiplier is:

Multiplier = 1/(1 - MPC)

 An important number in this formula is the marginal

propensity to consume (MPC).
 Itis the fraction of extra income that a household consumes
rather than saves.
A Formula for the Spending Multiplier

 If the MPC is 3/4, then the multiplier will be:

Multiplier = 1/(1 - 3/4) = 4
 In this case, a 20 Crores increase in government
spending generates 80 Crores of increased demand for
goods and services.
The Crowding-Out Effect

 Fiscal policy may not affect the economy as strongly as

predicted by the multiplier.
 An increase in government purchases causes the interest
rate to rise.
 A higher interest rate reduces investment spending.
Changes in Taxes

 When the government cuts personal income taxes, it

increases households’ take-home pay.
 Households save some of this additional income.
 Households also spend some of it on consumer goods.

 Increased household spending shifts the aggregate-demand

curve to the right.
Banking Industry: Policy and Challenges

 Financial Sector in India Comprises:

Money Market and Capital Market
Credit, Equity, Insurance and Pension
Different Regulator for each Segment(Recommendations of FSLRC)
Credit Market can be studied under:
1. Banks
2. NBFCs
Banks act as intermediaries: facilitating flow of savings. Major source of capital in pre reform era.
Evolution of banking industry in Independent India: Nationalization and Liberalization.
Major types of Credit: CC Limits and Term Loans.
Major Challenges: Bad Loans, Capitalization, Liberalization, Technology, Income
Banking Industry: Policy and Challenges
Banking Industry: Policy and Challenges

 Causes for NPA accumulation

 Excessive Lending during good times
 System based recognition
 Interference by politicians, promoters
 Sluggish Economy, Stalled Projects in specific sectors
 Slow Legal reforms

 Effects of Rising Bad Loans

 Credit Crunch for industry: Deliberate and PCA
 Lost Income on account of higher provisioning
 Capital Erosion: Need for budgetary allocation/Basel Norms
 IBC
Banking Industry: Policy and Challenges

 Industry Specific Ratios

 Credit to deposit ratio
 Capital adequacy ratio
 Non-performing asset ratio
 Provision coverage ratio
 Return on assets ratio
 Net Interest Margin
 Leverage
All The Best!

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Request you to please report to:
Aakash Sharma | Kshitij Bansal
Senior Club Coordinators | Public Policy Club
e: ppc@iift.edu