Economics - Zell Education 2024

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Table of Contents
Topics in Demand and Supply Analysis 4
Elasticity 4
Demand and Supply 17
The Firm and Market Structures 26
Perfect Competition 26
Monopolistic Competition 37
Oligopoly 43
Monopoly and Concentration 51
Aggregate Output, Prices, and Economic Growth 62
GDP, Income, and Expenditures 62
Aggregate Demand and Supply 72
Understanding Business Cycles 90
Business Cycle Phases 90
Inflation and Indicators 99
Monetary and Fiscal Policy 111
Money and Inflation 111
Monetary Policy 123
Introduction to Geopolitics 145
Geopolitics & Geopolitical Risk 145
International Trade and Capital Flows 153
International Trade Benefits 153
Trade Restrictions 159
Currency Exchange Rates 171
Foreign Exchange Rates 171
Forward Exchange Rates 178
Managing Exchange Rates 181
Formula 187
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Authored by: Dhrumi Doshi, Prabhjyot Taluja, Esha Vora

Illustrated by: Ravi Gupta
Topics in Demand and Supply Analysis

Exam Focus
Understanding and familiarizing with notions such as supply and demand, utility-maximizing
consumers, and the product and cost curves of firms.
Economics is Discipline that deals with factors affecting the production, distribution, and
consumption of goods and services.
Two Broad areas of Economics are:
i. Macroeconomics: Deals with the production and consumption of the overall economy
i.e. GDP, Interest rates, Inflation rate etc.
ii. Microeconomics: Deals with demand and supply of goods and services at a micro level
Elasticity
Calculate and interpret price, income, and cross-price elasticities of demand and
describe factors that affect each measure.
Demand Concept
The willingness and ability of consumers to purchase a given amount of good or service at a given
price.
LAW OF DEMAND
⮚ As the price of a good rises, consumers will want to buy less of it.
⮚ Other factors that impact consumer demand include prices of other substitute and complement
goods, customers’ incomes, and individual tastes and preferences.
Demand Function:
QDx = f(Px, I, Py)
Where;
QDx = Quantity Demanded for Goods X
Px = Price of Goods X
I = Income
Py = Price of Goods Y (Substitute/Complementary)
Following demand function for petrol:
QDPETROL= 100 – 5PPETROL+ 0.04I + 0.10PPUBLIC TRANSPORT – 0.005PPETROL VEHICLE
Demand Curve Represents highest quantities willingly purchased at each prices as well as highest
price willingly paid for each unit.
Slope of demand curve = ΔQ/ Δ P

Slope of demand curve = f (units of measurement for price and quantity)
What do you mean by Own-Price Elasticity of Demand?
⮚ Own-price elasticity is a measure of the responsiveness of the quantity demanded to a change

in price
⮚ Price Elasticity of Demand = % Change in Quantity Demanded / % Change in Price

%𝛥 𝑄𝐷
𝐸𝑑 =
% 𝛥𝑃
∆𝑄 𝑃
= ×
∆𝑃 𝑄
∆𝑄
⮚ The term = Slope of A Liner Demand Function
∆𝑃
Quantity demanded = a + b × price
Where,
a = constant term
b = slope of the curve
A demand curve is the inverse of the demand function, in which price is given as a function of
quantity demanded.
For e.g.: In case of a demand function with A = 50 and B = –5,
Q = 100 – 2P
Because demand function is inverse in nature,
Slope of demand function = inverse of slope term

Slope = - 1/5
In a downward–sloping demand curve (i.e., prices ↑ with an ↓ in quantity demanded)

Its own price elasticity is negative.
Types of Elasticity:
⮚ Elastic (When Elasticity>1)
⮚ Perfectly Elastic (When Elasticity=∞)
⮚ Unit Elastic (When Elasticity=1)
⮚ Inelastic (When Elasticity<1)
⮚ Perfectly Inelastic (When Elasticity=0)
Elastic demand = Price Elasticity > 1.
When quantity demanded is very responsive to a change in price, e.g., luxury goods,
In case of availability of many/ good substitutes, the demand is said to be elastic as a small change
in the price causes a large change in the quantity demanded. E.g., In case of an ↑ In price of Pepsi,
your quantity demanded for Pepsi ↓,
However, your quantity demanded Coca Cola ↑
Inelastic demand = Price Elasticity < 1
When quantity demanded is not very responsive to a change in price, e.g., necessities,
In case of the absence of good substitutes or few substitutes quantity demanded is inelastic as a
large change in the price causes a small change in the quantity demanded.
For e.g., In the case of a hike in prices for oil, the quantity demanded doesn’t change much as it is a
necessity-based demand for nations.
Unit elastic: An elasticity of 1 is said to be unit elastic. Change in demand is same as Change in price.
Perfectly Elastic demand = With no change in price, the change in quantity demanded is infinite,
Example: A good example of perfectly elastic products would be luxury products such as jewels, gold
and high-end cars. The moment the price for these products is increase, the demand drops.
Perfectly Inelastic demand = Irrespective of a change in the price, the quantity demanded doesn’t
change, e.g., in most cases of demand for oil.
Example: A good example of perfectly inelastic demand would be a lifesaving drug. No matter how
dramatically the price changes, the demand would still remain the same.
Which are the other factors that affect demand elasticity in addition to substitutes?
ELASTIC INELASTIC
Portion of If a large portion of the income is If a small portion of the income is
income spent spent on the good. spent on the good.
on a good
For e.g.: In the USA, a small For e.g.: If a change in the price
reduction in the mortgage rate of a matchstick won’t make the
led to a boom in the housing consumer shift his brand of
sector market as consumers matchstick as it covers a small
started buying houses rather than part of the income.
renting them due to the low
rates.
Time Longer periods after an ↑ in Shorter periods after an ↑ in
prices are more elastic as you prices are less elastic as you have
have more time to adapt or less time to adapt or substitute
substitute to the change. to the change.
For e.g.: In case of a rise in the For e.g.: In case of a rise in price
price of electricity, in the long for electricity, in the short run,
run, you can adjust to the change you can adjust to the change by
by shifting to renewable energy reducing the overall use for the
without cutting down your use. time being
Availability of If there are close substitutes for a If there are no close substitutes,
Substitutes good and the price of the good the demand is less elastic.
increases, then the quantity
demanded for the good will
decrease substantially implying
the demand is highly elastic.
Discretionary The demand for necessary goods While the demand for
vs. Non- is less elastic, e.g. bread. discretionary goods is more
Discretionary elastic, e.g. vacations.
Note: Elasticity is not equal to the slope of a demand curve

👩🏫 Illustration
Given a demand function for petrol,
QDPETROL= 10,000 – 500 PVEHICLE PRICES
Calculate the price elasticity at a petrol price of $10 per barrel.
Solution
For QD of petrol:
QDPETROL= 10,000 – 500 PVEHICLE PRICES
QDPETROL= 10,000 – 500 (10)
QDPETROL= 5,000 barrels.
For Price
Elasticity: Ed
%𝛥 𝑄𝐷
=
% 𝛥𝑃
∆𝑄 𝑃
= ×
∆𝑃 𝑄
∆𝑄
Since, = - 500
∆𝑃
P = $10
Q = 5000 barrels
Thus,
Ed = 10/5000 x (- 500) = -1.
Thus, at this demand for petrol is unitary elastic.
Explain how elasticity changes along a linear demand curve?

The Upper Segment/ High The Midpoint (known as The Lower Segment /
Elasticity Range Unitary Low
Elasticity) Elasticity Range
Ed>1 Ed = -1 Ed < 1
In the upper segment at Thus, the elasticity at point In the lower segment
point (b) means that a 1% ↑ In of the curve at point
(a) of the DD curve, Elasticity Price = 1% ↓ In Quantity (b), the
Is Demanded. Elasticity Is < 1
> 1 (in absolute value);
This is the point of % Change in Quantity
Equilibrium where Total Demanded Is < %
% Change in Quantity
Revenue is Maximized. Change in
Demanded >
% Change in Price. Price
As seen in the graph, As seen in the graph, As seen in the graph,

At a price level > $5 (Elastic The equilibrium price with At a price level< $5
level), the best total revenue is (P × (Inelastic level),
Q), which =
The Percentage ↓ Quantity 5 × 5 = $25 The Percentage ↓
Demanded >Percentage ↑ in Quantity Demanded
Price. <Percentage ↑ in
Price.
Price & Total Expense* will Change in price will have no Price & Total Expense*
move in opposite direction. impact on total expense*. move in the same
direction.
*Total Expense = Quantity Sold X Price of Goods
How is Income Elasticity of Demand different from Cross-Price Elasticity of Demand?
INCOME ELASTICITY OF DEMAND CROSS-PRICE ELASTICITY OF DEMAND

The sensitivity of quantity demanded to a The sensitivity of quantity demanded
change in income is called as income elasticity to changes in prices of related goods
(substitutes and complementary
goods)
Keeping other variables constant, Keeping other variables constant,

Ed = % Change in Quantity Demanded / %
Change in Income Ed = % Change in Quantity Demanded
%𝛥 𝑄𝐷 / % Change in
=
% 𝛥𝐼𝑁𝐶 Price of Related Goods
∆𝑄 𝐼
= ×
∆𝐼 𝑄 %𝛥 𝑄𝐷
=
% 𝛥𝑃
∆𝑄𝑌 𝑃𝑋
= ×
∆𝑃𝑋 𝑄𝑌
For Normal goods, (e.g., luxury cars, jewellery) For substitutes (e.g., tea and coffee,
Income Elasticity = Positive laptop and desktops) Elasticity =
An, ↑ in income = ↑ in quantity demanded Positive
An ↑ in the price of one good = ↑ in
the quantity demanded of substitutes
For Inferior goods (e.g.: margarine, used cars) For complementary goods (e.g.:
Income Elasticity = Negative petrol & cars, milk
↑ in income =↓ in quantity demanded. & cheese)
Elasticity = Negative
An ↑ in the price of one good = ↓ in

the quantity demanded of
complementary good
For e.g.: When the income elasticity of a good For e.g.: When the price of petrol ↑
is 0.34, it means that for a 1% ↑ in income, by 1% the quantity demanded for CNG
the quantity demanded ↑ by 0.34%. (substitute good) ↑ and quantity
demanded for petrol cars
(complementary good) ↓
Kinds of movement in demand curve:
Movement along the demand curve:

When a good’s own price changes, the quantity demanded changes, all else equal.
Shift in the demand curve:
A change in the value of any other variable will cause the demand curve to shift. This is called
change in demand. For instance, shift in demand is caused by changes in consumers’ incomes,
price of substitutes, and price of complements.
Calculate the income elasticity of the cars when the % Δ in income is 50% and the % Δ in quantity
demanded 40%.
Solution
Ed = % Change in Quantity Demanded / % Change in Income

40%
⸫ Ed =
50%
Ed = 0.8
Rani has the following demand function for petrol:
QDPETROL= 100 – 5PPETROL+ 0.04I + 0.10PPUBLIC TRANSPORT – 0.005PCARS
Assuming the car price is $19,000, income is $30,000, the price of public transport $10, and the
price of petrol is $5 per litre.
Calculate
a. Income elasticity of petrol,

b. The cross-price elasticity of petrol demand with respect to the price of public transport.
Solution
QDPETROL= 100 – 5(5) + 0.04(30,000) + 0.10(10) – 0.005(19,000)
QDPETROL= 100 – 25 +1200 + 1 - 95
QDPETROL= 1181 per litre.
For income elasticity

QDPETROL= 100 – 5(5) + 0.04(income) + 0.10(10) – 0.005(19,000)
QDPETROL= - 19 + 0.04(income)
QDPETROL= - 19 + 0.04(30,000)
QDPETROL= 1181
Thus 0.04 is the slope.
% ∆𝑄
Ed =
% ∆𝐼𝑛𝑐
∆𝑄 𝐼
= ×
∆𝐼 𝑄
30000
= × 0.04 = 1.02
1181
For a 1% Δ in the income the QD of Petrol Δ’s by 1.02%
For cross elasticity (public transport)

QDPETROL= 100 – 5(5) + 0.04(30,000) + 0.10PPUBLIC TRANSPORT – 0.005(19,000)
QDPETROL = 1180 + 0.10PPUBLIC TRANSPORT
QDPETROL = 1180 + 0.10(10)
QDPETROL = 1181.
Slope = 0.10
Ed = % Change in Quantity Demanded / % Change in Price of Related Goods

%𝛥 𝑄𝐷
=
% 𝛥𝑃
∆𝑄𝑌 𝑃𝑋
= ×
∆𝑃𝑋 𝑄𝑌
=10/1181 x 0.1 = 0.008.

For a 1% Δ in the price of public transport the QD of Petrol Δ by 0.008%.
1. Price elasticity of demand=
A. Price Elasticity of Demand = % Change in Quantity Demanded / % Change in Price

B. Price Elasticity of Demand = % Change in Quantity Demanded x % Change in Price
C. Price Elasticity of Demand = % Change in Price /% Change in Quantity Demanded
2. Total revenue is highest in the segment of a demand curve that is:
A. Elastic
B. Inelastic
C. Unit elastic.
3. The demand function for kitchen appliances is given by:
QDkitchen appliances= 1,000 – 5P Kitchen appliances+ 0.05 income + 20 PElectricity Fan– 2P Electricity
At current average prices, a kitchen appliance costs $500, a fan costs $20, and electricity costs
$100. Average income is $40,000. The income elasticity of demand for kitchen appliances is
closest to:
A. 2.05.
B. 2.86.
C. 3.00.
4. A product is classified as an inferior good if its:
A. Income elasticity is -ve.

B. Price elasticity is -ve.
C. Cross-price elasticity is -ve.
5. Which of the following factor is least likely to affect the shift in the demand curve of Ethnic
wear clothes?
A. Per Capita GDP

B. Prices of Products
C. Change of Fashion
Answers
1. A is correct. Price Elasticity of Demand = % Change in Quantity Demanded / % Change in Price.
2. C is correct. Total revenue is highest at the output at which, own-price elasticity = –1.
3. B is correct
Substituting the figures in the equation we get;
QD kitchen appliances= 1,000 – 5 ($500) + 0.05 income + 20 ($20) – 2($100)
QD kitchen appliances = 1000 -2500 + 0.05 income + 400 – 200
QD kitchen appliances= -1300 + 0.05 income. QD
kitchen appliances= - 1300 + 0.05 ($40,000)
QD kitchen appliances= 700.
Therefore,
The slope of income is 0.05, and for an income of $40,000, QD = 700

𝐼 ∆𝑄 40000
Income elasticity = 𝑄0 × ∆𝐼
= 700
× 0.05 = 2.86
0
4. A is correct an inferior good has a negative income elasticity of demand.
5. B is correct. Change in prices of the products can lead to movement along the demand curve.
Demand and Supply
Compare substitution and income effects.
SUBSTITUTION EFFECTS INCOME EFFECTS
↑ in the price of a good X ↑quantity Price of good X ↓, it leads to ↑ Real Income

demanded of the substitute good Y, and ↓ which means higher disposable income,
in quantity demanded of good X. which can lead to an increase or decrease in
Substitution effect is always positive the demand for good X. Income effect can
be positive or negative.
Thus, we can conclude with three possible outcomes of in the Price of Substitute Good:
1. The substitution effect = positive,

The income effect = positive
⸫ Consumption of Good X will ↑.

The income effect = negative, (Δ Income effect <Δ Substitution effect)
⸫ consumption of Good X will ↑.

The income effect = negative, (Δ Income effect >Δ Substitution effect)
⸫ consumption of Good X will ↓.
Distinguish between normal goods and inferior goods

How is an inferior good meaning different from person to person?
⮚ Normal goods, (e.g., luxury cars, jewellery)

When Income Elasticity = Positive
An, ↑ in income = ↑ in quantity demanded
⮚ Inferior goods (e.g., margarine, used cars)

When Income Elasticity = Negative
↑ in income =↓ in quantity demanded.
⮚ For e.g.: As a school student for ten years, you travel by bus, but you are gifted a bike when you
turn 18 years old. This, when a bike becomes a normal good for you and bus travel, becomes an
inferior good.
⮚ Further when you start earning you buy yourself a car this when your bike becomes an inferior
good and car becomes a normal good.
Differentiate between Giffen Goods and Veblen Goods.
GIFFEN GOODS VEBLEN GOODS

An inferior good where, Goods where ↑ price = good more desirable
The Negative Income Effect > The Positive and quantity demanded ↑
Substitution Effect When Price ↓
It has an upward-sloping demand curve Utility to a consumer is achieved via a high-
Thus at ↓ prices = ↓ quantity status tag.
demanded due to ↑ in real income ↑ ↑ Price = ↑ Status
income effect versus substitution effect. For e.g.:
Diamonds, Chanel bags, etc
Positively sloped demand curve, but there is
a limit to it, or else the price will rise with no
limit
For e.g.: In the case of fast-food prices in For e.g.: Women carry expensive high-end
India, handbags like Gucci, Dior, or Chanel despite
When the prices of rice ↓ from ₹ 16 k/g to knowing that a regular handbag would serve
₹ 14 k/g the quantity demanded (rice) ↓ their purpose. This is for snob appeal or
This is because the excess real income due status symbol.
to a fall in the price of rice can be used to
purchase a superior product such as meat.
Describe the phenomenon of diminishing marginal returns
What do you understand by diminishing marginal returns?

⮚ Factors of production are the resources a firm uses to generate output. The 4 Factors of
production are:
Land—where the business facilities are situated.
Labour— it consists of all workers from unskilled labour to the highest management.
Capital— sometimes called physical capital (plant and machinery, equipment) to differentiate it
from financial capital (stocks, bonds, etc.). Refers to manufacturing facilities, equipment, and
machinery.
Materials—refers to inputs into the productive process, including raw materials, such as coal or
water, or manufactured inputs, such as software chips or wires.
⮚ However, for economic analysis, we mostly consider only two inputs, capital and labour.
⮚ Quantity of output that a firm can produce = f(amounts of capital and labour employed). This is
called a production function.
⮚ At a given amount of capital (a company’s plant & machinery),
⮚ When we ↑ the amount of labour employed = ↑ in production (↑ in total product)
⮚ The output with only one worker is considered the marginal product of the first unit of labour.
⮚ Adding a 2nd worker will ↑ product by the marginal product of the second worker.
⮚ The marginal product of (additional output from) the 2nd worker is > than the marginal product
of the 1st.
⮚ This is true only if we assume that two workers shall double the output based on teamwork or
specialization of tasks.
Marginal product = Change in Total Products
Change in Labours
⮚ At this ↓ rate of labour input (holding capital constant), we can say that the marginal product of
labour is ↑.
⮚ In case of a constant increase in the number of workers, after a limit, adding one more worker
shall increase total output at a much lower rate than the increase in output in case of an addition
of the previous worker; however, the total production continues to increase.
⮚ When we reach the amount of labour for which the ↑ output for each additional worker begins
to ↓, we have reached the point of diminishing marginal productivity of labour, or that labour
has reached the point of diminishing marginal returns.
⮚ Beyond this amount of labour, the ↑ output from each ↑ worker continues to ↓.
⮚ There is, theoretically, some amount for labour at which the marginal product of labour is
negative
As seen in the graph above,
For quantities of labour from 0 to A, the marginal product of labour is ↑ (slope is ↑).
From points, A-B, the marginal product of labour is still positive but decreasing.
Crossing the quantity of labour at B, ↑ workers ↓ total output.

The marginal product of labour in this arena is negative, and the production function slopes
downward.
Determine and interpret breakeven and shutdown points of production.

What is the relationship between the terms short-run and long-run and factor costs?
SHORT RUN LONG RUN

The costs of few factor inputs are fixed The costs of all factor inputs are
in the short run. variable in the long run.
⸫ no Δ in the scale of production ⸫ Δ in the scale of production is
possible
E.g., Labour, rent, etc
What do you understand by the shutdown and breakeven under perfect competition?
⮚ Shutdown and Breakeven Under Perfect Competition
⮚ In case of perfect competition, when,

Total Revenue = Total Cost (Variable + Fixed Cost) = Breakeven Output Quantity
⸫ at breakeven quantity Economic Profit = 0
⮚ The producer is the price taker
⮚ Using the graph of cost functions to evaluate the success of the company at we have;
At price P1, price and average revenue = average total cost.
At the production level of Point A, the company makes an economic profit = zero.
At a price > P1, economic profit
At prices < P1, economic losses

⮚ For short-run
a. Average revenue/Price > average variable costs (price between P1and P2) of the product, the
shop must continue to work to diminish losses and thus covering the fixed costs,
loss = liability of fixed costs
b. If the products are sold and Average Revenue < Their Average Variable Cost, price < P2
⸫Loss > Liability of Fixed Costs.

Thus, losses incurred shall be lessened by shutting down the business in the short run, as loss
from running the business is more than the loss incurred through fixed costs –
⮚ For long term
All costs are variable, so a company can avert its (short-run) fixed costs by shutting down.
For this reason, if the price is expected to remain less than the minimum average total cost (fixed
+ variable costs) in the long run, the firm will shut down rather than continue to generate losses.
In case of:
a. AR ≥ ATC, the company must operate in the market in both the short and long run.
b. AR ≥ AVC, however; AR < ATC, the company must stay in the market in the short run but shall
leave the market in the long run.
c. If AR < AVC, the company must completely shut down for both the long and short term.
What do you understand by the shutdown and breakeven under imperfect competition?
Shutdown and Breakeven Under Imperfect Competition
⮚ For price-searcher companies (e.g., under monopoly) facing downward-sloping demand curves,
we can correlate AR to ATC and AVC in perfect competition to identify shutdown and breakeven
points.
⮚ However, Marginal Revenue ≠ Price, despite this, we can recognize the circumstances under
which a firm is breaking even, should shut down in the short run, and should shut down in the
long run (at Total Revenue and Total Cost).
⮚ These conditions are:

TR = TC: break even.
TC > TR > TVC: companies must continue to operate in the short run but shut down in the long
run.
TR < TVC: companies must shut down in the short run and the long run.
⮚ Since, Price ≠ Marginal Revenue for a company under imperfect competition, evaluation built on
total costs and revenues is more appropriate for examining breakeven and shutdown points.
⮚ Thus, the explained relations hold for both price-taker and price-searcher firms.
⮚ If the entire TC curve > TR (i.e., no breakeven point), the firm wishes to diminish the economic
loss in the short run by operating at the quantity equivalent to the smallest (negative) value of
TR – TC.
For the year 2019-20, Microsoft had stated a total revenue of $275,000, a total variable cost of
$300,000, and total fixed costs of $125,000. Analyse if the company should continue functioning in
the
a. short run
b. long run Solution
For short run
The firm must shut down
Since,
Total Revenue < Total Cost = $275,000 < $ 425,000
Total Revenue < Total Variable Cost =$275,000 <$300,000
Thus, the amount lost in case of a shutdown = Total Fixed Cost = $125,000,
Which is less than the operating cost of (Total Revenue - Total Cost)
= $ 425,000- $275,000 = $150,000
For long run
The firm must shut down.

Since,
Total Revenue < Total Cost = $275,000 < $ 425,000
Thus, In the long run the total revenue it isn’t sufficient enough to cover all costs.
Describe how economies of scale and diseconomies of scale affect costs.

How can economies and diseconomies of sale affect the costs?
While plant size is fixed in the short run, in the long run, companies should opt for the most gainful
scale of operations.
This is because the long-run average total cost (LRATC) curve is drawn for several varying plant sizes
or scales of operations. Every point along the curve signifies the minimum ATC for a given plant size
or scale of operations.
As seen above, the companies LRATC curve and with short-run average total cost (SRATC) curves
for several varying plant sizes, with, e.g., SRATC2 depicting a greater scale of operations v/s
SRATC1
LRATC curve is U-shaped.
ATC first ↓ with larger scale and ultimately ↑.

The Minimum Efficient Scale
The lowest point on the LRATC correlates with the scale or plant size when the ATC is least.
In perfect competition, companies must function at a minimum efficient scale in long-run

equilibrium; thus, the LRATC = Market Price. Since, under perfect competition, companies make
zero economic profit in long-run equilibrium. Companies that have chosen a different scale of
operations with ↑ ATC shall make economic losses. Therefore, they must either leave the
industry or change to a minimum efficient scale.
The downward-sloping section of LRATC curve signifies those economies of scale (or higher
returns to scale) are present. Economies of scale occur from factor inputs such as:
⮚ Labour specialization,
⮚ Mass production, and
⮚ Investment in more efficient equipment and technology.
Additionally, the company may bargain lower input prices with suppliers as company size ↑ and ↑
capital is bought.
A firm operating with economies of scale could surge its competitiveness by growing production and
lower costs.
The upward-sloping segment of the LRATC curve signifies the diseconomies of scale. Diseconomies
of scale may be an outcome of the rising bureaucracy of bigger companies which leads to:
⮚ Inefficiency,
⮚ Demotivation amongst the larger workforce, and
⮚ Larger barriers to innovation and business activity.
A firm operating under diseconomies of scale will want to ↓ output and go back at a level of minimum
efficient scale. E.g., Auto sector in the USA.
Thus, there might be a relatively flat portion at the end of the LRATC curve that depicts continuous
returns to scale. Thus, above a range of continuous returns to scale, costs are for the various plant
sizes.
The factors contributing to economies of scale and a lower ATC are as follows:
Increasing returns to scale: increase in output is relatively larger than the increase in input
⮚ Division of labor/management.
⮚ Technologically/economically efficient equipment that results in increased productivity.
⮚ Effective decision-making.
⮚ Reduce waste and lowering costs through better quality control.

⮚ Bulk purchases resulting in lower prices.
The factors contributing to diseconomies of scale and a lower ATC are as follows:
⮚ Decreasing returns to scale: Increase in output is relatively less than the increase in input. The
right side of Q3 shows decreasing returns to scale.
⮚ Higher resource costs due to supply bottlenecks.
⮚ Improper management because of size.
⮚ Duplication of product lines.
⮚ Higher labor costs.

1. If a company’s long-run ATC increases by 6% when production is increased by 6%, the company
is experiencing:
A. Economies of scale.
B. Diseconomies of scale.
C. Constant returns to scale
2. When the price of a good decreases its quantity purchased also decreases, it is most likely that:
A. Both the substitution effect and income effect lead to a decrease in the quantity purchased.
B. The substitution effect leads to a decrease in the quantity purchased, while the income effect
leads to an increase in the quantity purchased.
C. The income effect leads to a decrease in the quantity purchased, the substitution effect leads to
an increase in the quantity purchased.
3. When average revenue is greater than average variable costs but less than average total costs,
a firm will most likely:
A. Operate in the short run but shut down in the long run.
B. Shut down in the short run but operate in the long run.
C. Shut down in both the short run and the long run.
4. If a firm’s output is increased by 7%, its long-run average total cost also increases by 7%. The
firm is most likely experiencing:
A. Economies of scale.
B. Diseconomies of scale.
C. Constant return to scale.
Answers
1. B is correct increasing long-run ATC as a consequence of rising output demonstrates

diseconomies of scale.
2. C is correct. When price decreases, the substitution effect will always lead to an increase in the
quantity purchased. The quantity purchased of a good will decrease when price decreases only
if the income effect is both negative and greater than the substitution effect.
3. A is correct. When total revenue is enough to cover variable costs but not total fixed cost in full,
the firm can survive in the short run but would be unable to survive in the long run.
4. B is correct. If the long-run average total cost increases as output increases, then we have
diseconomies of scale.
The Firm and Market Structures

Exam Focus
Focus on the four market structures: perfect competition, monopolistic competition, oligopoly, and
monopoly
Understanding and studying the different market structures like numbers of firms, firm demand
elasticity and pricing power, etc
Interpreting the two quantitative concentration measures, their application for market structure,
pricing power, and restrictions.
The following concepts are required to analyse the industry competition and pricing power of
companies.
Perfect Competition
Describe characteristics of perfect competition, monopolistic competition,

oligopoly, and pure monopoly.
What do you mean by a market? What are the four types of market structures?
Market
⮚ An arena where a group of buyers and sellers meet to exchange goods
⮚ Price for the exchange is also fixed in this market. E.g., Physical markets like malls or even online
markets on e-commerce platforms
The four market structures are:
1. Perfect Competition
Several firms are producing homogenous products present in the same market. Firms are price
takers with a perfectly elastic demand curve competition is based on price. E.g., Agriculture,
Forex market, etc. in India.
Example: There are several farmers in India selling similar products in the market to many buyers.
In this market, the prices are easier to compare. Therefore, agricultural markets often get close
to perfect competition.
2. Monopoly
Only one firm is producing the product with No close substitutes. Price searcher with significant
pricing power. E.g., Indian Railways IRCTC.
Luxottica is a company that owns all the major brands of sunglasses (e.g., Dolce & Gabbana, Giorgio
Armani, Prada, Vogue eyewear and Versace). The company has brought a lot of brands, but have kept
the names and operations different – giving the customer the illusion that they have a variety of
sunglasses to choose from although they are all manufactured by one company.
3. Monopolistic competition
Many sellers and differentiated products.
Example: Fast Food companies like McDonald’s and Burger King are the perfect example of
monopolistic competition. Even though both of them are renowned for their burgers, soft drinks,
fries and other similar products, there is no congruency between the products sold by the two brands.
4. Oligopoly
Few firms compete in a variety of ways. E.g., Telecom Sector – VIL, Jio, Airtel
The music industry is dominated by 3 major labels – Sony, Universal Music Group and Warner Music
Group. To give you a context of how dominant these 3 are, they own a combined 90% of the United
States and Canadian market. They own the rights to well-known artists such as The Beatles, Beyonce,
Badshah, Justin Bieber, Eminem and thousands of others (probably any artist you can think of falls
under one of these 3 labels).
Which are the five factors required to analyse the market for the industry?
We can analyse where an industry falls by evaluating these five factors:
1. Number of firms and their relative sizes.
2. Degree to which firms differentiate their products.
↑ in products = ↑ in substitutes for consumers
3. Bargaining power of firms with respect to pricing.
Price taker (Quantity DD < Quantity SS) or Price Maker (Quantity DD < Quantity SS)
4. Barriers to entry into or exit from the industry.
E.g., the defence industry in India has ↑ barriers to entry, while the FMCG sector has ↓ barriers
to entry.
5. Degree to which firms compete on factors other than price.
E.g., Competition based on quality, quantity, customer service, etc.

What are the characteristics of perfect competition, monopolistic competition, oligopoly, and pure
monopoly in a market?
PERFECT MONOPOLIST OLIGOPOLY MONOPOLY

COMPETITIO IC
N COMPETITIO
N
Number of Several Firms Several Firms Few Firms Single Firm
firms
Barriers to Very Low Low High Very High
entry
product Very Good Good Either Very No
differentiation Substitutes Substituted Good Substitutes
but Slightly Substitutes or
Different Differentiated
Non-price NONE Marketing Marketing Advertising
competition
Pricing power None Some Some To Significant
Significant
Example Rice, Barley FMCG Sector Oil Defence
etc
Explain relationships between price, marginal revenue, marginal cost, economic

profit, and the elasticity of demand under each market structure.
Describe and determine the optimal price and output for firms under each market
structure.
Explain factors affecting long-run equilibrium under each market structure.
Explain the curve in case of a Perfect competition.

In case of a Perfect competition.
⮚ Producers do not influence the price
⮚ Market demand and supply regulate the price
⮚ An individual firm has a perfectly elastic demand curve

⮚ As seen above, for a perfectly competitive market, an individual company shall keep on
expanding production until marginal revenue (MR) = marginal cost (MC).
⮚ MR = increase in total revenue by selling one extra unit of a good or service.
⮚ In the case of a price taker, MR is the price as all extra units are supposed to be sold at that exact
(market) price.
⮚ In pure competition, a company’s MR = Market Price, and a firm’s MR curve, as seen above, is
similar to its demand curve.
Explain economic profit under perfect competition. Use a graph.
For making the highest profit, firms shall produce the quantity, Q*, when MC = MR.
⮚ Thus, produce and sell at a price where MR = MC
⮚ Economic profit = Total Revenue - Opportunity Cost of Production,

This includes:
Cost of usual return on all factors of production + invested capital.
What do you mean by short-term marginal and total approach under perfect competition?
⮚ As seen above, for(a), in the short run,
⮚ Profit maximizing output is where MR = MC
⮚ Price is charged on the AR curve. Here , AR = MR = Price
⮚ As Price > ATC, economic profit is positive.
⮚ As seen above, for (b), profit maximized at Q where TR – TC is maximum
Total revenue > total cost by the maximum amount.
Similarly, Economic loss is the output for which MR < MC,
How is equilibrium maintained in a perfectly competitive market?

⮚ As seen above, under a perfectly competitive market, companies will not generate economic
profits for a significant period.
⮚ It is assumed that new firms (having average and marginal cost curves similar to those of
prevailing firms) shall enter the business to earn economic profits.
⮚ This leads to an ↑ in the market supply and ultimately ↓ market price where,
Market price = Average Total Cost (ATC).
⮚ At equilibrium, every company produces the output for which P = MR = MC = ATC to remove any
chance for companies to earn economic profits.
⮚ Thus, every firm produces the quantity at which ATC is minimum (Q when, ATC = MC). This
equilibrium situation is depicted above
Explain the concept of economic losses and shutting down point.
⮚ The above graph portrays that firms shall generate economic losses when, P < ATC.
⮚ In such a situation, the company needs to decide whether to keep operating.
⮚ A company shall diminish its losses in the short run by continuing to operate when,
P <ATC but P >AVC. i.e ATC > P >AVC
Up until the company covers the variable costs and part of the fixed costs,
Loss < Short- Run Fixed Costs.
⮚ However, If the company is generating revenue that only covers its variable costs (P = AVC), then
the company is functioning at its shutdown point.
⮚ When a company is unable to cover its variable costs (P < AVC), then by continuing to operate,
Loss >Fixed Costs.
⮚ Thus, the company shuts down at 0 output, and they lay off their employees.
⮚ Losses are limited to fixed costs (e.g., rent and debt costs).
⮚ In the future, if Price does not surpass ATC shutting the business is the only option to cut down
the fixed costs.
What is the difference between short-run firm supply and short-run market supply under perfect
competition?
⮚ Under perfect competition, the long-run equilibrium production level for perfectly competitive
companies is when MR = MC = ATC, where ATC is minimum.
⮚ This is when economic profit = 0, only a normal return is generated.
⮚ As discussed above, price takers shall produce where P = MC.
⮚ Thus, as seen in graph (a), the company will shut down when P <P1. From P1- P2, a company will
keep operating in the short run. At P2, the company is generating a normal profit.
⸫ Economic profit = 0. At Prices over P2, a company is generating economic profits and shall
expand its output along the MC line.
⮚ Thus, the SRAS curve for a company = MC line above the AVC.
⮚ The supply curve depicted in graph (b) = SRAS (MARKET), which is the horizontal addition of
quantities from all companies at each price of the MC curves in the industry.
⮚ Since companies shall supply ↑units at ↑ prices, the short-run market supply curve slopes
upward to the right.
Explain the short-run Changes in Demand, Entry and Exit, and Changes in Plant Size.
⮚ In the short run, an ↑ in market demand (rightward shift of DD curve) leads to ↑ equilibrium
price & ↑ quantity
⮚ However, a ↓ in market demand leads to ↓ in both equilibrium price and quantity.

⮚ The change in the equilibrium price will change the perfectly elastic demand curve.
⮚ As seen above, an ↑ in market demand from point D1 to D2 ↑ the short-run equilibrium price
from P1- P2 and output from Q1- Q2.
⮚ In graph (b), we observe the short-run effect of the higher market price on the output of an
individual firm.
Higher price = Better Profit-Maximizing Production, Q2.

At a greater output level, a company will generate an economic profit in the short run.
⮚ In the long run, some companies their scale of operations in reply to the increase in demand.
⮚ New firms will enter the industry.
⮚ In response to a decrease in demand, the short-run equilibrium P & Q will ↓, whereas, in the
long run, companies will ↓ their scale of operations or leave the market.
For Short-Run Adjustment to an Increase in Demand under Perfect Competition
⮚ A firm’s long-run adjustment to a shift in industry demand and the subsequent price change may
be to cut the size of its production unit or exit the market completely.
⮚ Several companies ↑ output in reply to ↑ market demand.
⮚ Companies, such as Ford, have ↓ the production unit size to ↓ economic losses. This strategy is
known as downsizing.
⮚ When a new company enter the market, the equilibrium output ↑ and the equilibrium price ↓
⮚ Thus, companies produce less at lower prices
⸫ Every individual company shall move down its supply curve. Resulting
Company’s TR and economic profit will ↓.
⮚ In case of economic losses, some of these firms will exit the market. This ↓ industry supply and
↑ equilibrium price.
⮚ Every remaining company in the industry will move up its supply curve and ↑ production at ↑
market price.
⮚ This will cause total revenues to ↑, ↓ any economic losses which the outstanding companies
had been facing
Explain the permanent Changes in Demand, Entry and Exit, and Changes in Plant Size.
⮚ A permanent change in demand the entry of companies or exit of companies in a business.
⮚ The primary long-run industry equilibrium state exposed in Graph (a) is at the node of demand
curve D0 and supply curve S0, at price P0 and quantity Q0.
⮚ As shown in Graph (b), at the market price of P0 each company produces q0.
⮚ ⸫ every company generates a normal profit, and economic profit = 0.
⮚ Now, assume that the industry demand always increases, where the industry demand curve in
Graph (a) shifts to D1. The new market price = P1 and industry output ↑ to Q1. Thus, at the new
price P1, prevailing companies shall produce q1 and generate an economic profit since P1> ATC.
⮚ ⸫ Positive economic profits = new firms to enter the market.
⮚ When these new firms ↑ total industry supply, the industry supply curve eventually shifts to S1,
and the market price reduces back to P0.
⮚ At the market price of P0, the industry shall now produce Q2, with a higher number of companies
in the business, each producing at the initial quantity, q0.
⮚ The individual companies will no more generate an economic profit as ATC = P0 at q0.
The Summary of the similarities and differences between perfect competition and monopolistic
competition.
Similarities
⮚ Long-run economic profit is zero
⮚ Profit-maximizing output: MR = MC
Differentiation
⮚ In the long run, profit-maximizing output quantity of MC is lower than PC.

⮚ Economic cost in MC includes advertising cost for product differentiation.
⮚ PC is efficient as surplus is maximized.
PC: Price = Marginal Cost MC: Price > Marginal Cost
⮚ Deadweight loss in MC because firms have some amount of pricing power and consumer
surplus is lost.
⮚ Prices are lower in PC, but consumers have little variety.
1. In the case of a company operating under pure competition, marginal revenue is equivalent to:
A. Total Cost
B. Price.
C. Marginal Cost.
2. In case of a perfect competition, the short-term supply curve of a company is equivalent to:
A. ATC Curve
B. AVC Curve
C. MC Curve
3. The factor most likely to promote a case of a monopoly includes:
A. High barriers to entry/exit

B. Diseconomies of scale
C. Availability of substitutes
4. From the options are given below, under which market structure could a company’s supply role
be explained as its MC curve above its AVC curve?
A. Monopoly
B. Perfect competition
C. Monopolistic competition.
5. Which of the following is, has significant pricing power?
A. Monopolistic competition
B. Monopoly
C. Perfect competition
Answer
1. B is correct. Price A company that operates under pure competition, MR = Price. Since, under
pure competition, demand is perfectly elastic (Elasticity = infinity), Thus, MR is constant and
MR= Price.
2. C is correct MC Curve. A price taker shall maximize his profits at a production level is where
P=MC, as price increase the intersection node on MC Curve is the point at which P=MC.
3. A is correct. High barriers to entry.
4. B is correct. Supply role is not well-explained in markets except those that can be categorized
as perfect competition.
5. B is correct. Monopoly, Due to supply < demand.

Monopolistic Competition
Monopolistic competition has the following market characteristics:
Large number of independent sellers:
1. Every company has a fairly small market share; (e.g., McDonald’s, Burger King, etc. in the fast-
food industry).
2. Companies are required only to consider the average market price. (e.g., McDonald’s and Burger
King’s burgers are all similar prices).
3. There are several companies in the business for collusion (price-fixing) to be possible (e.g.,
Britannia, ITC, Nestle, etc., in the FMCG Sector).
Differentiated products:
Every manufacturer has an item that is slightly different from its competitors.
They are close substitutes for one another (e.g., Coca-Cola and Pepsi).
Companies compete on the grounds of price, quality, and marketing:
Price and quantity could be decided by companies as they face a downward-sloping demand curves.
However, there is generally a solid correlation between quality &price that firms can charge.
Marketing is necessary to update the market about an item’s differentiating features (e.g., Tele
marketing, social media marketing, newspaper marketing, etc.)
Low barriers to entry
Companies are free to enter and leave the market. In the case of the existing businesses generating
economic profits, new firms shall be projected to enter the business. Companies in the monopolistic
competition have a downward-sloping demand curve
(Price searchers).
DD curves = highly elastic since competing goods are seen by consumers as close substitutes. (E.g.,
Nike, Adidas, Puma, etc. in the sportswear category)
For instance, the market of biscuit, it is differentiated based on factors like taste, size, price,quality,
etc.
Differentiate between long and short-run features under monopolistic competition.

SHORT RUN FEATURES LONG RUN FEATURES

As seen above, Graph (a) depicts the short- Graph (b) depicts the long-run equilibrium for
run price/output features of monopolistic a demonstrative company after new
competition for an individual company. companies have entered the market.
As shown, companies in monopolistic As shown, the entry of new companies shifts

competition maximize economic profits by the demand curve of each separate firm
producing where marginal revenue (MR) = down to the point where P* = ATC*; thus,
marginal cost (MC), and by levying the price the economic profit = 0.
for that Q based on the demand curve, D.
At this stage, there is no more benefit for
Here the company generates positive new firms to enter the market, and long-run
economic profits as price, P* > ATC*. equilibrium is recognized. The company in
monopolistic competition keeps producing at
Due to low barriers to entry, competitors Q where MR = MC; however, there isn’t any
will enter the market with expectations of positive economic profit.
high economic profits.
Explain the long-run equilibrium in markets with monopolistic competition.
Under monopolistic competition, price >marginal cost,
ATC is not at a minimum for the total output produced = excess capacity/inefficient scale of
production.
Price is slightly higher than v/s perfect competition, where there is no product differentiation.
For e.g.:
Company Production for Monopolistic and Perfect Competition In a situation with only one brand
of biscuit exists.
Thus, the average production costs would be ↓.

Product differentiation has costs, but it also has incentives for consumers. Customers gain from
brand name promotion and advertising as they receive information about the nature of a product.
This usually allows customers to make better purchasing decisions.
For e.g.:
In the case of fairness creams where consumers are convinced that these creams will actually boost
their self–esteem.
The idea of ↑ self-esteem from using a particular product is worth the excess cost of advertising.
Some customers would reason that the ↑ cost of advertising and sales is not acceptable by the
incentives of these activities.
Which are the excess costs incurred under monopolistic competition
⮚ Product innovation
Necessary for:
1. Economic Profit
2. Innovations = less elastic markets
3. Additional innovation costs < economic profit generated
4. Sufficient innovation cost, MR (additional innovation) = MC (additional innovation)
⮚ Advertising expenses
Necessary for:
1. Informing about Unique features
2. Due to close substitutes, the requirement to promote your brand is higher under monopolistic
competition v/s perfect competition’ & monopoly
3. Thus, the total cost for the monopolistic competition is higher which further, reduces with a
rise in output
Since the costs are fixed and can be distributed over a bigger number of outputs.
⮚ Brand names
Necessary for:
1. Signifies the quality of the product under the brand
2. Many companies have huge budgets to promote brand name.

For e.g.: Nike, Prada, Mercedes, etc
Thus, the product quality is assumed to be good based on these high-end brand names.
1. Under monopolistic competition, the demand for goods is relatively elastic, based on:
A. Substantial barriers to entry.

B. Abundance of close substitutes.
C. Abundance of complementary goods.
2. A company shall most likely maximize gains at the quantity of production for which:
A. Price = MC.
B. Price = MR.
C. MC = MR.
3. Which of these is least likely an excess cost, under monopolistic competition:
A. Product innovation
B. Purchase cost
C. Advertising Cost
4. In the case of a business earning positive economic profits under a monopolistic competitive
market, the most likely situation to occur is:
A. Losses in a short period

B. Price takers shall get overshadowed by price searchers
C. New companies shall enter the market, thereby driving the economic profit down to 0
5. A marketplace with the presence of a large number of sellers and differentiated products is best
described as:
A. Oligopoly
B. Perfect competition
C. Monopolistic competition
Answer:
1. B. is correct Abundance of close substitutes. If a company increases its price for a product, it shall
lose its clients to companies trading substitute goods at lower prices.
2. C is correct. MC = MR. Profit-maximizing production is the quantity at which MR = MC. In the

case of a price-searcher business structure, price > MR.
3. B. is correct. Purchase cost. Purchase cost is a cost required under every market. The other two
costs are exclusively incurred under monopolistic competition.
4. C is correct. New companies shall enter the market, thereby driving the economic profit down
to 0, by sucking up the excess demand.
5. C is correct. Monopolistic competition, e.g. A marketplace like India.

Oligopoly
What do you mean by oligopoly? State the models used for price and quantity equilibrium.
Oligopoly
⮚ High barriers to entry v/s monopolistic competition
⮚ Interdependence of companies in the business
E.g., an ↑ in the price by Firm A = ↑ in prices by all other Firms
⮚ Four models used for their consequences on price and quantity under oligopoly are:
1. Kinked demand curve model/ Pricing Interdependence Strategy

2. Cournot duopoly model.
3. Nash equilibrium model / Prisoner’s dilemma / Game Theory
4. Stackelberg dominant firm model
What do you mean by Kinked demand curve model?
⮚ Assumption:
↑ in price by one company does not lead to ↑ in price by competitors, but
↓ in price by one company ↓ in price by competitors
⮚ Belief
Each company has a belief that their demand curve is more elastic above a given price, i.e., the kink
in the demand curve v/s the below the given price
⮚ As seen above, the kink price = PK and production QK.
A firm believes that if it ↑ its price above PK,

Competitors will continue to be at PK, thus, a loss of market share since it has the maximum price.
At prices over PK, the demand curve = relatively elastic,
Thus, a small price ↑ = a large ↓ in demand.
⮚ However, if a firm’s price ↓ below PK, competitors will match the price reduction]
⸫ All firms will undergo a relatively small ↑ in sales concerning any price reduction. Thus, Q K is
the profit-maximizing level of output.
Note: As seen above, with a kink in the aggregate demand curve, we observe a gap in the MR curve.
For any firm with an MC curve passing through this gap, the price for which the kink is present =
firm’s profit-maximizing price.
DISADVANTAGE: oligopoly is incomplete because what regulates the market price (where the kink
is located) is outside the scope of the model.
What do you mean by Cournot model?
⮚ Developed In the 19th century
⮚ Assumption: only two firms are present (duopoly) with identical & constant MC
⮚ The quantity produced by the competitor in the previous period is used to create the other
company's demand curve for the coming period, assuming a no Δ in quantity produced by the
competitor in the coming period.
⮚ Thus, Market Demand Curve - Quantity Produced (competitor) is used for constructing demand
curve and MR curve for the other company, thus producing at a profit-maximizing point.
For e.g.: If the Total Demand for the goods in the market is 100 units and Firm A produces 40
units, Firm B can construct its own demand curve for 60 units (100 – 40) and create a profit-
maximizing price and output (Q < 60 units, to produce less at higher prices).
⮚ The quantities keep fluctuating until both the firms produce equal quantities (50 – 50).
Thus, the opportunity to earn extra profits by selling less quantity disappears.
Price < Profit Maximizing Point, but Price > MC
⮚ When new firms enter the market, the equilibrium price ↓
⮚ This model was a primary version of strategic games, decision models where; the best option for
a firm = f (the actions of other firms).
⮚ A universal model of this strategic game was developed by John Nash, who developed the
concept of a Nash equilibrium.
What do you mean by Nash equilibrium?
⮚ The equilibrium point is the best option for all firms to maximize their profits.
⮚ Prisoner’s Dilemma is one such strategic game.
⮚ There are two prisoners, A and B, who are said to have committed a serious crime. However,
the prosecutor feels that the police don’t have sufficient evidence for a judgement.
⮚ The prisoners are separated and offered the following deal:
o If Prisoner A confesses and Prisoner B remains silent, Prisoner A goes free, and Prisoner B
receives a 10-year prison sentence.
o If Prisoner B confesses and Prisoner A remains silent, Prisoner B goes free, and Prisoner A
receives a 10-year prison sentence.
o If both prisoners remain silent, each will receive a 6-month sentence.
o If both prisoners confess, each will receive a 2-year sentence.
⮚ Both the prisoners have no idea what the other prisoner will choose.
⮚ The Prisoners dilemma states:

Prisoner B (silent) Prisoner B
(confesses)
Prisoner A A → 6 Months A → 10 Years
(silent)
B → 6 Months B → Free
Prisoner A A → Free A → 2 Years

(confesses) B → 10 Years B → 2 Years
⮚ The Nash equilibrium is for both prisoners to confess and to get a sentence of two years each.
⮚ Despite the best outcome would be for both the prisoners to remain quiet and get sentences of
six months.
⮚ Neither of these outcomes (except confess/confess) is a Nash equilibrium because the silent
prisoner in both cases can improve his situation by confessing rather than remaining silent.
⮚ Confess/confess is the Nash equilibrium since A/B prisoner can individually ↓ his sentence by
changing to silence.
⮚ This outcome can also be seen as that no matter what the other prisoner chooses to do, the best
sentence for a prisoner comes from confessing.
⮚ We can plan a parallel two-firm oligopoly game where the equilibrium outcome asks both firms
to cheat the collusive agreement by charging a low price, despite the best overall outcome for
both is to honour the agreement and charge a high price.
For e.g.:
Company B Company B
(honours) (cheats)
Company A A’s gain = ₹ 1,500 A’s gain = ₹50
(honours) B’s gain = ₹ 1,500 B’s gain = ₹2,000
Company A A’s gain = ₹2,000 A’s gain = ₹ 1,000
(cheats)
B’s gain = ₹ B’s gain =
500 ₹1,000
⮚ As seen above, both firms honouring = best profit, due to the presence of a collusive agreement,
which is when A & B both honour the agreement and earn ₹ 1,500.
⮚ There are, however, regulations (anti-trust laws) opposing such collusive agreements to avoid
competition &to protect the interests of the consumers.
For e.g.: The OPEC oil cartel is such a collusive agreement; however, the proof is present that
cartel members frequently cheat on their agreements to share the best output of oil.
⮚ Thus, collusive agreements for higher prices in an oligopoly market leads to more success
(Cheating less) when,
o There are fewer firms.
o Identical Products.
o Identical Cost structures.
o Small and frequent purchases.
o Certain and severe Retaliation by other firms for cheating.
o Less actual /potential competition from firms outside the cartel.
What do you mean by a dominant model in oligopoly?
⮚ A final model of oligopoly is the dominant firm model.
⮚ This model states that there is only one firm that has a significantly large market share due to its
larger scale and lower cost structure. This firm is known as the dominant firm (DF).
⮚ The dominant firm essentially decides the market price, while the other competitive firms (CF)
are the price takers.
⮚ The dominant firm thinks that the quantity supplied by the other firms reduces at lower prices
⮚ Thus, as seen above, the dominant firm’s demand curve = f (the market demand curve).
Based on this demand curve (DDF) and its connected marginal revenue (MRDF) curve, the firm shall
procure the highest profits at a price of P*.
⮚ Whereas the competitive firms procure the highest profits by producing the quantity where
marginal cost (MCCF)= P*, quantity QCF.
⮚ A price ↓ by any one of the CF’s = ↑ QCF in the short run,
The DF shall retaliate by ↓ its price ↓ output by CF’s or exit of these CFs from the market in the
long run.
⮚ As a result, in the long run, such a price reduction by competitors below P* causes a decrease
in the overall market share of CF’s and improves the market share of the dominant firm.
⮚ As seen above, the final price will be between the price based on perfect collusion that would
maximize total profits to all firms in the market (the monopoly price) and the price that would
result from perfect competition and realize 0 economic profits in the long run.
1. What is the assumption under a kinked demand curve?
A. Rise in price by one company shall not lead to a rise in price by competitors, however A fall in
price by one company leads to a fall in price by competitors
B. Constant prices for all firms
C. Rise in price by one company shall lead to a rise in price by competitors, however A fall in price
by one company shall not lead to a fall in price by competitors
2. What do you understand from duopoly?
A. Only 2 companies are present

B. Only 2 customers are present
C. Only Dominant company is present
3. An oligopolistic industry has:
A. Few barriers to entry

B. Few economies of scale
C. A great deal of interdependence among firms
Answer:
1. A is correct. Rise in price by one company shall not lead to a rise in price by competitors, however
a fall in price by one company leads to a fall in price by competitors
2. A is correct. Only 2 companies are present according to the Cournot model, under oligopoly
3. C is correct. A great deal of interdependence; Oligopoly has a great arrangement of

interdependence among firms. One company’s pricing choices or advertising doings shall affect
the industry as a whole.
Monopoly and Concentration

What do you mean by monopoly market?
⮚ One seller
⮚ Downward sloping demand curve
⮚ High barriers to enter the market
⮚ Profit maximization = trade-off between price and output
⮚ Two pricing strategies that are possible for a monopoly firm are:
1. Single-price
When price discrimination isn’t possible, the monopoly charges a single price.
E.g., IRCTC, ITC (tobacco market)
2. Price discrimination.
In case of an absence of reselling, monopolistic producers can maximize their profits by levying
different prices to different groups of customers. E.g., Lawyers, doctors, etc.
⮚ To maximize profit, monopolists will increase output until; MR= MC.
Do monopolists charge the highest possible price?
⮚ No, as monopolists wish to maximize profits, not price.
⮚ One way to calculate MR for a firm that faces a downward-sloping demand curve and sells at a
single price is:
MR = P (1 – 1/EP),
Where;
P= current market price,
Ep= absolute value of price elasticity of demand
⮚ Thus, we can also state that:
MC= P (1 – 1/EP),
Explain the revenue-cost structure faced by the monopolist.

⮚ As seen above, Production will increase till MR = MC at optimal output Q*.
⮚ One must analyze the demand curve for the price at which the firm shall sell Q* units. The
demand curve by itself cannot decide the optimal behaviour of the monopolist.
⮚ Similar to the perfect competition model, the profit-maximizing output is where,
MR = MC.
⮚ To guarantee a profit, the demand curve must lie above the firm’s ATC curve at the optimal
quantity,
⮚ Thus, Price > ATC. The ideal quantity shall be in the elastic range of the D curve.
⮚ Economic profit = (P* – ATC*) × Q*.
⮚ Monopolists = price searchers
⮚ They have imperfect information concerning market demand. Thus, they must test with different
prices to find the appropriate price that maximizes profit.
What do you understand by price discrimination?
⮚ Price discrimination
The exercise of charging different consumers different prices for the same product or service. For
e.g.: The Canadian entertainment company, Cineplex, a firm that uses the price discrimination
strategy by charging different prices based on the age factor, senior citizens and infants are
charged at a less rate compared to young adults
⮚ In order for price discrimination to work, the seller needs:
a. A downward-sloping demand curve.
b. Minimum two identifiable groups of customers with varying price elasticities of demand for the
product. (E.g., the middle-class group has an elastic demand for air-ticket prices v/s the rich)
c. To prevent the clients paying the lower price from reselling the product to the higher paying
customers.
⮚ As long as these conditions are met, firm profits can be increased through price discrimination.
⮚ As seen above, price discrimination =↑ the total quantity supplied, and ↑ economic profits v/s
a single-price pricing strategy.
⮚ We assumed no fixed costs and constant variable costs so that MC = ATC.
⮚ In graph (a), the single profit-maximizing price is $100 at a quantity of 80
(MC = MR), which realizes a profit of $2,400.
⮚ In graph (b), the firm separates the clients, charges one group $110 and sells them 50 units, and
sells an additional 60 units to another group (with more elastic demand) at a price of $90. Total
profit is ↑ to $3,200, and total output is ↑ from 80 units - 110 units.
⮚ Compared to output produced in perfect competition, the output produced by a monopolist

decreases the consumer + producer surplus by an amount represented by the triangle labelled
as deadweight loss (DWL).
⮚ Graph (a), Consumer surplus is decreased not only by the fall in quantity but also by the rise in
price relative to perfect competition. Thus, Monopoly is inefficient since the fall in output v/s
perfect competition decreases consumer + producer surplus.
⮚ Since marginal benefit >marginal cost, less than the efficient quantity of capital is allocated to
the production process.
⮚ Price discrimination decreases this inefficiency by improving output toward the quantity where
marginal benefit = marginal cost.
NOTE: Deadweight loss is less in graph (b).
⮚ The firm generates profits from clients with inelastic demand, simultaneously providing goods to
customers with elastic demand.
⮚ This leads to production taking place even when it would not have otherwise.
⮚ An extreme (theoretical) case of price discrimination is perfect price discrimination.
⮚ If it were likely for the monopolist to levy on every customer the maximum that they are ready
to pay for each unit, a deadweight loss would be absent.
⮚ This is because a monopolist would produce the same quantity as under perfect competition.
Thus, an absence of consumer surplus.
What is the difference in allocative efficiency between monopoly and perfect competition?
What do you mean by natural monopoly?
⮚ Natural Monopoly occurs when the production scale causes a single firm to supply the entire
market demand for the product.
⮚ Huge economies of scale = ↓ in average cost of production, since the sole firm produces more &
more output.
⮚ For e.g.: Tap water, The fixed costs of producing tap water, like constructing the pipelines and
related mediums to deliver it to households, are quite high.
The MC of providing tap water to one more house or of providing extra tap water to a house is quite
low.
↑ tap water provided = ↓the average cost per unit.
Thus, natural monopoly is when the average cost of production for an individual firm for the
relevant range of consumer demand.
The entry of a new firm into the business shall distribute the production between the two firms
⸫ higher average cost of production than for a single producer.
Thus, in the case of large economies of scale in an industry, there are significant barriers to entry.
Left free, a single-price monopolist will maximize profits where MR = MC, producing QU and levying
a price PU.
Given the economies of scale, entry of another firm in the market would ↑ the ATC significantly.
As seen above, if two firms each produced approximately 50%of output QAC, the average cost for
each firm would be much higher than for a single producer producing QAC.
Thus, signifying a potential profit from monopoly due to lower average cost production when LRAC
decreases so that economies of scale lead to a single supplier.
Pricing Regulators frequently attempt to ↑ competition and efficiency through ↓ artificial barriers
to trade, e.g., licensing requirements, quotas, and tariffs.
Since monopolists produce < optimal quantity, government control aims at improving resource
allocation by controlling the prices that monopolies may charge.
This is practiced through average cost pricing or marginal cost pricing.
What do you understand by average cost pricing & marginal cost pricing?
Average cost pricing Marginal cost pricing

The most common form of also referred to as efficient regulation
regulation
This leads to a price of PAC and an Compels the monopolist to lower the
output of QAC. It compels price to a point where the firm’s MC
monopolists to decrease the price to curve joins the market demand curve.
where the firm’s ATC meets the This ↑’s output and ↓ ‘s price, but
market demand curve. leads to a loss for the monopolist as
Price < ATC
This will: Government subsidy is needed to
↑ output and ↓ price. provide the firm with a normal profit
↑ social welfare (allocative and protect it from exiting the market
efficiency). completely.
Ensure the monopolist earns a
normal profit since price = ATC Another way of controlling a monopoly
needs the government to sell the
monopoly right to the highest bidder.
For e.g.: The right to construct a petrol
station, food court on a toll, etc.
Winning bidder = efficient supplier that

bids,
Where amount =to the value of
expected economic profit and sets
prices equal to long-run average cost
The Example of monopoly worldwide.

Companies like Aramco in Saudi Arabia or PDVSA in Venezuela are government monopolies of
oil development created through the nationalization of resources and existing firms.
The United States Postal Service is also a government monopoly.
Describe a firm’s supply function under each market structure.
SHORT-RUN SUPPLY FUNCTION

(Sum of quantities supplied at each price
across all firms)
PERFECT COMPETITION MC curve above the AVC curve,
Price = Marginal Revenue
MONOPOLISTIC No well-defined supply function
COMPETITION
OLIGOPOLY No well-defined supply function
MONOPOLY No well-defined supply function
NOTE:
No well-defined supply functions since all these structures have a downward-sloping demand
curve, For;
Equilibrium Quantity = Intersection of MR &MC curve
Equilibrium Price = Analysis of Demand curve

Describe pricing strategy under each market structure
What is the pricing strategy under each market structure?
⮚ Perfect competition
Profits are maximized by producing the Q where MC = MR.
Note: MR = Price ⸫ Price = MC, at the profit-maximizing quantity.
⮚ Monopoly:
Profits are maximized by producing the Q where MC = MR.
Since the firm's demand curve is downward sloping, Price > MR > MC.
⮚ Monopolistic competition:
Profits are maximized by producing the Q where MC = MR. Similar to monopoly, the firm's
demand curve is downward sloping and price > MR > MC.
⮚ Oligopoly:
One of the core features of oligopoly is the interdependence of firms’ pricing and output
decisions. Thus, the optimal pricing strategy depends on our assumptions about the reactions of
other firms to each firm’s actions.
Therefore under;
1. Kinked demand curve:

Competitors are assumed to match a price ↓ but not a price ↑.
Firms produce Q, where MR=MC.
However, the MR curve is discontinuous (there’s a gap in it)
⸫ for most cost structures, the optimal quantity is the same, given they face the same kinked
demand curve.
2. Collusion:
All producers decide to share the market to maximize total business profits.
The total quantity produced is where MR = MC and levy a price from the industry demand curve
at which that quantity can be sold.
3. Dominant firm model:

We assume one firm has the lowest cost structure and a large market share as a result. The DF
will maximize profits by producing the quantity where MC=MR and charge the price on its firm
demand curve for that quantity. Other firms in the market will take that price as given and
produce the quantity for which MC = Price.
4. Game theory:
Due to the interrelationship of oligopoly firms’ decisions, assumptions about how a competitor
will react to a particular price and output decision by a competitor can determine the optimal
output and pricing strategy. Given the diversity of models and assumptions about competitor
reactions, the long-run outcome is unknown. We can only say that the price will be between
price(monopoly) & price (perfect competition)
Describe the use and limitations of concentration measures in identifying market

structure.
What are the uses and limitations of concentration measures in identifying market structure?
⮚ % Of market share is used to identify the power of the company in the market.
⮚ Often, mergers or acquisitions of companies in the same industry or market are not permitted
by government authorities due to high combined market share.
⮚ Thus, instead of estimating the elasticity of demand, concentration measures for a market are
generally used as a measurement of market power.
⮚ One such concentration measure is,

N-firm concentration ratio= Sum or % market shares of the largest N firms in a market. However,
it does not directly measure market power or elasticity of demand.
⮚ One limitation of the N-firm concentration ratio is,
The Relative insensitiveness to mergers of two firms with large market shares.
⮚ Solution to this problem is using an alternative measure of market concentration, the Herfindahl-
Hirschman Index (HHI).
⮚ The HHI = the sum of the squares of the market shares of the largest firms in the market.
Note: Barriers to Entry are not considered in either case
Given the market shares, calculate the 4-firm concentration ratio and the 4-firm HHI, both before
and after a merger of A and B.
FIRM MARKET SHARE %

A 20
B 15
C 20
D 15
E 10
F 5
Solution
Before Merger
CONCENTRATION RATIO
For, A + B + C + D
= 20 + 15 + 20 + 15
= 70%
HHI
For, A + B + C + D
= 0.22 + 0.152 + 0.22 + 0.152
= 0.125
After Merger
CONCENTRATION RATIO
Let (A+B) Merger = K
= 20 + 15 = 35%
For,
K + C + D+ E
= 35 + 20 + 15 + 10
= 80%
HHI
For,
K + C + D+ E
= 0.352 + 0.152 + 0.22 + 0.12
= 0.195
In India, companies with a turnover of > ₹ 3,000 crores cannot acquire another Indian company
without prior notice
1. Which of the given option is most likely a benefit of the Herfindahl-Hirschman Index versus the
N-firm concentration ratio? The HHI:
A. Is easier to estimate.
B. Examines the barriers to entry.
C. Is more sensitive to mergers
2. Amongst the given statements, which statement must accurately defines a substantial variance
between a monopoly firm and a perfectly competitive firm? For a perfectly competitive firm, it:
A. Minimizes costs; a monopolistic firm maximizes profit.

B. Maximizes profit; a monopolistic firm maximizes price.
C. Takes price as given; a monopolistic firm must search for the best price.
3. What is the slope of the demand curve under monopoly?
A. Upward sloping
B. Perfectly elastic demand curve
C. Downward sloping demand curve
4. Monopoly generates _________because monopolies produce a quantity where; consumer

surplus + producer surplus is not maximized.
A. Deadweight loss
B. No loss
C. Only profits
5. In the case of a controlling agency, it needs a monopolist to use average cost pricing; the intent
is to price the merchandise where:
A. The ATC curve meets the MR curve.

B. The MR curve meets the demand curve.
C. The ATC curve meets the demand curve.
Answer:
1. C is correct. While the N-firm concentration ratio is easy to compute, it can be comparatively
insensitive to mergers amongst firms with large market shares. Neither the HHI nor the N-firm
concentration ratio examines the barriers to entry.
2. C is correct. Monopolists must look out for the profit-maximizing price (and output) since they
do not have perfect information concerning demand. Companies under perfect competition
take the market price as given and only determine the profit-maximizing quantity.
3. C is correct. Downward sloping demand curve.
4. A is correct. Monopoly generates a deadweight loss because monopolies produce a quantity
where; consumer surplus + producer surplus is not maximized.
5. C is correct. The ATC curve meets the demand curve. When a controlling agency needs a
monopolist to use average cost pricing, the intent is to price the merchandise where the ATC
curve meets the market demand curve. An issue in using this technique is to really determine
what exactly the ATC is.
Aggregate Output, Prices, and Economic Growth

Exam Focus
Introduction to macroeconomics and measurement of macroeconomic concept.

Understanding concepts like aggregate demand, short-run, and long-run aggregate supply
Understanding and measuring various measures of aggregate income nominal and real GDP,
national income, personal income, and personal disposable income
GDP, Income, and Expenditures
Calculate and explain gross domestic product (GDP) using expenditure and income
approaches.
What is GDP (Gross Domestic Product), and what are the components uses in its calculations?
⮚ The total market value of the final goods and services produced in a country within a certain
period.
⮚ Goods and services that are included and excluded are mentioned below.
INCLUSION EXCLUSIONS
Purchases of newly-produced goods and Transfer Payments like relief
services only. measures, unemployment, etc
For example:
In the case of a car, the prices of intermediate
goods like steering wheels, engine, etc., are
not calculated. The final price of the consumer
good (car) is directly counted, including all the
costs of these intermediate goods.
Government services like police, defence, Environmental
judiciary, etc., despite being sold in the damage For
market. It is only calculated as a cost to the example:
government. Water pollution is caused by the
waste water released by factories
directly damaging the rivers, lakes,
etc.
The harmful fumes of the factories
cause air pollution
Value of self-owned and occupied houses just No resale of goods and services
like rented houses.
Produced within the domestic boundaries Produced outside domestic
boundaries
What are the two methods of calculating GDP?
a. Income approach; Total income earned by households + governments + businesses in a particular

period. For example: Income from laborer’s (wages and salaries), profits of businesses, and rent
are included.
b. Expenditure approach; Total amount spent on these goods and services.
The two methods of calculation are:
1) Sum of value-added method; value at each stage of production is added.
2) Value of final output method; value of final goods and services are taken.
Compare the sum-of-value-added and value-of-final-output methods of calculating

GDP.
What is the difference between the two expenditure methods of GDP?
1. Sum of value-added method; value is added at each stage of production.
2. Value of final output method; value of final goods and services are taken.
For example:
Stages of Production Value of Sales Value-added

Farmer supplies milk 100 100
Ice cream maker factory 300 200
Vendor 500(for case 1) 200
Total 500(for case
2)
However, as seen above, in the case of both the methods, the GDP calculated is the same ($500).
Thus, the value of final goods and services = value of goods at each stage of production
Compare nominal and real GDP and calculate and interpret the GDP deflator.
What is Nominal GDP vs Real GDP, and how is it calculated?
Nominal GDP
⮚ Nominal GDP= f (current market price)
⮚ Nominal GDP = ∑ (the price of good “X” in year t) × (quantity of good “X” produced in year t).
= ∑PnQn
⮚ The nominal GDP can ↑ with ↑ P and ↑ Q. as it's based on current market price. Thus, Nominal
GDP can rise even with no change in output due to inflation.
⮚ For Example: A country that only produces steel manufactures 100 kg of steel at $10 per kg in
2019. The price of the same steel is $15 in 2020. What is the Nominal GDP in 2020?
Solution
100*15= $1,500
Real GDP
⮚ It measures current year output using base-year prices.
⮚ It reflects an ↑ in the overall output and not the price, thus eliminating the effect of inflation.
⮚ Real GDP = (price of good “X” in year 0) × (quantity of good “X” produced in year t) = Base Year
Price X Current Year Quantity
⮚ For Example: A country that only produces steel manufactures 100 kg of steel at $10 per kg in
2019 (base year). The price of the same steel is $15 in 2020 with no change in output. What is
the Real GDP in 2020?
Solution
100*10= $1,000
How does a GDP Deflator work, and how does it tackle the problem of inflated prices?
GDP Deflator
⮚ It helps in converting the nominal GDP into real GDP, eliminating the problem of inflation through
a change in prices.
⮚ It measures inflation across all the sectors of the economy, e.g., government, export/import,
business, etc
⮚ GDP Deflator = NOMINAL GDP in year T/ Value of year T output at base year price (REAL GDP)
*100
For Example:
The GDP Deflator for the above example is calculated as;
1500/1000 *100 = 150.
This shows that there has been a 50% ↑ in the price in the year 2020.
Explain per capita GDP

⮚ It is used to calculate the economic well-being of the citizens
⮚ Per capita GDP= Real GDP/Population size
Nominal GDP per capita in 2020-21 is estimated at ₹ 145,679 against ₹ 151,760 2019
for -20.
This fall is due to the pandemic worldwide, which has slowed down the economy.
👩🏫 Illustration:
a) The GDP in 2018, Australia is $2.7 billion at 2018 prices and $2.5 billion calculated using 2017
prices. Calculate the GDP deflator.
Solution
GDP deflator = Nominal GDP/ Real GDP *100
=2.7/2.5*100
=108
This shows an 8% ↑ in the price levels in the last one year.
b) Nominal GDP is $1000 billion in 2019 and $750 billion in 2014. The GDP deflator is 112.
Calculate;
i Real GDP for 2019
ii The compound annual real growth rate of economic output from 2014 to 2019.
Solution
i. For Real GDP
112= 1000/ REAL GDP*100
REAL GDP = $892.85
ii. For compounded real growth in the
output:
Assuming that nominal and real GDP is the same for the base year,
= (892.85/750) ⅕ - 1
= 3.54%
Compare GDP, national income, personal income, and personal disposable

income.
How would you explain GDP using the expenditure method?
The expenditure approach of calculating GDP comprises of the following components:
⮚ Consumers spending on final goods and services
⮚ The amount of money that businesses invest in their own country (capital, plant, inventory)
⮚ Government spending (infrastructural development, healthcare, education, etc.)
⮚ Net Exports (when, exports>imports)
⮚ It is calculated as, GDP = C + I + G + (X – M)
Where,
C= Consumption
I= Investment
G= Government Spending
(X-M) = Net Exports
We can further divide C and I into private and government portion. Thus, the equation expands:
GDP = (C + G^ C) + (I + G^ I) + (X – M)
Where:
G^ C = government consumption (spending on defence, police, infrastructure projects,

etc.) G^ I = government investment (capital, plant, and machinery)
PARTICULARS AMOUNT ($)

Transfer Payments 50
Interest Income 100
Depreciation 20
Wages 45
Gross Private Investment (I) 112
Business Profits 208
Indirect Business Taxes 65
Rental Income 72
Net Exports (X-M) 15
Net foreign factor income 12
Government Purchases (G) 150
Household consumptions (C) 356
Calculate the GDP using the expenditure method.
GDP= C+I+G+(X-M)
= 356+112+150+15
=$633.
Explain the income approach of GDP?
⮚ It is also known as Gross Domestic Income (GDI), i.e., the income received from all factors of
production
⮚ It is calculated as
GDP = national income + capital consumption allowance + statistical discrepancy
Where,
Capital consumption allowance (CCA) = Depreciation expense maintained to meet the wear and tear
of physical capital
Statistical discrepancy = the difference between the calculations of income and expenditure
approach of GDP.
National income = sum of the income received by all factors of production
= compensation of employees (wages and salaries including cash and in-kind instruments like
ESOP’s, corporate profit sharing, etc.)
+ Corporate and government enterprise profits before taxes; this includes NGO’s as well
+ Interest income
+ Unincorporated business net income (business owners’ incomes)

+ Rent
+ Indirect business taxes,
- Subsidies included in final prices
National income excludes transfer payments
PARTICULARS AMOUNT ($)

Transfer Payments 50
Interest Income (i) 100
Depreciation 20
Wages (W) 45
Gross Private Investment 112
Business Profits (PR) 208
Indirect Business Taxes (statistical discrepancy) 65
Rental Income (R) 72
Net Exports 15
Net foreign factor income 12
Government Purchases 150
Household consumptions 356
Calculate the GDP using the income method.
Solution
National income = sum of the income received by all factors of production
= W+I+R+PR.
NI= 45+100+72+208
=$425.
GDP = national income + capital consumption allowance + statistical discrepancy
= 425+20+65
=$510.
What is personal income?
Personal income
- Consumer capacity to make consumptions
- PI = Salaries/Wages Received + Interest Received + Rent Received + Dividends Received + Any

Transfer Payments
What is household disposable income?
Household disposable income or personal disposable income
- Household personal income = disposable income – personal taxes.
- It helps in determining the purchasing power of the citizens.
Explain the fundamental relationship between saving, investment, fiscal balance, and the
trade balance.
Show how private savings are related to investment, government sector, and foreign trade?
- Under Total Expenditures
GDP = C + I + G + (X – M).
- Total Income GDP = C + S + T where:
C = consumer spending on final goods and services
S = household and business savings
T = net taxes (taxes paid minus transfer payments received)
Since, total income = total expenditures,
C + I + G + (X – M) = C + S + T
Thus, S = I + (G – T) + (X – M)
(G – T) = Fiscal balance
(X – M) = Trade balance
(G – T) = (S – I) – (X – M)
In this case of a Fiscal deficit (G – T)
It must be financed by:
1. NEGATIVE trade balance and/or
2. POSITIVE private saving

1. Which of the following measurements include the sum of wages, interest income, proprietors’
income, rent, etc.?
A. Personal income.
B. National income.
C. Disposable income.
2. In the case of GDP that is calculated using the sum of the value-added method, the GDP
calculated using the value of the final output method will lead to the GDP being:
A. Influenced upwards.
B. Equivalent under both methods
C. Influenced downwards.
3. Which of the following component is not included in the calculation of GDP:
A. Relief measures.
B. Defence services.
C. Self-owned housing
4. An economy’s GDP is to/than its aggregate income
A. Less
B. More
C. Equal
5. GDP Deflator =
A. Real GDP/Nominal GDP*100

B. Nominal GDP/ Population size *100
C. Nominal GDP/ Real GDP *100
Answer:
1. B is correct. National income. National income is the income generated from all factor inputs
used in the production of the final output.
2. B is correct. Equivalent under both methods. GDP calculated under both methods is always
equal.
3. A is correct. Relief measure. Transfer payments like relief measures, unemployment are not
included in the calculation of GDP.
4. C is correct. Equal. An economy’s GDP (aggregate output) should be equivalent to its aggregate
income.
5. C is correct. Nominal GDP/ Real GDP *100.

Aggregate Demand and Supply
Explain how the aggregate demand curve is generated
What relationship does the aggregate demand curve portray?
Aggregate demand curve
⮚ As seen above, the income output represents the x-axis.
⮚ The price level Is plotted on the y axis.
⮚ The intersection price of the IS and LM curve determines the equilibrium price and real GDP at a
given level of the real money supply.
⮚ Our intuitive understanding of that relationship—lower price allows us to buy more of a good
with a given level of income—does not apply here because income is not fixed.
Instead, aggregate income/expenditure (GDP) is to be determined within the model along with
the price level. Thus, we need to explain the relationship between price and quantity demanded
somewhat differently.
⮚ The AD curve depicts the relationship between Income/Output (Y) and price level, stating that a
higher price level reduces output and vice versa
Wealth Effect:
⮚ The wealth effect is based on the concept of purchasing power of nominal wealth, including
nominal value of the money held by consumers, physically or in a bank account.
⮚ Nominal wealth does not change: One British pound is always worth one British pound. Similarly,
one euro is worth one euro, and one yen is worth one yen.
⮚ The real value, however—the value of money in terms of goods and services—is not fixed. It
fluctuates with the prices of goods and services.
⮚ The effect of the change in the price level and the resulting change in the real value of money
holdings give the wealth effect its name, because as the real value of our money holdings
changes, so does our real wealth.
⮚ The wealth effect is one reason that the aggregate demand curve is downward sloping. An
increase in the price level decreases the quantity of goods and services that can be purchased
with the fixed quantity of nominal wealth—consumers are less wealthy (in real terms) and
therefore demand fewer goods and services.
The Interest Rate Effect
⮚ When the price level changes, the demand for money also changes.
⮚ We need to get more money—our demand for money increases. With a fixed supply of money,
the price of money increases. Because the price of money is the interest rate, then as the price
level increases, the interest rate increases.
⮚ Our demand for money may decreases also. With a fixed supply of money, the price of money
decreases. Therefore, as the price level decreases, the interest rate decreases.
⮚ Changes in the interest rate affect the quantity of goods and services demanded. If interest rates
increase, businesses invest less because their borrowing costs increase.
⮚ This shift leads to fewer profitable projects to invest in and also negatively affects the demand
for commercial real estate. In addition, higher interest rates lead to lower consumption—
especially for large purchases such as automobiles or residential real estate, which are usually
purchased with loans.
⮚ If interest rates decrease, then businesses have more profitable projects to invest in, and
consumers would be expected to spend more.
⮚ This leads us to the interest rate effect. A higher price level creates greater demand for money,
which raises the interest rate.
⮚ The higher interest rate decreases demand for investment and consumption expenditures, which
leads to less demand for goods and services.
⮚ Conversely, a lower price level leads to a lower demand for money, which leads to a lower
interest rate. The lower interest rate increases demand for investment and consumption
expenditures, which leads to more demand for goods and services.
The Real Exchange Rate Effect
⮚ An increase in the domestic price level causes appreciation of the real exchange rate.
⮚ A higher price level affects the real exchange rate and makes domestic goods more expensive in
other countries, reducing exports.
⮚ It also makes non-domestic goods less expensive domestically, increasing imports. The result is
lower demand for domestic goods and services.
⮚ Conversely, a decrease in the domestic price level (assuming the price level abroad remains
unchanged) leads to a depreciation of the real exchange rate. This decrease in the real exchange
rate makes domestic goods less expensive in other countries, increasing exports, and non-
domestic goods more expensive domestically, decreasing imports. The result is higher demand
for domestic goods and services.
⮚ This dynamic gives us the real exchange rate effect.
Explain the aggregate supply curve in the short run and long run.
How would you like to explain the concept of aggregate supply in the long and short run?
⮚ As seen above, the real GDP is plotted on the x-axis
Price is plotted on the y axis
⮚ In the case of a very short-term aggregate supply curve, the supply curve is parallel to the x-axis,
indicating a perfectly elastic supply curve.
This means that in the very short run, the supply of output ↑/↓ even when the price level is
unchanged.
This is because Firms can change output by adjusting the labours hours and plant utilization in
response to changes in demand with no change in prices.
⮚ In the case of a short-term aggregate supply curve, the supply curve is upward sloping and is
relatively elastic.
As expected ↑ price level leads to proportionate ↑ in output prices,
However, since input costs like wages, capital, etc. are sticky (fixed) in the short run,
It leads to ↑ output prices ↑ price level but input prices (short-run)  Greater Profits In Mumbai, in
March 2021, the prices of public transport like taxis and rickshaws surged (due to the high loan re-
payments). The prices have ↑ by only a few denominations. However, the sudden ↑ in aggregate
supply due to these ↑ prices are unbelievable. The drivers can now earn more and also afford the
increasing fuel rates.
⮚ In the case of a long-term aggregate supply curve, the supply curve is parallel to the y axis; it is
a perfectly inelastic supply curve.
Irrespective of the change in prices, the supply doesn’t change.
This is because, in the long run, all input cost varies with the price level. Thus, AS is not influenced
by price level; this is called potential GDP or full-employment GDP.
Explain causes of movements along and shifts in aggregate demand and supply
curves
What are the reasons to cause a shift in the aggregate demand curve towards the right?
The aggregate demand reflects the change in expenditure by consumers, businesses, government,
etc.
Several factors can affect this level of expenditures and cause the AD curve to shift; however, a
change in price level only causes a movement on the same aggregate demand curve
GDP = C + I + G + net X
The factors included in the shift of the demand curve to the right (↑ in demand) are:
Consumer’s wealth Household wealth ↑ when the value of investments of shares, real
estate, etc. ↑ This leads to ↑consumption and reduces savings. Thus ↑
AD.
Business ↑ in the opportunities for fruitful projects in the future leads to ↑
expectations investments in these projects. E.g., growth in artificial intelligence,
renewable energy products, etc
Consumer ↑ in consumption spending currently based on employment stability

expectations of and wage hike in the future.
future income
High-capacity Companies when through proper allocation of resources produce at a

utilization high capacity it leads an ↑ in investments in capital goods like plant and
machinery, technology, etc
Expansionary Increasing the supply of money by central banks through expansionary

monetary policy: monetary policy like reducing interest rates induces capital investments
by businesses due to low borrowing costs.
For example:
In India, the RBI ↓ is the repo rate for commercial banks who thereby ↓
their lending rate and promote cheaper loans for businesses.
Expansionary fiscal ↑ in demand is caused by either an ↑ in government spending (E.g.,
policy spending on construction of roads and bridges, health care, etc.) or an ↓
in taxes levied by Central Government.
Exchange rates A ↓ in local currency causes an ↑ in exports and ↓ in imports which

causes a rightward shift of the demand curve.
Global economic Increasing economic growth overseas creates export opportunities

growth domestically, thus causing an ↑ in demand.
For e.g.:
An ↑ in the growth rate of developed countries like Japan, U.S.A, etc. ↑
the export opportunities for developing countries like India, China, etc
In India, in 2011, the SENSEX index was at almost 16,000 points, and now in 2021, it has ↑ to almost
55,000 points. It has ↑ by almost 240%, which has caused a ↓ in savings and ↑ in consumption and
has caused the demand curve to shift to the right.
The consumer expectations in India had fallen below 60 in late 2008, which was the lowest it had
been since 1980. However, it has ↑ back to a level of low 80s in 2021, which is considered close to
being considered a healthy state.
How can you explain the shifts in short term aggregate supply curve?
The short-run aggregate supply (SRAS) curve reflects the change in output when wages and other
input prices are held constant.
A change in output due to a change in price level is called a movement on the same supply curve.
Several factors can affect this ↑ in supply (as shown in the graph above), the factors are:
Labour productivity ↑ in the labour efficiency causes an ↓ in per-unit labour costs for the
producers, thus causing a rightward shift om the SRAS.
Input price An ↓ in input prices like wages, raw materials, etc. ↓ , the production
costs leads to the manufacturer producing ↑ units.
Expectations of future When producers feel that the prices of their inputs will ↑ shortly,
output prices they shall produce ↑ right now, compensating for the future.
For e.g.:
If the price of sugar due to draught may ↑ in the near future, it shall
result in higher input costs for the ice cream factory. Thus the
producer shall produce more ice cream now at cheaper sugar rates
and then store it for sale in the future.
Taxes and A ↑ in government subsidies or a fall in taxes can cause a ↓ in cost of

government subsidies production and thus an ↑ in supply.
Exchange rates In the case of an ↑ in local currency in the exchange rate market,
imports become cheaper for producers, thus causing a fall in costs
and ↑ in SRAS.
In the U.S.A, 1985 – 1986, the average price of crude oil ↓ from $24 a barrel - $12 a barrel causing a fall
in input costs and ↑ in output, resulting in an ↑ in supply.
In the U.S.A, the output per hour index was about 106 in 2014.
In 1972, the index was 50, thus showing an improvement in labour productivity maily through
investments in human capital (education, skill development, etc.) and technology
Indian start-ups raised about Rs 4,500 crore ($600 million) of venture debt in 2021, more than double
the previous high for an asset class which is seen as the new kid on the block, as companies went on a
shopping spree and investors raised larger funds.
What are the factors that cause a shift in the Long-Run Aggregate Supply Curve?
The long-run aggregate supply (LRAS) curve is perfectly inelastic in nature, i.e., parallel to the y axis
at full employment.
Factors triggering these shifts are:
↑ in the supply and LRAS functions at full employment only

quality of labour An ↑ in the labour force shall increase the full-employment
output and LRAS or,
An ↑ in labour quality through investments in human
capital (e.g., by investing more in education and skills of
employees) ↑ LRAS and potential real employment
output.
↑ in the supply of An ↑ in the supply of natural resources can only cause the shift as
natural resources LRAS/ potential GDP.
For e.g.:
Now since non-renewable resources are limited, switching to
abundant renewable resources can cause an ↑ in LRAS
↑ in the stock of A ↑ in capital like plant and machinery can cause an LRAS shift
physical capital towards the right.
Technology Better technology= better productivity of labour, thus increasing
supply.
Developed countries like the U.S.A have reached full capacity and now invest their funds in
R&D of Technology in order to ↑ their supply.
How does the change in price level affect the movement along aggregate demand and supply
curves?
⮚ In the case of aggregate demand
With a ↑ in prices, the aggregate demand ↓ causing an upward movement along the same
demand curve is called the contraction in the demand curve. There is an inverse relationship
between price and output
⮚ In the case of aggregate supply
With a ↑ in prices, the aggregate supply ↑s causing an upward movement along the same demand
curve is called the expansion of supply.
There is a direct relationship between price and output.
Describe how fluctuations in aggregate demand and aggregate supply cause short-
run changes in the economy and the business cycle.
Distinguish between the following types of macroeconomic equilibria: long-run
full employment, short-run recessionary gap, short-run inflationary gap, and
short-run stagflation.
Explain how a short-run macroeconomic equilibrium may occur at a level above or
below full employment.
What do you mean by Equilibrium GDP?
⮚ Equilibrium GDP is the intersection point of AD, SRAS, and LRAS curve.
⮚ Factor inputs are at full employment
⮚ in the long run Equilibrium GDP =Potential GDP
What do you mean by a recessionary gap?
⮚ In the case of the aggregate demand curve shifting downwards from AD1 to AD2, there is a ↓ in
demand caused by any of the factors as mentioned above, like ↑ in taxes, ↓ in government
spending, etc.
⮚ This ↓ in-demand causes the GDP to fall from Y1 to Y2 and the price to fall from P1 to P3.
⮚ Fall in demand causes a fall in the employment rate leading to problems like unemployment.
⮚ Equilibrium GDP < Potential GDP

⮚ Thus, the economy starts functioning below the full employment stage, facing a recessionary gap
(Y2-Y1).
⮚ Classical economists believed that unemployment would ↓ labour rates which in turn would ↑
SRAS and return the economy to its full-employment level of real GDP.
⮚ Keynesian economists, believe that increasing aggregate demand through government spending
and lower tax rates is preferred.
⮚ Both expansionary fiscal policy (G>T) and expansionary monetary policy (increasing money
supply) are methods to ↑ aggregate demand and return real GDP to its equilibrium though at
lower prices.
What do you understand by inflationary gap?
The curve should be the opposite of ↓ in-demand curve
⮚ In case of the aggregate demand curve shifting upwards from AD1 to AD2, there is a ↑ in demand
caused by any of the factors mentioned above like ↓ in taxes, ↑ in government spending, etc
⮚ This ↑ in-demand causes the GDP to ↑ from Y1 to Y2 and the price to ↑ from P1 to P3.
⮚ ↑ in demand causes problems like over-time by workers and overexploitation of resources.
⮚ Equilibrium GDP > Potential GDP, resulting in higher salaries and wages.
⮚ Thus, the economy starts functioning above the full employment stage, and the economy faces
an inflationary gap (Y2-Y1).
⮚ Competition among producers for factor inputs might cause a ↓ in supply. As a result, the
economy reaches to equilibrium GDP but at a higher price level.
⮚ Further, the policymakers can also ↓ the aggregate demand by contractionary fiscal policy (G<T)
and contractionary monetary policy (reducing the money supply
What do you mean by stagflation?
⮚ Under stagflation, the results from supply-side bottlenecks, the SRAS curve shifts to the left,
causing a ↓ in supply.
⮚ In the aggregate output ↓ from Y1 to Y2, there is evidence of high inflation and high
unemployment.
⮚ Eventually, the supply < demand it will cause a ↑ in prices of factors of production and curve
shall shift to the right
In India, in April 2021, the year-on-year WPI inflation caused by rising global oil prices, was 10.49%
(the highest in the last decade)
Rural and urban unemployment ↑ to 8.57% and 11.42%. Thus, India too is reaching a stage of
stagflation if proper measures aren’t taken to prevent it.
What do you mean by excess supply?
⮚ Aggregate Supply > Aggregate demand temporarily
⮚ As seen above, at price equilibrium (P), the Aggregate Supply > Aggregate demand.
⮚ This induces the producers to temporarily push their prices down to (P1) to make the product
more attractive.
Analyze the effect of combined changes in aggregate supply and demand on the
economy.
How can you explain the combined effect of changes in aggregate supply and demand on the economy?
↑ in Aggregate Supply ↓ in Aggregate Supply

↑ in Real GDP ↑ Price Level ↑s
Aggregate Change in price levels depends Change in GDP depends upon the
Demand upon the relative size of change in relative size of change in AD and AS.
AD and AS GDP ↑if ↑AD >↓AS
P↑ if ↑ AD >↑ AS GDP↓ if ↑AD < ↓AS
P↓ if ↑ AD <↑ AS
↓ in Price Level ↓ Real GDP ↓
Aggregate Change in GDP depends upon the Change in price levels depends
Demand relative upon the relative size of change in
size of change in AD and AS AD and AS.
P↓ if ↓AD >↑AS P↑ if ↓ AD <↓ AS
P↑ if ↓AD <↑AS P↓ if ↓ AD >↓ AS
Describe sources, measurement, and sustainability of economic growth
Which are the five important sources of economic growth?

Labour supply
This includes the labour force, which is the total number of people between the age of 16 -59 years
in an economy. Labour force also includes the total number of unemployed people. The total
number of hours worked = Labour force*average hours worked per worker
⸫ an ↑ in the working class is an indicator of possible economic growth
In China, the total employed labour force is projected to decline by 13% between 2017 and 2037.
Thus, making the cost of labour expensive.
Human capital.
The quality of the labour force is as important as the size of the labour.Thus, investments by the
government in the development of human skills and knowledge not only ↑ the productivity of the
employees but also opens doors for various innovations.
In October 2018, the World Bank published the Human Capital Index (HCI). It measures the economic
success of countries. It ranks countries according to how much is invested in education and health
care for young people; Singapore tops this list.
Physical capital stock

Higher investment rate = higher investments in physical capital like machinery, plant, equipment,
etc. Higher investments lead to higher productivity and higher economic growth
Example: In the case of countries like South Korea, India where start-ups are booming, the major
investments by these companies is in physical capital to create a product that is worth being sold.
Technology
Better technology requires higher investments in R&D, developed countries like the U.S.A, Japan,
etc. who have reached their state of full employment and are experiencing diminishing marginal
returns from labour/ capital; they must invest in technology which in return ↑ the GDP since the ↑
you invest in technology the ↑ is the productivity.
Natural resources
Raw materials such as coal, crude oil, etc., are necessary for meeting the output requirements. They
may be renewable (e.g., solar energy) or non-renewable (e.g., oil). Countries with better reserves
of natural resources can achieve higher economic growth.
What do you mean by the sustainability of economic growth?
Potential GDP = Aggregate Hours Worked × labour Productivity
Or
Economic Growth; Growth in Potential GDP = Growth In labour Force + Growth In labour
Productivity
Example: If UK’s labour force is anticipated to reduce by 2%, and its labour efficiency is expected to
grow by 4%,
The growth in potential GDP is: –2% + 4% = 2%.
The sustainable rate of economic growth is significant as long-term equity returns are highly
dependent on economic growth over time.
The sustainable rate of economic growth in India is between 6%-7% in 2021.
Describe the production function approach to analysing the sources of economic

growth.
What do you have to say about the production function approach?
A production function describes the relationship of output to the factor inputs.
Economic output = f (labour, capital, and productivity), depending on the technology available.
That is: Y = A × f (L, K)
Where:
Y = aggregate economic output
L = size of labour force
K = amount of capital available
A = total factor productivity
The multiplier, A, is referred to as total factor productivity and quantifies the amount of output
growth that is not explained by ↑ in the size of the labour force and capital.
⮚ Total factor productivity is closely related to technological advances.
⮚ The production function can be stated on a per-worker basis, suggesting that labour productivity
can be ↑d by either ↑technology or ↑physical capital per worker.
⮚ Production function = f (diminishing marginal productivity) for capital, labour, and other factor
inputs,
⮚ Thus, sustainable long-term growth cannot be achieved by simply ↑ the factor inputs.
Example: In the case of a country like Japan, where full employment has already been reached, and
the resources are already exhausted at its best, in the long run, only a technological investment to
improve the labour efforts and an ↑ in labour force can cause a ↑ in the substantial economic growth
rate.
Distinguish between input growth and growth of total factor productivity as

components of economic growth.
How would distinguish between input growth and growth of total factor productivity as components of
economic growth?
According to the Solow model or neoclassical model,
⮚ Growth In Potential GDP = Growth in Technology + WL (Growth In labour) + WC (Growth In

Capital)
Where,
WL and WC = Contribution by labour and capital respectively in national income.
⮚ However, since technology can ↑ the overall productivity of capital and labour.
⸫ technology is the main driver of GDP in an economy.
For example,
In a country like India where labour contribution > capital contribution.
WL= 0.8 WL=0.2
A 1% ↑ in the labour force will be more fruitful in increasing the economic output v/s a 1% ↑
in the capital.
⮚ Growth In Per-Capita Potential GDP = Growth in Technology + WC (Growth in The Capital To-
labour Ratio)
For example: In a country like the U.S.A, With WC = 0.45 a 1% ↑ in the capital cause the GDP
per worker to ↑ by 45%.
1. Which are the factors that are least likely to shift the aggregate demand curve?
A Change in the future expectation (business)

B Change in the taxation policy
C Change in price
2. In case of an increase in the aggregate demand and short-run aggregate supply, price:
A Increases
B Decreases
C May increase/decrease
3. A Long-run average supply curve is in nature,
A Perfectly inelastic
B Perfectly elastic
C Inelastic
4. In the case of INR/USD, in India. A stronger INR rate against USD is most likely to results in:
A A leftward shift in the aggregate supply curve

B A leftward shift in the aggregate demand curve
C An upward movement along with the aggregate demand
5. In a developed country, the main cause of growth in the potential GDP is:
A Physical capital.
B Increase in labour supply.
C Technology advances
6. The sustainable growth rate in a country is best describes as the addition of growth rates for:
A Consumption + personal investments

B Labour force and its productivity
C Government spending + private spending
7. Nominal GDP is $ 500 million, and the GDP deflator is 120. By using the base year prices,
calculate Real GDP (closest):
A $413 million
B $443 million C. $417 million
8. Under stagflation, there is a situation of:
A Low unemployment + high inflation

B High unemployment + low inflation
C high unemployment + high inflation
9. A production function describes the relationship of output to the .
A Revenue
B Factor inputs
C GDP
Answer:
1. C is correct. Change in price. A change in price causes a movement on the same AD curve and
not a shift.
2. C is correct. May increase/decrease. An increase in the AD increases the price. However, an

increase in the SRAS decreases the price. Thus, the combined effect on the price depends on
the relative size of the impact on the price.
3. A is correct. Perfectly inelastic, parallel to the y-axis.
4. B is correct. A leftward shift in the aggregate demand curve. Stronger local currency leads to a
fall in exports and a rise in imports; this causes the AD curve to shift to the left.
Simultaneously, the cost of raw materials should fall in terms of the local currency, causing the
SRAS curve to shift to the right). Changes in the prices cause movement along with the AD and
AS curves; in this case, it will be a downward movement.
5. C is correct. Technology advances. Technology is the main source because capital per labourer
is already high enough, signaling diminishing marginal productivity of capital
6. B is correct. Labour force and its efficiency
7. C is correct. Real GDP = 500/1.2
8. C is Correct. high unemployment + high inflation simultaneously take place in case of stagflation
9. B is Correct. Factor inputs. Economic output = f (factor inputs), depending on the technology
available.
Understanding Business Cycles

Exam Focus
Understanding why business cycles are the starting point of any top-down financial analysis
Learning the various economic indicators and understanding their reference as either leading or
lagging
Focusing on the unemployment and inflation part to understand the monetary and fiscal policy
significance.
Business Cycle Phases
Describe the business cycle and its phases.
What is a business cycle?
Business cycle
Fluctuations in the economic activity
GDP and Unemployment are the core instruments required in evaluating the stage of the business
cycle in the economy
What are the various phases of a business cycle?
a. Expansion phase: the phase wherein the GDP ↑ at a fast pace
b. Peak phase: It’s the phase when the GDP stops increasing.
c. Contraction Or Recession: GDP is ↓continuously
For example: The recession of 2008 and the fall of Lehman Brothers in the USA led to a recession
in the global economy as a whole.
d. Trough: GDP bottoms out, and the GDP rate starts ↑
The average business cycle in US is about 6 years. They have had approximately 11 business
cycles since 1945. Investors and economists analyze these cycles to prepare for future
investment, changing current investments, and even unemployment.
EARLY LATE PEAK CONTRACTION

EXPANSION/Re EXPANSION
covery/Trough
MEANING GDP ↑ for at GDP ↑ at a The last GDP ↓ for at
least 2 high rate phase before least two
quarters. GDP starts ↓ quarters.
ECONOMIC GDP starts ↑, Exponential Interest rates Interest rates ↑
CONDITION Interest rates ↑ in ↑ Business Investments ↓
↓ investments investments Production
Business ↑ in ↓ Production activities↓
investments↑ production activities↓. tremendously
Production activities due until it reaches
to low the trough
activities↑
lending rate. stage.
EMPLOYME Through a ↑ in ↓ Hiring Hiring stops

NT investing and unemploymen reduces. Unemployment
production t However, the rate ↑
activities rates unemployme
Employment ↑ hiring rates nt rate ↓ due
to a lag.
↑. There is a ↓
in the laying off
rate.
DISPOSABLE Due to a ↑ in Capital Capital Capital
INCOME the income expenditure expenditure expenditure ↓
patterns, the ↑s. starts to tremendously.
consumer Consumer reach its peak Consumer
spending also Spending to maintain Spending of
↑s mainly on rates of the business individuals and
durables, individuals growth. businesses,
housing etc. and Consumer especially on
businesses ↓ Spending of durables ↓,
individuals due to
due to
and uncertain
diminishing
businesses ↓ times and
marginal at a fast pace recession

utility. to start saving expectations.
for future
INFLATION Reasonable Inflation may high inflation Inflation ↓ but

inflation rates ↑ rates with a lag.
The 2002 Dot Com Crisis, USA. The years from 1996 to EARLY 2000’s are known as years of glory for
the USA. With large investments in the booming IT sector via companies like Amazon, Yahoo, etc.
NASDAQ ROSE BY 400%.
The GDP started growing at the rate of 3%-5% from 1996 – 2000.
In March 2000, the economy reached its peak, NASDAQ reached its highest at 5,048.62 points. The
people started overvaluing companies like Cisco and Oracle with Growth Rates > Annual GDP
Growth.
However, the .com companies were under heavy net operating losses as they had spent heavily on
marketing
This was when the software fall happened.
The probability of recession was high, and then the economy collapsed. The GDP growth rate fell to 0.098%.
Finally, On November 9, 2000, Pets.com , a well-known company that had backing from
Amazon.com, went out of business only nine months after completing its IPO. By that time, most
Internet stocks had declined in value by 75% from their highs, wiping out $1.755 trillion in value.
The NASDAQ is the second largest stock exchange in the world. It was the first electronic stock
exchange in 1971.
Explain the classical growth and classical growth cycles.
a. Classical cycle: It includes the expansion and contraction phase in the levels of aggregate
economic activity.
Shorter troughs and longer expansions are witnessed.
It is not used that often since a sudden drop from peaks to lows is not witnessed frequently.
b. Growth cycle: Deviations from long term trend of the growth rate of the economy. E.g.,
Singapore with long term growth rates. The lower part of the “wave” captures fluctuation of
actual activity from trend growth activity. The “gaps” depict the difference in actual and
predicted trends.
c. Growth rate cycle: Expansion and contraction are recognized earlier in this stage than in the
other two phases. Economic activity growth fluctuations are measured and analyzed.
Describe how resource use, housing sector activity, and external trade sector
activity vary as an economy moves through the business cycle.
What do you mean by credit cycles and their relationship to the business cycle?
⮚ Besides GDP conditions of credit and property prices is used to analyse cyclical variations.
⮚ Credit cycles through changing availability and pricing of credit depict the cyclical changes.
⮚ The improving investment situations through higher usage and loan availability portray an
expansive business cycle stage.
⮚ Improving economy leads to lenders extending loans through cheaper credit
Weakening economy leads to lenders tightening loans through expensive credit
⮚ This credit is majorly used in property investments, and thus the major effects of a change in the
lending sector can be seen in this sector.
Application of Credit Cycle
⮚ Loose credit conditions for the private sector financing as seen under various financial crises like
the Lehman brothers leads to downfall and crash of economies in general
⮚ Changes in the availability of external finance and the presence of financial frictions lead to
deeper recessions and longer expansions.
⮚ Thus, credit cycles are longer than witnessed business cycles.
How does resource use fluctuate through the various stages of business cycle?
Resource use fluctuation concerning inventories, labour and physical capital is explained below.
INVENTORIES Firms maintain enough inventory to meet the current demand; however,
they don’t overdo it as it blocks a large part of their capital money.
In times of
Stable growth.
The inventory to sales ratio = current demand and is at the normal level.
Peak
Due to slow revenue growth and high inventory stocks, the inventory to
sales ratio is higher than normal. This is wrongly read in the GDP
calculation as high economic output, wherein it's just the case of stagnant
demand.
Trough
The opposite happens in the case of a trough; inventory to sales is low due
to ↑ in revenue growth > ↑ in output, This isn’t the case of low economic
output, and it’s just the case of meeting rising demand. For example:
Post the second wave in India, the production will take time to re-open
and get back to normal. Until then, the previous inventory stock is used to
meet the growing demand, leading to a low inventory to sales ratio.
LABOUR Labour cannot fluctuate throughout the business cycle phases as re-hiring
and training are costly for the companies.
However, changes in shift timings like
⮚ Overtime during expansion
⮚ Cancelling overtime during contraction is made
⮚ Only in case of an extreme expansion or contraction shall the hiring or lay
off be practised respectively.
PHYSICAL Continuous buying and selling of physical capital at every stage of the
CAPITAL business cycle can be costly.
Hence changes in the use of physical capital can be practised by
↑production capacity in expansion.
↓ production capacity in contraction.
E.g.: Extensive use of machinery during expansion v/s cutting down on the
use of machinery during contraction to save electricity costs, maintenance
costs etc.
In India, during the 2020 COVID – 19 pandemic, the companies performed with 20% employee layoff
due to an extreme contraction in the business cycle
How are the factors in the housing sector activity affected by the business cycle?
Housing Sector Activity
Despite contributing to a very small portion of the GDP in the USA, a small change in the housing
sector activity results in a large change in the overall economic activity. E.g., the Lehman Brothers
Mortgage Crisis, 2008.
The determinants of Housing Sector Activity are:
⮚ Mortgage rates
↓rates lead to a large increase in buying of properties, both home and constructions. ↑
rates lead to a large fall in buying of properties both home and constructions.
⮚ Housing costs relative to income
When ↑ Income is more than an ↑ in mortgage rates, it leads to a higher purchase of properties
E.g.: In April 2021, the USA housing sector purchase was 34% higher than a year ago. The rise
in income post the pandemic is faster than the rise in the prices of houses.
⮚ Speculative activity
People generally purchase at higher prices because they speculate that property prices will
further ↑ in the future. However, this leads to an ↑ in buildings and construction sites which
excess supply v/s demand thus bringing the prices of properties down.
In the USA, 2006 – 2008 excessive property investments through high leverage lead to a boom in the
real estate sector; however, a market correction of these property prices leads to massive defaulting
as the prices of properties fell due to excess supply, the economy crashed.
⮚ Demographic factors
Population chunk in the age gap of 25-40 years is considered as potential buyers of properties.
Factors related to the migration of people, older people vacancy etc., all affect the housing sector
demand.
For Example: Urbanisation in India has caused an ↑ in the development of housing sectors in the
cities to meet the rising demand.
How does the External Trade Sector Activity get affected by the business cycle?
⮚ Imports>Exports, when the domestic GDP ↑
⮚ Exports (e.g., India) > Imports when the trading partners economy’s (e.g., USA) GDP ↑ and ↑ in
foreign incomes
⮚ If the domestic currency depreciates, then the purchase of goods become cheaper for foreign
countries
Describe theories of the business cycle.
What do you understand by the neo-classical theory of business cycle?
⮚ Shift in AD and AS is due to change in technology in the long run
⮚ They believe that the economy has a strong likelihood towards full-employment equilibrium,
This is because, on the one hand, recession puts a downward burden on the money wage rate,
and Over-full employment puts an upward burden on the money wage rate.
⮚ Thus, this theory explains a temporary deviation from the long-term equilibrium, which lasts for
a short period.
⮚ However, business cycles universally have been more severe and longer than the neoclassical
model would suggest.
What are your thoughts on the Keynesian School of economics and their interpretation of the
business cycle?
⮚ Wages are downward sticky, thereby not allowing a fall in wage rate to increase the aggregate
supply in the short run
⮚ Changes are based on future growth expectations.
⮚ They overinvest and overproduce when they are too optimistic about future growth in potential
GDP
⮚ The opposite happens in case of expectations of fall in future GDP
⮚ Thus, policy reforms are required, like ↓interest rates and ↑ government spending through
expansionary monetary and fiscal policies.
⮚ The New Keynesian further stated that the prices of productive inputs except for labour are also
“downward sticky,” this further adds barriers to the restoration of full-employment equilibrium.
According to the Monetarist school, what are the causes for the change in the business cycle?
⮚ Monetarists believe that variations occur in the AD curve due to the mismanaged changes in the
supply of money, which disturbs the equilibrium.
⮚ They believe that to keep the aggregate demand stable and growing, the central bank should
follow a policy of steady and predictable ↑s in money supply
Is the Austrian school theory similar to the Keynesian school?
Austrian school
⮚ Both the school theories require government intervention to mediate the AD and AS in the
economy.
⮚ However, the Austrian school theory believes that artificially low-interest-rate induces
businessmen to invest money in speculative long term investment projects versus consumer
demand. When the speculative projects fail, businesses reduce the production of goods
What does the New Classical school theory emphasise on?
⮚ It emphasises real business cycle theory (RBC)
⮚ They believe in changes are caused by real economic variables such as changes in technology
and external shocks, as opposed to monetary variables (e.g., Inflation)
⮚ Thus, the central bank should not change either monetary or fiscal policies during expansion or
contraction and let the marginal utility cycle do its job of controlling and expanding
demand/supply.
1. In case of an expansion phase of the business cycle, it is least likely indicated by:
A. Increase in GDP rates

B. Rising unemployment rates
C. Rising prices for goods and services
2. In the case of INR/USD in India, what is the most likely effect on the exports of India if the US
economy is growing at a higher rate compared to India:
A. Export increases
B. Export decreases
C. No change in the exports
3. In case of a contraction phase, the:
A. GDP rates are increasing

B. Capital Expenditures are falling
C. Consumer spending rises
4. The causes for business cycle fluctuations, according to the Keynesian school theory, are based
on:
A. Fluctuations in money supply

B. Changes in expectations of economic growth
C. Technological advancements over time
5. According to the Neo-classical theory of business cycle, a shift in the AD & AS curve is caused
by:
A. Fluctuations in money supply

B. Changes in expectations of economic growth
C. Technological advancements in the long run
Answer:
1. B is correct. Rrising unemployment rates. Unemployment rates are said to fall in case of an
expansion phase.
2. A is correct. Export increases as domestic currency (INR) gets cheaper for buyers in the USA.
3. B is correct. Capital Expenditures are falling due to higher interest rates which increase the cost
of production and the possibility of uncertain future times.
4. B is correct. changes in expectations of economic growth. Business cycle fluctuations, according

to the Keynesian school theory, are based on changes in expectations of economic growth,
which leads to overinvesting in expectations of higher future economic growth and vice versa.
5. C is correct. A shift in the AD and AS curve is caused due to technological changes in the long
run
Inflation and Indicators
Describe types of unemployment and compare measures of unemployment
Which are the three categories of unemployment?
Frictional unemployment
A time lag exists due to employees moving from one job and finding their ideal job that requires
their skills. It can be voluntary quitting, migrating or firing by employers. Temporary in nature
always present in the economy to a certain extent
Structural unemployment
Long term changes like change in technology cause a long-term change in the employment.
Permanent in nature since the skills of the employees are no more required.
For example: Invention of e-books causing structural unemployment in printing publishing houses
Cyclical unemployment
Unemployment due to changes in the business cycle stage. Temporary in nature. Cyclical
unemployment is positive when the economy is operating at less than full capacity and can be
negative when an expansion leads to employment temporarily over the full employment level.
Example: An example of cyclical unemployment is when workers an automobile worker is laid off to
cut labour costs during recession. The demand for vehicles during recession period are low so
manufacturer doesn’t need any many workers.
What are the few terminologies used in relation to unemployment?
UNEMPLOYMENT Not Working + Actively searching for work

Long-term unemployment is when a citizen is continuously finding
jobs for several months.
The unemployment rate is the total % of people in the labour force
who are unemployed.
LABOR FORCE Employed + Unemployed (16-64 years)
People willingly not a part of the labour force are said to be
voluntarily unemployed and are not included in the labour force.
For example:
China, India etc. countries are said to have the highest labour force
population being the driving force.
UNDEREMPLOYED Part-time worker willing to work full time +
Employee not being paid enough despite being highly skilled and
qualified
Calculating the number of underemployed is subjective and not
easily distinct from employment figures.
PARTICIPATION Working-age population,
RATIO Employed+ Seeking employment
(Also known as
Activity
Ratio or Labour
Force
Participation Rate)
In India, the participation ratio fell at an all-time low of 46.3% in Dec 2020 due to COVID – 19.
How is the unemployment rate a lagging economic indicator?
⮚ Unemployment Rate = Unemployed / Civilian Labour Force
⮚ It is a lagging indicator as job seekers behaviour shifts in response to changes in the business
cycle.
⮚ Thus, it is an inappropriate measure of predicting the direction of the economy since:

a. Layoff isn’t affordable during the recession as
Re-hiring and training new employees in future =↑ costs
Thus, the unemployment rate is constant despite a contraction in the economy.
b. Discouraged workers
During a recession, workers stop looking for jobs which leads to a rise in the unemployment rate,
in the future, expansion expectations lead to these workers re-applying for jobs, resulting in ↑ the
unemployment rate despite an expansion phase.
⮚ This leads to a ↓ labour productivity during contractions and vice versa
Explain inflation, hyperinflation, disinflation, and deflation
1. Inflation
⮚ Continuous rise in prices over a period of time

⮚ Increasing prices for majorly all goods and services
⮚ Reduction in purchasing power of money
⮚ Inflation rate = % increase in the price level
⮚ Monetary and fiscal policy decisions are taken to balance the future changes in the business
cycle
⮚ For Example: ↓ in interest rates to↑ in money supply
In India's case, the inflation rate had consistently ↑increased from 3.43% in 2018 to 6.2% in 2020.
2. Hyperinflation
⮚ Prices rise at a rate of more than 50%

⮚ Prices increase daily
⮚ Hoarding of basic consumer goods starts
⮚ Destruction of the monetary system leads to social and political upheavals
In 2018 Venezuela, inflation was at 65,000%. A new cryptocurrency, the "petro”, was introduced
because it couldn’t afford to print new paper currency.
3. Disinflation
⮚ The rate of rise in Price levels falls, but it is yet greater than zero
⮚ The level of rising in price level slows down
⮚ For Example: When the ↑ in price levels, is 12% in 2018, 10% in 2019 and 9% in 2020.
4. Deflation
⮚ Continuous fall in prices of majorly all goods in services

⮚ Deflation leads to Recession
⮚ Delay in purchases due to expectations of cheaper prices in future
⮚ ⸫ ↓in revenue for businesses and ↑in fixed costs
In U.S. Great Recession, which officially lasted from December 2007 to June 2009, was one of the
largest deflations of all time. In Dec 2008, the CPI index ↓ by 1.7%, retail prices ↓ by 10%
Explain the construction of indexes used to measure inflation.
What do you understand by Consumer Price Index (CPI)?
⮚ Inflation = % change in price index
⮚ Where, Price Index = Average prices of defined basket goods and services
⮚ Now, CPI = Change in the price level from base year to current year
CPI = Cost of Market Basket in Current Year ÷ Cost of Market Basket in Base Year *100
⮚ Every country has its own weight, way of data collection and designated basket –
For Example; List of few goods included in the USA basket is housing, food and beverage, apparel
etc.
The prices and quantity of few basket goods are:
Goods Quantity Price in 2012 Price in 2020

SALT 500 25 40
CRUDE OIL (litres) 1000 75 100
SMART PHONE 20 12,000 30,000
Calculate the change in the price index for this basket from the base period to the current period.
Solution
Base basket price (2012)
PRODUCT PRICE * QUANTITY AMOUNT

SALT 500*25 12,500
CRUDE OIL (litres) 1000*75 75,000
SMART PHONE 20*12000 2,40,000
TOTAL 3,27,500
Current market price (2020)
PRODUCT PRICE * QUANTITY AMOUNT

SALT 500*40 20,000
CRUDE OIL (litres) 1000*100 1,00,000
SMART PHONE 20*30000 6,00,000
TOTAL 7,20,000
Now, CPI = Cost of Market Basket in Current Year ÷Cost of Market Basket in Base Year *100
= 7,20,000 / 3,27,500*100
= 219.85
= 219.85/100 – 1
= 1.19.
Thus, the index is ↑ by 119%.
In India, The CPI was 160.4 in May, 2021 vs the 157.9 in April 2021. The index ↑ by
0.01% pm.
What do you understand by personal consumption expenditure index?
⮚ An alternative measure of consumer price inflation is the price index for personal consumption
expenditures.
⮚ Survey business patterns rather than consumer patterns
⮚ Price increase in producer prices leads to a Price increase in consumer goods
⮚ The two commonly used indexes are a producer price index (PPI) or a wholesale price index
(WPI).
⮚ In the case of PPI, the different stages (raw materials, intermediated goods, finished goods) are
considered to check for pricing pressure.
Wholesale prices in India ↑ by 12.94 percent in May 2021 vs May 2020.

Distinguish between headline and core inflation?
HEADLINE INFLATION CORE INFLATION

Price index includes all goods and The price index excludes food and
services energy
Food and energy prices are More useful in analyzing the trend in
unpredictable in nature prices due to the predictability.
Compare inflation measures, including their uses and limitations.
Which are the factors that cause Laspeyres index of consumer prices to be biased upward?
Lapsers index of consumer prices used by several countries has a fixed basket of goods.
The factors that cause an upward bias are:
⮚ New goods
Highly-priced new goods replace the older, less expensive goods Thus,
causing a ↑ bias in the index as its price-weighted
⮚ Quality changes
↑ In Quality = ↑ Price = ↑ In Price Index,

However, ↑In Price Index is not due to ↑ Inflation (prices) and is because of an improvement in
product quality
To solve this, A technique known as hedonic pricing can be used to adjust a price index for
product quality
⮚ Substitution
When Prices of Laspeyres Index’s Fixed Basket Good increase, it leads to an increase in the
Consumption of Substitute Goods. Thus, the purpose of using a fixed basket gets destroyed. To
solve a substitution bias, authorities can use a chained or chain-weighted price index such as a
Fisher index.
What do you mean by Fisher Index, and how does it work?
⮚ A Fisher index is the geometric mean of a Laspeyres Index and a Paasche Index.
⮚ A Paasche index uses:

Current consumption weights,
Prices from the base period
Prices in the current period.
𝐼 = √𝐿𝑎𝑠𝑝𝑒𝑦𝑟𝑒𝑠 𝐼𝑛𝑑𝑒𝑥 × 𝑃𝑎𝑎𝑠𝑐ℎ𝑒 𝐼𝑛𝑑𝑒𝑥

Goods Quantity 2020 Price in 2012 Price in 2020

SALT 1000 25 10
CRUDE OIL (litres) 500 75 100
SMART PHONE 20 12,000 13,000
Calculate:
a. Paasche index for the current period,
b. Compare the difference to the Laspeyres index (previously calculated as 219.85) Solution
For Paasche Index
PRODUCT PRICE * QUANTITY AMT (A) PRICE * QUANTITY AMT (B)

(2012) (2020)
SALT 1000*25 25,000 1000*10 10,000
CRUDE OIL 500*75 37,500 500*100 50,000
(litres)
SMART PHONE 20*12000 2,40,000 20*13,000 2,60,000
TOTAL 3,02,500 3,20,000
Paasche index
= 3,20,000 ÷3,02,500*100
= 105.7
The Paasche index is ↓ than Laspeyres index (219.85) because consumers substituted for CRUDE
OIL, which had the largest percentage change in price.
Distinguish between cost-push and demand-pull inflation.
Differentiate between demand-pull and cost-push inflation.
BASE DEMAND- PULL INFLATION COST - PUSH INFLATION

DEFINITION Increase in Aggregate demand leads to Decrease in Aggregate Supply caused
↑ in prices and by: ↑ in prices of factors (e.g., labour,
↑ overall output in the short run raw material),
Leads to ↑ in overall prices
GRAPH
GDP RATE Assumption in a normal situation: ↓ GDP & ↑ Prices,

REAL GDP < POTENTIAL GDP GDP falls because, despite higher
In the case of demand-pull inflation, prices, the productivity falls, which
REAL GDP ≥ POTENTIAL GDP lowers the standard of living.
⸫ prices ↑ in the short run as it's ⸫ ↑in prices of factor inputs= ↑Prices
unexpected ↑ in GDP
SHIFT The AD curve shifts to the right The SRAS curve shifts to left
CONSEQUENCES Persistent increase in GDP leads to a Fall in GDP leads to a rise in Prices
rise in Prices This is known as cost-push inflation
This is known as demand-pull inflation
INFLATIONARY Inflationary Gap is when, When the employment rate for certain
GAP/WAGE Actual GDP > POTENTIAL GDP skills is low in few segments, higher
PUSH INFLATION wages are demanded, which causes a
Wage Push
Inflation. E.g.: IT skills.
CAUSES Changes in monetary and fiscal policies Changes In Factor Inputs:
↓ Interest Rates = increase in Money A fall in the Natural Rate of
Supply, which increases the aggregate Unemployment due to the
demand absence of technology leads to a
↑ In Government rise in Wages, Reduces
Spending ↑ In Exports Productivity and leads to an
Etc. increase in Unit Labour Costs An
increase in Future Inflation
Expectations leads to a rise in the
Wage rate through labour unions
THEORIES Monetarist Theory suggests when Upward pressure on wages is more
Supply of Money > The Available likely to emerge when cyclical
Goods and Services (GDP Rate) It unemployment is low
Leads to increase In Prices
POLICY Restrictive monetary and fiscal policies To counter cost-push inflation, the
RESPONSE AND to control the aggregate demand government needs to increase the
IMPACT needs to be implemented. aggregate supply by reducing the tax
Policies like raising taxes to absorb the rate to produce more from the cost
excess cash in the market, increasing savings. Central banks can levy
the interest rate to reduce consumer contractionary monetary policies by
spending on durables etc.
increasing the interest rates, thereby

inducing investments.
Interpret a set of economic indicators and describe their uses and limitations
What is the difference between the various Economic indicators?
BASE LEADING INDICATORS COINCIDENT LAGGING

INDICATORS INDICATORS
DEFINITION Change in direction before Change direction at Change in direction
peaks or troughs in the roughly the same until after
business cycle time as peaks or expansions or
troughs contractions.
INDEX Average weekly hours in Employees on Average duration of
manufacturing; initial nonfarm payrolls; unemployment;
claims for unemployment real personal inventory-sales ratio;
insurance; manufacturers’ income; index of change in unit labour
new orders for consumer industrial costs; average prime
goods; manufacturers’ new lending rate;
production;
orders for non - defense commercial and
manufacturing and
capital goods ex-aircraft; industrial loans; ratio
trade sales. of consumer
Institute for Supply
Management new orders instalment debt to
index; building permits for income; change in
new houses; S&P 500 the consumer price
equity price index; Leading index.
Credit
Index; 10-year Treasury to
Fed funds interest rate
spread; and consumer
expectations.
Kavya Gujral has gathered the following economic reports:
FEBUARY, 2021 JANUARY, 2021

CPI -0.4% -0.78%
AVERAGE WEEKLY HOURS, +5% +4%
MANUFACTURING
AVERAGE DURATION OF -0.6% -0.9%
UNEMPLOYMENT
SENSEX +2% +1.56%
Based on these indicators, what should Kavya conclude with regards to the business cycle?
An increase in Leading Indicators,

- Average Weekly Hours, Manufacturing&
- SENSEX
Indicates a future expansion.
A decrease in Lagging Indicators,
- Average Duration of Unemployment
- CPI
Indicates an end in the contraction phase.
1. Core inflation is measured using a price index:
A. That measures the price increases in factor inputs,

B. That includes the prices of all goods and services. C. That eliminates few goods with fluctuating
prices.
2. Mention the economic indicator for which the turning points occur before the turning points in
the business cycle are witnessed:
A. A lagging indicator.
B. A leading indicator.
C. A trailing indicator.
3. Which of the biased statements about the CPI index mentioned below is least likely true:
A. An increase in price due to advancements in quality leads to an increase in the CPI

B. With the entry of new expensive goods in the market, the original basket of goods used for
household cost measurement becomes less accurate
C. The built-in biases present underestimate the CPI index
4. Cost-push inflation is a result of:
A. Surplus short-run aggregate demand

B. Increasing short-run aggregate supply
C. Substantial rise in the prices of factor inputs
5. In case of unemployment due to lack of proper information with regards to the jobs available in
the market, it is known as:
A. Underemployment
B. Cyclical unemployment
C. Frictional unemployment
Answer:
1. C is correct. Core inflation is measured using a price index that excludes food and energy prices
which are volatile in nature.
2. B is correct. Leading indicators have turning points that occur before an impact in the business
cycle is witnessed.
3. B is correct. The net effect of the built-in bias tends to overestimate the CPI index by 1%.
4. C is correct. Substantial rise in the prices of factor inputs leads to a decrease in short-run
aggregate supply.
5. C is correct. Frictional unemployment is caused due to a time lag between the employer’s
seeking skills and the employees possessing those relevant skills but are unaware of each
other’s situation.
Monetary and Fiscal Policy

Exam Focus
Understanding the demand and supply of money.
Understanding the monetary, fiscal policies and the relationship between them.
Understanding the functions and limitations of central banks.
Money and Inflation
Compare monetary and fiscal policy.
What is a fiscal policy, and explain the types of budgets?
⮚ Government’s decision on taxes and spending to regulate the economic activities.
⮚ In a Balanced Budget Government Tax Revenues=Government Spending
⮚ In a Surplus Budget Government Tax Revenues > Government Spending E.g., Germany in 2019
had a budget surplus of $15 billion
⮚ In a Deficit Budget, Government Tax Revenues< Government Spending. In 2020 India reported a
budget deficit of ₹ 7.96 lakh crore
What is a Monetary Policy, and explain its types?
⮚ Central banks pronouncement that affects the quantity of money and credit in the economy to
regulate the economic activity.
⮚ Monetary policy is said to be expansionary when the central bank the quantity of money and
credit in an economy.
⮚ When the central bank is ↓ the quantity of money and credit in an economy, the monetary
policy is said to be contractionary.
What is the role of monetary and fiscal policies?
a. Ensure stable prices,
b. Promote Economic growth and development, and
c. Fiscal policies can be used for redistribution of income and wealth between the rich and poor
ensuring social welfare.
Describe functions and definitions of money.
Define money and also describe its functions?
MONEY
Generally accepted medium of exchange. A better system than a barter system and results in
indirect exchange.
For instance;
In the case of a foreign transaction between an Indian spice vendor and a South American cotton
vendor, the existence of a barter system would hinder the transaction with regards to the quantity
of cotton or spices that will be needed to settle the trade. There is no common ground.
This is when the existence of a currency eases the process. You can now convert either of the
currencies to come to a common one (e.g., dollars) and settle the trade.
Functions of Money
a. Medium of exchange – For instance, in India, Rupees (notes and coins) are accepted countrywide
in exchange for goods and services.
b. Unit of account- Common scale for measuring the value of goods and services. Helps in
determining the commodity’s worth in terms of a certain currency like Dollars, yen, rupees, etc.
c. Store of value- Money received now can be stored in cash or banks, investments, etc., to be used
in the future.
What are the different types of money?
Narrow money
It consists:
⮚ Notes (currency) and coins in circulation (e.g., Rupees, dollars)
⮚ Balances in checkable bank deposits.
Broad money
Includes narrow money +
Any amount available in liquid assets (e.g., savings deposits, post office deposits, time deposits, etc.)
that can be used for purchases.
Broad measures of money
Money that is less liquid. Every economy has its own characterization of broad money.
In India, the most common measures of money supply areM1, M2, M3 & M4.
Explain the money creation process.
Since we are aware of money and its function, what are promissory notes, and how is money created?
Promissory Notes
A financial instrument that contains a written promise by the borrower to pay the lender a fixed sum
of money, either on-demand or at a specified future date.
History
When clients deposited gold (or any precious metal) with early bankers, they were issued a
promissory note, which acted as a guarantee by the banker to return that deposited gold on demand
from the client. Thus, Promissory notes by themselves became a medium of exchange. Bankers
realised that all the deposits would never have to be withdrawn at the same time. Thus they started
lending a portion of deposits to earn interest. This led to what is called fractional reserve banking
Fractional reserve banking
In a fractional reserve banking system, a bank holds a proportion of deposits in reserve. When cash
is deposited in a bank, the portion that is not required to be held in reserve can be loaned out,
part of which further gets loaned out.
1
This is known as the multiplying effect, money multiplied = 𝑅𝑒𝑠𝑒𝑟𝑣𝑒 𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑚𝑒𝑚𝑛𝑡
𝐴 𝑛𝑒𝑤 𝑑𝑒𝑝𝑜𝑠𝑖𝑡
The money that gets created = 𝑅𝑒𝑠𝑒𝑟𝑣𝑒 𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑚𝑒𝑚𝑛𝑡
In the case of a 10% CRR requirement by the government, how is money created under the
fractional reserve banking system?
ASSETS LIABILITIES
FOR BANK 1
RESERVES (10%) ₹1,000 DEPOSITS ₹10,000

LOANS (10,000 – 1,000) ₹9,000
FOR BANK 2
RESERVES (10%) ₹900 DEPOSITS ₹9,000

LOANS ₹8,100
FOR BANK 3
RESERVES (10%) ₹810 DEPOSITS ₹8,100

LOANS ₹7,290
Hence,
𝐴 𝑛𝑒𝑤 𝑑𝑒𝑝𝑜𝑠𝑖𝑡 10000
Money created = = = 1,00,000
𝑅𝑒𝑠𝑒𝑟𝑣𝑒 𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑚𝑒𝑚𝑛𝑡 0.10
1 1
Money multiplied = 𝑅𝑒𝑠𝑒𝑟𝑣𝑒 𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑚𝑒𝑚𝑛𝑡 = 0.10 = 10 𝑡𝑖𝑚𝑒𝑠
In case of a 5% requirement by the government, what is the amount of money that gets created by
depositing an additional $4,000?
SOLUTION
Money created = 4000 / 0.05 = $80,000.
Explain and throw light on the Relationship between Money and Price Level.
What do you mean by the Quantity theory of money?
The quantity theory of money
Money spending in an economy is in proportion to the quantity of money.
Quantity equation of exchange money supply × velocity = price × real output (MV = PY) Where,
Velocity = the number of times the money is circulated in the economy
Generally, output (Y) and velocity (V) changes slowly. Keeping Y and V constant, an increase in money
supply will lead to a proportionate increase in price
Example
A 4% ↑ in the money supply causes the average price to ↑ by 4%, leading to inflation.
Thus, inflation can be regulated using monetary policies as per Monetarists. The belief that real
variables like GDP and velocity remain uninfluenced by monetary variables like money supply and
prices is called Money Neutrality.
Describe theories of the demand for and supply of money.
Describe the Demand for Money.
The amount of wealth that households and firms in an economy choose to hold in the form of money
and NOT investments in financial securities like stocks and bonds is known as demand for money.
What are the three reasons for holding money?
a. Transaction demand:
Money that is held and is required for carrying out transactions.
As the level of real GDP ↑s, the size and number of transactions will ↑ thus and ↑ in demand
for money.
Example: When you hold money in your wallet or in your bank account to buy groceries later in
the month, you are holding the money because this transaction requires money to be completed
b. Precautionary demand:
Money held for unforeseen future needs.
Example:
COVID 19, an unforeseen calamity, saw how the security reserves came in handy for
governments, industries, and people personally when there was a global fallout and lockdown
everywhere.
Countries like Spain, Italy, and the UK have faced a severe downfall, whereas countries like
Taiwan, Finland, and South Korea have not been severely hit.
In short larger firms and economies have larger precautionary demand for money. ↑ Output
leads to ↑ precautionary demand.
c. Speculative demand:
The need to have money for the purpose of leveraging on future investments opportunities.
It is inversely related to returns; ↑ interests rates lead to less money held for speculative
purposes and more money invested.
It is positively related to risk; ↑ the risk in investing, ↑ the money held, and lower the money
invested in financial instruments.
As seen above when:
⮚ At a 2.7% interest rate, the money held in the economy is 300 as lower interest rates call for
short selling of financial instruments,
⮚ At a 3.2% interest rate, the money held in the economy is 100 as ↑ interest rate means more
buying of financial instruments.
The people of Japan have more money held for transactions and consumption due to the negative
interest rates (-0.10%) and increasing level of GDP. Whereas in India, the people have less money
held for transactions due to the lower level of rates
How does the Supply of Money affect the interest rates?
⮚ The central bank of the country determines the supply of money.
⮚ It is independent of the interest rate and therefore has a perfectly inelastic supply curve.
⮚ Short-term interest rates are determined by the equilibrium between money supply and money
demand, as seen above in the graph.
⮚ Suppose the interest rate is above the equilibrium rate, supply of money > demand of money.
Thus, consumers start purchasing more securities, thus pushing the interest rate down.
⮚ Suppose interest rates are below equilibrium rate, supply of money < demand of money. Thus,
the consumers start selling the securities and hold the money, pushing the interest rates up.
Central banks can affect short-term interest rates by increasing or decreasing the money supply.
Add numbers in graph and not table
Quantity of money Interest rate

100 3.20%
300 2.70%
An ↑ in the money supply (shift of the money supply curve to the right, from 100-300) will put
downward pressure on interest rates.
However, the consumers start excess purchasing of financial securities at ↑ interest rates (3.2%),
putting downward pressure on the interest rates causing it to fall (2.7%).
If the central bank ↓ s the money supply, excess demand for money balances results in sales of
securities and an ↑ in the interest rate.
Describe the Fisher effect.
How is the Fisher effect consistent with money neutrality?
The Fisher effect states that the nominal interest rate is simply the sum of the real interest rate and
expected inflation.
RNom = RReal + E[I]
RNom = nominal interest rate, RReal = real interest rate, E[I] = expected inflation.
The idea behind the Fisher effect is that:
⮚ Real rates are relatively constant, and changes in interest rates are driven by changes in expected
inflation.
⮚ It is consistent with money neutrality.
⮚ Investors are uncertain about the Expected inflation rates (e.g., the expected pre-covid expected
inflation rates for the year 2020-21 are completely different from the actual rates)
Thus, Investors require an additional return (a risk premium) for bearing this risk.
Therefore,
RNom = RReal + E[I] + RP
Where RP = risk premium for uncertainty
Describe the roles and objectives of central banks.
What is the role of the central bank in an economy?
a. Sole supplier of currency
Only the Central Bank has the right to print currency (E.g., The Reserve Bank of India)
Earlier the money printed was backed by gold; however, in the case of fiat money, the currency
need not be backed by gold as long as it holds its value.
In 2008, Zimbabwe faced major hyperinflation, with inflation rates reaching as high as 89.7 sextillion
percent. The Reserve Bank of Zimbabwe was unable to hold its currency value, and it lost its power
of printing legal tender money/fiat money
Legal tender money requires no backing by gold, and the money that the central bank prints is
accepted country-wide for the exchange of goods and services.
b. Banker to the government and other banks
The central bank provides banking services to not only the government but also to other commercial
banks.
For instance:
In case of urgent need of funds, the Central Bank grants loans to both the government and other
commercial banks.
It also offers these institutions an opportunity to earn interest,

c. Regulator and supervisor of the payments system
For example
In India, The Reserve Bank of India supervises the commercial banks by controlling the credit and
velocity of money through instruments like repo rate, reverse repo rate, SLR and CRR rate, etc.
Central banks also oversee the payments system to ensure smooth operations of the clearing
system domestically and internationally. E.g., The RBI is the clearinghouse for all commercial banks
in India.
d. Lender of last resort
In case of no other possibility, the central banks offer to step in and save the situation by granting
money to the commercial bank or government by printing extra money.
In 2008, the Federal Bank of U.S.A (central bank) saved not only the Lehman brothers but also the
economy by printing more notes. This helped in regaining the trust of people in the banking
system as their deposits were now secure.
e. Holder of gold and foreign exchange reserves
Central banks are often the storehouses of the nation’s gold and reserves of foreign currencies.
They control the exchange rates by controlling the circulation of foreign currency in the economy.
f. Conductor of monetary policy
Central banks influence the aim of inflation control and price stability through monetary policies.
For instance, a central bank may ↓ the amount of money by selling government bonds under a “sale
and repurchase” agreement, thereby taking in money from commercial banks. Instruments like open
market operations, short-term interest rates are some other measures.
What are the objectives of the central bank to maintain balance in the economy?
⮚ Control inflation & Establish price stability
⮚ Avoid menu costs; the continuous adjustments in the prices of goods and services provided by
firms and industries. This acts as a cost to these firms every time it's updated. Thus, the prices
need to be adjusted less frequently.
⮚ Avoid shoe leather costs; in case of inflation, the interest rates also tend to appreciate, which
results in continuous loss of time and effort of customers who time and again go and deposit their
money with the banks and keep less money in hand for spending, which in turn slows down the
economy.
What are the goals of the central bank besides price stability?
Stability in exchange rates; with foreign currencies through infusing and controlling foreign currency
in the open markets.
Full employment; better the employment rate better the spending and investment rate, which leads
to economic growth.
Sustainable positive economic growth; through capitalization.
Moderate long-term interest rates.
How does the concept of target inflation work?
The target inflation rate in most developed countries ranges around 2% to 3% and NOT zero as those
lead to a ↑ in deflation risks.
In the United States, due to the additional goals of maximum employment and moderate long-term
interest rates, it doesn’t have a medium-term target inflation rate.
In Japan, it is because deflation (-0.1% interest rate), rather than inflation, has been a persistent
problem in recent years.
What do you mean by pegging of currencies?
In pegging, the local currency is pegged in terms of another foreign currency to maintain foreign
exchange stability.
A pegged rate can help in keeping a country's exchange rate low, thus helping with exports. Equally,
pegged rates can also lead to rising long-term inflation
For e.g.:
Since 1932, Nepal currency Nepalese Mohar (NPR) is pegged against INR.
1 INR = 1.60 NPR.
The domestic country (NPR) always tries to target and achieve the inflation rate of the pegged
country (INR) to achieve exchange rate stability.
Contrast the costs of expected and unexpected inflation.
What is the difference between expected and unexpected inflation?

EXPECTED INFLATION UNEXPECTED INFLATION
Actual Inflation = Anticipated Inflation Actual Inflation ≠ Anticipated Inflation
Fewer implications for the economy More implications for the economy
For e.g.: A Bias between lenders and borrowers
In India, if the expected inflation is 4% and ↑ Actual Inflation Rate v/s Anticipated
the actual inflation shall also be 4% Inflation Rate
inevitably, then the inflation is perfectly Borrower benefits as compared to the
anticipated. The prices for all goods and lender as the purchasing power of money
wages can be indexed to this inflation rate. deteriorates. When the lender had lent
Thus, every month both wages and prices ↑ $100 to the borrower, the expected
nearly one-half percent. inflation rate was assumed to be 8% at
maturity, and the interest rate was levied
accordingly. However, at maturity, when
the actual inflation was 10%, the lender gets
back the same $100, but the purchasing
power of that same $100 is now less as
compared to the anticipation.
The opposite happens in the case of a fall in

actual inflation v/s the expected inflation,
and the lender gains from that situation.
Increased demand for a product shall cause a Positive relation between interest rates and
monthly price rising of more than one-half %, uncertainty
and decreased demand shall be seen in
prices that increased by less than one-half ↑ uncertainty of inflations leads to the
percent per month. lender demanding ↑ interest rates as the
risk of future purchasing power also ↑s.
This, in-turn ↑s the cost of borrowing and
discourages capital enhancement.
One consequence of high inflation is that Uncertain future Market prices

even if it is perfectly anticipated, the cost of Assume that when expected inflation is 6%, a
having money on hand is higher than producer notices that prices for his goods
investing in interest-bearing securities have risen by 10%.
because its purchasing power falls steadily.
If this is understood as an increase in demand
This will decrease the quantity of money that for the product, the producer shall increase
people are willing to hold. volume and production in response to the
perceived increase in demand.
If the price inflation is 10% rather than the
expected 5% over the current period, the
price increase in the producer’s product did
not result from an increase in demand.
The increase in production will result in
excess inventory and volume. The firm will
decrease production, thus firing workers and
decreasing or eliminating expenditures on
increased capacity for some time.
Because of these effects, unexpected
inflation can increase the scale or rate of
business cycles. The disrupting effects of
inflation, either higher than expected or
lower than expected, because of less
information content of price changes impose
real costs on an economy.
However, even under perfectly anticipated

rate, if the rates are high, it leads
Cost of holding money > investing in
securities due to ↓ purchasing power.
It leads to a transfer of money from interest
paying financial instruments to cash or
noninterest-bearing deposit accounts to
facilitate transactions. However, technology
has reduced these issues
1. If the money supply is decreasing and velocity is increasing:
A. Prices fall.
B. Real GDP decreases.
C. Can’t say with regards to the impact on prices and real GDP
2. Reasons to be concerned for a fiscal deficit does not include:
A. Ricardian equivalence
B. Fall in long term economic growth rates
C. Crowding out effect
3. Assuming that the government of Japan manages a balanced budget, the possible effects of a
tax increase on; government expenditure and real GDP are:
A. Increase in both
B. Decrease in both
C. Increase in government expenditure and decrease in the real GDP
4. For identifying the expansionary/contractionary monetary policy, an analyst must compare the
central bank policy rate with:
A. Inflation rate (target)

B. Neutral rate of interest
C. long term growth rate
5. In the case of money neutrality, the effect of a decrease in the money supply is:
A. Lower prices.
B. Lower output.
C. Higher unemployment.
Answer:
1. C is correct. Can’t say with regards to the impact on prices and real GDP. An increase in money
supply leads to a simultaneous increase in velocity and vice versa; however, in this situation, the
impact on price and GDP depends on which component is larger, a decrease in money or an
increase in velocity.
2. C is correct. In the case of Ricardian equivalence, the private savings rise in expectations of higher
future taxes. The crowding-out effect of excessive government borrowing and the fall in the long-
term economic growth rate due to higher future taxes are reasons for concern about the fiscal
deficit.
3. A is correct. To manage a balanced budget, an offset for a rise in taxation is nullified by a rise in
government expenditure. Further, the impact of a rise in government expenditure > rise in
taxation, thus leading to higher GDP rates.
4. A is correct. Neutral rate of interest. Neutral rate of interest = target inflation rate + long term
growth rate. Expansionary monetary policy is a situation where the policy rate < neutral rate of
interest and vice versa.
5. A is correct. Lower prices. Money neutrality states that changes in the money supply do not affect
the real output or the velocity of money. Thus, a decrease in the money supply can only decrease
the price level.
Monetary Policy
Describe tools used to implement monetary policy.
What are the different monetary policy tools?
Policy rates
Also knows as the discount rate in the U.S.A and the refinancing rate for the European Central Bank.
The rate at which the central banks buy securities from commercial banks and lends money to them
with an agreement to be repurchased by the commercial banks at ↑ prices in the future. Central
bank lending rate to commercial banks = Purchase price - Repurchase price
Base rate (interbank borrowing rate), federal funds rate (for American banks) are few other
examples of policy rates.
Thus, by increasing policy rates, the lending rate for commercial banks ↑ which leads to an ↑ in the
lending rate for the citizens, decreasing the money supply and reducing inflation; the opposite
happens in the case of a ↓ in the policy rates
Thus, the central banks can control the credit and circulation of money in the economy via policy
rates.
Reserve requirements
By changing the reserve requirements, the central banks can control the money supply and the
lending situation in the economy.
By increasing the reserve requirement, the availability of loanable funds contracts in the economy,
thus money supply ↓ and interest rates ↑.
By decreasing the reserve requirement, the availability of loanable funds expands in the economy;
thus, money supply ↑s and interest rates fall.
For instance,
The RBI can ↑ the CRR and SLR ratio for commercial banks to curb the credit growth in the economy
to reduce inflation.
Open market operations
Buying and selling of securities in the market by the central bank.
To ↑ the money supply and lending in the economy, the central bank buys securities from the public
and infuses excess cash into the market. It also ↓ the borrowing costs.
To ↓ the money supply and lending in the economy, the central bank sells securities to the public
and extracts excess cash in the market. It also ↑s the borrowing costs.
Post the 2008 crisis, The Federal Reserve Bank (Central Bank of United States) had purchased
$175 million Mortgage-Backed Securities from commercial banks and had infused money
supply in the economy, which had caused a fall in the borrowing costs and improved the value
of local currency.
Describe the monetary transmission mechanism
Throwing light on monetary transmission mechanism, how does a change in the short-term
monetary policies, especially the policy rate, affects the price level and inflation in the economy?
POLICY RATE
SHORT
ASSET EXPECTATIONS EXCHANGE RATE
TERM
PRICES AND
LENDING
CONFIDENDECE
RATE
A. Short term lending rate
For example, by increasing the repo rate from 4% to 5%, the central bank ↑s the cost of
borrowing for commercial banks, which further pass this ↑ in cost to the end consumer by
increasing their short-term lending rate.
This ↑s the borrowing costs, which leads to a drop in investments in new business opportunities
and also leads to lower demand for goods and services as lower cash in hand.
B. Asset prices
Bond prices are inversely related to interest rates. A sudden ↑ in interest rates due to an ↑ in
the policy rate causes the prices of bonds and equities to fall as they now have to be discounted
at a ↑ rate of interest.
C. Expectations and confidence
A ↑ policy rate implies a ↑ growth rate of the economy, which leads to ↑ employment and
profitability expectations.
It could also mean that the economy is growing at a very fast pace. Therefore measures need to
be taken to tame the fast-growing inflation rate, which ↓ the confidence of the people. This
leads to an ↑ in savings and less expenditure.
D. Exchange rate
A sudden ↑ in policy rate leads to a ↑ in value of domestic currency, which in turn makes export
difficult as it becomes more expensive for overseas buyers. This ↓ the demand for export
products.
An ↑ in the official rate, therefore, leads to;
⮚ A ↓ in overall demand
⮚ Puts downward pressure on the price level.
Describe the qualities of effective central banks.
What are the qualities that central banks must adapt to in order to prove its effectiveness and
efficiency?
a. Independence
No political involvement even in deciding the policy rates, or even in matters like choosing of
Central bank officials
In case of political involvement, the parties get the authority to boost the economy and reduce
unemployment during their tenure or right before elections, thereby manipulating the public by
performing such mal-practices
Having operational independence where the target is set by the fiscal authorities and policies
are implemented independently by the central bank.
Target independence wherein the central bank decides the target inflation level, which tools to
implement, and when to achieve the target. E.g., Canada, New Zealand.
Some countries have only operational independence; their government decides their target
inflation rate, and the rest of all decisions are made by the central bank itself. E.g., Few
Developing countries
b. Credibility
The central bank needs to follow what it claims to the public,
E.g., If in a country where the country is buried under huge debt, the government decides the
target inflation rate, it will be unfair to the economy as it can be manipulated.
Hence, the Central banks must make all the monetary decisions unbiasedly to save the public
from manipulation and misconduct by officials.
Anticipated and actual inflation must be close to each other.
c. Transparency
The central bank must periodically (e.g., monthly in India) publish its inflation reports.
It must represent the actual condition of the economy, and further monetary policies must be
implemented based on this.
Explain the relationships between monetary policy and economic growth, inflation,
interest, and exchange rates
In the short run, how can changes in monetary policy affect the real economic growth and interest rates,
inflation, and foreign exchange rates?
The effects of a change to a more expansionary monetary policy (lower short-term interest rates)
may include any or all of the following:
⮚ The central bank buys securities, which ↑s bank reserves.

⮚ The interbank lending rate ↓ s as banks have more money supply to lend to each other.
⮚ Other short-term rates ↓ as the ↑ in the supply of loanable funds ↓ s the equilibrium rate for
loans.
E.g., a lower CRR and SLR ratio leads to less money being kept aside and causes an ↑ the amount
that can be loaned.
⮚ Longer-term interest rates also ↓ since continuous fall in short term rates.
⮚ The ↓ in real interest rates causes the currency to depreciate in the foreign exchange market.
E.g., When the supply of rupees is more v/s the dollars, the local currency of rupees depreciates.
⮚ The ↓ in long-term interest rates ↑s business investment in plant and equipment due to lower
borrowing costs.
⮚ Lower interest rates cause consumers to ↑ their purchases of houses, autos, and durable goods.
⮚ Depreciation of the currency ↑s foreign demand for domestic goods. It gives ↑ to exports as it
is now cheaper for overseas buyers
⮚ These ↑s in GDP all ↑ aggregate demand.
Post the Lehman Brothers crisis, as the Fed’s short - term Treasury bills proceeds to buy long –
term treasury notes to keep interest rates down
How does the ↓ in interbank lending rates affect the economy?

1. Lending rates for the short and long-term fall due to a fall in base rates.
2. A ↑ in asset prices due to a smaller discount factor and inverse relationship of price and interest
rates.
3. As we know, lower rates now means ↑ rates in the future, thus increasing the future
expectations of employment and profitability.
4. The domestic currency ↓ in value which enhances exports.
5. The ↑ in the consumption v/s savings due to lower interest rates and positive net exports
(imports<exports) ↑ the aggregate demand of the economy and thus increasing the domestic
inflation.
Contrast the use of inflation, interest rate, and exchange rate targeting by central
banks.
What are the various economic indicators that the central banks use to make various monetary policy
decisions?
INTEREST RATE INFLATION TARGETING EXCHANGE RATE

TARGETING TARGETING
↑ the money supply Inflation target of 2-3% is The central banks set a
when: interest rate> generally used, +/- 1%. target currency to establish
target interest rate bands the exchange rate band.
0% is not advisable as a
deviation downwards, e.g.: For instance, if African CFA
0.5%, causes a ↑ in the Franc (XOF) ↓ v/s French
problem of deflation. Fran, then the West Africa
Central Bank uses its franc
reserve to purchase XOF’S
(reducing the money supply)
and thus pushing up the
interest rate to its target
exchange rate. This method
creates great volatility in the
market.
↓ the money supply Central banks don’t target However, there is a certain
when: interest rate<target the current inflation rate as limit to this short-term
interest it is based on prior policies measure. E.g., If the foreign
rate bands and events. reserve gets over and the
domestic rate is yet below
They target the inflation the target, then there is a
rate in the range of 2 years problem.
from now.
The targeting country (WEST
AFRICAN UNION) needs to
constantly imitate the
inflation rate of target
country (FRANCE), thus
adapting to the various
changes in the monetary
policies.
Russia till 01/2014, Japan E.g., U.K., Brazil, Canada, Adapt the low inflation
till 2013. Australia, Mexico, India. country experience.
Determine whether a monetary policy is expansionary or contractionary.
How to realize whether a monetary policy is expansionary or contractionary?
⮚ Long-term sustainable real growth rate is called the real trend rate.
⮚ Trend rates change with the structure of the economy. E.g., U.S.A is a debt-heavy economy the
consumers there strictly believe in credit card purchasing, therefore consuming more and not
saving, now if they decide to change this and save more by consuming less, this would cause a
shift in the economy and reduce the trend growth rate
⮚ The neutral interest rate of an economy is the growth rate of the money supply that neither ↑s
nor ↓ s the economic growth rate: neutral interest rate = real trend rate of economic growth
+ inflation target
a. Contractionary Monetary Policy

⮚ It’s used in case the inflation rate crosses above the target inflation rate
⮚ Due to High Inflation growth, the central banks resort to this measure to tame down the
economy.
⮚ The central banks ↑ the policy rates, thus increasing the borrowing costs and reducing the
inflation rate back to the inflation target rate.
b. Expansionary Monetary Policy
a. To boost the economy, the central banks reduce the policy rates, thus reducing the borrowing
cost and bringing the inflation back to its target rate.
b. However, this is a short-term approach in the long-term neutral rate approach holds.
For instance;
When the trend rate is 2% and the neutral rate 6% when,
I)Policy rate (7%) > neutral rate = Contractionary policy
II) Policy rate (7%) < neutral rate = Expansionary policy
What are the sources of inflation?
The sources of inflation are:
A. Demand shock
↑ in consumption due to ↑ customer confidence.
Increasing policy rates must be used to control inflation.
B. Supply shock
An unexpected event that suddenly changes the supply of a product or commodity, resulting in
an unforeseen change in price
In the 1980’s the sudden ↑ in oil prices called for a ↑ in policy rate measure to control the
situation however, this would create unemployment.
Describe the limitations of monetary policy.
What are the limitations of monetary policies?
⮚ Long term interest may not imitate the effects of the short-term interest rates as they are based
on actual expectations
E.g., A ↓ in the money supply (due to ↑ monetary policy rates) leads to a fall in the inflation rate
in the shorter term but NOT in the long term.
This is because, for long-term bonds, rates are higher due to expectations of higher inflation in
the future; this causes an ↑ in the investments currently in these long-term bonds. This increase
in investments leads to falling interest rates in the future as available money supply in the
economy ↑s and leads to economic growth.
⮚ Thus, an investor becomes a bond vigilante, a bond market investor who protests monetary or
fiscal policies is considered inflationary (via high-interest rates and ↓ government spending) by
selling bonds, thus increasing yields and lowering bond prices.
⮚ Liquidity trap: It is a situation where demand for money is elastic; individuals willingly hold more
money even without a ↓ in short-term rates.
⮚ Quantitative easing,
In the case of Japan, from the 1990’s – 2021 interest rate keeps falling, and there is yet no sign of
any encouragement in purchasing investments. Thus, it now has a deflation rate of -0.1%
In 2008 despite a fall in short - term rates and reserve ratio, the banks were yet hesitant to lend.
Thus, billions of dollars were made available by excess printing for the Fed to buy assets and the
economy. This is known as Quantitative easing.
boost
How do the monetary policies look like in developing countries like India?
⮚ Lack of liquid bond market which disables smooth open market operation measures
⮚ Difficulty in formulating a neutral/trend rate
⮚ Lack of confidence of people in the Central Banks thus no independence in target rate
computation.
Describe the roles and objectives of fiscal policy.
What is the role of fiscal policy in bringing stability to an economy?
Fiscal Policy
⮚ Government’s decision of taxes and spending and its impact on the economic activities.
⮚ In a Balanced Budget Government Tax Revenues=Government Spending
⮚ In a Surplus Budget Government Tax Revenues > Government Spending (E.g., Germany,
Japan, and few other major developed countries)
⮚ In a Deficit Budget Government Tax Revenues< Government Spending (E.g., India,

Bangladesh, and few other developing countries)
⮚ ↑ taxes and less government spending = lower budget deficit and thus a lower demand,
economic growth, and employment.
⮚ Keynesian economists believe that fiscal policy can greatly affect economic growth by targeting
aggregate demand.
⮚ Monetarists believe that monetary policy should be used to ↑ or ↓ inflationary pressures over
time.
What do you mean by Discretionary fiscal policy?
⮚ Discretionary fiscal policy means a change in government spending and taxes based on
policymaker's decisions.
For example: In case of extreme inflation and the need to control it through contractionary fiscal
policy, the government can procure the excess funds from the public by increasing taxes and
reducing government spending.
What are automatic stabilizers?
Automatic stabilizers are built-in fiscal devices triggered by the state of the economy.
In case of High inflation, the tax receipts ↑ and government spending ↓ on unemployment
benefits. Both of these will reduce budget deficits and are hence contractionary in nature.
For e.g.: As seen during the pandemic, tax receipts fell, and government expenditures on
unemployment insurance payments rose. This led to an ↑ in budget deficits and are
expansionary in nature.
What are the main goals of fiscal policy implementation?
a. Influencing the level of economic activity and aggregate demand.
b. Unbiased distribution of wealth and income among the rich and poor.
c. Proper resource allocation among all the segments.
In India, 70% of the population (770 million people) stay in rural areas. If the government allocates
all of its resources in the infrastructure development of cities, the rural areas get neglected, and
the economy suffers from a major setback.
Describe tools of fiscal policy, including their advantages and disadvantages.
What do you mean by spending tools and revenue tools with reference to fiscal policies?
Spending Tools
⮚ Transfer payments
Providing welfare schemes to the poor by taxing the rich in order and redistributing wealth in
the economy
Example: Prime Minister's Rozgar Yojana (PMRY), The Public Distribution System (PDS), etc. Not
included in GDP calculation
⮚ Current spending
Regular recurring spending on goods and services Example:

National Security, Healthcare, Education, etc.
⮚ Capital spending
Anticipated to Boost economic progress in the future. Infrastructure, roads and bridges, schools,
medical centres, etc.
For example: The development of infrastructure, schools, health care by the government through
the taxes of the citizens has made Finland the happiest country in the world. Out there, the
income is so well distributed that there is no extreme richness or poorness. The citizens are
extremely happy with the government and its spending.
Justification for spending tools:
⮚ Services such as national defence benefit the country as a whole.
⮚ Invest in infrastructure, which also includes human capital development to enhance economic
growth.
Support the country’s growth and unemployment targets by directly affecting aggregate
demand.
Example: The more people are employed, the more is income, consumption, and investments.
⮚ Provide a minimum standard of living.
In India, the minimum standard of living costs anywhere between rupees 15,000 – 20,000 p.a. The
government of India must assure this basic standard to all the citizens through appropriate
management and allocation of taxes and spending.
⮚ Subsidize R&D for economically growing projects. Example: Green technology, organic food, etc.
Revenue Tools
⮚ Direct taxes
Levied directly on the income, property, and wealth of an individual

Example: Income tax, wealth tax, corporate tax, etc
Progressive taxes like Income and wealth tax help in redistributing income and wealth.
⮚ Indirect taxes
Taxes levied on goods and services

Example: Sales tax, GST, value-added tax extra.
How do indirect taxes help in regulating the consumption of certain harmful products?
By levying ↑ taxes on products like alcohol, tobacco, etc., the government can control their
consumption pattern by making them more expensive.
Mention few Desirable attributes of tax policy and how should they can be implemented?
⮚ Simplicity
It should be easy to understand and implement. It should not have any kind of loopholes,
complexity, etc.
In India, the VAT, sales tax, concise duty, etc., system was not only complicated and full of loopholes,
but it also caused a huge loss of revenue for the government. The introduction of GST (Goods and
Services Tax) irradicated this problem completely. It is simple and easy to follow with no loopholes.
Attributes of tax policy:
⮚ Efficiency
The government tax policy should not hinder the mechanism of the market
⮚ Fairness
The two commonly held beliefs are:
Horizontal equality Vertical equality

Citizens in similar situations should pay Richer people should pay more in taxes. This
similar taxes. is also known as progressive taxing.
E.g., an individual with a $100 income E.g., an individual with a $100 income
should be taxed at the same rate as an should be taxed at a lower rate than an
individual with a $1000 income. individual with a $1000 income.
⮚ Sufficiency
Tax Revenue ≥ Spending, thus covering all expenditures
What are the Advantages and Disadvantages of Fiscal Policy?
Advantages Disadvantages
Welfare policies like discouraging practices Capital spending also takes a long time to
like gambling, alcohol, and tobacco implement. The economy may have
consumption through ↑ taxes. recovered by the time its impact is felt.
Changes in the Indirect taxes system can be Direct taxes and transfer payments take time
implemented almost instantly, thereby to implement, delaying the impact of fiscal
generating revenue for the government policy.
immediately at almost no cost.E.g., VAT,
Concise duty, etc., were eradicated, and GST
was implemented almost instantly.
Post the Lehman Brothers crisis of 2008, the Federal Bank of America tried its best to build back
the public confidence and induce capital spending; however, the impact had already been felt, and
recession had already destroyed the economy.
How can a change in fiscal policy have an effect on the expectations of people?
⮚ ↑ in taxes may immediately reduce current consumption, thus reducing the aggregate demand.
For instance:
Post GST in 2017, cigarette prices have shot up tremendously and have thus reduced its
affordability rate, affecting the consumption pattern.
Spending tools are often used to ↑ aggregate demand.
⮚ Tax reductions are somewhat less operative, as people may not spend the entire amount of the
tax savings.
Tax reductions tend to be more useful in the case of lower-income categories as their major
income is spent on consumption.
What is a Fiscal Multiplier?
Fiscal policies aid in changing the aggregate demand through changes in government spending and
taxes.
Lower taxes and ↑ government spending explain the change of the ↑ in demand.
The Fiscal Multiplier explains the magnitude of these changes.

1
Fiscal multiplier =
1−𝑀𝑃𝐶(1−𝑇)
Where in,
MPC= Marginal propensity to consume
T= Tax rate
The government decides to spend $1000. Tax rate is 20%. MPC is 50%.
Calculate the total multiple of spending?
When the government spends $1000, the amount of ↑ in say X’s income = $1000
However, the disposable income the amount available post-tax = $800 [ 1000 – {1000*20%}]
Since, MPC IS 50% the actual money available for spending= $400 [800*50%]
This $400 further becomes an income for a person Y who further pays taxes and post MPC the
amount left for spending is $160.
Thus,
1
Fiscal multiplier =
1−𝑀𝑃𝐶(1−𝑇)
= 1/ 1 – 50% (1-20%)
= 1.667
This means that with an ↑ of $1000 in government spending, the potential ↑ in the aggregate
demand is $1,667 (1,667*1000)
Describe what relationship does the fiscal multiplier hold with the tax rate and MPC?
⮚ Fiscal multiplier has an inverse relationship with tax rate,
For e.g.: The tax rates fall for an in-demand, thus increasing the household disposable income
and fiscal multiplier.
Direct relationship with MPC.
↑ disposable income = ↑ consumption = ↑ MPC
What do you mean by Balanced Budget Multiplier? -

↑ in Government Spending = ↑ in Tax Revenue
⮚ No ↑ /↓ in the budget.
How does your aggregate demand decrease?
When the government spending ↑s ($1000), we need to ↑ the tax collected by $1000 to maintain a balance
in the economy.
This further ↓ s the total individual spending amount,
Decrease in demand (rising tax) = ↑ in Government Spending*MPC*Fiscal Multiplier

For our example, 1000*50%*1.667=$833.5.
⮚ Thus, combining the ↑ in demand via government spending and ↓ in demand via tax revenue,
we get a positive ↑ in demand of $833.5 (1667-833.5)
What does the Ricardian Equivalence state?
⮚ ↑ in current deficit= ↑ in future taxes
⮚ People start consuming less now and save the money for the future ↑ in taxes.
If the savings (entire country) = principal + interest of the debt taken by the government to fill the ↑
in current deficit, there is NO CHANGE in the aggregate demand.
Describe the arguments about whether the size of a national debt relative to GDP
matters.
How can the debt ratio affect the economy?
⮚ A country’s debt ratio is the ratio of aggregate debt to GDP, interest expense, annual deficit, etc.
can all be compared relative to this ratio.
India’s debt ratio ↑ from 74% to 90% during the pandemic, which can be quite alarming.
⮚ If the economy's interest rate on debt > growth rate, it leads to an increasing debt ratio.
⮚ If the interest rate on debt < growth rate of the economy, it leads to decreasing debt ratio
What are the Arguments for and against fiscal deficit?
FOR CONCERNS FOR FISCAL DEFICIT AGAINST CONCERNS FOR FISCAL DEFICIT
↑ future taxes = lack of motivation to work = Debt issued:
slow long term economic growth a. Domestically, then the problems are
exaggerated.
b. If for economic development, then the
future benefits shall cover the current costs.
Continuous increasing debt ratio= loss of If Ricardian equivalence holds (private

public confidence (less repayment) = sector savings in anticipation of future taxes
government defaulting/ printing, more = government deficit), then the deficit isn’t
money= ↑ inflation alarming.
In fact, it may prompt needed tax reforms
Crowding effect: Excessive government If the economy is running below full

borrowing causing increasing interest rates= employment, then the deficit is used for
lower investments by the private sector in productive projects only. Hence the future is
new projects. profitable. Thus ↑ GDP and employment
In 2011, the EU bond yields rose due to excessive government borrowing, which was at the
expense of ↑ interest rates on government debt and lower private - sector borrowing.
Explain the implementation of fiscal policy and difficulties of implementation
What are the conditions based on which fiscal policy decisions are implemented?
For instance, under:
⮚ Discretionary fiscal policy is effected through changes in government taxation and expenditure
as against automatic stabilizers
⮚ Decisions need to be taken concerning the business cycle situation.
⮚ In the period of economic boom, when the economy is working at full employment, the
government must implement a contractionary fiscal policy wherein the government taxes more
and spends less.
⮚ The opposite happens during the recession the government implements expansionary fiscal
policy where they tax less and spend more.
⮚ These policy decisions directly affect aggregate demand.
For example: to ↑ the aggregate demand, the government takes up infrastructural
projects to ↑ the employment and thus the consumption.
Issues in implementing fiscal policy
1. Incorrect forecasting can lead to incorrect policy decisions forecasting
2. The change in Fiscal policies implementation and actual occurrence of the business cycle phase
doesn’t always match.
3. There is a time lag between inflationary/recessionary economic pressures and the impact on the
economy of changes in fiscal policy. Three-time lags are as follows: recognition lag, action lag, and
impact lag.
What are the time lags faced by the fiscal policy implementations?
a. Recognition lag
This situation a ↑s when there is a time gap in realising the change in the stage of the economy
(from boom to recession).
For instance:
Before COVID-19 hit, the European nations were in a boom phase; however, before the nations could
understand the severity of the situations (like unemployment, health, etc.) and change the fiscal
policies, the loss was already done.
b. Action lag:
Once the policymakers understand the situation, they need to discuss it, get the majority vote
for the changes introduced, and then implement it.
E.g., Post the pandemic, the relief measures that need to be introduced for unemployment,
health care, small businesses, etc., first need to be discussed in the parliament, which will take
several months to implement.
c. Impact lag
It may take some time before the results of the implemented policies are actually seen.
Despite measures like free stay, cheap airfare, vaccine drives, etc., implemented by the European
Union to promote tourism, there has been no movement in the tourism rate; it will take some
time for things to get back to normal.
What are the macroeconomic factors that may hinder the usefulness of fiscal policy?
⮚ Misreading economic statistics:
The full employment level for a country can’t be measured accurately. If the government depends
on expansionary fiscal policy incorrectly at a time when the country is already at full employment,
it will simply lead to higher inflation.
⮚ Crowding-out effect:
Excessive government borrowing causing increasing interest rates = will crowd out investments
by the private sector in new projects.
⮚ Supply shortages:
If economic activity is running slow because of input limitations (like less accessibility of labour/
other inputs) and not because of low demand, the expansionary fiscal policy shall not succeed in
achieving its goal and shall possibly cause higher inflation.
For example:
During the pandemic, the businesses were shut, and now as and when things are getting better, the
aggregate demand is rising. In contrast, the supply isn’t causing an ↑ in inflation resulting in
counterproductive expansionary policies.
⮚ Limits to deficits:
Expansionary fiscal policy has its limit. If the markets notice that the deficit is already at its peak
as a proportion to the GDP, funding the deficit and providing fiscal stimulus gets difficult.
In the case of Zimbabwe, in 2008, it was the least valued currency in the world. Huge foreign and
public debt had ↑ the deficit tremendously, which lead to excessive printing of currency and loss
of people’s confidence. This resulted in inflation reaching as high as 1000% monthly.
⮚ Multiple targets:
If the economy has high unemployment coupled with high inflation, fiscal policy cannot address
both problems simultaneously
For example:
In order to eradicate employment, the government must create employment opportunities that
further ↑s the income and consumption leading to a ↑ in inflation as well.
Determine whether a fiscal policy is expansionary or contractionary.
How to identify whether a fiscal policy is expansionary or contractionary?
⮚ An ↑ (↓) in surplus is indicative of a contractionary (expansionary) fiscal policy.
⮚ An ↑ (↓) in deficit is indicative of an expansionary (contractionary) fiscal policy.
⮚ In order to examine the kind of policies, the authorities need to look at the stage of the business
cycle and not the deficit.
Explain the interaction of monetary and fiscal policy.
How can various combinations of monetary and fiscal policy affect the economic conditions in a
country?
EXPANSIONARY FISCAL POLICY CONTRACTIONARY FISCAL

POLICY
EXPANSIONARY ⮚ High aggregate demand ⮚ Low aggregate demand
MONETARY ⮚ Lower interest rates, therefore, ⮚ Government spending ↓
POLICY increasing private sector as a result of contractionary
investments and future economic fiscal policy
boom ⮚ Private sector participation ↑s
due to low interest rates
CONTRACTIONA ⮚ High aggregate demand ⮚ Low aggregate demand

RY MONETARY ⮚ High public spending due to ⮚ ↑ interest rates, therefore,
POLICY expansionary fiscal policy reducing private sector
⮚ High interest rates causing a fall in investments and future
private sector participation economic fall.
For all kinds of fiscal stimulus (policies to boost the economy), the influence is greater when the
fiscal actions are combined with expansionary monetary policy. This may reflect the impact of
greater inflation, falling real interest rates, and the resulting ↑ in business investment.
1) A decrease in the policy rate will most likely lead to a decrease in:
A. Capital expenditures.
B. Spending for consumers on durables
C. The exchange value of local currency.
2) Monetary policy is least responsive to domestic economic environments when the central
banks employ:
A. Exchange rate targeting.

B. Interest rate targeting.
C. Inflation rate targeting
3) In the case of India, if it has a real trend rate of 3%, and RBI has set an inflation target of 5%.
Further, to meet the target rate, the central bank has set the policy rate at 7%. Monetary policy
is most likely:
A. Balanced.
B. Expansionary.
C. Contractionary.
4) If the monetary policy is aiming at overcoming rising inflation, the central bank shall achieve this
by undertaking which action of open market operation:
A. Selling Treasury securities, which lead to an increase in the aggregate demand

B. Selling Treasury securities, which lead to a decrease in the aggregate demand
C. Purchasing Treasury securities, which lead to a decrease in the aggregate demand
5) Target Inflation rate is set at , by the central banks.
A. 0-3%
B. 0%
C. >3%
6) An increase in the fiscal surplus is indicative of:
A. Expansionary fiscal policy

B. Contractionary fiscal policy
C. Can’t say
7) In the case of contractionary monetary policy and expansionary fiscal policy, the most likely effect
on interest rates and the private sector share in GDP are:
A. Lower Interest rate, lower Share of private sector

B. Higher Interest rate, higher Share of private sector
C. Higher Interest rate, lower Share of private sector
8) A government reduces spending by $20 million. The tax rate levied is 20%. Consumers depict an
MPC of 70%. The change in aggregate demand due to the change in government spending is
closest to:
A. –$60 million.
B. –$45 million.
C. –$50 million.
9) ________ is a built-in fiscal device triggered by the state of the economy
A. Government spending
B. Liquidity Trap
C. Automatic stabilizer
10) Sales in the wholesale segment have been slow, and consumer confidence has declined, leading
to fewer planned purchases. In response, the finance ministry sends an expansionary
government spending plan.
The plan was submitted on January 31st, 2018, and the legislature refines and approves the terms
of the spending plan on March 31st, 2018.
What type of fiscal plan is being considered, and what type of delay did the plan experience
between January and March?
Fiscal Plan Type of Lag

A. Automatic Action
B. Discretionary Action
C. Discretionary Recognition
Answer
1) C is correct. The exchange value of local currency. Decrease in the policy rate leads to a decrease
in the longer-term interest rates. This leads to an increase in consumption spending on durable
goods and an increase in capital expenditure. The fall in rates, however, makes investment in the
domestic economy less attractive to foreign investors, decreasing the demand for the domestic
currency, which leads to a decrease in the local currency.
2) A is correct. Exchange rate targeting. Exchange rate targeting needs monetary policy to have a
stable exchange rate with the targeted currency, irrespective of the domestic economic
environment.
3) B is correct. Expansionary. Neutral rate = trend rate + inflation target = 3% + 5% = 8%. Since, the
policy rate < the neutral rate, monetary policy is expansionary.
4) B is correct. Selling Treasury securities, which lead to a decrease in the aggregate demand by
reducing the consumer spending on durables, capital expenditures, etc.
5) B is correct. 0-3%.
6) B, A contractionary fiscal policy that reduces the aggregate demand by reducing the government
expenditure.
7) C is Correct. Contractionary monetary policy and expansionary fiscal policy both lead to rising
interest rates. Contractionary monetary policy reduces private sector growth, while expansionary
fiscal policy increases the public sector contribution, thus, reducing the overall contribution of the
private sector in GDP.
8) B is correct. –$45 million.
Fiscal multiplier = 1 / [1 – MPC (1 – T)] = 1 / [1 – 0.70(1 – 0.2)] = 2.27
Change in government spending = –$20 million
Change in aggregate demand = – (20 × 2.27) = –$45.4 million
9) C is correct. Automatic stabilizer.
10) B is correct. Discretionary Fiscal Plan, and Action Lag. The expansionary plan originated by the
finance ministry and approval by the legislature is an example of discretionary fiscal policy. The
lag from the time of the submission in January through the time of the vote in March is known as
action lag.
Introduction to Geopolitics
Geopolitics is a study of how geography has an influence on politics and international relations.
Most recent examples on Geopolitics are
US Speaker Nancy Pelosi’s visit to Taiwan – In response to the visit, China launched military
exercises very close to Taiwan. China halted over 100 Taiwanese brands of food imports and also
stopped selling sand to Taiwan.
Russia Ukraine war – The war sent shockwaves around the world with increasing inflation, debt
and higher energy prices. As many as 25 African countries, including many least developed
countries, import more than one third of their wheat from Ukraine and Russia and 15 of them
over half. Wheat prices have risen by 60 % because of the war. Countries like Indonesia (heavily
dependent on wheat imports from Ukraine), Mongolia (with 98% energy dependence on Russia),
Thailand, Pakistan, Bangladesh, Sri Lanka and Vietnam have been significantly affected due to the
war.
Geopolitics & Geopolitical Risk
Geopolitics from a cooperation vs competition perspective
Within the field of Geopolitics, analyst study actions of national governments, political leaders or
country leaders (state actors) and corporations, non-government organisations and individuals
(non-state actors).
The actions are studied in terms of diplomacy, military matters and economic and cultural
interaction. From economics point of view – actions are viewed in terms of trade agreements,
movement of labour and capital across borders, standardization of rules and regulation and transfer
of information and technology.
A country might be more / less corporative or non-corporative with other countries on the matters
mentioned above. The degree of cooperation can change overtime.
Motives for cooperation
1. National Security / Military Interest – This involves the safety of the country including its citizens,
economy, and institution from external threats like terrorism, cyber-crimes, and even natural
disasters. Geographic factors play a really important role in determining the country’s national
security approach and the extent to which it will be cooperative. Countries that are well-connected
to trade routes, like Singapore, or nations that operate as a conduit for trade, like Panama, could
also be able to influence larger international dynamics by their physical location.
2. Economic Interest – National security has also expanded into economic factors like energy, food or
water. Social stability is an important concept of National Security which can be achieved by growing
national wealth and limiting income inequality domestically. Global operations are increasingly
important for national businesses. One of two motivations may drive nations to cooperate in order
to advance their economic interests: either to level the playing field for their companies globally or
to engage in trade for strategic resources.
3. Geophysical Resource Endowment – We can analyse a country’s national interest as a hierarchy with
its top priorities being to ensure its survival. The abundance of geophysical resources in a nation may
influence its priorities. For instance, a nation that lacks arable land but has mineral riches must trade
minerals for food.
4. Standardization – The process of creating procedures and protocols for production, sale, transport
or use of a good or service is called Standardization. An example for standardization is IRFS
(International Financial Reporting Standards) for firms presenting their accounting data. Another
example you can relate to is Society for Worldwide Interbank Financial Telecommunication (SWIFT)
which was setup to provide a global financial infrastructure for cross border payments.
5. Cultural Considerations and “Soft Power” – Countries may have cultural reasons for cooperating
with others. These reasons can be long-standing political ties, cultural similarities, immigration trends
or common experiences. Countries may use soft power - the ability to influence without using
force/coercion. Soft power can be developed using cultural programs, advertisement, travel grants,
and university exchange. A few examples to note:
a. Japan’s high level of investment in may globally recognized electronics and auto industry companies
wields them great power in business.
b. Korea’s K-pop music attracts fans all around the globe.
c. United States has an education soft power due to its high-quality institutions and scholars. Hence,
they attract many international students.
Role of Institutions
Institutions are established organisations. They are either formal (like a university) or informal (like
customs or behavioural patterns important to the society – charities, media, political parties etc.).
Strong and Stable institutions make cooperation easier for state and non-state actors.
Hierarchy of Interests
Factors that are crucial for the survival are at the top of the country’s national interest hierarchy
whereas other factors which are good but not so crucial will be lower in the hierarchy.
Power of the Decision Maker
Different governments may prioritize different national interests over its predecessor. The tenor of
the nation’s political cycle may affect its priority. Governments with shorter cycles are less likely to
concentrate on longer-term goals, even if such goals might be advantageous to society. The
intentions of decision makers can affect a nation's cooperative and uncooperative decisions. This
adds a psychological element and an element of unpredictability to decisions made along the
hierarchy of a nation's requirements, which can influence geopolitical relationships.
Political Non-Cooperation
Most countries eventually cooperate to standardise some rules on a worldwide scale. However,
there are rare cases of extreme non-cooperation—countries for which the right to political self-
determination is more significant than the advantages of any cooperative measures. Example: 2015
saw the imposition of international sanctions against Venezuela as a result of its drug trafficking
and lack of assist in the fight against terrorism. Sanctions against Venezuela were applied by the US
and the EU, which constitutes a non-cooperative strategy designed to sway a nation's or its political
leadership's behaviour. Venezuela’s non-cooperative stance indicates that its political self-
determination is a priority above that of the humanitarian cost being inflicted on its citizens.
1. Which of the following is most likely a cooperative approach a country would follow with other countries?
A. Rule Standardization
B. Restricted Trade/Capital flows
C. Lack of Technology Exchange
2. Which of the following is not a motive for cooperation?
A. Economic Interest
B. Cultural Considerations
C. Globalization
3. Which of the following is the most important in terms of country’s s hierarchy of interests?
A. National Security
B. Cultural program
C. Trade
4. Which of the following is least likely a form of geopolitical cooperation?
A. Following standardized rules and regulations

B. Using soft/hard power
C. National Security
Answers:
1. A is correct. B&C are non-cooperative approaches.
2. C is correct.
3. A is correct. For any country national security is at the top in terms of hierarchy of interest and cultural
programs are at the bottom.
4. B is correct because both soft power and hard power (military retaliation) are examples of non-
cooperative behavior, with the former being less extreme means to influence another country’s decisions
without force or coercion.
Geopolitics and its relationship with globalization
The process of interaction and integration between individuals, businesses, and governments on a global
scale is known as Globalization.
70
60.74
60 52.10
50
% of GDP
40
30
20 24.98
10
0
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
2006
2008
2010
2012
2014
2016
2018
2020
Year
Trade (% of GDP)
The data clearly shows international trade has as a % of total GDP has increased from 25% in 1970s
to 60% in 2008.
The promotion of a country's own economic interests at the expense of or in opposition to those of
other nations is known as anti-globalization or nationalism. Limited economic and financial
cooperation is a nationalist trait.
The actions of nations can be categorised along a spectrum from globalisation to nationalism.
Autarky (non-cooperative and nationalism) – In Autarky, a country focuses on national self-

reliance i.e., producing most or all of the necessary goods and services domestically. The term
"autarky" is frequently used to describe a society where the state dominates all aspects of society
including media and industry. Example: North Korea
Hegemony (non-cooperation and globalization) - Hegemonic countries tend to be regional or even

global leaders, and they use their political or economic influence of others to control resources.
Example: Russia’s control over the gas pipelines gives it significant political leverage over other
countries particularly in Europe. Even after sanctions being put on Russia by the EU and the US,
Europe has suffered the most due to increase in Natural Gas prices due to supply shortages. To
understand the scale, here’s a datapoint – Russia is the 2nd largest producer of Natural gas in the
world and biggest exporter of gas to Europe.
Multilateralism (cooperation and globalization) - Multilateralism describes nations that actively

participate in mutually beneficial trade relations and other types of cooperations with several other
nations. Example: The Paris Agreement (climate agreement) - The Paris Agreement is a legally
binding international treaty on climate change. It was adopted by 196 Parties at COP 21 in Paris, on
12 December 2015 and entered into force on 4 November 2016. The Agreement includes
commitments from all countries to reduce their emissions and work together to adapt to the
impacts of climate change, and calls on countries to strengthen their commitments over time.
Bilateralism (cooperation and nationalism) – Bilateralism refers to cooperation between 2

countries. A nation that practises bilateralism may have numerous such partnerships with other
nations while generally avoiding participation in multi-nation agreements. For example: Trading
blocs - They may agree to provide trade benefits to one another and higher barriers to those outside
that group. Some countries may exhibit regionalism, cooperating multilaterally with nearby
countries but less so with the world at large.
1. A country focuses on national self-reliance is
A. Hegemony
B. Autarky
C. Bilateralism
2. Paris Agreement between 196 nations is most likely an example of:
A. Multilateralism
B. Bilateralism
C. Autarky
3. Nations that use their political or economic influence of others to control resources are
A. Hegemony
B. Autarky
C. Bilateralism
Answers:
1. B is correct. Hegemonic countries tend to be regional or even global leaders, and they use their political
or economic influence of others to control resources. Bilateralism refers to cooperation between 2
countries.
2. A is correct. B is incorrect because there are more than 2 parties. C is incorrect because Autarky is based
on self-reliance.
3. A is correct.
Tools of Geopolitics and its impact on world economies
Tools of Geopolitics
National security tools Economic tools Financial tools
National Security tools - Armed combat, espionage, and bilateral or multinational agreements meant to
support or prevent armed conflict are all potential national security tools. Armed conflict is a direct and
an active national security tool. It impacts economies capital stock and causes migration away from
conflict areas. For example, the North Atlantic Treaty Organization (NATO), an alliance between the
European Union, United States, United Kingdom, and Canada, is used to discuss and de-escalate potential
conflict among members and between members and outside states.
Economic tools – These can be cooperative or non-cooperative. Cooperative examples include free trade
areas, common markets, and economic and monetary unions. Examples of non-cooperative economic
tools include VER, tariffs and quotas & Domestic Content Requirements.
Finance tools – These include foreign exchange and foreign investment. Examples of cooperative
financial tools include the free exchange of currencies across borders and allowing foreign investment.
Examples of non-cooperative financial tools include limiting access to local currency markets and
restricting foreign investment.
Describe geopolitical risk and its impact on investments.
Geopolitical Risks are the risk associated with wars, terrorist acts, and tensions between states that
affect the normal and peaceful course of international relations.
There are 3 types of risks:
Event Risk – Timing of the event is known but outcome is unknown. Fed interest rate meeting to decide
the Interest rate hike/cut. The dates are well known in advance, but the outcome is not. Elections, data
driven events such as housing data, inflation etc are also examples.
Exogenous Risk – Exogenous Risks refers to unanticipated risks such as sudden uprising, invasion or wars
(Ukraine – Russia War)
Thematic Risk – These risks have effects over longer period like Climate change, migration pattern, cyber
threats.
To assess geopolitical risks, investors consider three areas:
Likelihood it will occur – More cooperative and globalized the economy, less the likelihood of
occurrence of a geopolitical risk
Velocity or the speed of the impact – This is the pace at which it impacts the investors portfolio. It can
be classified as short-term or “high velocity” impacts, medium-term, and long-term or “low velocity”
impacts. Exogenous Risks & Black Swan Risk (low likelihood but substantial effect) would fit the short-
term or “high velocity” category. Investors with longer time frame do not react to these events but
investors with shorter term time frames would react to it. Risks that have a medium-term impact could
start to affect a company's operations, expenses, and investment prospects, lowering its valuation. Since
these risks are frequently concentrated in particular industries, some organisations will be significantly
more impacted than others.
Size and nature of the impact - When we analyse the geopolitical risks, its important to understand the
impact it is likely to have – high or low. High impact risks are studied more extensively. Impact can be
discrete or broad in nature. Discrete impacts are the ones that affect a sector or a company at a time
(Example: whereas Broad impacts a country or the global economy as a whole.
Because geopolitical threats do not develop linearly, it is challenging to track and predict the likelihood,
speed, and magnitude of an impact. Therefore, investors may use qualitative or quantitative scenario
analysis and signposting to identify the impact of it on the portfolio.
Scenario Analysis is the process of investigating and assessing future events or scenarios and forecasting
multiple potential outcomes.
A signpost is an indicator or data point or an event that signals likelihood of an event. Example: VIX
indexes.
1. Which of the following is an example of an event risk?
A. Election
B. War
C. Tsunami
2. Which of the following is not an example of Exogenous Risks?
A. War
B. Pandemic
C. Fed meet for interest rate decision
3. Exogenous Risks are described as:
A. unanticipated risks
B. risks where the timing of the event is known but the outcome is unknown
C. known risks that have effects over longer period
4. Which of the following is true about geopolitical risks?
A. More cooperative and globalised economies, less vulnerability to geopolitical risks

B. High velocity impacts have long term effects
C. Discrete impacts affect the country / global economies
Answers:
1. A is correct. Timing of the event is known but outcome is unknown.
2. C is correct. Exogenous Risks refers to unanticipated risks such as sudden uprising, invasion, or wars. C is
an event risk.
3. A is correct. Exogenous Risks refers to unanticipated risks such as sudden uprising, invasion, or wars. B is
incorrect because it is an event risk and C is incorrect because it is Thematic Risk.
4. A is correct. B is incorrect because – High Velocity impacts have short term effects. C is incorrect because
Broad impacts affect the country / global economies.
International Trade and Capital Flows

Exam Focus
Understanding and learning about international trade and currency exchange
Learning about comparative advantage leading to welfare gains in international markets and
studying the two models of the sources of comparative advantage
Learning about types of trade restrictions and their effects on local price and quantity while focusing
on how a balance in the capital account must offset the balance in the trade account
Understanding the difference in domestic investment, expenditure, savings, and investment
International Trade Benefits

Basic terminologies
Sr. Term Explanation

no
1. Imports The purchase of goods and services from sellers
overseas For example:
India imports crude oil, electronic chips from The United States
of America.
2 Exports The sale of goods and services to buyers overseas.
For example:
India exports spices and pharmaceutical equipment’s to the USA
3 Autarky or A country that considers itself self-sufficient and does not trade
closed with any country.
economy For example, North Korea.
4 Free trade An economy where there is no restriction with regards to import
and export
The global price = domestic price, the
worldwide demand and supply set the
equilibrium price
For example, countries like Australia, Canada, Columbia, etc.
5 Trade Government imposing restrictions on import and export to
protection protect local industries and jobs
6 World price The price of goods and services in the world market for those
who follow free trade
7 Domestic price The price of goods and services in the domestic country,
assuming no free trade exists.
For example:
The price of an apple phone (iPhone 12 Mini) is Rs 59,286 in the
USA and is priced at Rs 74,900 in India, Rs 67,186 in UAE, and Rs
62,068.98 in Singapore
8 Net exports Net Export= Export –

Import For Example:
In a given year the country’s export is $3 Billion, and its import is
$2.5 billion
Net exports = $0.5 billion (3 - 2.5)
9 Trade surplus Positive net exports
Exports > Imports
For example: Countries like Germany, Canada, Japan, etc.
10 Trade deficit Negative
net exports
Exports <
Imports
For
example:
Countries like India, Nepal, etc.
11 Terms of trade The country’s terms of trade measure the export prices of a
(TOT) country concerning its import price at a base value of 100
An ↑ in the price of exported goods in global markets leads to an
↑ in the TOT.
12 Foreign direct When a company takes controlling ownership in a business unit
investment overseas. For example, Microsoft in India, Apple in China, etc.
13 Multinational MNC is a FDI in one or more countries overseas, business

corporation units, etc For example, Coco cola, P&G, Nestle, etc.
(MNC)
Before the LPG movement in 1991, India too was a closed economy suffering from a great
recession
India levies a good 20.4% Custom Duty on Medical Equipment. After GST India levies a good 30%
Export Duty on iron
In India, the TOT anticipated as of the end of 2021 is 77.67 points and is expected to fall to 71.40
points in 2022, which means rising imports and falling exports, leading to a fall in TOT.
Compare gross domestic product and gross national product
Distinguish between GDP and GNP

GROSS DOMESTIC PRODUCT (GDP) GROSS NATIONAL PRODUCT (GNP)
It measures the total domestic production of Total of overall economic activities by the
goods and services, including goods citizens of the country, including those of
produces by foreign corporations/citizens. citizens residing overseas (e.g., NRI’s).
It is considered with the location of the It is considered with the citizenship of the
goods and services. individuals.
E.g., In India, Coca Cola though being an E.g., In India, an Indian citizen working in the
MNC, the income produced from this entity U.S.A is known as an NRI; this NRI’s income
is included in GDP since the goods are is considered in GNP. Since he is a citizen of
produced on the land of India. India, the location of his service doesn’t
matter.
GDP= C+I+G+(X-M) GNP=GDP+NET PORPERTY INCOME
ABROAD
Helps in understanding the economic Helps in understanding the contribution of
situation of the country citizens of the country.
Higher exports = Higher GDP Higher exports = Higher GDP, depending
upon the company’s place of origin
For Example, the 2019 GDP rate in India is For Example, the 2019 GNP rate in India is
has grown by 4.2%, has grown by 4.16%.
In 1999, India’s GDP for approximately 459 billion US dollars according to the World Bank. In
2018, the country generated the equivalent of 2.726 trillion US dollars.
Describe benefits and costs of international trade
What are the benefits and costs of international trade?
BENEFITS
⮚ Lower cost of goods for importing countries (developed)
For Example: India exports textile, labour to the U.S.A because of an increase in demand overseas
due to cheaper local currency.
It increases the level of employment, salaries, and business profits locally (India).
COSTS
⮚ Loss of jobs
By opening doors for foreign companies, you are shutting doors for several domestic companies,
thus causing many citizens to lose their jobs.
Laying off is also not an option, as re-hiring and training new employees are costly for the company.
For Example: In India, an ↑ in foreign banks lead to several public sector banks shutting down as
they couldn’t meet the high productivity and technology used by these foreign banks
Distinguish between comparative advantage and absolute advantage.
How do you mean by absolute and comparative advantage?
ABSOLUTE ADVANTAGE
When a country produces goods at a lower cost in terms of resources than the other country
COMPARATIVE ADVANTAGE
When a country produces goods at a lower opportunity cost in terms of other goods, trading is
beneficial for two countries
Thus, irrespective of which country has an absolute advantage, potential gains from trade are
possible as long as opportunity cost under comparative advantage is present.
What do you mean by production possibility frontier (PPF)?
Consider two countries and the production of agriculture and capital goods. The
output created by per unit of labour is:
AGRICULTURE (tons) CAPITAL GOODS (units)

India 100 80
USA 120 150
Assuming no trading costs,
⮚ The USA could trade capital goods for agriculture,
⮚ India could trade agriculture for capital goods,

Thus, both countries can have more output for each of the products.
For analytical purposes, understand that:
a. In India, a single production day could be utilized to produce either 100 tons of agriculture or 80
units of capital goods.
The opportunity cost of capital goods is 100 / 80 = 1.25 tons of agriculture, and the Opportunity
cost of agriculture is 80 / 100 = 0.8 units of capital goods.
b. USA’s opportunity cost of capital goods is 120/ 150= 0.8 tons of agriculture, and,
The opportunity cost of agriculture is 150 / 120 = 1.25 units of capital goods.
Thus, India has a comparative advantage in the production of agriculture as its opportunity cost is
1.25 tons, and the USA has a comparative advantage in the production of capital goods at the
opportunity cost of 1.25 units of capital goods.
Thus, according to comparative advantage, India must trade agriculture in return for capital goods
from the USA.
The USA has an absolute advantage for both agriculture and capital goods.
However, under PPF, we take comparative advantage under consideration.
As seen above in the graph, The PPF curve points out all efficient output combinations from India
producing agriculture and the USA producing capital goods, causing a win-win situation for both
countries.
Compare the Ricardian and Heckscher–Ohlin models of trade and the source(s) of
comparative advantage in each model.
What do you understand from the Ricardian and Heckscher–Ohlin model?

Every country exports its specialty and imports the rest; for example, India exports spices, pharma
products, etc., and imports machinery, crude-oil from the west.
RICARDIAN MODEL OF TRADE

Under this model, labour is the only Factor, and any changes in production are caused due to
differences in labour productivity from technology.
HECKSCHER-OHLIN MODEL
Assumes redistribution of wealth amongst the labourers and their employers.
From our above example for capital goods and agriculture production in India and the USA, we get
the price for a more available factor of production within the country rises with the increase in
demand and production.
For instance, the wage rate in India (v/s USA) rises due to higher agricultural production
For instance, the capital costs in the USA (v/s India) rises due to higher capital goods production
As a result, the price for the product that a country imports (agriculture for USA & capital goods for
India) fall, simultaneously the price of the product that a country exports rises (agriculture for India
& capital goods for the USA).
1. To calculate the economic activity within a country, the most appropriate method of
measurement is:
A. GDP
B. National Income
C. GNP
2. Under the Ricardian Model of trade; the basis of comparative advantage is:
A. Labour productivity – capital productivity

B. Capital productivity
C. Labour productivity
3. Which of the given effects will mostly occur in a country that increases its openness to global
trade?
A. Rise in price levels of consumer goods.

B. Improved specialization for domestic output.
C. Reducing employment in exporting businesses.
Yards of Cloth (meters) Oil (gallons)

UK 100 80
UAE 150 180
4. From the table given above, UK has a comparative advantage from producing:
A. Yards of cloth
B. Oil
C. Can’t Say
5. Which of the reasons given below are not in favour of trade restrictions?
A. National Security
B. Infant industry protection
C. Promoting domestic industries
Answer:
1. A is correct. GDP. It measures the total domestic production of goods and services within the country.
Whereas GNP is the measurement of income of citizens settled overseas.
2. C is correct. Labour productivity. Under this model, labour is the only Factor, and any changes in
production are caused due to differences in labour productivity from technology.
3. B is correct. Openness to global trade improves specialization as production shifts to those products
in which local producers have a comparative advantage. Greater competition from imports tends to
reduce prices for consumer goods. Higher international trade is likely to increase profitability and
employment in exporting industries but may decrease profitability and employment in industries that
compete with imported goods.
4. A is correct. yards of cloth. For producing yards of cloth UK has to forgo 80/100 = 0.8 gallons of oil,
While UAE has to forgo 180/150 = 1.2 gallons of oil, Since the UK has a lower opportunity cost (oil),
it has a comparative advantage from producing yards of cloth.
5. C is correct. Promoting domestic industries. Free trade improves employment opportunities for
export businesses; thus, it is a reason against trade restriction. The other two reasons are in favour
of promoting trading restrictions.
Trade Restrictions
Compare types of trade and capital restrictions and their economic implications.
What are the reasons for governments to impose trade restrictions?
Trade restrictions, concerning economic welfare, when:
Adhered to domestic protection, they are economically justified and
Trade restrictions that make imports expensive to reduce trade deficit are understandable.
What are the reasons in favour and against of trade restrictions?
Reasons that are in favour include:
⮚ Infant industry
Infant Industries are industries that are new in the business and require protection from foreign
companies during their formative years,
In 2018, to boost the steel industry, an import duty of 12.5% was imposed on steel products
⮚ National security
Despite cheaper import rates, the government should protect the domestic producers of goods
and services that adhere to national security.
For example: Defence, to protect the country and meet the demand in case of a war.
Reasons that are against, include:
⮚ Protecting domestic jobs
Certain sectors lose their jobs through free trade, but it also Increases jobs in export industries
With no import restrictions levied, it also leads to lower prices for domestic consumers
⮚ Protecting domestic industries
Absence of foreign competition leads to the creation of a monopoly in several sectors of the economy;
this leads to poor efficiency and higher prices.
For example, the Nationalization of banks in India in 1969.
What are the types of trade restrictions imposed and justify their economic implications?
Types of trade restrictions include:
a. Tariffs
Taxes are levied on the goods imported by the economy.
Tariffs make imported goods expensive for domestic consumers; thus, ↓the import demand and ↑
the local demand
Local producers gain from this, and the government too gets to earn tariff revenue.
For fruits and vegetables, the Indian tariffs are bound at an average of 101.1% - 150%. Such rates
for Indonesia and Brazil are 45.6% - 60%, and 34.1% - 37.1% respectively.
b. Quotas
Limit on the quantity of imports allowed over a while, generally a year. This increases the domestic
price, and as such domestic consumers lose and domestic producers gain.
An import license is needed to import goods from overseas, which adds to the import prices and
government revenue.
In India, the exporters and importers must register for an IEC - Importer Exporter Directorate
General of Foreign Trade (DGFT). Quota rent is the economic rent (domestic price – free trade
price) received by the owner of the imported good in the absence of an import license charge.
In India, As of March 2018, the pulses producers have requested the central government to
dismiss the quota of 5 million tons pulses import as the prices were already running below the
minimum support, and the high import would create higher supply leading to a further ↓ in
prices.
c. Voluntary export restraint
It’s a voluntary agreement by the exporting country to limit the quantity of goods exported.
It is mainly for political reasons and not economic by avoiding tariffs and quotas.
It Results in welfare loss to the importing country equal to quota with zero quota rents
Limitation on auto exports to the USA by Japan in 1981.
d. Export subsidies
These are Government payments to producers to promote the export of goods and services.
However, in the case of a small country where imports > exports, these government subsidies lead
to an increase in prices domestically.
This increase in price = the government subsidy + world price for the product
This increase in price to combat import expenditure is levied via instruments like counter-tariffs,
quotas on imports.
E.g., Vatican City, Monaco, etc. to control the expenditure on imports
On the other hand, in the case of large countries that influence the world price
They use their influence to reduce the consumer surplus by lowering the world prices for making
imports cheaper for their citizen buyers. E.g., the USA, EU union.
The Service Exports from India Scheme (SEIS) inspires sellers who export notified services (e.g.,
advocate services, insurance agent, company director, etc.) An incentive of 3 - 7% of the net
foreign exchange earnings is provided
e. Minimum domestic content
Requirement that some percentage of product content must be from the domestic country.
NAFTA countries require at least 62.5% of the products to be originated domestically to enjoy
duty - free
What are the welfare effects of tariffs and quotas?
Understanding the welfare effects of tariff and quota on a small country,
Where,
Tariff = Quota
P protection = Protection Price, free trade price
World= World Price,
Now,
In case of PW before any trade protection, the Quantity DD QD1> Quantity SS QS1, ∴Quantity
imported = QD1 – QS1
Placing a tariff on imports.
Domestic price ↑ due to trade protection, which ↑ the domestic supply and reduces the domestic
demand ∴Decrease in the quantity imported = QD2 – QS2.
Thus,
It leads to:
Overall loss in consumer surplus
Gain in producer surplus (selling at market price)
Gain to the government by using tariffs/quotas for revenue
Deadweight loss due to trade restriction
The loss in consumer surplus is only partially offset by the gains in domestic producer surplus and
the collection of tariff revenue.
Note:
In the absence of n0 quota rents being captured by the domestic government, the overall welfare
loss to the local economy > by the amount of the quota rents.
Welfare loss= consumer surplus – producer surplus
What do you understand by capital restrictions imposed on the flow of financial capital across
borders?
⮚ The central bank or government implements tight control to balance the flow of foreign money
in the country.
In June 2015; The European Bank withdrew its support to Greece due to its high debt crisis in
Europe.
In return, the Greece government, through its monetary policy, restricted the flow of currency
between countries and also drew a limit on the amount of cash withdrawal.
⮚ Capital restrictions have helped the developing countries with great FII and FDI inflow during
expansion and vice versa during contraction.
⮚ In the long term, it leads to a ↓ in economic welfare.

Explain motivations for and advantages of trading blocs, common markets, and
economic unions
The spirit of all agreements is to reduce the trade barriers among the countries.
Thus, promoting free trade.
Free trade, as seen above, can have positive & negative effects on economic welfare.
The positive effects are a result of:
i. Higher trade activities due to comparative advantage,
ii. Increased competition amongst businesses in member nations.
The negative effects are:
i. Decrease in wealth and incomes of businesses, individuals, etc.

ii. Workers in the negatively impacted industries have to learn new skills now to get new jobs. (e.g., VCD,
cassettes, etc. developers)
Note: Sometimes the restrictions levied on imports from non-member nations outweigh the welfare gains
from free trade.
Which are the different types of agreements involved in regional trading blocs?
⮚ Free Trade Areas
Zero trade barriers amongst member countries Customs Union
Free trade areas + common trade policies with the non-member nations
For example: The customs union of Russia, Belarus, and Kazakhstan was formed in 2010.
⮚ Common Market
Custom union + a free flow labour and capital goods among the member nations.
For example:
In 1957, France, West Germany, Italy, the Netherlands, Belgium, and Luxembourg recognized the
European Economic Community (EEC)
⮚ Economic Union
Common market + common institutions and economic policies.
For example, the European Union
⮚ Monetary Union
An economic union + common currency
For example, 18 nations of the EU have EURO as their common currency

Describe common objectives of capital restrictions imposed by governments.
What are the objectives of capital restrictions imposed by the government?
The objectives include:
⮚ Protect strategic industries
Import capital restrictions are to protect the national security of the country, e.g., Defence
⮚ Reduce the volatility of domestic asset prices
In times of economic crisis, in the case of a free economy, the financial markets crash due to FII’s,
FDI’s pulling out their invested capital
⮚ Maintain fixed exchange rates
Scarce forex reserve countries impose restrictions on export so that they can easily meet their
target rate.
They also promote domestic economic goals (For example, Colombia, Bulgaria, etc.)
⮚ Keep domestic interest rates low
By controlling the outflow of invested capital, countries can manage to keep their interest rates
low and also manage their supply of money in the country through lower interest rates.
⮚ Capital restrictions are said to reduce economic welfare in the long-term
Describe the balance of payments accounts, including their components.
What do you understand by balance of payments?

Balance of Payment (BOP)
⮚ A double-entry record of all international transactions for a country.
⮚ In case of import, the buyers are required to purchase foreign currency to settle their transaction
with the foreign seller,
In case of export, the seller is required to purchase domestic currency to settle the transaction with
foreign buyers
⮚ The three accounts included in the BOP are:
a. the current account records the flow of goods and services majorly
b. the capital account includes capital transfers and non-financial transfers
c. financial account records investment flows

How would you like to explain the three accounts mentioned in BOP?
a. CURRENT A/C
The components involved in the calculation of the current account are
1.Net Export of Goods (X – M)
Export goods (E.g., in India spices, agriculture produce, etc.)
Import Goods (E.g., in India oil, machinery, etc.)
2. Net Export Services (X – M)
Export services – import service (E.g., advocate, engineering, etc.)
3. Net income receipts
Investment income from the foreign asset owned by locals – payments on local assets to foreign
owners
4. Unilateral transfer of assets
One-way transactions, for example, foreign aid, gifts, and grants, etc.
b. CAPITAL A/C
The components involved in the calculation of capital account are
1. Capital transfers
Liability foregone; debt forgiven
E.g., When a migrant leaves the country, the goods and services are transferred with him
It also includes the transfer of title to fixed assets
E.g., inheritance taxes, death duties, etc.
2. Sales and purchases of non-financial assets
This includes rights to natural resources
Intangible assets like patents, copyrights, etc.
c. FINANCIAL A/C
The components involved in the calculation of financial accounts are
1. Government-owned assets abroad
Gold, FDI’s, reserves with IMF, etc
2. Foreign-owned assets in the country
Direct investments in foreign companies, portfolio investments with no decision-making control (e.g.,
shares, bonds), etc.
How would you explain the relationship between the three accounts mentioned?
When Imports> Exports = Current A/C Deficit, and
When, Imports < Exports = Current A/C Surplus
Trade deficit is balanced by a net surplus in capital and financial account
Thus, the deficit must be offset by sales of assets and debt incurred to foreign entities.
While a surplus must be offset by purchases of foreign physical or financial assets.
In India, there was a current account surplus of 3.1 percent of GDP in the first half 2020 – 21 v/s a
deficit of 1.6 percent in the first half of 2019 – 20. This current a/c surplus needs to be balanced by
the additional purchase of foreign financial and physical assets.
Explain how decisions by consumers, firms, and governments affect the balance of
payments.
How do decisions by consumers, firms, and governments affect the balance of payments?
To understand this better, let’s consider that:
(X – M) = private savings + government savings – investment
When,
Investments > government savings + private savings,
Excess investments are financed by foreign borrowing
This leads to a capital a/c surplus and trade deficit
Trade deficit (X<M) occurs from:
⮚ High investments by the private sector
⮚ Low savings by individuals
⮚ Government deficit through spending > tax revenue
E.g., Countries with a trade deficit as of 2019 are India, Bangladesh, etc.
The perception here is that low private or government savings concerning private investment in
domestic capital requires foreign investment in domestic capital.
There also exists a distinction between a trade deficit resulting from high government or private
consumption and one resulting from high private investment in capital.
For premier case, borrowing from foreign countries to finance high consumption (low savings)
increases the domestic country’s liabilities without increasing its future productive power.
For the latter case, borrowing from foreign countries to finance a high level of private investment in
domestic capital, the added liability is accompanied by an increase in future productive power
because of the investment in capital.
Increase in current account deficit occurs from:
⮚ Low investments by the private sector
⮚ High savings by individuals
⮚ Government surplus through spending < tax revenue
E.g., Countries with trade surplus as of 2019 are China, Germany, Russia, etc.
Describe functions and objectives of the international organizations that facilitate

trade, including the World Bank, the International Monetary Fund, and the World
Trade Organization.
What are the functions and objectives of the international organizations that facilitate trade?
⮚ International Monetary Fund aims at
Encouraging global monetary cooperation;

Helping in the development along with balanced growth of international trade;
Encouraging foreign exchange constancy;
Supporting the establishment of a multidimensional system of payment; and
Making resources available to members experiencing balance of payments difficulties.
⮚ World Bank aims at
To aid developing countries in technological progress, eradicating poverty, etc.
The World Bank’s current core goal is eradicating extreme poverty of people having a standard
of below $1.25 a day to 3%
The two institutions involved in the no/low-interest loan category are IBRD and IDA.
The IBRD aims to reduce poverty in developing countries, while IDA focuses on the world’s
poorest countries.
⮚ World Trade Organization aims at
Managing trade agreements.

Acting as a medium for trade discussions.
Settling trade disputes.
Reviewing national trade policies.
Building the trade capacity of developing economies.
Cooperating with other international organizations

For example: GATT, GATS, TRIPS are examples of WTO agreements.
1) In the case of India, when the government signs an agreement with the USA to limit the volume of its
exports, it is known as:
A. A tariff.
B. A voluntary export restraint.
C. A minimum domestic satisfaction rule.
2) The main goals for IMF include:
A. Promoting foreign exchange rate stability

B. Reducing poverty worldwide
C. Resolving disputes related to trade for member nations
3) The party that benefits least from tariffs are:
A. Consumers overseas
B. Local producers
C. Local consumers
4) _______ is the most integrated type of a trading bloc
A. Local market
B. Monetary Union
C. Financial Union
5) Which of the given option is least likely a part of the current account?
A. Unilateral transfers.
B. Goods and services trade
C. Purchase and sale of fixed assets.
Answer:
1. B is correct. Voluntary export restraints are agreements to bound the quantity of goods and
services exported to another country. Minimum domestic content rules are limitations imposed
by a government on its domestic firms. Import quotas are limitations on imports, not on exports.
2. A is correct. The main goal for IMF is Promoting foreign exchange rate stability. Poverty
eradication is the goal for World Bank & Resolving trade disputes is the goal for WTO.
3. C is correct. local consumers

Tariffs are taxes on imports. Thus, local consumers are the ones that suffer the most, while local
producers and government benefit from this.
4. B is correct. Monetary Unions tend to have the most integrated type of a trading bloc due to the
use of one common currency.
5. C is correct. Purchases and sales of fixed assets are recorded in the capital account. The other
two are a part of the current account.
Currency Exchange Rates

Exam Focus
Understanding spot exchange rates, forward exchange rates, etc
Focusing on calculations of currency appreciation and depreciation
Learning and understanding under the elasticities and absorption approach the effectiveness of
maintaining a trade balance
Foreign Exchange Rates
Define an exchange rate and distinguish between nominal and real exchange rates
and spot and forward exchange rates.
What do you mean by exchange rate?
An exchange rate is simply the price or cost of units of one currency in terms of another
For example:
In the case of 72 INR/USD,
For every $1, you can exchange ₹ 72.
Now, how do you interpret that?
You read the “quote” 72 INR/USD as
72 INR per USD, which translates to ₹ 72 for $1.
USD is the base currency as this is the currency being valued and remains fixed.
INR is the price currency as USD is being measured in terms of INR, which will vary from time to time.
What is the difference between direct and indirect quotes?
DIRECT QUOTE INDIRECT QUOTE

When foreign currency is measured in terms of When the domestic currency is measured in
domestic currency terms of foreign currency
Foreign Currency = Base Currency Foreign Currency = Price Currency
Domestic Currency = Price Currency Domestic Currency = Base Currency
For example: For example:

72 INR/USD is a direct quote for the Indian 72 INR/USD is an indirect quote for the USA, an
investor India based investor
What do you mean by Bid price and Ask price?
BID PRICE ASK PRICE

Price, a buyer, is willing to pay] Price a seller willing to accept
For example, in the case of 1 USD - ₹ 70/₹ 72 For example, in the case of 1USD - ₹ 70/₹ 72
quote, the buyer pays ₹ 72. quote, the seller offers to receive ₹ 70.
NOMINAL EXCHANGE RATE REAL EXCHANGE RATE

Quoted currency exchange rate at any given Inflation – adjusted nominal rates.
time
In case of: Real exchange rate =
72 INR/USD Nominal exchange rate × CPI BASE CURRENCY / CPI
To purchase goods and services of $1 in the PRICE
CURRENCY
USA, the cost is ₹ 72
It portrays the relationship of relative purchasing
power /real exchange rate and:
- Direct relations with the nominal exchange rate
and base currency,
Inverse relations with price currency
What do you understand by Nominal Exchange Rate and Real Exchange Rate?
In 2015, The CPIs of India and the USA were both 100 at the base period, and the exchange rate is
₹ 72/ $. In 2020, the exchange rate was ₹ 70/ $, and the CPI has risen to 120 in India and 140 in the
USA. What is the real exchange rate?
Solution
In this case:
₹ 70/ $ is Current Quote,
INR is the Price Currency,
The USA is the Base Currency.
Real Exchange Rate= Nominal exchange rate × CPI BASE CURRENCY / CPI PRICE CURRENCY
= ₹ 70 × 140/120
= 81.67 ₹/$, which means that:
In 2015, 1$ was worth ₹ 72
In 2020 $1was worth ₹ 81.67.
Thus, the real exchange rate has fallen, suggesting that Indian goods and services that cost ₹ 72 in
2015 now only cost ₹ 60(in real terms) in 2020.
Why is there a need of an inflation differential?
Inflation Differential is required to reduce any price advantage to the base currency investors
(Indian) from a reduction in the
₹ /$ exchange rate over the period and vice-versa.
The country with the lower inflation rate = ↑ import prices.
In the case Of South America and the USA (Rand/USD) exchange rate,
In 1980, Rand was trading at R1 = $1 as a starting point. However, as time passed, due to the
actual inflation, the rates fluctuated. Thus, really overly negative or overly positive environment
affects the exchange rate.
What is the difference between spot and forward rates?
SPOT EXCHANGE RATE FORWARD EXCHANGE RATE

Exchange rate for immediate delivery Exchange rate for future delivery at the rate
discussed today.
Settled in T+2 days. Settlement occurs based on the agreement
tenure, e.g., 30 days, 60 days, 90 days, etc.
For Example: For Example:
In case of an urgent requirement for USD, If you expect the INR/USD rate to fall in the
you purchase the dollars at the exchange future and you have a USD payment to be
rate on that day made 30 days from now, you enter into a
forward contract with exchange rates of
today and delivery in future. This eliminates
future uncertainty
Describe functions of and participants in the foreign exchange market.
What is the difference between hedging and speculation?
HEDGING SPECULATION
Under foreign currency exchange, hedging is Speculation is trading on the confidence that
a transaction performed to safeguard an a currency price shall go up or down.
existing or anticipated position from an
undesirable move in exchange rates.
When an individual Is dicey about a Speculation is when a transaction in the
transaction due to cross-border risk, and he foreign exchange markets increases currency
wishes to avert it, he can enter into a risk.
forward contract and hedge (avert) foreign
exchange risk.

A farmer from India exports his produce to An Indian investor buys ₹ when it falls and
the USA and expects the ₹/$ rate to fall at expects to sell it when it appreciates in the
the time of his delivery, thus safeguards his future to earn exponential profits.
high currency exchange rate by entering into
a forward contract.
Who are the main participants in an FX Market?
SELL-SIDE
Large commercial banks like HSBC, Barclays, JP Morgan.
⮚ Other banks come below these large corporations.
BUY-SIDE
⮚ Corporations
Constant engagement in cross border transactions
Thus, they enter into forward contracts to mitigate their risk factor.
E.g. Goldman Sachs Asset Management International, Capital Group, and Wellington Management.
⮚ Investment accounts
Accounts held for hedging or speculation it is further divided into

a. Real money accounts
Constrained use of leverage.
Hedging > Speculation
E.g.; Mutual funds, pension funds, etc.
b. Leveraged accounts
High use of leverage
Hedging < Speculation
E.g., derivative trading like algorithmic trading
⮚ Governments and government entities
Sovereign Wealth funds is a government-driven investment in foreign financial assets. It

occurs only due to a surplus in the economy.
E.g., Norway Government Pension Fund Global, China Investment Corporation, Abu Dhabi
Investment Authority
Central bank intervention is also required to control the exchange rate.
⮚ Retail Market
Dealings by households and relatively small institutions

E.g., tourism, investments, speculations.
Calculate and interpret the percentage change in a currency relative to another

currency.
How would you measure and calculate percentage change in a currency relative to another currency?
👩🏫 Illustrations:
If the INR/USD exchange rate had fallen from ₹ 72/ $ in 2015 to ₹ 70/ $in 2020, calculate the %
change in the currencies and explain it.
Solution
The USD depreciated by
= 70/72-1
= -2.78%
The INR appreciated by:
First convert this INR/USD indirect quote to a direct quote:
⸫ for USD/INR,
In 2015, 1/72= 0.0138
In 2020, 1/70 = 0.0142
= 0.0142/ 0.0138 – 1
= 2.89%
Thus, % ↑ in INR = % ↓ in USD as the % change applies to the base currency and not the price
currency
Calculate and interpret currency cross-rates
What do you mean by currency-cross rate? Explain with example?
⮚ An exchange rate between two countries implied by a common third currency
⮚ In case of no active market for a currency pair, cross rates are necessary.
Thus, we use both the currencies of the inactive countries and one common currency, generally a
USD or EUR, to calculate the exchange rate.
For example
The GBP/EUR rate is 12 and the EUR/JPY is 1.2,

Calculating the GBP/JPY we get;
GBP/JPY = GBP/EUR x EUR/JPY
= 12 x 1.2
= 14.4 pounds per yen.

Note: In the above example, If the rate of 1.2 was given for JPY/EUR instead of EUR/JPY, we must
inverse the rate to calculate the GBP/JPY cross rate.
The spot exchange rate for the Australian Dollar (AUD) and the USD is AUD/USD = 1.8000, and the
spot exchange rate between the Mexican Pesos (MXN) and the U.S. dollar is MXN/USD = 2.5000.
Calculate the AUD/MXN spot rate.
The AUD/MXN cross rate is:
(AUD/USD) / (MXN/USD) = 1.8000/2.5000 =
0.72 AUD for each MXN.
1. In 2019, the nominal exchange rate for INR/USD was ₹ 71. As of 2020, the real exchange rate
has risen by 2%. This most likely suggests that:
A. The nominal exchange rate is less than INR/USD ₹ 70.50.

B. The buying power of USD has grown by almost 2% in terms of Indian goods.
C. Inflation in the USA was probably 2% higher than inflation in India.
2. The European Euro (EUR) exchange rate with Canadian dollar (CAD),
For 2018 was CAD/EUR 50
For 2019 was CAD/EUR 52. The EUR has:
A. Decreased by 3.8%, and the JPY has increased by 4.0%.

B. Increased by 3.8%, and the JPY has decreased by 4.0%.
C. Increased by 4.0%, and the JPY has decreased by 3.8%.
3. The spot rate for the Mexican peso (MXN) for today is MXN/USD 19.81.
On the other hand, the Australian dollar trades at AUD/USD 1.32. The AUD/MXN cross rate is:
A. 0.0667
B. 15.0076
C. 26.1492
4. In case of domestic currency depletion, the most likely impact on the balance of trade, with
regards to the import goods is, when:
A. The demand is relatively inelastic

B. Goods have close substitutes
C. The demand is perfectly inelastic
5. Members in the forex markets that can be categorized as “real money a/c’s” include:
A. Insurance firms
B. Central Banks
C. Hedge funds
Answer
1. B is correct. The buying power of USD has grown by almost 2% in terms of Indian goods. An
increase in the real exchange rate INR/USD (the number of INR per USD) suggests that USD has
a higher buying power (real) in India.
Variations in the real exchange rate are based on the variation in the nominal exchange rate
compared to the difference in inflation. By itself, a real exchange rate cannot suggest the directions/
degrees of variations in either the nominal exchange rate or the inflation difference.
2. C is correct. EUR has increased since it is worth more in term of CAD. % increase =
52−50
= 4.0%
50
% Decrease CAD V/S EUR, convert the exchange rates to direct quotations for Canada:
1 1
50
= 0.02 𝐸𝑈𝑅/𝐶𝐴𝐷 & 52
= 0.0192 𝐸𝑈𝑅/𝐶𝐴𝐷
0.0192−0.02
% decrease = 0.02
= −3.8%
3. A is correct. 0.0667.AUD/MXN = (AUD/USD) ÷ (MXN/USD)

AUD/MXN = 1.32 ÷ 19.81 = 0.0667
4. B is correct. Goods have close substitutes.

Higher elasticity of imports/exports goods leads to higher impact on the balance of trade. Thus,
goods with close substitutes (e.g., durables) have high elasticity and thereby have a great
impact on the Balance of Trade.
5. A is correct. Insurance firms

Insurance firms are real money a/c’s because these forex buy-side members don’t use
derivatives.
Forward Exchange Rates
Convert forward quotations expressed on a points basis or in percentage terms

into an outright forward quotation.
Forward Quotations
⮚ A Forward exchange quotation = Spot Exchange Rate - The Forward Exchange Rate
- It is always denoted with a 4-point decimal space For example:
A quote of +12.5 points for a 120-day forward exchange rate indicates that the forward rate is
0.00125 higher than the spot exchange rate.
FORWARD EXCHANGE QUOTATION FORWARD EXCHANGE QUOTATION

(POINTS) (PERCENTAGE)
The INR/USD spot exchange rate is 70, The INR/USD spot exchange rate is
with the 90-day forward rate quoted at 71.50, with the 180-day forward rate
+1.2 points. What is the 90-day forward quoted at - 0.042%. What is the 180-day
INR/USD exchange rate? forward INR/USD exchange rate?
Solution Solution
The 90-day forward INR/USD exchange The forward exchange rate for
rate = 70 + 0.00012 = 70.00012. INR/USD: = 71.50 (1- 0.00042) =
71.4699.
Explain the arbitrage relationship between spot rates, forward rates, and interest
rates.
Calculate and interpret a forward discount or premium.
Calculate and interpret the forward rate consistent with the spot rate and the
interest rate in each currency
How would you explain the arbitrage relationship between spot rates, forward rates, and interest rates?
⮚ In case of free trade and forward currency contracts:

% Difference between forward Rate and spot exchange Rates =
Interest Rate in Country A - Interest Rate in Country B,
This equation is known as the no-arbitrage condition.
⮚ In case of an absence of this equation, it gives rise to a market for arbitration/riskless profit.
For instance;
In case of an incorrect forecast of the forward rates, An
investor can:
a. Borrow Currency A at interest rate A (3%),
b. Convert this borrowed currency to B’s Currency at the spot rate and invest it to earn the
interest rate on B (5%),
c. On the settlement date, the investor pays back the lender and keeps the excess profit, which he
earned through the difference in interest rates with him.
This is possible only when, The Cost of Borrowing < Profit from Investing.
⮚ Thus, for spot and forward rates stated as price currency/base currency, the no-arbitrage
relation (interest rate parity) is:
Forward/Spot = (1 + interest rate price currency) ÷ (1 + interest rate base currency)

What do you understand by forward discount/premium? Explain with example.
⮚ Forward discount/premium is calculated relative to the spot exchange rate.
⮚ Forward discount/premium Base currency = % (Forward price – Spot Price)\ For example:
INR/USD spot = ₹ 70,
INR/USD 120-day forward = ₹ 71 For,
forward premium /discount on USD:
Forward/spot – 1 = 71/ 70 – 1 = 1.429 %.
Since the result is positive, the percentage increase is taken as a forward premium on USD by
1.429%.
Further, we can annualize the discount by multiplying it by 3 (12 / 4).
Since the forward quote > the spot quote, it will take more rupees to buy one USD 120 days from
now, so the USD is expected to appreciate over rupees.
If the forward quote < than the spot quote, the calculated amount would be negative, and we would
interpret that as a forward discount.
The spot rate is S INR/USD= 72.
The 120-day Risk-free rate (India) = 5% and
The 120-day Risk-free rate (USA) = 2%
For interest rates, use the 360-day convention unless told otherwise.
Calculate the forward rate.
Solution
F INR/USD =SINR/USD × 1.05*120/360 / 1.02*120/360
= 72 × 1.016 / 1.006
= 72.7157
The FINR/USD>S INR/USD (72.7157/72 -1) by 1%
Which is the 120-day INR rate – 120-day USA

= 0.0167 - 0.0067 = 1%
Thus, the forward rate should be 72.7157, or else there exists a possibility of arbitrage.
1) In the case of a foreign exchange rate, where currency trade is decided today, and the
transaction takes place 120-days from now is known as:
A. Spot exchange rate

B. Forward exchange rate
C. Nominal Exchange rate
2) The spot exchange rate for USD/GBP is 1.6. The 120-day forward rate for USD/GBP is down by
50.5 points. The 120-day forward USD/GBP exchange rate is closest to:
A. 1.595
B. 1.615
C. 1.485
3) The yearly interest rates in the UK (GBP) and USA (USD) are 2% and 5% per annum,
respectively. However, If the current spot rate for USD/ GBP is 5.05, Calculate the 1-year
forward rate in USD/ GBP is closest to:
A. 5.1
B. 5.2
C. 4.98
4) The spot rate today for the USD/EUR is $1.4500, and the 90-day forward rate is $1.4100.
Compared to the euro, the U.S dollar is trading closest to a 90-day forward, at:
A. Discount of 2.03%.
B. Premium of 2.83%.
C. Discount of 2.83%.
5) The yearly no-arbitrage interest rate is 5% in the UK (GBP) and 3% in India (INR), and the 1year
forward rate for GBP/INR is 0.60. Calculate the current spot rate for GBP/INR; it is closest to:
A. 0.56
B. 0.45
C. 0.59
Answer:
1. B is correct. Forward exchange rate It is the exchange rate for future delivery at the rate
discussed today
2. A is correct. for USD/GBP 120 day forward rate = 1.6 – (50.5 / 10,000) = 1.595
3. B is correct. the 1 year forward rate for; USD/GBP = 5.05 X (1.05/1.02) = 5.198
4. B is correct. Premium of 2.83%.
To calculate the forward premium/loss for US dollar we need to convert USD as the base currency, thus
the spot rate for GBP/USD = 1 / 1.45 = 0.6897, and 90-day forward rate for GBP/USD = 1/ 1.41 =
0.7092, since USD has appreciated in terms of euro, the currency trades at a forward premium of
(0.7092/0.6897) – 1 = 2.83%
5. C is correct. 0.59.
Spot rate for GBP/INR = 0.6 x (1.03/1.05) = 0.5886, thus the forward GBP shall be falling compared
to the spot rate.
Managing Exchange Rates
Describe exchange rate regimes.
An exchange rate regime is a way a monetary authority of a country (generally the central bank)
manages the local currency with that of other countries in the FX market.
In India, since Independence, the exchange rate system in India has navigated from
1.Fixed exchange rate regime, INR pegged to GBP from the 1970s -1980s
2.As of now, India follows the market-determined exchange rate regime, 1993-present
What do you understand by the two IMF categorized exchange rate regimes?
A. For countries that do not have their currency
⮚ Formal dollarization is practised

Using the currency of another country.
⮚ They don’t have the right to implement their domestic monetary policy For example:
Monetary union; countries part of this union use a common currency. For instance, Euro for the
European Union, the EU central bank forms monetary policies for all the countries as a whole.
Post - World War II, the French colonies in West Africa had formed their monetary union and
currency, the West African CFA Franc (XOF) shared by eight West African nations. However, the
XOF had to be depreciated by 50% against the French franc to be accepted as currency.
B. For countries that do have their currency, it includes:
1. Currency board arrangement

One currency is pegged to another currency under the fixed-exchange-rate regime
Unlike Formal dollarization the country can formulate its currency and monetary policies. E.g.,
India, before the LPG movement, had INR pegged to GBP under the fixed-rate regime.
2. Conventional fixed peg arrangement A band (+/- 1%) is fixed in which through
a. direct policies like buying/selling of foreign currencies
b. indirect policies like policy changes, the exchange rate can fluctuate.
In 2006, 49 nations under IMF had followed this regime by either pegging to a single currency or
a basket of currencies.
3. Target zone
A band >+/- 2 % is fixed,
⸫ Monetary authority = ↑policy choices
In 2006, European Exchange Rate Mechanism (ERM) II could fall under this category, but they
opted out. Only Tonga was the country that followed this system.
4. Crawling peg
Exchange rate adjusted periodically, further divided into:
i. Passive peg
Changes in the rate post the inflation changes in the prior period.
ii. Active peg
Changes in the rate before inflation in the subsequent period. g., Austria, Hungary, Chile, etc.
5. Management of exchange rates within crawling bands

A width (e.g., +/- 1%) is prescribed within which the rates can fluctuate.
It helps in developing a fixed peg to a floating rate
6. Managed floating exchange rates

Free movement in exchange rates.
Periodic intervention by the monetary authorities through economic indicators like BOP, inflation rates,
etc., is needed to avoid extreme scenarios. Eg., Singapore
7. Independently floating
Intervention is required to avoid any short-term fluctuations in the exchange rate. E.g., the USA,
Japan, etc.
Explain the effects of exchange rates on countries’ international trade and capital flows.
How can a change in exchange rates affect a country’s BOT using the two approaches?
ELASTICITIES APPROACH ABSORPTION APPROACH

Impact of exchange rates =can increase or To offset the Trade deficit by a surplus, a
decrease the total value of imports and Trade deficit leads to a ↑ Capital a/c and
exports. not just goods flow.
For example: In a country like India that It is a macroeconomic method that focuses
experiences a trade deficit on the capital account.
(Imports>Exports), a further depreciation of
local currency makes imports more
expensive and exports cheaper for foreign
countries, thus to balance the deficit, we
must increase our exports and reduce our
imports.
This depreciation should affect the total

expenditure on imports and exports and not
the quantity.
↓/↑ Total Expenditure = f (demand

elasticity) ↑ Elasticity Import/Export goods
= ↑ Exchange rate impact
The Marshall-Lerner BOT = National income – Total

condition states: WX εX + WM Expenditure Thus, to improve the economy
(εM – 1) > 0 where: towards trade surplus, when:
WX = proportion of total trade that is X – M ≡ (S – I) + (T – G)

exports. WM = proportion of total trade that ⸫ – M= (S + T) – (I+G)
is imports εX = absolute value of price Now, for this -ve imports (- M) to balance,
elasticity of demand for exports we need:
εM = absolute value of price elasticity of An ↑ in domestic Investment Via ↑ in
demand for imports foreign inflow only
↑ in domestic savings and tax collection
Assuming, When domestic currency (dc) and

WX= WM, εX+ εM = 1. economy is operating at less than full
employment:
However, when domestic currency (dc) , Domestic goods and assets get more
Exports = ↑ (buyers overseas ↑ due to attractive v/s foreign goods and assets.
cheap prices) Shift in demand= ↑expenditures +
Imports = ↓ (Expensive foreign currencies) ↑income.
Thus, (X – M) ↑ towards trade surplus. As part of the income ↑ will be saved,

National Income >Total Expenditure
Import or export goods that can affect the
BOT are mostly luxury goods, goods with Thus, improving the balance of trade
close substitutes, and goods that represent a
large proportion of overall spending.
When the economy is operating at full
employment (capacity), an ↑ domestic
spending =↑ domestic prices, which can
reverse the relative price changes of the
domestic currency ↓.
The Marshall-Lerner conditions states that:

1. In short-run (X – M), quantities may be
relatively inelastic to a domestic currency
(dc) ↓
2. In the long run (X – M), quantities gets
elastic, and trade deficit is balanced by a ↓
in imports.
3. Trade deficits worsening begins to improve
the domestic currency.
4. This short-term increase in the deficit
followed by an increase when the
Marshall-Lerner condition is met is referred
to as the J-curve
It is from a Microeconomic Viewpoint It is from a Macroeconomic Viewpoint

In India post the second wave in 2021, the In India post the second wave in 2021, the
value of INR ↓ v/s USD. value of INR ↓ v/s USD.
Since the country is operating below full
Exports ↑ and you manage a ↓ Imports employment
All these goods are elastic in nature, causing An ↑ in domestic spending on domestic
a ↓ Trade deficit. goods shall ↑ National Income, thus ↑
INR v/s USD.
1. Keeping other things constant, which of the following is most likely to reduce India’s trade
deficit?
A. Increasing the capital account surplus.

B. Reduce expenditures compared to income.
C. Reduce local savings v/s local investment
2. Depreciation of domestic currency to recover its trade deficit would most likely be profitable for
a producer of:
A. High-end cars.
B. Monopolistic goods.
C. Salt
3. For countries that don’t have their currency, is practiced.
A. Formal dollarization
B. Currency board arrangement
C. Crawling peg
4. Under the Absorption Approach, Balance of Trade =
A. Exports - Imports
B. National income – Total Expenditure
C. GDP – GNP
5. The monetary authority of Nepal will exchange its currency for INR at a 1:1 ratio. As a result,
the exchange rate of Nepal with INR is 1.00, and many industries in the countries shall accept
INR in dealings. This particular exchange rate regime is known as:
A. Fixed peg.
B. Dollarization.
C. Currency board
Answer:
1. B is correct. Reduce expenditures compared to income.

To reduce a trade deficit, we require that local savings rise v/s local investment, thus reducing a
capital account surplus. Reducing expenditures compared to income indicates a rise in local
savings.
2. A is correct. High-end cars. Since depreciation of domestic currency makes a purchase for
overseas buyers cheap, Luxury goods that have a higher elasticity of demand benefit the most.
While goods that have no close substitutes or inelastic demand don’t benefit.
3. A is correct. Formal dollarization. Formal dollarization is using the currency of another country
4. B is correct. National income – Total Expenditure
5. C is correct. This exchange rate rule is a currency board regime. Nepal continues to issue a
domestic currency. Hence it has not been formally dollarized. A fixed peg allows for a small
degree of variation around the target exchange rate.
Formula 187
Formula
Topics in Demand and Supply Analysis

% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑
● Own Price Elasticity: % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑜𝑤𝑛 𝑝𝑟𝑖𝑐𝑒

● Income Elasticity: % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑐𝑜𝑚𝑒

● Cross Price Elasticity: % 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑟𝑒𝑙𝑎𝑡𝑒𝑑 𝑔𝑜𝑜𝑑𝑠
● Breakeven points:
o Perfect Competition: AR=ATC
o Imperfect Competition: TR=TC
● Short-run Shutdown Points:

o Perfect Competition: AR<ATC
o Imperfect Competition: TR<TC
Aggregate Output, Prices, and Economic Growth
● Nominal 𝐺𝐷𝑃𝑡 for year t = ∑𝑁

𝑖=1 𝑃𝑖,𝑡 𝑄𝑖,𝑡
∑𝑁
𝑖=1 (𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑔𝑜𝑜𝑑 𝑖 𝑖𝑛 𝑦𝑒𝑎𝑟 𝑡 − 5) × (𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑔𝑜𝑜𝑑 𝑖 𝑝𝑟𝑜𝑑𝑢𝑐𝑒𝑑 𝑖𝑛 𝑦𝑒𝑎𝑟 𝑡)
● Real GDP for year t = ∑𝑁

𝑖=1 𝑃𝑖,𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 𝑄𝑖,𝑡
∑𝑁
𝑖=1 (𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑔𝑜𝑜𝑑 𝑖 𝑖𝑛 𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟) ×
(𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑔𝑜𝑜𝑑 𝑖 𝑝𝑟𝑜𝑑𝑢𝑐𝑒𝑑 𝑑𝑢𝑟𝑖𝑛𝑔 𝑡ℎ𝑒 𝑦𝑒𝑎𝑟 𝑡)
∑𝑁
𝑖=1 𝑃𝑖,𝑡 𝑄𝑖,𝑡
● GDP deflator for year t =
∑𝑁
× 100
𝑖=1 𝑃𝑖,𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 𝑄𝑖,𝑡
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃 𝑓𝑜𝑟 𝑦𝑒𝑎𝑟 𝑡

× 100
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑦𝑒𝑎𝑟 𝑡 𝑜𝑢𝑡𝑝𝑢𝑡 𝑎𝑡 𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 𝑝𝑟𝑖𝑐𝑒𝑠
Formula 188
● GDP, expenditure approach:
GDP = C+I+G+(X-M)
where:
C = Consumption
I = Investment
G = Government Spending
X= Exports
M= Imports
● GDP, income approach: GDP = national income + capital consumption allowance + statistical
discrepancy
● National income = Compensation of employees (wages and salaries including cash and in-kind
instruments like ESOP’s, corporate profit sharing, etc.) + Corporate and government enterprise profits
before taxes; this includes NGO’s as well + Interest income + Unincorporated business net income
(business owners’ incomes) + Rent + Indirect business taxes - Subsidies included in final prices Growth in
potential GDP = growth in technology + WL(Growth in labour) + WC(Growth in capital)
Where:
𝑊𝐿 = labour’s percentage share of national income
𝑊𝐶 = capital’s percentage of national income
● Growth in per-capita potential of GDP = 𝑔𝑟𝑜𝑤𝑡ℎ 𝑖𝑛 𝑡𝑒𝑐ℎ𝑛𝑜𝑙𝑜𝑔𝑦 +

𝑊𝐶 (𝑔𝑟𝑜𝑤𝑡ℎ 𝑖𝑛 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑡𝑜 𝑙𝑎𝑏𝑜𝑢𝑟 𝑟𝑎𝑡𝑖𝑜)
Understanding Business Cycles

100
Consumer Price Index (CPI) = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑏𝑎𝑠𝑘𝑒𝑡 𝑎𝑡 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑝𝑟𝑖𝑐𝑒 × 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑏𝑎𝑠𝑘𝑒𝑡 𝑎𝑡 𝑏𝑎𝑠𝑒 𝑝𝑒𝑟𝑖𝑜𝑑 𝑝𝑟𝑖𝑐𝑒𝑠
Monetary and Fiscal Policy

1
● Money Multiplier = 𝑟𝑒𝑠𝑒𝑟𝑣𝑒 𝑟𝑒𝑞𝑢𝑖𝑟𝑒𝑚𝑒𝑛𝑡
● Equation of exchange: Money supply × velocity = price × real output (MV=PY)
● Fischer effect:
o Nominal interest rate = real interest rate + expected inflation rate
o Neutral interest rate = real trend rate of economic growth + inflation target
Formula 189
1
● Fischer multiplier =
1 − 𝑀𝑃𝐶(1−𝑡)
where:
t = Tax rate
MPC = Marginal propensity to consume
Currency Exchange Rates

𝐶𝑃𝐼 𝑏𝑎𝑠𝑒𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦
● Real exchange rate = 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑒𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒 × (𝐶𝑃𝐼 𝑝𝑟𝑖𝑐𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦)
𝐶𝑃𝐼 𝑏𝑎𝑠𝑒𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦
● Real exchange rate = 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑒𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒 × ( )
𝐶𝑃𝐼 𝑝𝑟𝑖𝑐𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦
● Forward premium (+) or discount (-) for the base currency
𝑓𝑜𝑟𝑤𝑎𝑟𝑑
−1
𝑠𝑝𝑜𝑡
● Interest rate parity:
𝐹𝑜𝑟𝑤𝑎𝑟𝑑 1 + 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 𝑝𝑟𝑖𝑐𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦

=
𝑆𝑝𝑜𝑡 (1 + 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 𝑏𝑎𝑠𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦)
● Marshall-Lerner condition:
WX εX + WM (εM – 1) > 0
Where:
WM = proportion of trades that is imports
εM = elasticity of demand for imports
WX = proportion of trades that is exports
εX = elasticity of demand for exports

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Authored by: Dhrumi Doshi, Prabhjyot Taluja, Esha Vora

Topics in Demand and Supply Analysis

Two Broad areas of Economics are:

Following demand function for petrol:

QDPETROL= 100 – 5PPETROL+ 0.04I + 0.10PPUBLIC TRANSPORT – 0.005PPETROL VEHICLE

Slope of demand curve = ΔQ/ Δ P

What do you mean by Own-Price Elasticity of Demand?

⮚ Own-price elasticity is a measure of the responsiveness of the quantity demanded to a change

⮚ Price Elasticity of Demand = % Change in Quantity Demanded / % Change in Price

Quantity demanded = a + b × price

b = slope of the curve

For e.g.: In case of a demand function with A = 50 and B = –5,

Slope of demand function = inverse of slope term

In a downward–sloping demand curve (i.e., prices ↑ with an ↓ in quantity demanded)

⮚ Elastic (When Elasticity>1)

⮚ Perfectly Elastic (When Elasticity=∞)

⮚ Unit Elastic (When Elasticity=1)

⮚ Inelastic (When Elasticity<1)

⮚ Perfectly Inelastic (When Elasticity=0)

Elastic demand = Price Elasticity > 1.

However, your quantity demanded Coca Cola ↑

Inelastic demand = Price Elasticity < 1

Note: Elasticity is not equal to the slope of a demand curve

QDPETROL= 10,000 – 500 PVEHICLE PRICES

Calculate the price elasticity at a petrol price of $10 per barrel.

QDPETROL= 10,000 – 500 (10)

QDPETROL= 5,000 barrels.

Ed = 10/5000 x (- 500) = -1.

Thus, at this demand for petrol is unitary elastic.

Explain how elasticity changes along a linear demand curve?

As seen in the graph, As seen in the graph, As seen in the graph,

How is Income Elasticity of Demand different from Cross-Price Elasticity of Demand?

INCOME ELASTICITY OF DEMAND CROSS-PRICE ELASTICITY OF DEMAND

Keeping other variables constant, Keeping other variables constant,

An ↑ in the price of one good = ↓ in

Kinds of movement in demand curve:

Movement along the demand curve:

Shift in the demand curve:

Ed = % Change in Quantity Demanded / % Change in Income

QDPETROL= 100 – 5PPETROL+ 0.04I + 0.10PPUBLIC TRANSPORT – 0.005PCARS

a. Income elasticity of petrol,

QDPETROL= 100 – 5PPETROL+ 0.04I + 0.10PPUBLIC TRANSPORT – 0.005PCARS

QDPETROL= 100 – 5(5) + 0.04(30,000) + 0.10(10) – 0.005(19,000)

QDPETROL= 100 – 25 +1200 + 1 - 95

QDPETROL= 1181 per litre.

For income elasticity

QDPETROL= 100 – 5(5) + 0.04(income) + 0.10(10) – 0.005(19,000)

Thus 0.04 is the slope.

For a 1% Δ in the income the QD of Petrol Δ’s by 1.02%

For cross elasticity (public transport)

QDPETROL= 100 – 5(5) + 0.04(30,000) + 0.10PPUBLIC TRANSPORT – 0.005(19,000)

QDPETROL = 1180 + 0.10PPUBLIC TRANSPORT

QDPETROL = 1180 + 0.10(10)

Ed = % Change in Quantity Demanded / % Change in Price of Related Goods

=10/1181 x 0.1 = 0.008.

For a 1% Δ in the price of public transport the QD of Petrol Δ by 0.008%.

1. Price elasticity of demand=

A. Price Elasticity of Demand = % Change in Quantity Demanded / % Change in Price

2. Total revenue is highest in the segment of a demand curve that is:

3. The demand function for kitchen appliances is given by:

4. A product is classified as an inferior good if its:

A. Income elasticity is -ve.