Macroeconomics refers to the study of the overall performance of the economy. Macroeconomics deals with the overall aggregate effect of microeconomics. Macroeconomics is crucial for the government to understand and predict the long-term consequences of their decisions.

Summary

• Macroeconomics refers to the study of the aggregate economy.
• The primary goals of macroeconomics are to achieve stable economic growth and maximize the standard of living.
• Economic indicators are a good source of information to track macroeconomic performance.
• Monetary policy and fiscal policy are tools used by the government to control economic performance and reach macroeconomic goals.

Goals of Macroeconomics

The overarching goals of macroeconomics are to maximize the standard of living and achieve stable economic growth. The goals are supported by objectives such as minimizing unemployment, increasing productivity, controlling inflation, and more. The macroeconomy of a country is affected by many forces, and as such, economic indicators are invaluable to assessing different aspects of performance.

Macroeconomic Factor

A macroeconomic factor is a pattern, characteristic, or condition that emanates from, or relates to, a larger aspect of an economy rather than to a particular population. The characteristic may be a significant economic, environmental, or geopolitical event that widely influences a regional or national economy.

A macroeconomic factor can include something that affects the course or direction of a given large-scale economy. Monetary policies and other regulations, for example, can affect national and state economies, while also coming with potentially great global consequences.

Inflation, gross domestic product (GDP), national income, and unemployment levels are examples of macroeconomic factors. Such economic performance metrics are closely tracked by states, companies, and consumers alike. The correlation between various macroeconomic factors is extensively researched in the field of macroeconomics.

Inflation

Inflation is a progressive increase in the average cost of goods and services in the economy over time.

Economic Growth Rate

The economic growth rate is the percent change in the cost of the output of goods and services in a country across a specific period of time, relative to a previous period.

Price Level

A price level is the variation of existing prices for economically produced goods and services. In broader terms, the level of prices refers to the costs of a good, service, or security.

Gross Domestic Product (GDP)

The gross domestic product (GDP) is a quantitative measure of the market value of all finished goods and services produced over a given time period.

National Income

National income is the aggregate amount of money generated within a nation.

Unemployment Level

The level or rate of unemployment is the unemployed share of the labor force in a given country, calculated and stated as a percentage.

Types of Macroeconomic Factors Importance of Macroeconomic Factors

Economic experts and researchers frequently refer to macroeconomic factor trends as they try to find ways to clarify economic policy objectives and strive to achieve economic prosperity. They also attempt to forecast future rates of employment, inflation, and other main macroeconomic factors. Such forecasts affect the decisions taken by states, individuals, and businesses.

What is the GDP Formula?

There are two primary methods or formulas by which GDP can be determined:

What are the Types of GDP?

GPD can be measured in several different ways. The most common methods include:

• Nominal GDP – the total value of all goods and services produced at current market prices. This includes all the changes in market prices during the current year due to inflation or deflation.
• Real GDP – the sum of all goods and services produced at constant prices. The prices used in determining the Gross Domestic Product are based on a certain base year or the previous year. This provides a more accurate account of economic growth, as it is already an inflation-adjusted measurement, meaning the effects of inflation are taken out.
• Actual GDP – real-time measurement of all outputs at any interval or any given time. It demonstrates the existing state of business of the economy.
• Potential GDP – ideal economic condition with 100% employment across all sectors, steady currency, and stable product prices.

Why is GDP Important to Economists and Investors?

Gross Domestic Product represents the economic production and growth of a nation and is one of the primary indicators used to determine the overall well-being of a country’s economy and standard of living. One way to determine how well a country’s economy is flourishing is by its GDP growth rate. This rate reflects the increase or decrease in the percentage of economic output in monthly, quarterly, or yearly periods.

Gross Domestic Product enables economic policymakers to assess whether the economy is weakening or progressing, if it needs improvements or restrictions, and if threats of recession or inflation are imminent. From these assessments, government agencies can determine if expansionary, monetary policies are needed to address economic issues.

Investors place importance on GDP growth rates to decide how the economy is changing so that they can make adjustments to their asset allocation. However, when there is an economic slump, businesses experience low profits, which means lower stock prices and consumers tend to cut spending. Investors are also on the lookout for potential investments, locally and abroad, basing their judgment on countries’ growth rate comparisons.

What are Some Drawbacks of GDP?

Gross Domestic Product does not reflect the black market, which may be a large part of the economy in certain countries. The black market, or the underground economy, includes illegal economic activities, such as the sale of drugs, prostitution, and some lawful transactions that don’t comply with tax obligations. In these cases, GDP is not an accurate measure of some components that play a large role in the economic state of a country.

Income generated in a country by an overseas company that is transferred back to foreign investors is not taken into account. This overstates a country’s economic output.

Gross Domestic Product (GDP) is the most common measure to estimate the size of a country’s economy. It represents the total value of final goods and services produced domestically, in a given time period. India’s GDP was approximately USD 2.3 trillion for financial year 2015. What this means is that the total value of final goods and services produced inside the geographical boundary of India between April 2014 and March 2015 was USD 2.3 trillion.

GDP calculation only includes value of final goods and services, as the value of intermediary goods & services will automatically be included in the final price. For example, GDP doesn’t include the value/price of a computer chip, as the same is included in price of a computer when it is sold. When calculating GDP, all end goods and services manufactured within the country is considered, regardless of the country of origin of the manufacturing company. So the value of a Samsung mobile manufactured in India will be included in GDP, even though Samsung is a foreign company.

GDP growth rate is the percentage change in GDP, compared to the previous financial year. It is commonly used to see how many additional goods and services were produced, compared to the previous year. It is also helpful in comparing two different economies. If GDP growth rate of India is 7.5% and that of China is 7.0%, it means that Indian economy is expanding faster than China’s. However, this does not tell us anything about the overall size of the economy – which is measured by the absolute GDP number.

Let us consider a small example to understand this.

Suppose, last year, India’s GDP was USD 1000 and GDP of china was USD 10,000. This year, GDP growth rate of India is 9% and that of China is 6%. This means, the value of additional goods and services produced by India is USD 90 (9%*1,000) and that in China is USD 600 (6%*10,000). Thus, we can say that India is expanding rapidly, but the absolute value of additional goods and services, produced by India, is still less than China’s because of China’s higher base (previous year’s GDP).

GDP per capita is defined as the total GDP divided by the total population. A higher GDP per capita signifies a higher living standard, as more number of goods and services are available for each individual within the country.

There are different types of inflations like:

• Creeping Inflation
• Galloping Inflation
• Hyperinflation
• Stagflation and
• Deflation.

Inflation measures how much more expensive a set of goods and services has become over a certain period, usually a year

Inflation is an economic concept that refers to increases in the price level of goods over a set period of time. The rise in the price level signifies that the currency in a given economy loses purchasing power (i.e., less can be bought with the same amount of money).

The causes for inflation in the short term and medium term remain a contested issue among economists all over the world. However, there is a consensus that, in the long term, inflation is caused by changes in the money supply.

How is Inflation Calculated?

Inflation is most commonly calculated by observing changes in price indices. Generally, changes in the Consumer Price Index (CPI) are used as a proxy for inflation. Let’s say that the CPI for a given nation was 210 at the end of 2017 (the base year) and 220 at the end of 2018. Calculating the percent change in those values will provide us with the inflation over this time period:

Inflation= (220-210/210)* 100 =4.76%

Thus, we can conclude that inflation was approximately 5% in 2018.

If inputs to produce high-demand, inelastic goods (such as oil or medication) increase in price, suppliers will be compelled to raise their prices to compensate. This can be due to a number of reasons, such as environmental catastrophes, tariffs, government sanctions, or scarcity. If widespread enough, the phenomenon can nudge the CPI higher, resulting in inflation.

The opposite is also true – whereby lower input costs can result in deflation.

How Does Consumer Demand Affect Inflation?

Holding other factors the same, a rise in consumer demand for goods will lead to an increase in the price of goods (CPI), as shown below:

Consumer demand for goods may increase due to various factors, such as changes in consumer appetite, long-term scarcity prospects, or an increase in the money supply. The opposite is also true; a decrease in consumer demand will result in a lower CPI, and thus deflation.

How Does Money Supply Affect Inflation?

In the long run, money supply affects the purchasing power of a currency as per supply and demand rules. The diagram below illustrates how an increase in the money supply in an economy would affect inflation:

The money supply can increase in a variety of ways, namely if governments print more money or make credit more easily accessible. Lower interest rates may spur consumer borrowing and lead to an increase in the money supply. In the diagram above, we can see that an influx of money in an environment where demand remains the same will result in a devaluation of the currency in question.

The opposite is also true; if governments restrict the money supply and all else remains constant, the currency will begin to appreciate in value.

Effects of Inflation

Investing in FDs thinking you will earn 8% returns?

From an individual investor’s perspective, inflation is one of the most important indicators to understand and track. Inflation indicates an overall increase in the general price level of goods and services in a country. When we read that last year inflation was 7%, it doesn’t mean that price of every product like milk, cars, clothes, etc., increased by 7%. It means compared to the previous year on average prices of all goods and services increased by 7%.

Each one of us would have definitely experienced the impact of inflation in our lives. In 90s, our overall college education fees never used to be more than few thousand rupees, but now it’s always in lakhs and crores. We know that since our childhood, prices of almost all goods and services have jumped manyfold. Let’s take a basic example:

Example1 If your current monthly expenses are `30,000/- per month, then after 20 years you will require `80,000/- a month to just maintain the same lifestyle!

Example 2 An education degree for your child which currently costs `20 lakh could cost over `34 lakh after 11 years!
This example clearly shows how inflation reduces value of money. Over a period of time, the same amount of money will buy less units of the same good, thereby reducing the individual’s purchasing power. Hence it is very important to invest one’s money and grow it.

Over the last decade, average inflation in India was around 8.4%. After-tax average rate of return on fixed deposits (assuming tax @ 20%) was around 6.2%. Thus, by investing in FDs you were actually reducing the value of your money by 2.2% every year, instead of growing it.

Now that we know what inflation is, we need to understand what causes it. Inflation depends on price, which is determined by demand and supply. So if people have more money leading to more demand than supply, price increases. This is called demand pull inflation and is caused by too much money chasing too few goods. On the other hand, if supply is less compared to demand, again prices increase and cause inflation. This is called supply push inflation.

Deflation is a decrease in the general price level of goods and services. Put another way, deflation is negative inflation. When it occurs, the value of currency grows over time. Thus, more goods and services can be purchased for the same amount of money.

Deflation is widely regarded as an economic “problem” that can intensify a recession or lead to a deflationary spiral.

Causes of Deflation

Economists determine the two major causes of deflation in an economy as (1) fall in aggregate demand and (2) increase in aggregate supply.

The fall in aggregate demand triggers a decline in the prices of goods and services. Some factors leading to a decline in aggregate demand are:

An increase in aggregate supply is another trigger for deflation. Subsequently, producers will face fiercer competition and be forced to lower prices. The growth in aggregate supply can be caused by the following factors:

Effects of Deflation

Frequently, deflation occurs during recessions. It is considered an adverse economic event and can cause many negative effects on the economy, including:

Deflation spiral

This is a situation where decreasing price levels trigger a chain reaction that leads to lower production, lower wages, decreased demand, and even lower price levels. During a recession, the deflation spiral is a significant economic challenge because it further worsens the economic situation.

Recession is a term used to signify a slowdown in general economic activity. In macroeconomics, recessions are officially recognized after two consecutive quarters of negative GDP growth rates

Causes of a Recession

Stagflation is an economic event in which the inflation rate is high, economic growth rate slows, and unemployment remains steadily high. Such an unfavorable combination is feared and can be a dilemma for governments since most actions designed to lower inflation may raise unemployment levels, and policies designed to decrease unemployment may worsen inflation.

Causes of Stagflation

There is no consensus among economists on the causes of stagflation. Each economics school offers its own view on its origins. However, two main theories may be derived: supply shock and poor economic policies.

The supply shock theory suggests that stagflation occurs when an economy faces a sudden increase or decrease in the supply of a commodity or service (supply shock), such as a rapid increase in the price of oil. In such a situation, prices surge, making production costlier and less profitable, thus slowing economic growth.

A second theory states that stagflation can be a result of a poorly made economic policy. For example, the government can create a policy that harms industries while growing the money supply too quickly. The simultaneous occurrence of these policies can lead to slower economic growth and higher inflation.

Example of Stagflation

Stagflation is costly and difficult to eliminate, both in social and fiscal terms.

There could be many reasons, but the concept of “supply shock” allows us to understand the causes of stagflation the best. Suppose tomorrow all oil producing nations decide to cut supply and suddenly there is shortage of oil everywhere. Obviously the price of oil will start increasing. Oil is the lifeblood of any economy as it is used in various activities like transportation, power generation, manufacturing of goods etc. Thus rising oil price will push up prices of all goods. Consider oranges, to get farm produced oranges to a far off market, there is a huge transportation cost involved which will increase with rising oil prices.

Stagflation is a situation where economy is stagnating, i.e. it is not experiencing any GDP growth and at the same time there is also high inflation. It is a nightmare situation for any country, as high prices kill purchasing power and harm the poor, while low or negative GDP growth worsens the situation by causing unemployment.

The number of people at work is generally closely related to whether an economy is growing at a reasonable rate

Unemployment is a term referring to individuals who are employable and actively seeking a job but are unable to find a job. Included in this group are those people in the workforce who are working but do not have an appropriate job. Usually measured by the unemployment rate, which is dividing the number of unemployed people by the total number of people in the workforce, unemployment serves as one of the indicators of a country’s economic status.

Back in the depths the global financial crisis in 2009, the International Labour Office announced that global unemployment had reached the highest level on record.

t was not a coincidence that the global economy experienced the most severe case of unemployment during the worst economic crisis since the Great Depression. Unemployment is highly dependent on economic activity; in fact, growth and unemployment can be thought of as two sides of the same coin: when economic activity is high, more production happens overall, and more people are needed to produce the higher amount of goods and services. And when economic activity is low, firms cut jobs and unemployment rises. In that sense, unemployment is countercyclical, meaning that it rises when economic growth is low and vice versa.

But unemployment does not fall in lockstep with an increase in growth. It is more common for businesses to first try to recover from a downturn by having the same number of employees do more work or turn out more products—that is, to increase their productivity. Only as the recovery takes hold would businesses add workers. As a consequence, unemployment may start to come down only well after an economic recovery begins. In fact, in the last three recessions, the unemployment rate continued to rise after the end of the recessions; a phenomenon called “jobless recoveries.”

The phenomenon works in reverse at the start of a downturn, when firms would rather reduce work hours, or impose some pay cuts before they let workers go. Unemployment starts rising only if the downturn is prolonged. Because unemployment follows growth with a delay, it is called a lagging indicator of economic activity.

How sensitive is the unemployment rate to economic growth? That depends on several factors, most notably labor market conditions and regulations.

Generally high unemployment rate signals recession and problems with the economy. Thus it is very important to observe and track unemployment levels in an economy to determine its health.

A business cycle is a cycle of fluctuations in the Gross Domestic Product (GDP) around its long-term natural growth rate. It explains the expansion and contraction in economic activity that an economy experiences over time.

A business cycle is completed when it goes through a single boom and a single contraction in sequence. The time period to complete this sequence is called the length of the business cycle. A boom is characterized by a period of rapid economic growth whereas a period of relatively stagnated economic growth is a recession. These are measured in terms of the growth of the real GDP, which is inflation-adjusted.

Stages of the Business Cycle

In the diagram above, the straight line in the middle is the steady growth line. The business cycle moves about the line. Below is a more detailed description of each stage in the business cycle:

The profit that you make on selling a long-term capital asset is called a long-term capital gain. But as you know, inflation erodes the value of money. For instance, the value of Rs 100 was worth more 10 yrs ago than what it is today. That is why when computing the gains on selling a capital asset, it is important to adjust the purchase price to account for inflation.

This is done by way of indexation, a method used to reduce tax liability on selling a capital gain. Indexation accounts for inflation from the year of purchase of an asset to the year of sale.

How does indexation work?

It inflates the purchase price of an asset by accounting for inflation until the year of the sale
It reduces the capital gains you earn on selling an asset
Finally, it brings down your tax on capital gains
Before looking at an example, let us understand what are capital assets and capital gains.

• Capital asset: This is an asset that you hold for over a year with an intention to not to resell but derive benefits from it for a longer period of time. These can be financial securities, real estate, and so on in the form of short- or long-term assets. But for the purpose of indexation, we shall focus on long-term capital assets—held for 12 to 36 months depending on the asset class.
• Capital gain The profit you earn on selling a capital asset after you have held it for a minimum holding period is called a capital gain. So when you sell a residential property after holding it for at least 3 yrs, the profit you make thereon is a long-term capital gain. Simply put, a capital gain is a difference between the sale price and the purchase price of a capital asset. As with any other taxable income, long-term capital gain also attracts income tax.

For instance, if you had bought a residential property for Rs 10 lakh in Mar 2003 and sold it for Rs 35 lakh in Mar 2020, then you have earned a capital gain of Rs 25 lakh. Here, the property is a long-term capital asset and the profit is long-term capital gain, which attracts income tax. Assuming the rate of tax on long-term capital gains is 10%, your tax liability on the sale of the property would be Rs 2,50,000! But thanks to indexation, you don’t have to pay tax on Rs 25 lakh. Here’s why.

As mentioned, indexation inflates the purchase price of an asset. Keeping the sale price of the asset constant, a lower purchase price increases your capital gain and tax liability. On the contrary, a higher purchase price decreases long-term capital gain and tax thereon. For this purpose, you ascertain the indexed cost of acquisition. Meaning adjusting Rs 10 lakh for inflation over 17 yrs of holding period so it reflects today’s value.

The rate of inflation considered here is derived from the government’s Cost Inflation Index (CII), available on the income tax department’s website. Once you have the CII data, you can calculate the indexed cost of acquisition of the asset or its inflation-adjusted value as follows:

Indexed cost of acquisition = Original cost of acquisition x (CII of the year of the sale/CII of year of purchase)

In our example, the indexed cost of acquisition of the residential property = Rs 10 lakh x (280/105) = Rs 26,66,667

Effectively, the capital gains will now be Rs 8,33,333 (Rs 35,00,000 minus Rs 26,66,667) as against Rs 25 lakh before indexation. Naturally, your tax on capital gain also reduces to Rs 83,333 as against Rs 2,50,000 before indexation.

By now you may have understood the benefit of indexation. It helps reduce your long-term capital gains and, in turn, brings down your overall taxable liability.

Interest rate is one of the most common economic terms that we use in daily life. Simply put, interest rate is the return earned on money lent out. So if you lend Rs 100 to your friend and ask her to give back Rs 110 after one year, interest rate charged by you is 10%. Similarly, if you put Rs 100 in your bank account, the bank will pay interest as in this case it’s the bank who is taking money from you. If the bank offers an interest rate of 4%, then after one year you will get Rs 104 from the bank and will earn Rs 4 as interest.

This interest rate that we just discussed and the ones that we generally hear & read about is called the nominal interest rate. Now let’s see why nominal interest rate is not very relevant. The basic motive behind investing money is to earn returns/interest that allows us to retain purchasing power as well as to grow the savings kitty. This should allow us to improve our standard of living over a period of time. Let us consider an example. Suppose, you have Rs 1,00,000 and want to buy a high-end motor bike costing Rs 1,08,000. You decide to invest your money in a fixed deposit at 9% interest rate. You thought that you will have Rs 1,09,000 at the end of the year and will easily buy your favourite bike.

But after one year, you realize that the price of the bike has gone up to Rs 1,15,000 (increased by approx 6.5%). You are sad, as again you cannot buy the bike. What really happened here? Due to general inflation of around 6.5% in the economy, price of the bike increased proportionately during the course of the year. So in order to achieve your target of buying the bike you should have invested in an instrument that returned 15% after a year. That would have allowed you to beat inflation of 6.5% and in addition earn real returns of 8.5%.

Real Interest Rate = Nominal Interest Rate – Inflation Rate

In our example nominal interest rate is 9% and inflation is 6.5% and hence real interest rate is 2.5% (9%- 6.5%). When we invest our money, some part of what we are earning is always being eaten away by inflation.

Investors will be able to retain their purchasing power only when they earn returns equal to or more than the inflation rate. Suppose the inflation rate is 9% and interest rate is 8%, in real sense you will actually lose 1% of your money, rather than gain anything. So rather than being able to buy more things after a year, you won’t even be able to buy the same basket of goods bought earlier, as their market price will be higher than your investment kitty.

Compared to savings bank accounts, fixed deposits, bonds and other instruments, only equities as an asset class have generated positive real rate of return in the last decade. To make money in real sense over the long term, invest in equities.

Let’s continue our discussion on currency market and movements that we started in our previous article. We just understood what a currency market is and why currency appreciates and/or depreciates. In this article let’s try to understand why this upward/downward movement of currency is so important.

Suppose you want to import a costly laser machine from USA. The cost of machine is USD 1000. Currently the conversion rate given to you by your dealer is USD 1 = INR 65. So as of today, you will have to spend INR 65,000 to buy this machine. Due to some issues, you postpone your purchase and decide to buy it next month. Meanwhile due to reasons beyond your control, USD appreciates. We know that USD appreciation means INR depreciation. Thus, we will have to pay more in order to buy each unit of Dollar. Now after one month, you again ask for a quote from your dealer and he quotes USD 1 = INR 70. Thus, you will now have to pay more to import the same machine because of USD appreciation (INR depreciation).

Let’s take another example. Suppose you manufacture cycles. You want to export one cycle to US for INR 6000. The person importing this cycle in US will have to pay in INR and thus asks for a quote from his dealer to buy INR. His dealer quotes 1USD = 60 INR. So to buy INR 6000, he will have to spend USD 100 (6000/60). Just as in previous example, he also faces some issues and postpones his purchase by one month. After one month, you are again willing to sell the cycle at INR 6000, but suppose USD appreciated. Now it becomes USD 1 = INR 65. Thus, the US buyer will only have to pay USD 92.5, in order to buy the same product.

Above examples make it very clear that when foreign currency appreciates (domestic currency depreciates), local goods become cheaper in other countries, as foreigners will have to pay less to buy the same amount of INR. At the same time, it makes foreign goods costly as you will have to pay more to buy each unit of foreign currency. So when local currency depreciates, imports become costly and price of exported goods becomes cheap for foreign nationals. As price of imported goods increases, demand for imported article decreases and as price of goods exported becomes cheaper for foreigners, foreign demand for local goods increases. Hence we can now conclude that domestic currency depreciation leads to higher exports and lower imports. Opposite will happen when domestic currency appreciates.

India is a major oil importer as it doesn’t produce sufficient crude oil to meet its energy demands. Thus when rupee depreciates, it becomes more expensive for the Government to import oil. Higher oil prices increases the overall price level, as explained in our article on stagflation. Thus, it becomes important for many countries to ensure that their currency doesn’t excessively depreciate. But if a country doesn’t import many things, then it would want local currency to depreciate, so that local goods become cheaper in other countries and exports increases. Countries with excessive focus on exports use currency depreciation technique to boost their exports.

Foreign exchange market (FX, currency market) can be thought of as a global network of banks and financial institutions, selling and buying currencies from each other; an Indian bank buying Dollars by paying in Rupees, a European bank buying Rupees by paying in Dollars etc. Suppose you are planning a trip to Australia and need Aussie Dollars for being able to buy goods and services in Australia. You can go to your local bank like HDFC/ICICI or a currency dealer and can buy Aussie Dollar by paying in Rupees. Instead of an individual, suppose there is an Indian automobile manufacturer who wants to import auto parts manufactured in Japan. The company will have to pay in Japanese Yen to buy these auto parts. So it will buy Yen from a bank or a dealer by paying in Rupee and then pay Yen to the company from which it is buying these parts. Just like you and this company, there are hundreds of thousands of individuals and companies around the world seeking foreign currency for various reasons. They go to their banks and dealers for their needs and these banks and dealers deal with each other to fulfill the needs of such individuals and companies. Hence currency market can be described as an interconnected network of these institutions.

Every day in the newspapers, we keep reading that currency is falling or that the government is doing nothing about currency deprecation etc. The natural question is why is these so important that it needs so much of our attention and why does currency actually fall or rise? First, let’s discuss the second part of our question. Just like other goods and services, price of a currency is also determined by its demand and supply. Suppose today price of USD 1 is Rs 62. Now assume, lot of Indians suddenly start travelling to USA or many Indian companies start buying products from the USA or many Indians start investing in the US in the hope of better opportunities, all these activities will lead to greater demand for US Dollars from India. We have already learnt that as demand for a product/service increases, price of the same also increases. So now USD 1 becomes RS 65 ie we need to pay more, in order to buy USD 1. In this example, USD appreciated with respect to Rupee by 4.84% [(65-62)/62]. In an opposite case when demand for USD decreases, its price will decrease and we will have to pay less. Suppose USD 1 becomes equal to RS 60. In this case, USD depreciated with respect to Rupee by 3.23% [(62-60)/62]. It is important to understand that if demand for USD is increasing from India, it doesn’t mean that it’s increasing from rest of the world as well. So USD might not appreciate against other currencies, as its demand is increasing only against Rupee.

So when a currency appreciates, it means we need to pay more in order to buy 1 unit of the currency. Similarly if currency depreciates, we need to pay less in order to buy 1 unit. As you might have already noticed, price of one currency is given in another currency. In our example, price of USD was given in Rupee. So when one currency in the pair appreciates, another is depreciating simultaneously and vice versa. Let’s say initially USD 1 = INR 60 or 1 INR = 1/60 USD. Now USD depreciates. This means we will have to pay less to buy 1 USD. Suppose it becomes 1USD = 58 INR. So INR 1 becomes USD 1/58. Initially we had to pay USD 1/60 to buy INR 1, but now we will have to pay USD 1/58, which is more. Thus, Rupee appreciated when USD depreciated. Hence, we say that for a currency pair, if one currency is appreciating, the other depreciates and vice versa.

Monetary policy is an economic policy that manages the size and growth rate of the money supply in an economy. It is a powerful tool to regulate macroeconomic variables such as inflation and unemployment.

Monetary policy is the process by which the monetary authority of a country, generally the central bank, controls the supply of money in the economy by its control over interest rates in order to maintain price stability and achieve high economic growth. In India, the central monetary authority is the Reserve Bank of India (RBI).

It is designed to maintain the price stability in the economy. Other objectives of the monetary policy of India, as stated by RBI, are:

Monetary policy committee

The Reserve Bank of India Act, 1934 (RBI Act) was amended by the Finance Act, 2016, to provide a statutory and institutionalised framework for a Monetary Policy Committee, for maintaining price stability, while keeping in mind the objective of growth. The Monetary Policy Committee is entrusted with the task of fixing the benchmark policy rate (repo rate) required to maintain inflation within the specified target level. As per the provisions of the RBI Act, three of the six Members of the Monetary Policy Committee will be from the RBI and the other three Members will be appointed by the Central Government.

The Government of India, in consultation with RBI, notified the 'Inflation Target' in the Gazette of India Extraordinary dated 5 August 2016 for the period beginning from the date of publication of the notification and ending on the March 31, 2021 as 4%. At the same time, lower and upper tolerance levels were notified to be 2% and 6% respectively. Inflation rate in 2020 is 6.2% .

Monetary operations

Monetary operations involve monetary techniques which operate on monetary magnitudes such as money supply, interest rates and availability of credit aimed to maintain price stability, stable exchange rate, healthy balance of payment, financial stability, and economic growth. RBI, the apex institute of India which monitors and regulates the monetary policy of the country, stabilize the price by controlling inflation.

Instruments of monetary policy

These instruments are used to control the money flow in the economy:

Latest RBI Bank Rates in Indian Banking - 2022 RBI Repo Rate Trend Chart

Repo rate also known as the benchmark interest rate is the rate at which the RBI lends money to the banks for a short term. When the repo rate increases, borrowing from RBI becomes more expensive. If RBI wants to make it more expensive for the banks to borrow money, it increases the repo rate similarly, if it wants to make it cheaper for banks to borrow money it reduces the repo rate. Current repo rate is 4%

Reverse Repo rate is the short term borrowing rate at which RBI borrows money from banks. The Reserve bank uses this tool when it feels there is too much money floating in the banking system. An increase in the reverse repo rate means that the banks will get a higher rate of interest from RBI. As a result, banks prefer to lend their money to RBI which is always safe instead of lending it others (people, companies etc) which is always risky.

Repo Rate signifies the rate at which liquidity is injected in the banking system by RBI, whereas Reverse Repo rate signifies the rate at which the central bank absorbs liquidity from the banks.

RBI joined other central banks and slashed the repo rate, reverse repo rate and CRR to help maintain stability as a response to the Corona Virus crisis. In April 2020, RBI cut the reverse repo rate so banks will get lower interest rate which will push them to give out more loans to the general public and companies. In May 2020, they slashed repo and reverse repo rate again. RBI also extended the moratorium on payment of loans by another three months till August.

Fiscal policy refers to the budgetary policy of the government, which involves the government controlling its level of spending and tax rates within the economy. The government uses these two tools to influence the economy. It is the sister strategy to monetary policy. Although both fiscal policy and monetary policy are related to government revenues and expenditures and both seek to correct situations of excess or deficient demand in the economy, they do so in very different ways.

Origins of Fiscal Policy

Before the Great Depression, governments across the world followed the policy of Laissez-faire (or Let it be). This approach to the economy was based on the teachings of classical economists such as Adam Smith and Alfred Marshall. Classical economists believed in the power of the invisible hand of the market. They were of the opinion that the government should not interfere in the economy, as any interference in the market was uncalled for.

However, the 1929 stock market crash that ushered in the Great Depression fundamentally changed the course of economic thought. The Depression resulted in low economic demand along with high unemployment. Classical economics could not provide any solution to the crisis.

In 1936, British economist John Maynard Keynes published “The General Theory of Employment, Interest, and Money” (known simply as “The General Theory”). In it, Keynes called for an increase in government spending to combat the recessionary forces in the economy. He believed that an increase in government spending would bring about an increase in demand for commodities in the market.

Since Central bank is an autonomous body it is not under any obligation to follow Government orders/directives. In such a scenario, how do Governments increase/decrease money supply in the economy, independent of Central bank’s actions? Read on to know more.

From our article on measuring GDP, we know that both consumption by households and Government expenditure on public goods are used in calculating GDP. As consumption and/or Government expenditure increases, GDP also increases. In order to know more about how government increases/decreases money supply, first we need to understand consumption and government expenditure in detail. Consumption is contingent on income and higher the income, higher will be the consumption

How Does Fiscal Policy Work?

Proponents of Fiscal Policy utilization believe that public finance can influence inflation and employment by manipulating two key variables:

• The level of government spending or the amount of money the government spends
• The tax rate or the amount of money the government earns

Government expenditure includes building schools, roads, bridges, ports etc. It also includes expenditure on social welfare schemes as well as salaries paid to various government employees. Whenever Government increases its expenditure, it results in creation of more public goods or higher allocation to welfare schemes like education or healthcare. This leads to increased income for labourers building the road, teachers in the school or hospital workers. So we can conclude that increased Government expenditure puts more money into the hands of the people or increases their income, leading to higher GDP.

When government increases expenditure and reduces tax rate, it acts as a double booster and transfers more money to individuals. This results in increased consumption and higher GDP. Such policies are called expansionary fiscal policy. On the other hand, increasing tax rate and reducing Government expenditure, takes away money from individuals, lowering consumption and GDP. Such policies are called contractionary fiscal policy.

This can also be understood through Government’s deficit. Tax represents Government’s income and and it’s spending is the amount invested in creating public goods and implementing welfare schemes. . If the Government is spending more than what it earns, it will have a deficit. If the deficit is expanding, it could be because of increasing expenditure, decreasing tax or both. In such cases, Government is following an expansionary fiscal policy. Similarly, if Government deficit is decreasing, it is following a contractionary fiscal policy.

Monetary policy and fiscal policy are two different tools that have an impact on the economic activity of a country.

Monetary policies are formed and managed by the central banks of a country and such a policy is concerned with the management of money supply and interest rates in an economy.

Fiscal policy is related to the way a government is managing the aspects of spending and taxation. It is the government’s way of stabilising the economy and helping in the growth of the economy.

Governments can modify the fiscal policy by bringing in measures and changes in tax rates to control the fiscal deficit of the economy.

Below are certain points of difference between the monetary and fiscal policy