PREFACE

Leading a debt-free life is the biggest gift one can reward oneself with. The need
to achieve complete nancial freedom acts as a pre-requisite to achieve any
major goal in life. We all wish to remain nancially independent throughout our
lives but often struggle to achieve that. If there is one lesson to be learnt from the
most celebrated entrepreneurs such as Warren Buffett, Dhirubhai Ambani, Sir
Richard Branson etc., it is to start early. This alone was their rst step on the road to
a lifelong nancial supremacy and has been our inspiration to launch India’s
rstever nancial literacy campaign.

In our nation, while literacy – the ability to read and write – is a fundamental part
of the socio educational structure, there is little emphasis on nancial literacy.
Students complete their schooling without any formal nancial education, which
results in not only poor personal nancial skills but also in non-structured
understanding of nance as a subject. It is our endeavor to make young minds
understand the art of managing and understanding money.

Congratulations for being a part of the nancial literacy brigade. And may you
spread the wings of nancial literacy far and wide!

International Finance Olympiad Association

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 INDEX
Section A : Historical Approach
1. GRAND NATIONS AND HISTORY OF FINANCE 6
2. CREDIT, INTEREST, LOANS, DESIRES & ROTTING FISHES
- IT IS ALL IN HERE! 14
3. LESSONS FROM JACK & THE BEANSTALK & FROM
THE RICHTER SCALE 22
4. BIRTH OF FISCAL - WELFARE, WARFARE AND THE
ITALIAN JOB 29
5. CREATIVE DESTRUCTION, CORPORATE 37

Section B : Comprehensive Approach

6. FINANCIAL MARKETS 43

7. ECONOMY 53

8. INFLATION AND INFLATION CONTROL 62

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SECTION A
Historical Approach

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 Chapter 1
GRAND NATIONS AND
HISTORY OF FINANCE

LEARNING OBJECTIVES
• Conceptual Framework of History and Finance
• Powerful Nations and Story of Finance
• Spanish Case Study :
Story of Ination and Hyperination

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The Ascent of Man, a compelling work by Jacob Bronowski was rst televised on BBC
in 1974. The Ascent of Man explores the evolution of man from proto-ape, alks of
early human migration, provides a foundation for the development of tools,
architecture, sculpture, re, metals and of course alchemy. It then moves on to the
creation of mathematics, astronomy, industrial revolution and physics.

The Ascent of Man is arguably one of the nest works on history and provides a
historical surmise of the importance of money for the development of all
explorations. Infact, it would not be unfair to say that development of a money
system preceded any form of medieval – modern exploration and the presence or
absence of the same caused success or failure of any such explorative endeavor of
humankind.

History taught us that great nations were built either through war (example
Alexander’s Greece), through message of peace (example Ashoka’s India) or
through nancial strength (example Croesus’ Lydia). Of the three, it was Croesus’
principle of utilising nancial strength to create formidable nation which requires
greater discussion.

Croesus in 550 BC, created a system of separating gold from silver ore, which
created trust on his kingdom’s gold coins and led the world to trade on his gold coins
or his kingdom’s currency. Lydia (now represented as areas of East Turkey) was
arguably the rst nation to have minted gold coins and silver coins.

Trade had developed worldwide then and the coins printed at Lydia became a
symbol of trust. Croesus’ rise was phenomenal. Today also Croesus’ name is
synonymous with extreme wealth. Lydia, became one of the most wealthy and
powerful nation until Cyrus defeated Croesus.

The difference between mere sustenance and prosperity will be knowledge of utilizing
money. Better savings, better investments, better budgeting will lead to nancial
welfare and creation of enterprises which are value based and will lead to a grander
India. Corruption has tarnished our country’s image.

With adequate nancial knowledge and planning, the Indian community would earn
passive income (through interest, dividends, rents etc.) and would be more ethical,
overall improving the economic image of our nation.

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You would later read about strong and robust monetary systems that through the
history have created various powerful nations across the globe. In subsequent pages
you would also see how a strong monetary system led to nations winning wars and
how misuse of such systems created internal rife, economic anarchy and even
revolutions.

Today the dollar of United States of America earns that respect as a currency. Gold, as
you may now understand has always been considered as a trustworthy commodity for
exchange and therefore is considered a safe investment.

History taught us that great nations were built either through war (example
Alexander’s Greece), through message of peace (example Ashoka’s India) or
through nancial strength (example Croesus’ Lydia). Of the three, it was Croesus’
principle of utilising nancial strength to create formidable nation which requires
greater iscussion..

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 ‘Mary had a little lamb’- Why is history so important?
There is a peculiarity about history. All developments in the world have been due to
a necessity to improve upon existing orders. These developments in some cases
created positive evolutionary impacts or in some cases created regressive impacts.
To grasp any concept or development, if the need for which it was developed is
known, the concept tends to get hammered in us. For example, if we understand the
need for the development of a telegraph it would be easier for us to understand and
appreciate its development and consequently its concept.

“Who could better explain the invention than the inventor himself ”

It is said that the rst great invention developed by Edison in Menlo Park (Menlo Park
is incidentally where Google was also born) was the tin foil phonograph. While
working to improve the efciency of a telegraph transmitter, he noted that the tape
of the machine gave off a noise resembling spoken words when played at a high
speed. This caused him to wonder if he could record a telephone message. He began
experimenting with the diaphragm of a telephone receiver by attaching a needle to
it. He reasoned that the needle could prick paper tape to record a message. His
experiments led him to try a stylus on a tinfoil cylinder, which, to his great surprise,
played back the short message he recorded,
“Mary had a little lamb.”

Similarly, to understand ination, one can just look back at history and argue that
one of the rst recorded inationary crises in the world may have been in Spain
after its conquest of South America. Not only does this historical fact make for an
exciting reading but also provides a base for understanding ination.

“Ination in its easiest form may be dened as too much money chasing too few a
goods.”

The Spanish conquest of South America led to the discovery of Peruvian mountains
rich in Gold and Silver for the world. The natives Incas, who were socialist in nature,
had developed a robust barter system and an advanced agricultural system.
Although, the Inca’s were the real owners of those gold and silver mines but due to
their economic structure they never realized the importance of gold and silver which
the Spaniards were easily able to exploit. It was in 1545 that an American Indian
named Diego Gualpa found the silver mountain of Potosi, now in Bolivia. This
discovery led to the immediate mining rush amongst the Spaniards who were ruling
those regions of South America. The Incas not only lost their complete independence
but were also subjected and exploited to work in those mines.
Like Lydia of 550 BC, Spain by 1550 AD was one of the most economically powerful

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1http://inventors.about.com/library/inventors/bledison.htm, Mary Bellis
 Are you angry that the world is so unfair?

Infuriated by fat-cat capitalists and billion bonus bankers? Throughout the history of
western civilization, there has been a recurrent hostility to nance and nanciers,
rooted in the idea that those who make their living from lending money are somehow
parasitical on the real economic activities of agriculture and manufacturing. This
hostility has three causes. It is partly because debtors have tended to outnumber
creditors and the former have seldom felt for the latter. It is also because nancial
crises and scandals occur frequently enough to make nance appear to be a cause of
poverty rather than prosperity, volatility rather than stability. And it is partly because,
for centuries, nancial services in all countries all over the world were
disproportionately provided by members of ethnic or religious minorities, who had
been excluded from land ownership or public ofce but enjoyed success in nance
because of their own tight knit networks of kinship and trust. -Adapted from ‘The
Ascent of Money’ by Niall Ferguson (Penguin 2009)

nations due to their exploitation of South American resources and the main ore was
Silver found at Potosi.

And what rises astronomically tends to fall. With such a huge reserve of silver and
gold coins, the Spaniards were plush with funds. But there was a catch. Spaniards
like other Europeans were warring for better part of the 16th century. There had
been little emphasis on production and agriculture. Therefore the supply of goods
and services was limited.

Now with their new found wealth after the conquest of South America, Spaniards
had enough gold and silver to purchase enough ‘need based’ and ‘luxury’ products
and services for themselves. The catch unfortunately was limited supply of goods
and services and the problem was magnied by further wars.

It is notably a classical case where too much money chased too few a products and
services. The prices started escalating and Spain was engulfed with Ination and
later on Hyper Ination. Ination throughout Europe in the sixteenth century was a
broad and complex phenomenon.

In Spain, its main cause was arguably the ood of bullion (precious metal coins)
from the Americas, along with population growth, and government spending.

In-fact in 1557, due to rising military costs and hyperination, Spain led for its rst
Bankruptcy or Moratorium. Spain to meet its burgeoning government
expenditures, started borrowing from neighboring European nations, started
defaulting on its payment and consequently went bankrupt.

By 1570, Spain resurfaced again on the back of Money and this time it was due to

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2Europe and England in the Sixteenth Century, T. A. Morris, 1998, pg 121-122
 In Spain, its (ination’s) main cause was arguably the ood of bullion (precious metal
coins) from the Americas, along with population growth, and government spending2.
The Flood of Bullion, as you would now appreciate was due to the Spanish
exploitation of South American resources. Population growth also adds to ination.
The supply is limited and the demand keeps increasing. So does Government
spending. Government expenditure tends to put more money in the economic
system, thereby fuelling ination. Had the expenditure been for increase of supply
of products or services, it would have been a different case. But in our example,
the Spanish Government spending was basically military expenditure, which
created further inationary pressures. Such was the dominance of the Spanish
Pieces of Eight that when the British authorities in Australia wanted to create a
local currency, they converted these Pieces of Eight into ve shilling coins.

the creation of their currency coins called the Pieces of Eight. Pieces of Eight were also
silver coins that were mined out from the large reserves of Potosi. Pieces of Eight
became the trusted coin for trade and maintained its dominance well into the
nineteenth century.

For Finance acionados, Potosi still remains proverbial

for its wealth. Spaniards today still say something is ‘vale
un Potosi’ which means ‘worth a fortune3.

Discovery of the Gold rich Potosi Mountains, Bolivia, led to massive mining rush
among the Spanish. With the accumulation of huge reserves of the most precious
metal, provided the Spanish with uncontrolled wealth supply. Stormed by the rising
military cost because of their ongoing wars, soon they became a victim of
hyperination and began borrowing from other countries. Consistently defaulting
on their debt repayment, In 1557, Spain went bankrupt!

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3“A History of the world in 100 objects”,Neil MacGregor, 2010, pg 522
Glossary
Alchemy:
Alchemy is an inuential philosophical tradition whose early practitioners’ claim
that profound powers were known to them, from antiquity. Practical applications of
alchemy produced a wide range of contributions to medicine and the physical
sciences.

Croesus:
Croesus was the king of Lydia from 560 to 547 BC until his defeat by the Persian
king Cyrus. Lydia (now eastern parts of Turkey) was arguably the richest nation
during his reign.

Cyrus:
Cyrus the Great (576 BC–530 BC) was the founder of Achaemenid Empire. He
defeated Croesus and controlled his empire till 530(BC).

Monetary System:
A monetary system is a scheme developed by a government to facilitate
exchange. It also provides a means to generate and measure wealth and debt.

Incas:
The Inca Empire was the largest empire in pre-Columbian America. The Inca
civilization arose from the highlands of Peru sometime in the early 13th century. The
Inca Empire was the last sovereign political entity that emerged from the Andean
civilizations before conquest by Spaniards.

Peru:
Peru is a democratic republic divided into 25 regions in the continent of South
America.

Need Base Products:

Products that are essentially required.

Luxury Products:
Luxury goods are products and services that are not considered essential.

Ination:
Ination is a general rise in prices of goods and services. Ination results in loss of
value of money.

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Hyper Ination:
Extremely rapid or out of control ination. Hyperination is a situation where the
price increases are so out of control that the concept of ination is meaningless.

Bankruptcy:
A legal proceeding involving a person or business that is unable to repay
outstanding debts.

Moratorium:
A period of time in which there is a suspension of a specic activity until future events
warrant a removal of the suspension or issues regarding the activity have been
resolved.

Pieces of Eight:
They are historical Spanish dollar Eight coins minted in the Americas from the late
15th century through the 19th century. Made of silver, they were in nearly worldwide
circulation by the late 19th century and were legal currency in the United States until
1857.

Acionado:
A person who is very knowledgeable and enthusiastic about an activity, subject, or
pastime. A legal proceeding involving a person or business that is unable to repay
outstanding debts.

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 Chapter 2
CREDIT, INTEREST, LOANS,
DESIRES & ROTTING FISHES
- It is all in here!

LEARNING OBJECTIVES
• Conceptual understanding of “Barter System”
• Evolution of Credit & Interest
• Evolution of “Letter of Credit”
• Conceptual understanding of
“Loan for consumption” and “Loan for production”
• Evolution of “Saving”

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Excess has always created debacles. We saw in the previous chapter when Spain
had excess of coins, it resulted in ination and an economic debacle. The French
Revolution was also caused due to a currency and stock mismanagement leading to
a nancial misfortune. Since 2008, we have witnessed a credit chaos, where
expansion of baseless credit facilities almost created another Depression
worldwide. Although, these discussions merit further explanation which we would
undertake subsequently, we must study and understand the evolution and the
concept of the word credit.

Credit facilities have been the backbone of any economic system. Assume a
situation, when there was no money and we all lived our lives on barter. A situation
where few individuals were involved in agricultural activities, few individuals were
shing and few perhaps hunting. The hunters gave away their meat for sh from the
shermen and the shermen gave away their shes for say barley. In simplest terms,
this is what a barter system or an exchange system looked like.

From being barbaric to being civilized, humans have come a long way. Civilization in
its simplest form ‘civility’ reects the ability of humans to co-exist in groups and
develop economically, socially and culturally. One of the earliest known civilizations,
the Mesopotamian Civilization, changed the way humans lived. It marked the
beginning of social order and the beginning of a change from individual sustenance
to community sustenance. The backbone of this community co-existence was the
Barter system.

Barter system for its success had a unique requirement of a single authority in case of
defaults on the barter. What if, our above mentioned farmers, required shes but
had to wait for the harvesting of barley to initiate this required exchange? Also
what if the farmer gave away the barley but sherman refused to provide the
shes?

This meant that the authority or the then government was required not only for
providing justice but also for providing solutions related to immediate consumption
for a future promise of exchange. The solution lay in the development of credit and
interest system.
Creditum, a Latin word for Credit reected the amount of money with which an
individual or a group could be trusted. The concept was simple one could borrow today
and repay later. This naturally would mean that the lender would be undergoing a
certain amount of risk of losing the money. For this risk appetite, the lender should be
rewarded in some manner. This reward came to be known as Interest.

Do You Know!! In India, we now have a creditworthiness check body called the CIBIL.

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 Marc Von De Mieroop in the book ‘The origins of Value - The Financial Innovations
that created Modern Capital Markets’ discusses the aspect of ‘Interest’ based on the
materials from the period of 3200-1600 BC, as they were found in South
Mesopotamia. Historians concur that ‘Credit’ and ‘Interest’ have therefore been
pivotal for the development of civilizations.

From the same period, it becomes evident that any nancial obligation that needed
to be fullled in the future was considered a loan. A promise to deliver wooden
objects at a certain point in the future, for example was also phrased as Loan4.

The image above shows a red clay with cuneiform inscription of around 1820 BC.
The text records the loan of 9.33 grams of silver to Nabi-Ihshu from Sharmash. The
tablet stipulates that the loan will be repaid with ‘Interest’

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4The Origins of value: The Financial Innovation that Create Modern
Capital Market.- William N Goetzman, K Geerth Rouwenhort Pg 17-25
A loan for consumption is a contract under which the lender provides the borrower
with consumable goods. And the borrower is obligated to return the goods with
specied quantity & quality, within a given time period.

Whereas a production loan is a borrowing for purposes of generating returns on

a commercial stage.

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The loan documents as shown in the adjacent image were generally red clay tablets
with cuneiform inscriptions. Because of the nature of the loan contract as a document
attesting that something was owed, it could be passed on from the original creditor to
another person. This meant that the loan document could also act as a ‘Letter of
Credit’5.

Over the past 3500 years, we have utilized the same concepts. And it is of no surprise
as human necessities, although evolved, fundamentally remain the same. The farmers
today also borrow from Micro credit agencies to sow seeds, the manufacturer
borrows from banks to purchase raw material and we as consumers tend to borrow
for fullling either our necessities such as homes or education or for fullling our wants
and luxuries.

The interest paid on these loans are now market determined and regulated and as
you can now appreciate are a reward that we pay to the nancial institutions for the
risk that they undertake while providing for a loan against our creditworthiness.

The concept of Loan can broadly be divided as Loans for Consumption and Loans for
Production.

Historically and even today, loans for consumption purposes are condemned as
imprudent. Going by the same logic you may raise a moral question over the usage
of personal credit cards.

Loans for production can be explained as borrowing for commercial purposes and
are expected to generate returns in future. Logic and ethics call for a prudent
behavior in dealing with such returns as the allocation of such returns should be rst
towards the repayment of the borrowed loans.

In the third millennium BC, Mesopotamians used both grains and ingots of silver as
mediums of exchange. The customary interest rates were 33.33% per annum for
loan of grains and 20% per annum for loan of silver.
The Mesopotamian code of Hammurabi (1800 BC) made these rates legal
maximums, establishing a tradition of interest rate regulations that has lasted
to the present.
- Homer, Sidney, Richar Sylla. A history of interest rates, 1996.

In the current context, the central bank manages these interest rates. In India, the
role of Central Bank is played by the Reserve Bank of India.

What Hammurabi wrote is still followed, almost 3000 years later!!

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Desire has no barter. As humans, we moved from the barter system to a more
elaborate nancial system and so did our desires, which moved with the same pace
and elaboration.

Because the desire to consume often does not match the timing of the receipts of
income, individuals regularly engage in saving (consuming income from the past) and
borrowing (consuming income from the future). And as mentioned above, saving is a
more prudent form of meeting desire than borrowing for consumption.

It is indeed hard to imagine what the regular Mesopotamian (Sumerian) sherman

who wanted barley must have done. The choice was either storing shes (letting them
rot without the modern facilities) or borrow in lieu of a promise to supply shes at a
later point of time!

Credit, Borrowing, Loans and Interest form a backbone of our neo nancial systems
but their roots are in history. Appreciating their necessity can further allow us to
rationalize on these concepts and perhaps but somewhat difcult, allow us to
rationalize our desires.

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Glossary
Risk:
Risk is the chance that an investment’s actual return will be different than expected.
Risk includes the possibility of losing some or all of the original investment.

Risk of Capital:
Risk of Capital is the risk of loss of the amount invested, faced by company /
individual.

Risk of Interest:
It is the risk of loss due to any change in the interest rates.

Risk of time frame:

Risk of time frame is the risk that an investment’s value will change according to the
different intervals of time.

Probability:
Probability is a measure of the expectation that an event will occur.

Richter Scale:
Richter scale is a Quantitative measure of earthquake-strength (magnitude) that
indicates the seismic energy released by an earthquake at its epicenter (measured
from a distance of 100 miles) on a 1 to 10 scale.

Pledge:
Pledge is a cash deposit or placing of owned property by a debtor (the pledger) to a
creditor (the pledgee) as a security for a loan or obligation.

Default:
Default is the inability to pay interest or principal when due. Default occurs when a
debtor is unable to meet the legal obligation of debt repayment. Borrowers may
default when they are unable to make the required payment or are unwilling to
honor the debt within a specied time period.

Sub-prime Crisis:
Subprime mortgage crisis is a set of events and conditions that led to the late-2000s
nancial crisis, characterized by a rise in subprime mortgage delinquencies and
foreclosures, and the resulting decline of securities backed by said mortgages. It all
started in 2006 with US Market tumbling down due to defaults by thesub-prime
borrowers.

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Money changers:
A money changer is a person / institution which exchanges the currency of one
country for that of another, at a xed or variable rate.

Medici Family:
The Medici family was a political, banking family & later a royal house. The family
originated in Mugello region and established the Medici bank in Florence, Italy. It
was the largest and the most respected bank in Europe during the 15th century AD.

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 Chapter 3
LESSONS FROM JACK & THE
BEANSTALK & FROM
THE RICHTER SCALE

LEARNING OBJECTIVES
• Understanding the Risk & Return Paradox
• Conceptual understanding of Risk of Capital,
Risk of Return, Risk of Time frame
• Introduction of “Probability” to Risk & Return Paradox
• Conceptual understanding of “Magnitude” in case of
Risk of Capital
• Evolution of Pledging, Mortgage Loans
• Evolution of Trade & Banking

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Jack was rewarded with a golden egg laying hen ONLY after he walked the
chancy extra mile of climbing the beanstalk. Higher risk has higher the
probability of high returns!

p23
Assuming you pay 1000 rupees to your friend, who promises to return 1100 in a
year’s time, can you identify the principal, interest component and possible risks that
you face?

To begin with, the principal would be your 1000 rupees. The return or interest
component is 100 rupees or in our case 10% over principal. This interest is what you
are charging for the risk that you take in giving your friend the 1000 rupees.

What is of signicance is the identication of the risk. The rst and foremost risk is
whether the capital will be returned, let alone the interest. The second risk is whether
you would actually get the promised interest (or the reward that you get in return for
taking this risk) and nally whether you would actually get your principal and
interest within a year’s time.

To simplify, we may call them the Risk of Capital, Risk of Interest and Risk of Time
frame.

What if, your friend is notorious for not returning or seldom returning the borrowed
amounts? Assuming your friend pays back only 3 out of 10 times that he borrows
what is the probability of his returning the money to you. In all simplicity, it is 0.3.
What if he never pays back, the probability is 0 and what if he always pays back
the probability is 1.

Ideally, you would not lend at all if the probability of return is 0 but you may still take
the risk of lending but at a higher interest. Similarly, you might not even charge
interest or charge an exceptionally low interest, if you are certain that he will return
the principal. Interest as we have discussed is the reward for taking that higher risk.

This pure logic of understanding Risk and Return are actually taught to us in our pre-
school days. Jack was indeed a brave boy, who took the grave risk of climbing a
beanstalk and was rewarded with a golden egg laying hen! It would not be wrong to

Seeds of Mortgage Crises!!

One of the great successes of the United States in this century has been the partnership
forged by the national government and the private sector to steadily expand the
dream of the homeownership to all Americans. Since 1993, nearly 2.8 million new
househ olds have joined the ranks of America’s homeowners, nearly twice as in the
previous 2 years. But we have to do a lot better. The goal of this strategy, to boost
homeownership to 67.5 percent by the year 2000, would take it to an all time high,
helping as many as 8 million American families across the threshold.-President Bill
Clinton Remarks on the National Homeownership Strategy
University of California- June 5 1995. (Adapted from The Rise & Fall of the US
Mortgage & Credit Markets, James R Barth, Pg 30)

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In all truthfulness, Jack took a brave risk and probability supported him.

“Risk magnies with magnitude.”

“Higher the Risk; Higher the Probability of high Returns”
and
“Lower the Risk; Lower the Probability of low Returns”

Returning to our favored example of your friend borrowing money from you, what if,
your friend actually required a greater sum of money?

Till now, we have spoken of interest as a reward for taking a risk but what if, our
magnitude of ‘risk of capital’ increases due to increase in loaned capital?

Earthquake is most devastative when it is above 6.0 on the Richter scale. Similarly
higher the capital loaned higher the devastation if there is a default on repayment.
The same concept can easily be related to modern day borrowing of a consumer for
home. Home loans are generally high capital loans and create serious risk of capital
for the lender. In the case of a home loan, the house is pledged with the lender or in

As mentioned in the previous chapter, excess has always been detrimental for
economies. In this case it was this excess of sub- prime lending that nally led to the full
blown sub-prime crises.

The development of entrepreneurship and international trade led to the prominence of

money-lending.

simpler terms, the house would be owned by the lender in case the borrower defaults
on repaying the loan. This measure safeguards the lender against possible default
by the borrower and reduces the risk of capital.

Mortgage Loans today, generally, refer to Housing Loans across the world. In-fact,
the US Sub Prime Crises was a direct effect of lending excessive loans to non credit
worthy individuals or sub-prime individuals.

The concept of Risk of Capital is not new. Although lending by pledging a personal
property was practiced in many ancient societies, the rst clear evidence of
specialized safeguarded lending or pledged lending came in the fth century AD
where Buddhist monasteries in China ran commercial operations of lending against
pledged property. It is argued that India may have been the center of rst such
commercial operations as Buddhism originated in India.6 Some temple run lending
commercial units may have been done for charitable purposes but it is said that
increasingly all such units started charging interest.

p25
6T. S Whelan, The Pawnshop in China, Ann Arbor, 1979.
By 1200’s, the government began to operate such operations and proceeds were
used to fund military expenditures of China. In medieval Europe, money lending was
mostly in the hands of the Jews and Italians.Why was the practice of money-lending
gaining prominence? The answer lay in development of entrepreneurship and
development of international trade. For international trade, capital was required
for purchasing raw material from one country and then for managing the logistics of
selling the raw material or semi nished product in another country.

International Trade created requirements not only of commercial lending shops but
also for shops that were moneychangers. In Europe, Italians became pioneers in both
money lending and money changing and the Medici Family of Florentine combined
the two for creating the base for the Banking System.

p26
Glossary
French Revolution:
The French Revolution (1789–1799), was a period of radical social and political
changes in France that had a major impact on the country and throughout the rest of
Europe. The absolute monarchy that had ruled France for centuries collapsed in
three years.

Depression:
Depression is a severe and prolonged recession characterized by inefcient
economic productivity, high unemployment and investments. There tends to be
general economic pessimism.

Credit:
Credit means to give or lend money

Barter System:
Barter System is a trading system in which goods are exchanged for goods. In
ancient times when money was not invented, trade as a whole was on barter system.

Civilization:
Civilization is an advanced state of human society in which a high level of culture,
science, industry and government has been developed.

Interest:
Interest is a fee paid by a borrower of assets to the owner as a form of
compensation for the use of the assets, over a period of time. It is most commonly the
price paid for the use of borrowed money.

Letter of credit:
A letter from a bank guaranteeing that a buyer’s payment to a seller will be
received on time and for the correct amount.

Loans for consumption:

Loans for consumption is a contract express or implied under which a lender hands
over certain consumable goods to a borrower and he is obligated to return the same
or equivalent type of goods within a specied or reasonable time period.

Loans for production:

It is the loan for Project / Business nancing and is linked to repayment through
revenue generation.

p27
Credit Card:
Any card that may be used repeatedly to borrow money or buy products and
services on credit.

Desire:
Desire is strong wants to which the person is dedicated. In economics, it is the
difference between ‘need’ and ‘want’.

Saving:
Saving is income not spent, or deferred consumption.

Mesopotamia:
Mesopotamia (Modern day Iraq) encompassed the land between the Euphrates and
Tigris rivers. The need for irrigation was the reason behind the evolution of Mesopo-
tamian Civilization.

p28
 Chapter 4
BIRTH OF FISCAL - WELFARE,
WARFARE AND THE ITALIAN JOB

LEARNING OBJECTIVES
• Conceptual understanding of government expenditure
• Conceptual understanding of Fiscal Surplus/Decit
• Dening Government Bonds
• Relation between price of bond and interest rate

p29
It becomes evident that warehousing as a concept has been with us for more than
4500 years. It is logical to assume that the governing body to solve the problems of
barter and to provide for rations engaged in warehousing and storage. The storage
dilemma was solved but someone had to bear the cost for the storage.

This cost, in simplest forms gave birth to Government Expenditure, an expenditure by

the Government (governing body) for social welfare and in our case to meet the
challenges of the Barter system.

In modern economic sense, all facilities including infrastructure investment and

research facilities provided by the Government to facilitate economic development
constitute government expenditure.

War and Finance

Nearly, all wars are fought due to a nation’s internal economic conditions (for
example scarcity of arable land), geographic greed (for example in search of more
arable land) and to resist external threats. The patterns of victory and defeat in
wars through the history have shaped the direction of the world economy and its
institutions8.

If successful, the wars of conquest more than paid for themselves as the victorious
nations lled up their coffers from the defeated country’s looted resources.

Barley as a key symbol in early Mesopotamia

p30 8Joshua S Goldstein, The Oxfort Enclyopedia of World History, Volume 5, pg 216
 More elaborate study of the historic time frames reveals that warfare more than
welfare, across these time frames constituted a larger percentage of the
government expenditure. Wars created powerful nations and power created
responsibility. Both welfare and warfare or social needs and security needs of the
public added a dimension of responsibility for the government and consequently
created a nancial burden of servicing them.

With the added dimension of warfare to welfare, we return to our unanswered

question, “Who pays for this expenditure?”
The Government has the option of nancing this expenditure through generating
revenues by levying taxes, by borrowing from the public or international community
(raising debts) and by printing currency.

The creation of gold coinage by Lydia is perhaps the earliest known methods of
nancing government expenditure. We have also read of how Spain’s issuance of
‘Pieces of Eight’ after its conquest of Potosi, dened Spanish economic success but
also magnied the inationary spiral.

Therefore printing currency could not have been the only solution. The Government
had to earn revenue and that came through Taxes. The earliest taxes were paid in
kind, since there was no money. Cattle, grain and wool were common in kind produce.
In kind payments required record keeping and measurements and gave birth to the
art of book keeping or modern day Accounting. Even with the invention of money, in
9
kind payments continued to exist, especially in the agrarian societies.

Whenever there is a time lag in receipt of income and immediate expenses, recall
how savings or borrowings come to the rescue for an individual. In the same manner,
the Government could also dig into its previous year’s surplus’ to meet current
expenditure. If there were to be no previous year’s surplus, and the current revenues
were not enough to meet the expenses then the government has no option but to
borrow.

For the Government it becomes prudent to manage its decit as greater the scal
decit, greater the chances of default by the government on its borrowings.
Corollary, greater the scal decit of any government, lesser would be its
creditworthiness in the eyes of potential lenders.

Assume a situation of a country which has excessively high scal decit but intends to

9David G Surdam, The Oxfort Enclyopedia of World History, Volume 5, pg 70-72 p31
10O’Sullivan, Arthur; Steven M. Sheffrin (2003). Economics: Principles in action.
borrow for meeting its current expenditure. What kind of interest would such a
country end up paying on its borrowings?

Recall the risk and return paradox and the answer is within your grasp.

The issuance of a promissory note by the government to repay the loan with interest
gave birth to one of the most important nancial instruments-Government Bonds. The
need to borrow by the government was necessitated across the ages by innumerous
wars and the burgeoning scal decits.

War, declared the ancient Greek philosopher Heraclitus, is the father of all things. It
was certainly the father of the bond market. The ability to nance war through a
market for government debt was, like so much else in nancial history, an invention of
11
the Italian Renaissance.

In simplest form: Fiscal policy is the use of government revenue collection (taxation)
and expenditure (spending) to inuence the economy.10

The Italian Job

As we learnt in the previous chapter, the Medici family of Florence, (Italy) combined
the art of lending and money changing and is credited with creation of the banking
system.

Like most of the large companies of medieval and Renaissance Italy, the Medici not
only housed an important banking but also brought and sold merchandise of all
kinds. They were merchants who were into nancial businesses as well and funded
their own expansion through the earnings of their enterprise.

Italian states during the course of fourteenth and fteenth century were at war with
each other. The states did not create their own armies but engaged independent
military units for these incessant wars with other states. Florence not only due to the
Medici’s but also due to ourishing trade was one of the richest states of Italy and
undertook heavy expenses on account of war.

The heavy expenses of war created a government decit and the government of
Florence engaged itself in raising loans from their own public.

A crucial feature of the Florentine system was that such loans could be sold to other
citizens if the investor needed ready money. In effect, then, Florence turned its
citizens into its biggest investors. By the early fourteenth century, two thirds of the
households had contributed in this way to nancing the public debt, though the bulk
12
of subscriptions were accounted for by a few thousand wealthy individuals.

p32 11Niall Ferguson, The Ascent of Money-A nancial history of the world, pg 70
12Niall Ferguson, The Ascent of Money-A nancial history of the world, pg 72-73
The Medici’s with a few other wealthy families also controlled most of the Florentine
government and took deep care in making sure that interest was paid on the
government borrowings against the issuance of the Bonds.
The Italians to serve their warfare requirements developed one of the most powerful
nancial tools, the Government bond, which not only nanced the debt but also
became a trade-able instrument.

As mentioned above, such loans could be sold to other citizens if the investor needed
ready money. How did Bonds become a trade-able instrument? And how were they
traded?

Assume a situation where the government required a loan to fund its war decit and
issued bonds of a particular currency. (Let us assume the currency as rupees.) So this
particular government issued bonds of Rs. 1000 for 15 years and was willing to pay
the investor say 5% on an annual basis. Corollary this meant that the public could
provide the government a loan of Rs 1000 for 15 years and would generate 5% or
50 rupees return on an annual basis. Let us call this bond ‘Bond A’

Returning to our Risk and Return paradox, the Capital risk is Rs 1000, the interest
rate risk is 5% and the time frame risk is 15 years.

Now within the same month, the government realized that its scal requirements are
not being met through the previous issue of bonds. Simply stated, the government
was in need of more loans. Higher loan meant that the chances of default by the
government went a notch higher and so did the risk of default for the public.
Consequently, the public demanded more interest in lieu of the risk that they were
taking. Let us assume that the interest rate was settled at 6%. This meant that the
government could now borrow from the public at 6% interest and not at 5%. This
also meant that the annual return on the bond for the public became 60 rupees from
the previous 50 rupees. Let us call this bond, ‘Bond B’

The government is the same and so are the risk for the public but the yields are
different. One bond provides Rs 50 interest while the other provides Rs 60 interest
to the public. Just in case someone wanted to sell Bond A in lieu of ready cash,
nobody would buy it. The disparity had to be removed.

What could be a way of removing this disparity between Bond A and Bond B?

In simplest terms, Rs 50 should ideally become 6% of the principal amount or

mathematically

p33
6% of X= 50

X= 50/6% or X=833.3

Notice how the price of the bond fell from Rs 1000 to Rs 833.3 as interest rate rose
from 5% to 6%.

The whole nancial bond market is a little more complicated than the current example
but the previous example should be enough to illustrate the reason for the inverse
relationship between the interest rate and the price of the bond.

The treasury bonds are also referred as Fixed Income Instruments or Debt Instruments.

Bond A: Bond B:
Price = Rs. 1,000 Price = Rs.1,000
Time =15 Years Time = 15 Years
Interest = 5% p.a. Interest = 6% p.a.

Let us just summarize what Debt really means.

Debt in simplest terms would mean ‘Promise to Repay’. Unfortunately in our Italian war
example, the heavy expense towards war nally led to a disastrous decit and the
Italian government actually defaulted on the repayment of the Bonds.

In modern jargons, if the government defaults on repaying the loans borrowed

through such bonds, the bonds are termed as ‘Junk Bonds’.
The Treasury bonds as they are referred today are one of the most traded
instruments in the world.

p34
Glossary
Government Expenditure:
The expenditure made by the government on purchase of nal goods and services. It
is used by the government to manage functions like Education, Banking, Defense,
Railways etc.

Debt:
Debt is the money borrowed by an entity from another. These entities/parties could
be government, companies, individuals etc. The debt incurred by a party on a
condition to be paid back on a later date, usually, with interests.

Currency:
Currency is something that is generally accepted and is used as a medium of
exchange.

Accounting:
The act of systematic recording, summarizing, analyzing and reporting of nancial
transactions of a business is referred to as Accounting.

Agrarian Society:
It is a society / Culture which relies heavily on agricultural activities as a means of
their livelihood.

Surplus:
Surplus is the quantity left due to fullment of the requirements.

Fiscal Policy:
Fiscal Policy deals with tax rates and government expenditures in order to control
macro economic factors like ination, unemployment, interest rates etc.

Fiscal Decit:
Fiscal Decit is the difference between government's expenditures and its revenue,
which is excludes borrowing.

Promissory note:
It is a written document between two parties, where one promises to pay a specied
amount to another on a specied date.

Renaissance:
Renaissance or rebirth, is a known revival of art, culture, literature, which began in
Italy and spread through Europe in the 14th century AD.

p35
Bond:
Bond is an instrument of indebtedness of the bond issuer to the holders.

Treasury Bonds:
Treasury bond is a marketable, xed-interest U.S. Government Bond, which is also
known as T – Bond. It has a maturity of more than 10 years.

Junk Bonds:
Junk Bonds are corporate bonds with high yield and high-risk.

p36
 Chapter 5
CREATIVE DESTRUCTION,
CORPORATE FINANCE AND
THE LEGACY OF MUSCOVY

LEARNING OBJECTIVES
• Conceptual understanding of raising capital for a company
• Dening working capital
• Introduction of rst-ever joint stock company
• Conceptual understanding of Limited Liability

p37
The development of the nancial system owed its success to agents who were willing
to innovate - the wild spirits (entrepreneurs) as coined by the Austrian-American
Economist, Joseph Schumpeter.

The earlier innovations like the Bond market, (as previously learnt) had supported
the government in meeting their expenditures but gradually the innovations in the
nancial systems, gained momentum with the creative destruction brought about by
the Entrepreneurs, who also gave birth to the capitalistic economic structures.

Much of the theory on entrepreneurship is laid down by Joseph Schumpeter. His

fundamental theories are often referred to as Mark I and Mark II. In the rst,
Schumpeter argued that the innovation and technological change of a nation comes
from the entrepreneurs, or wild spirits. He coined the word Unternehmergeist,
German for entrepreneur-spirit. In Mark II, he asserted that the agents that drive
innovation and the economy are large companies which have the resources and
capital to invest in research and development.13

The beginning of the twelfth century saw the feudalist system give way to the
creation of the commune or the newer corporations in economic life. Corporations
cropped out throughout Europe. Corporations for example in Italy came up in various
forms like the Mercadantia-a corporation of merchants and Artes-a corporation of
artisans.

Leaders of the corporations became important political leaders, as in the case of

Medici family of Florence, formerly representatives of the corporations of bankers
and traders. This in turn gave impetus to various entrepreneurs to corporatize, to get
legal sanctions and to develop mechanisms to access capital.

From a micro level standpoint, the need of capital was imminent. How could a rm
raise money to establish itself and to nance growth?

Throughout history, most of the rms were largely nanced through the risk appetite
of the rm’s owners and his or her friends, family and business acquaintances.

Working capital - the monies required to support the ongoing day to day activities
of the rm and investment capital-those monies required to nance long-term
development tended to be personal in nature.14 Increasingly, the entrepreneurs
found it difcult to grow with limited personal nance and started seeking working
capital from the banks and long-term investments from the stock market. With
industrialization, rms increasingly raised capital from the nancial markets through
equity capital and through issuance of its own corporate bonds.

The rst joint stock company was formed in 1553 called Muscovy.

p38 13Schumpeterian patterns of innovation Camb. J. Econ. (1995) 19 (1): 47-65

14Sue Bowden, Corporate Governance in a Political Climate. Chapter 8, pg 175
Bonds as learnt previously, are promissory notes and the corporations issued such
notes to raise capital to meet their long-term growth requirements. The corporations
promised xed interest rates to the loan providers. The concept is very similar to the
modern day concept of Non Convertible Debentures (NCD’s)

Entrepreneurs are wild spirits and the rst known joint stock company Muscovy is a
true testimony of the same. It was the year 1553 and England was in complete
economic mess. Few spirited individuals came together to create a company
Muscovy-’Mystery and Company of Merchant Adventurers for the Discovery of
Regions, Dominions, Islands, and Places Unknown’ - whose purpose was to create
mercantile relations with unknown geographical boundaries. The company’s grand
idea was to create a trading link up with the then Cathay or China. The company was
the joint enterprise of the crown (English Monarchy) and 200 inuential and wealthy
individuals who subscribed pound 6000 for the project.

Muscovy never made it to China but on their third voyage they met with success in
creating a mercantile relationship with Russia. Soon afterwards Levant and East
India Company were formed with similar concept in England.

Muscovy with its concept of joint stock created a very powerful corporate nancing
instrument-the equity.

Subscription to equity or stock meant that it was now possible for entrepreneurs to
raise nance which was not supported by a promissory note. Equity and Stock in true
sense meant ownership and the stock owners were owners of the corporation. The
return on the investment was completely linked with the success of corporation.
Stocks also provided an opportunity to the entrepreneurs to possibly take greater
risks in hope for greater rewards. Muscovy for example was indeed a very risky
venture and in the rst voyage lost all its crew members.

Non - convertible debentures are the debentures which can’t be converted

into shares or equities.

p39
The joint stock company was further rened with the legal denition of limited
liability, which restricts the liability of the members for the company’s debts

p40
Glossary
Entrepreneurs:
An entrepreneur is a person who organizes and operates business (es) and taking on
nancial risk to do so.

Feudalist System:
A system of ownership usually associated with pre-colonial England, in which the
king or other sovereign is the source of all rights.

Non Convertible Debentures:

Non-Convertible debentures are the debentures which can’t be converted into
shares or equities.

Joint Stock Company:

A joint stock company is a business entity which is owned by shareholders.

Limited Liability:
Limited liability is a type of liability in which the nancial liability of the person
remains xed.

p41
 SECTION B
Comprehensive Approach

p42
 Chapter 6
FINANCIAL MARKETS

LEARNING OBJECTIVES
• Introduction of Financial Markets
• Introduction of Primary & Secondary Market
• About IPO, Shares & Share Market
• Introduction of Equity and Equity Market
• Introduction of Derivates & Derivative Market

p43
Market
A market is dened as the sum total of all the
buyers and sellers in the area or region under
consideration. The area may be the earth, or
countries, regions, states, or cities.

The value, cost and price of items traded are

as per forces of supply and demand in a
market. The market may be a physical entity,
or may be virtual. It may be local or global,
perfect and imperfect.

Financial Market
The nancial market is a broad term describing any marketplace where trading of
securities including equities, bonds, currencies and derivatives occurs. Although some
nancial markets are very small with little activity, some nancial markets including
the New York Stock Exchange (NYSE) and the forex markets trade trillions of dollars
of securities daily.

A nancial market may be a physical location or a virtual one over a network (for
example, the Internet). Here, people who have a specic good or service they want
to sell (the supply) interact with people who wish to buy it (the demand).
Prices in a nancial market are determined by changes in supply and demand. If
market demand is steady, an increase in market supply results in a decline in market
prices and vice versa. If market supply is steady, a rise in demand results in a rise in
market prices and vice versa.

Producers advertise goods and services to consumers in a nancial market in order

to generate demand. Also, the term "market" is closely associated with nancial
assets and securities prices.

p44
WHY SHARES?
Let’s take an example to understand the concept:
In case you have always dreamt of starting your own business. You love pizza, and
you have done your homework to gure out how much it would cost to launch a new
pizza business and how much money you could expect to earn each year in prot.
For instance the hypothetical costs that you have identied are as follows:

• Building and Equipment would cost $500,000.

• Annual expenses (ingredients, employee salaries,
utilities) would cost an additional $250,000.
• With annual earnings of $325,000.
• You expect to make a $75,000 prot each year.

The only problem is that you don't have

$750,000 (building + equipment +
expenses) in cash to cover all of those
costs.

You could take a loan, but for that you

need to pay interest & thereby increase
your liability.

What about nding investors who would

give you money in exchange for a share
of the ownership of the restaurant?

This is the logic that companies use when they make the decision to issue stock to
investors. They believe that the company will
be protable enough that investors will see a
good return.

In this case, if investors paid a total of

$750,000 for shares in the pizza restaurant,
they could expect to earn $75,000 annually -
which means that they can expect a complete
10 % as return.

As the owner of the pizza restaurant, you can set the initial price of the company, as
well as the total number of shares of stock you want to sell. Each person who buys a
share of stock essentially owns a piece of the company and has a say in how the

p45
 company is run. That is why the understanding of
nancial markets becomes essential.

Securities Market
A securities market is an exchange where sale and
purchase transactions of securities are conducted on the
basis of demand and supply. A well-functioning
securities market should be able to provide timely and
accurate information on the past transactions, liquidity,
low transaction costs (internal efciency) and securities
prices that rapidly adjusted to all available information
(external efciency).

There are two levels of securities markets: A Securities market is an exchange where
sale and purchase transactions of securities are conducted on the base of demand
and supply. A well-functioning securities market should be able to provide timely
and accurate information on the past transactions, liquidity, low transaction costs
(internal efciency) and securities prices that rapidly adjusted to all available
information (external efciency).
Financial Market Overview

Finance Market

Capital Market Money Market

Primary Market Secondary Market

There are two levels of securities markets:

Primary & Secondary Market

The word "market" can have many different meanings, but it is used most often as a
catch-all term to denote both the primary market and the secondary market. In fact,
"primary market" and "secondary market" are both distinct terms.

The primary market refers to the market where securities are created, while the
secondary market is one in which they are traded among investors. Knowing how the
primary and secondary markets work is key to understanding how stocks trade.

p46
Without them, the stock market would be much harder to navigate and much less
protable.

The secondary market commonly referred to as the "stock market." This includes the
New York Stock Exchange (NYSE), Nasdaq and all major exchanges around the
world. The dening characteristic of the secondary market is that investors trade
among themselves. That is, in the secondary market, investors trade previously issued
securities without the issuing companies' involvement. For example, if you go to buy
Microsoft stock, you are dealing only with another investor who owns shares in
Microsoft. Microsoft is not directly involved with the transaction.

Initial Public Offering

An initial public offering (IPO) is the rst time that the stock of a private company is
offered to the public. IPOs are often issued by smaller, younger companies seeking
capital to expand, but they can also be done by large privately owned companies
looking to become publicly traded. In an IPO, the issuer obtains the assistance of an
underwriting rm, which helps determine what type of security to issue, the best
offering price, the amount of shares to be issued and the time to bring it to market.

An IPO is also referred to as a public offering. When a company initiates the IPO
process, a very specic set of events occurs. The chosen underwriters facilitate all of
these steps.

p47
An external IPO team is formed, consisting of an underwriter, lawyers, certied
public accountants (CPAs) and Securities and Exchange Commission (SEC) experts.

Shares and Share Market

The capital of a company is divided into
shares. Each share forms a unit of ownership of
a company and is offered for sale so as to raise
capital for the company Shares can be broadly
divided into two categories - equity and
preference shares. Equity shares give their
holders the power to share the earnings/prots
in the company as well as a vote in the AGMs of
the company. Such a shareholder has to share
the prots and also bear the losses incurred by
the company.

A stock market, equity market or share

market is the aggregation of buyers and
sellers of stocks (also called shares), which represent ownership claims on businesses;
these may include securities listed on a public stock exchange as well as those only
traded privately.

The stock market is a nancial market that

enables investors to buy and sell shares of
publicly traded companies. The primary stock
market is where new issues of stocks are rst
offered. Any subsequent trading of stock
securities occurs in the secondary market.

The Stock Market is a series of exchanges where

successful corporations go to raise large amounts
of cash to expand. Stocks are shares of ownership of a public corporation that are
sold to investors through broker dealers.

Equity and Equity Market

The value of a company, divided into many equal parts owned by the shareholders is
referred to as equity.

The equity market (often referred to as the stock market) is the market for trading
equity instruments.

Stocks are securities that are a claim on the earnings and assets of a corporation.
p48
An example of an equity instrument would be common stock shares, such as those
traded on the New York Stock Exchange.

Derivates and Derivate Market

Derivatives are nancial contracts that derive their value from an underlying asset.
These could be stocks, indices, commodities, currencies, exchange rates, or the rate
of interest. These nancial instruments help you make prots by betting on the future
value of the underlying asset. So, their value is derived from that of the underlying
asset. This is why they are called 'Derivatives'.

A derivative is a security with a

price that is dependent upon or
derived from one or more EARN MONEY ARBITRAGE
WITHOUT
underlying assets. The derivative PHYSICAL TRADING
itself is a contract between two or SETTLEMENT
more parties based upon the
asset or assets. Its value is
determined by uctuations in the HEDGING TRANSFER
underlying asset. AGAINST PRICE
FLUCTUATIONS
OF RISK

For example, a stock's value may

rise or fall, the exchange rate of a
pair of currencies may change, indices may uctuate, commodity prices may
increase or decrease. These changes can help an investor make prots. They can also
cause losses.

This is where derivatives come handy. It could help you make additional prots by
correctly guessing the future price, or it could act as a safety net from losses in the
spot market, where the underlying assets are traded.

The derivative market in India, like its counterparts abroad, is increasingly gaining
signicance. Since the time derivatives were introduced in the year 2000, their
popularity has grown manifold.

Understanding Derivatives Through a Detailed Example

Let us take an example, a farmer fears that the price of Wheat (underlying), when
his crop is ready for delivery will be lower than his cost of production due to the
bumper crop that led to high supply.

Let's say the cost of production is Rs.8,000 per ton. In order to overcome this
uncertainty in the selling price of his crop, he enters into a contract (derivative) with a
merchant, who agrees to buy the crop at a certain price (exercise price), when the
crop is ready in three months time (expiry period).
p49
In this case, say the merchant agrees to buy the crop at Rs.9,000 per ton. Now, the
value of this derivative contract will increase as the price of Wheat decreases and
vice-a-versa.

If the selling price of Wheat goes down to Rs.7,000 per ton, the derivative contract
will be more valuable for the farmer, and if
the price of Wheat goes down to Rs 6,000,
the contract becomes even more valuable.

This is because the farmer can sell the Wheat

he has produced at Rs.9000 per tonne even
though the market price is much less. Thus, the
value of the derivative is dependent on the
value of the underlying.

If the underlying asset of the derivative contract is coffee, wheat, pepper, cotton,
gold, silver, precious stone or for that matter even weather, then the derivative is
known as a commodity derivative.

If the underlying is a nancial asset like debt instruments, currency, share price index,
equity shares, etc, the derivative is known as a nancial derivative.

More about Derivatives

The primary objectives of any investor are to maximise returns and minimise risks.
Derivatives are contracts that originated from the need to minimise risk.
The word 'derivative' originates from mathematics and refers to a variable, which has
been derived from another variable. Derivatives are so called because they have no
value of their own. They derive their value from the value of some other asset, which is
known as the underlying.

For example, a derivative of the shares of Infosys (underlying), will derive its value
from the share price (value) of Infosys. Similarly, a derivative contract on Wheat
depends on the price of Wheat.
Derivatives are specialised contracts which signify an agreement or an option to buy
or sell the underlying asset of the derivate up to a certain time in the future at a
prearranged price, the exercise price.

The contract also has a xed expiry period mostly in the range of 3 to 12 months from
the date of commencement of the contract. The value of the contract depends on the
expiry period and also on the price of the underlying asset.

Derivative contracts can be standardized and traded on the stock exchange. Such

p50
derivatives are called exchange-traded derivatives. Or they can be customised as
per the needs of the user by negotiating with the other party involved.

Such derivatives are called over-the-counter (OTC) derivatives. Continuing with the
example of the farmer above, if he thinks that the total production from his land will
be around 150 quintals, he can either go to a food merchant and enter into a
derivatives contract to sell 150 quintals of Wheat in three months time at Rs 9,000
per ton. Or the farmer can go to a commodities exchange, like the National
Commodity and Derivatives Exchange Limited, and buy a standard contract on
Wheat.

The standard contract on Wheat has a size of 100 quintals. So the farmer will be left
with 50 quintals of Wheat uncovered for price uctuations.

However, exchange traded derivatives have some advantages like low transaction
costs and no risk of default by the other party, which may exceed the cost associated
with leaving a part of the production uncovered.

p51
 Chapter 7
ECONOMY

LEARNING OBJECTIVES
• Understanding Economy
• Understanding types of economy
• About Trade Cycle
• About Market Failure.

p53
Economy
Economy is the large set of inter-related production and consumption activities that
aid in determining how scarce resources are allocated. This is also known as an
economic system.
An entire network of producers, distributors and consumers of goods and services in
a local, regional or national
community constitutes the economy.

Economics is a social science

concerned with the production,
distribution and consumption of
goods and services.

I t s t u d i e s h ow i n d i v i d u a l s,
businesses, governments and
nations make choices on allocating resources to satisfy their wants and needs, and
tries to determine how these groups should organize and coordinate efforts to
achieve maximum output.

Economics can generally be broken down into macroeconomics, which concentrates

on the behaviour of the aggregate economy, and microeconomics, which focuses on
individual consumers.

Microeconomics
The word “Micro” has come from a Greek word “Mikros” which means millions of
parts. Microeconomics discusses about individual parts of the whole economy.
Microeconomics is also called price theory.

Microeconomics is the study of decisions that people and businesses make regarding
the allocation of resources and prices of goods and services. This means also taking
into account taxes and regulations created by governments. Microeconomics focuses
on supply and demand and other forces that determine the price levels seen in the
economy. For example, microeconomics
would look at how a specic company
could maximize its production and
capacity so it could lower prices and
better compete in its industry.

According to the economist Henderson

—“Microeconomics is the study of the
economic actions of individuals and
well dened groups of individuals.”

p54
Example - Micro economics:
Microeconomics gives its focus to individual sections of the economy, for example Raj
is concerned about the changes in the price of petrol, which is different from
macroeconomics at which Raj would serve his concern in the general increase in
prices (ination).
Another example could be that Apple Inc is concerned on how many iPhone 6 should
be exported to South Africa, as compared to American export of goods and
services in South Africa.

Importance of micro economics:

1. To understand the operation of an economy.

2. To provide tools for economic policies.
3. To examine the condition of economic welfare
4. Efcient utilisation of resources.
5. Useful in international trade.
6. Useful in decision making
7. Useful in optimal utilisation of resources and price determination.

Microeconomics occupies a vital place in economics and it has both theoretical and
practical importance. It is highly helpful in the formulation of economic policies that
will promote the welfare of the masses.

Macroeconomics:
The word “Macro” comes from a Greek word “Makros” which means large.
Macroeconomics is concerned with aggregates and averages of the entire
economy, such as national income, savings and investments, aggregate demand and
supply etc.

Macroeconomics deals not with individual quantities but with aggregates of these
quantities, not with individual incomes but with national income, not with individual
price but with price level, not with individual output but with national output.

Macroeconomics is the income theory that explains the level of total production and
why the level rises and falls. Macroeconomics is the eld of economics that studies
the behaviour of the economy as a whole and not just on specic companies, but
entire industries and economies.

This looks at economy-wide phenomena, such as Gross Domestic Product (GDP). It is

the broadest quantitative measure of a nation's total economic activity. More
specically, GDP represents the monetary value of all goods and services
produced within a nation's geographic borders over a specied period of time and
how it is affected by changes in unemployment, national income, rate of growth, and
price levels.
p55
For example, macroeconomics would look at how an increase/decrease in net
exports would affect a nation's capital account or how GDP would be affected by
unemployment rate.

Transfers Taxes
Government

Disposable Total Income

income = Total Production
Government GDP
borrowing

Investment
Households Financial Firms
Institutions

Consumption Consumption
plus net exports
Imports
Exports

Rest of
the world

Importance of Macro Economics

1. The study of macro economics becomes the basis of formulation and successful
execution of government economic policies.

2. The study of macroeconomics is indispensable for understanding the working of

the economy of a country.

3. No science can study its entire eld without attempting some sort of aggregative
approach.

THE TRADE CYCLE

The trade cycle refers to the ups and
downs in the level of economic activity
Level of Economic Activity

which extends over a period of several

Boom

Full ent
years. If we examine the past statistical Rec
e loym
ssi
on Emp
record of the business conditions, we will
Recovery
Boom

Dep
nd that business has never run smoothly ress
ion
for ever. There are many uctuations in
ry
the period. Sometimes prosperity is cov
e
Re
followed by adversity. In Economics this
tendency of the business activities, to Numbers of Years
uctuate from prosperity to adversity is
called business cycle.
p56
Phases of the trade cycle:

1. Slump or Depression :-
In the period of depression economic activities are low and there is a fall in the
national income, employment and production. The costs are relatively higher than the
prices. Prot falls and there is a reduction in the consumer and capital goods,
producer suffers loss. Bank credit demand also falls. Effective demand and savings
remains low.

2. Recovery :-
This phase develops when the stock with the businessman is exhausted. Due to this cost
begins to decline and the prices which are at its lowest level stop falling further.
There is complete harmony between cost and price. Prot begins to re-appear in the
business. The repairs and replacement of capital equipment starts. There is a
gradual re-employment of labour. The money income increases the purchasing
power. Government also starts some productive and non-productive projects. The
commercial banks also expand the credit.

3. Expansion Phase or Boom :-

In this phase economic activities increases production, prices, employment, wages,
interest rate, prot volume of credit and investment also increases. New plants and
factories are set up and old ones are fully utilized. Demand for labour increases and
there is a rich prot.

4. Recession :-
In this phase the costs begin to increase more than the prices. Because the less
efcient factors of production are employed at higher costs. The prot begins to
disappear. There is a fall in the production, Investment and employment. Even the
businessman closes the business.
The recession phase comes to an end and goes into depression. These four phases go
on replacing each other.

Impact of business cycle on economy

A volatile business cycle is considered bad for the economy. A period of economic
boom (rapid growth in GDP) invariably leads to ination with various economic costs.
This inationary growth tends to be unsustainable and leads to a bust (recession).

The biggest problem of the business cycle is that recession represents a large
wastage of resources. A prolonged period of unemployment can also lead to a loss
of labour productivity as workers get discouraged and leave the labour market.

The uncertainty created by a volatile business cycle tends to cause lower investment,
and this can lead to lower long-term economic growth.

p57
Some economists argue that the business cycle is an essential part of an economy.
Even downturns have their role to play as it tends to 'shake-up' the economy and
weed out 'inefcient' rms and creating greater incentives to cut costs and be
efcient. However, this view is controversial, and other economists argue that in a
recession, even 'good efcient' rms can go out of business leading to a permanent
loss of productive capacity.

How these phases of business cycle occur in an economy, let's take an example:

Recession
The 2008 recession was so nasty because the economy immediately contracted 2.7
percent in the rst quarter of 2008. When it rebounded 2 percent in the second
quarter, everyone thought the downturn was over. But it contracted another 1.9
percent in the third quarter, before plummeting a whopping 8.2 percent in the
fourth quarter.

The economy received another wallop in the rst quarter of 2009 when it
contracted a brutal 5.4 percent. The unemployment rate rose from 5.0 percent in
January to 7.3 percent by December.

Trough
The trough occurred in the second quarter of 2009, according to the NBER. GDP
contracted 0.5 percent. Unemployment rose to 9.5 percent.

Expansion
The expansion phase started in the third quarter of 2009 when GDP rose 1.3
percent. That was thanks to the stimulus spending from the American Recovery and
Reinvestment Act. The unemployment rate continued to worsen, reaching 10.0
percent in October. Four years into the expansion phase, the unemployment rate
was still above 7 percent.
That's because the contraction phase was so harsh.

p58
Peak
The peak that preceded the 2008 recessions occurred in the third quarter 2007.
GDP growth was 2.7 percent. For other examples, see History of Recessions.

Market Failure

Market failure happens when the price

mechanism fails to allocate scarce
resources efciently or when the
operation of market forces lead to a net
social welfare loss. Market failure exists
when the competitive outcome of markets
is not satisfactory from the point of view
of society.

Markets can fail for lots of reasons:

1. Negative externalities (e.g. the effects of environmental pollution) causing the

social cost of production to exceed the private cost

2. Positive externalities (e.g. the provision of education and health care) causing
the social benet of consumption to exceed the private benet

3. Imperfect information or information failure means that merit goods are

under-produced while demerit goods are over-produced or over-consumed

4. The private sector in a free-markets cannot protably supply to consumers pure

public goods and quasi-public goods that are needed to meet people's needs
and wants

5. Market dominance by monopolies can lead to under-production and higher

prices than would exist under conditions of competition, causing consumer
welfare to be damaged

6. Factor immobility causes unemployment and a loss of productive efciency

7. Equity (fairness) issues Markets can generate an 'unacceptable' distribution of

income and consequent social exclusion which the government may choose to
change.

Market Failure is an economic term that encompasses a situation where, in any given
market, the quantity of a product needed by consumers does not equate to the
number supplied by producers. In economics, market failure is a situation that
p59
allocation of products and services is not efcient. In simple terms market failure
occurs when markets do not bring about economic efciency. There is a clear
economic case for government intervention in markets where some form of market
failure is taking place

Governments intervene in markets to address inefciency. In an optimally efcient

market, resources are perfectly allocated to those that need them in the amounts
they need. In inefcient markets that is not the case; some may have too much of a
resource while others do not have enough. Inefciency can take many different
forms. The government tries to combat these inequities through regulation,
taxation, and subsidies.

p60
Glossary
Gross Domestic Product -
Gross Domestic Product is one of the primary indicators which is used to know the
growth and development of country’s economy.

Economic Growth -
Economic Growth is referred to an increase in aggregate productivity . There is an
increase in the capacity of an economy to produce goods and service, which is
compared from one period of time to another.

Negative Externalities -
Negative Externalities refers to the cost suffered by a a thrid party due to
production and consumption of good. The transaction can be monetary also.

Government Intervention-
Regulatory actions taken by a government in order to affect or interfere with
decisions made by individuals, groups, or organizations regarding social and
economic matters.

Recession -
A signicant decline in activity across the economy which may last longer than few
months which has a visible impact on GDP, Income, Employment, Industrial Production
and Retail Sales.

p61
 Chapter 8
INFLATION AND
INFLATION CONTROL

LEARNING OBJECTIVES
• Understand the concept of Ination.
• Classify the various types of Ination.
• Analyse the various measures to Control Ination
(Monetary and Fiscal Policies)

p62
Glossary
Finance -
Finance is a eld that deals with the study of investments.

Initial Public Offering (IPO) -

Initial public offering or stock market launch is a type of public offering in which
shares of a company usually are sold to institutional investors that in turn, sell to the
general public, on a securities exchange, for the rst time.

Stock Market -
It is a place where shares of pubic listed companies are traded.

The Primary Market -

is where companies oat shares to the general public in an initial public offering
(IPO) to raise capital.

Security and Exchange Board of India (SEBI) -

The secondary market or the stock exchanges are regulated by the regulatory
authority.

Derivative -
Derivative is a security with a price that is dependent upon or derived from one or
more underlying assets.

p52
CONCEPT OF INFLATION

Ever heard your grandparents recall how

simple life was during their time? Back in the
days, people could survive with basic
necessities by bringing just Rs. 100 as their
salary.
Did you know that when McDonalds launched
the big Mac in 1967 its cost was only $ 0.45
and in the year 1995 it cost $2.45 where as in
2015 it cost $5.30 but today the same Big Mac
costs $8.70!!!

Amidst all the expensive things today, one thing is for sure: prices would denitely
continue to rise. All because of one culprit, Ination.

"Ination is inevitable like death" is the saying of one of the economists.

What is Ination?

Ination is normally measured as a rate per year.

Ination occurs when prices rise. Low ination is a very important aim for any
country.

Economists today tend to agree that the main cause of ination is 'too much money
chasing too few goods’

p63
 Ination is the increase in the average price
level of goods and services over time.

When prices rise - Each unit of the currency buys

fewer goods and services.

Therefore it reduces the purchasing

power of money.

This means people are able to increase their spending on goods and services faster
than producers can supply the goods and services they want to buy.

The rise in spending causes an

excess of aggregate demand for
goods and services and their
prices are forced upwards.

p64
Consider the following scenario to understand the impact on a country when Ination
continues to prevail for a long period of time.

Country X - Rapid Ination

Workers wages will not buy as many goods as before
Which means that peoples real incomes will fall
Real income is the value in terms of what can be bought
of an income.
If a worker receives 5% wage increase but prices rise
by 10% then the workers real income has fallen by
50%. Workers may demand higher wages - so that
their real income increases.
Prices of the goods produced in Country X will be
higher than those in other countries. People may buy
foreign goods instead and hence jobs in Country X will
be lost.
Businesses will be unlikely to want to expand and
create more jobs in the future. The living standards in
Country X are likely to fall.

Causes of Ination:

There is no such cause that's universally agreed upon, but at least two theories are
generally accepted while the debate still goes on:

1. Demand-Pull Ination – This theory can be summarized as “too much money

chasing too few goods”. It is a mismatch between demand and supply if demand is
growing faster than supply, prices will increase. This usually occurs in growing
economies as more people gain purchasing power while the supply is not able to
catch up to growing demand. When the government of a country print money in
excess, prices increase to keep up with the increase in currency, leading to ination.

What are the main causes of Demand-Pull Ination?

1. A depreciation of the exchange rate increases the price of imports and reduces
the foreign price of a country's exports. If consumers buy fewer imports, while
exports grow, AD in will rise – and there may be a multiplier effect on the level of
demand and output.
2. Higher demand from a scal stimulus e.g. lower direct or indirect taxes or
higher government spending. If direct taxes are reduced, consumers have more
disposable income causing demand to rise. Higher government spending and
increased borrowing creates extra demand in the circular ow.
3. Monetary stimulus to the economy: A fall in interest rates may stimulate too

p65
 much demand – for example in raising demand for loans or in leading to house
price ination. Monetarist economists believe that ination is caused by “too much
money chasing too few goods" and that governments can lose control of ination if
they allow the nancial system to expand the money supply too quickly.
4. Fast growth in other countries – providing a boost to UK exports overseas. Export
sales provide an extra ow of income and spending into the UK circular ow – so
what is happening to the economic cycles of other countries denitely affects the
UK.

Some interesting facts about Ination

1. The Zimbabwean dollar bank note holds the record for the greatest number of
zeros shown (100,000,000,000,000). Hungary holds the record for the largest
banknote ever issued, but its bank note did not depict all the zeros—the amount
was spelled out.

2. The post-WWII hyperination of Hungary holds the record for the most rapid
monthly ination increase ever: 41,900,000,000,000,000% for July 1946, which
means prices doubled every 13.5 hours.

3. In 2008, the top three countries with the most ination were Zimbabwe
(12,563.0%), Burma (35%), and Guinea (23.4%).

4. In 2008, the three countries with the lowest ination rates were Naru (-3.6%), San
Marino (-1.5%), and Burkina Faso (-0.2%).

5. The rst country to hyperinate in the 21st century is Zimbabwe. In 2008, a loaf of
bread cost 1.6 trillion Zimbabwe dollars. Ofcials in Zimbabwe blamed it on rising
global food prices and international sanctions.

6. Twenty-eight hyperinations occurred in the 20th century, with twenty happening

after 1980.

7. Imported gold and silver from the New World caused widespread ination in
Europe between the 15th and 17th centuries.

8. The high mortality rate during the Bubonic Plague in Europe increased the supply of
available currency, which in turn created substantial ination until the mid 1370s.
Higher ination decreased the purchasing power of wage laborers, so that even
though they were paid more, their higher wages could not purchase more.

9. The annual ination rate in the United States has uctuated greatly over its history,
ranging from nearly zero ination to 23% ination. The federal government tries to
keep ination around 2-3%.

p66
10.Hyperination occurred in Germany in 1920, leading to great social unrest. The
purchasing power of money fell so low that the German currency, the Mark,
became cheaper than rewood. Hitler blamed the Jews for spiraling ination,
which helped pave the way for the Holocaust.a

2. Cost-Push Ination – When production costs go up, there is an increase in prices to

maintain prot margins. Increased costs can include things such as wages, taxes, or
increased costs of imports.

Cost-push ination occurs when rms respond to rising costs by increasing prices in
order to protect their prot margins.

There are many reasons why costs might rise:

1. Component costs: e.g. an increase in the prices of raw materials and other
components. This might be because of a rise in commodity prices such as oil,
copper and agricultural products used in food processing. A recent example has
been a surge in the world price of wheat.
2. Rising labour costs - caused by wage increases, which are greater than
improvements in productivity. Wage costs often rise when unemployment is low
because skilled workers become scarce and this can drive pay levels higher.
Wages might increase when people expect higher ination so they ask for more
pay in order to protect their real incomes. Trade unions may use their bargaining
power to bid for and achieve increasing wages, this could be a cause of cost-push
ination.
3. Expectations of ination are important in shaping what actually happens to
ination. When people see prices are rising for everyday items they get
concerned about the effects of ination on their real standard of living. One of the
dangers of a pick-up in ination is what the Bank of England calls “second-round
effects" i.e. an initial rise in prices triggers a burst of higher pay claims as workers
look to protect their way of life. This is also known as a “wage-price effect”.

p67
4. Higher indirect taxes – for example a rise in the duty on alcohol, fuels and
cigarettes, or a rise in Value Added Tax. Depending on the price elasticity of
demand and supply for their products, suppliers may choose to pass on the burden
of the tax onto consumers.
5. A fall in the exchange rate – this can cause cost push ination because it leads to
an increase in the prices of imported products such as essential raw materials,
components and nished products.
6. Monopoly employers/prot-push ination – where dominants rms in a market
use their market power (at whatever level of demand) to increase prices well
above costs.

To summarise - Causes of Ination:

In the demand-pull scenario, consumer demand for goods and services is greater
than the available supply. Thus, the pricing of those items is raised to prevent
inventories from being depleted.

Cost-push ination happens on the supply side. Sellers raise their pricing in order
to cover their increased production costs such as labour and components of the
items they produce.

p68
Let's see this phenomenon from Indian Economy perspective

As the nature of ination is not uniform in an economy for all the time, it is wise to
distinguish between different types of ination. Ination may be caused by a variety
of factors. Its intensity or pace may be different at different times. It may also be
classied in accordance with the reactions of the government toward ination.

II. TYPES OF INFLATION -

1. Creeping Ination
Creeping or mild ination is when prices rise 3% a year or less. According to the
Central Bank when prices rise 2% or less, it's actually benecial to economic growth.
That's because this mild ination sets expectations that prices will continue to rise. As
a result, it sparks increased demand as consumers decide to buy now before prices
rise in the future. By increasing demand, mild ination drives economic expansion.

2. Walking Ination
This type of strong ination is when prices rise between 3-10% a year. It is harmful to
the economy because it heats up economic growth too fast. People start to buy more
than they need, just to avoid tomorrow's much higher prices. This drives demand even
further, so that suppliers can't keep up. More important, neither can wages. As a
result, common goods and services are priced out of the reach of most people.

3. Galloping Ination
When ination rises to ten percent or greater, it wreaks absolute havoc on the
economy. Money loses value so fast that business and employee income can't keep up
with costs and prices. Foreign investors avoid the country, depriving it of needed
capital. The economy becomes unstable, and government leaders lose credibility.
Galloping ination must be prevented.

4. Hyper Ination
Hyperination is when the prices skyrocket more than 50% a month. It is fortunately
very rare. In fact, most examples of hyperination have occurred when the
government printed money recklessly to pay for war. Examples of hyperination
include Germany in the 1920s, Zimbabwe in the 2000s, and during the American
Civil War.

5. Stagation:
Stagation is just like its name says: when economic growth is stagnant, but there still
is price ination. This seems contradictory, if not impossible. Why would prices go up
when there isn't enough demand to stoke economic growth? It happened in the 1970s
when the U.S. went off the gold standard. Once the dollar's value was no longer tied

p69
to gold, the number of dollars in circulation skyrocketed. This increase in the money
supply was one of the causes of ination. Stagation didn't end until then-Federal
Reserve Chairman Paul Volcker raised the Fed funds rate to the double-digits -- and
kept it there long enough to dispel expectations of further ination. Because it was
such an unusual situation, it probably won't happen again.

III. MEASURES TO CONTROL INFLATION

Effective policies to control ination need to focus on the underlying causes of ination
in the economy.

There are three broad ways in which governments try to control ination.

These are-
1. Fiscal measures.
2.Monetary measures
3.Other measures

p70
Ination can, therefore, be controlled by increasing the supplies of goods and
services and reducing money incomes in order to control aggregate demand.

Measures to Control Ination

Monetary Fiscal Other

Measures Measures Measures

• Credit Control • Cut in Expenditure • Raise Production

• De-Monetization • Increase in taxes • Rational Wage Policy
of Currency • Increase in Saving • Price Control
• Issue of New Currency • Surplus Budget • Rationing
• Public Debt

1. Monetary Measures:
Monetary measures aim at reducing money incomes.

(a) Credit Control:

One of the important monetary measures is monetary policy. The central bank of the
country adopts a number of methods to control the quantity and quality of credit. For
this purpose, it raises the bank rates, sells securities in the open market, raises the
reserve ratio, and adopts a number of selective credit control measures, such as
raising margin requirements and regulating consumer credit. Monetary policy may
not be effective in controlling ination, if ination is due to cost-push factors.
Monetary policy can only be helpful in controlling ination due to demand-pull
factors.

(b) Demonetisation of Currency:

However, one of the monetary measures is to demonetise currency of higher
denominations. Such a measure is usually adopted when there is abundance of black
money in the country.

(c) Issue of New Currency:

The most extreme monetary measure is the issue of new currency in place of the old
currency. Under this system, one new note is exchanged for a number of notes of the
old currency. The value of bank deposits is also xed accordingly. Such a measure is
adopted when there is an excessive issue of notes and there is hyperination in the

p71
country. It is a very effective measure but is inequitable as it hurts the small depositors
the most.

2. Fiscal Measures:
Monetary policy alone is incapable of controlling ination. It should, therefore, be
supplemented by scal measures. Fiscal measures are highly effective for controlling
government expenditure, personal consumption expenditure, and private and public
investment.

(a) Reduction in Unnecessary Expenditure:

The government should reduce unnecessary expenditure on non-development
activities in order to curb ination. This will also put a check on private expenditure
which is dependent upon government demand for goods and services. But it is not
easy to cut government expenditure. Though this measure is always welcome but it
becomes difcult to distinguish between essential and non-essential expenditure.
Therefore, this measure should be supplemented by taxation.

(b) Increase in Taxes:

To cut personal consumption expenditure, the rates of personal, corporate and
commodity taxes should be raised and even new taxes should be levied, but the rates
of taxes should not be so high as to discourage saving, investment and production.
Rather, the tax system should provide larger incentives to those who save, invest and
produce more.
Further, to bring more revenue into the tax-net, the government should penalise the
tax evaders by imposing heavy nes. Such measures are bound to be effective in
controlling ination. To increase the supply of goods within the country, the
government should reduce import duties and increase export duties.

(c) Increase in Savings:

Another measure is to increase savings on the part of the people. This will tend to
reduce disposable income with the people, and hence personal consumption
expenditure. But due to the rising cost of living, people are not in a position to save
much voluntarily.

(d) Surplus Budgets:

An important measure is to adopt anti-inationary budgetary policy. For this
purpose, the government should give up decit nancing and instead have surplus
budgets. It means collecting more in revenues and spending less.

(e) Public Debt:

At the same time, it should stop repayment of public debt and postpone it to some
future date till inationary pressures are controlled within the economy. Instead, the
government should borrow more to reduce money supply with the public.

p72
Like monetary measures, scal measures alone cannot help in controlling ination.
They should be supplemented by monetary, non-monetary and non-scal measures.

3. Other Measures:
The other types of measures are those which aim at increasing aggregate supply
and reducing aggregate demand directly.

(a) To Increase Production:

The following measures should be adopted to increase production:

(i) One of the foremost measures to control ination is to increase the production of
essential consumer goods like food, clothing, kerosene oil, sugar, vegetable oils etc.
(ii) If there is need, raw materials for such products may be imported on preferential
basis to increase the production of essential commodities.
(iii) Efforts should also be made to increase productivity. For this purpose, industrial
peace should be maintained through agreements with trade unions, binding them not
to resort to strikes for some time.
(iv) The policy of rationalisation of industries should be adopted as a long-term
measure. Rationalisation increases productivity and production of industries through
the use of brain, brawn and bullion.
(v) All possible help in the form of latest technology, raw materials, nancial help,
subsidies, etc. should be provided to different consumer goods sectors to increase
production.

(b) Rational Wage Policy:

Another important measure is to adopt a rational wage and income policy. Under
hyperination, there is a wage-price spiral. To control this, the government should
freeze wages, incomes, prots, dividends, bonus, etc.
But such a drastic measure can only be adopted for a short period as it is likely to
antagonise both workers and industrialists. Therefore, the best course is to link
increase in wages to increase in productivity. This will have a dual effect. It will control
wages and at the same time increase productivity, and hence raise production of
goods in the economy.

(c) Price Control:

Price control and rationing is another measure of direct control to check ination.
Price control means xing an upper limit for the prices of essential consumer goods.
They are the maximum prices xed by law and anybody charging more than these
prices is punished by law. But it is difcult to administer price control.

(d) Rationing:
Rationing aims at distributing consumption of scarce goods so as to make them
available to a large number of consumers. It is applied to essential consumer goods

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such as wheat, rice, sugar, kerosene oil, etc. It is meant to stabilise the prices of
necessaries and assure distributive justice. But it is very inconvenient for consumers
because it leads to queues, articial shortages, corruption and black marketing.

Conclusion:
Ination or price rise has been a major concern of policymakers for a long long time.
Common man also lists price rise among his top most concerns. Responsibility of
controlling price rise lies with government and RBI.

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Glossary
Demonetisation -
Demonetization is the act of stripping a currency unit of its status as a legal
tender.

Black Marketing-
Illegal free market which ourishes in economies where consumer goods are scarce
or are heavily taxed.

Depreciation-
The monetary value of an asset decreases over time due to use, wear and tear or
obsolescence.

Credit -
It is a contractual agreement in which a borrower receives something of value now
and agrees to repay the lender at some date in the future.

Taxes -
A fee charged levied by a government on a product, income, or activity. If tax is
levied directly on personal or corporate income.

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