There are some assumptions relating to CLRM. These assumptions are necessary to show that the estimation technique, Ordinary Least Square Method has a number of desirable properties and also that the hypothesis tests regarding the coefficient estimates could be validly conducted.

The Assumptions are:

1. Linear Regression Model, that is, the model is linear in parameters and not necessarily in variables.
2. X (explanatory variable) is fixed or known to us. Hence, X is non-stochastic.
3. Mean of disturbance term, u is 0.
4. u is homoscedastic, that is, u has equal variance for all the terms.
5. There is not auto correlation between two disturbance terms, u. That is, covariance between them is 0.
6. 0 correlation between u and X. Therefore, X is exogenous.
7. Number of sample observations (n) is greater than number of parameters to be estimated.
8. Variance of X is finite, that is, greater than 0.
9. There is no specification bias or error in model, which means, all the relevant variables must be included in the linear regression model.
10. There exists no perfect linear relationship between explanatory variables.
11. Random error term u, follows Normal Distribution with mean 0.

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Latitude and economic prosperity are remarkably correlated. For instance, nations which are closer to the equator have lower levels of income per person than nations farther from the equator. Tropical climates near the equator have direct negative impact on productivity. Agriculture is more difficult in such areas, and diseases are more prevalent. This makes the production of goods and services more difficult.

Research by Daron Accmoglu, Simon Johnson, and James Robinson has suggested an indirect mechanism for the impact of geography on institutions. Their explanation is as follows,

In seventeenth, eighteenth, and nineteenth centuries, tropical climates posed an increased risk of disease like malaria and yellow fever to the European settlers. As a result, when Europeans were colonizing much of the rest of the world, they avoided settling in tropical areas like Africa etc.

In tropical climates, the colonial powers had set up authoritarian governments and institutions which aimed at taking advantage of area’s natural resources. These institutions did little to foster the economic growth of tropical regions.

The earlier institutions set up by European colonizers are strongly correlated with modern institutions in the former colonies. In tropical countries, there is less protection of property rights even today. When colonizers left, the extractive institutions were taken over by new ruling elites.

Hence, equality of institutions is a key determinant of economic performance. Where property rights are protected, people have more incentive to make investments which in turn lead to economic growth. In tropical nations, where property rights are not respected, investment and growth tend to lag behind.

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Almost from the inception of economic planning, the prevailing low level of saving and investment was assessed by the planners and then targeted to achieve a self reliant and self sustaining economic growth by achieving a sharp increase in the saving and investment rates. In the first three plan periods, the increase in saving rate was slow. From 10.4 percent of GDP, GDS rose to 14.5 percent at the end of the third plan. However, during this period, the financial infrastructure was established in the economy. During this period the household sector saving increased from 7.7 percent of GDP in 1950-51 to 9.9 percent in 1965-66. The public sector saving during the period increased from 1.8 percent of GDP to 3.1 percent of GDP, whereas the private corporate sector saving stagnated to around 1.5 percent of GDP. This low rate of domestic saving during the first three plan periods was because of low propensity to save in the agricultural sector, and because of the larger shares of agriculture in GDP. During the annual plans and the fourth plan the saving rate steadily went up to reach 18.4 percent of GDP in 1973-74. This rate of growth in saving was made possible by the increase in household saving with nationalisation of the major commercial banks along with rapid branch expansion and also by the setting up of regional rural banks. With green revolution, the income distribution in the agricultural sector became skewed and with this the propensity to save in agricultural sector increased. The public saving rate declined marginally and the private corporate saving rate stagnated.
The period 1975-70 is considered to be the high saving phase in the Indian economy. The saving rate in the economy increased to 23.2 percent of GDP by the end of the fifth plan. The tremendous growth in the saving rate was achieved because of the higher rate of saving achieved in the household sector and public sector whereas the increase in the saving rate of the private corporate sector was marginal. The special factors that were responsible for the increase in the household saving in this period were the increased foreign inward remittances which enhanced saving in the non-agricultural sector and the expansion in bank deposits as a result of branch expansion by nationalised banks. It was also found out that physical saving also increased during this period.
The sixth plan saw the fall in the GDS from 23.2 percent of GDP at the end of the fifth plan to 18.2 percent of GDP at the end of the sixth plan. This fall in the saving rate was caused due to the decline in the saving rate of all the three sectors. It was found that the growth in consumption lead to dampened household saving. The declining trend of public sector saving rate is on account of the increased dis-saving by the government administration.
There was a recovery in GDS to 22.41 percent of GDP by the end of the seventh plan. This growth rate has been almost steady. The corporate sector saving started showing steady improvements whereas the public sector saving drifted downwards due to the growth of defence expenditure, interest payments and subsidies.
During the eighth plan, the saving rate in the economy reached a new high of 25.1 percent of GDP in 1995-96, a rate comparable to developed European countries and that of the East Asian economies. This increase was made possible by the increase in the household sector’s saving to 20.3 percent of GDP and that of the private corporate sector to 3.9 percent of GDP. The public sector saving was on the downward path because of the dis-saving of the government administration to the tune of 2.4 percent of GDP. In the last year of the eighth plan and in the three years of the ninth plan, the GDS show a falling trend. By the year 1999-2000, the public saving rate has become -1.2 percent of GDP and there is a fall in the corporate saving rate during these years even though the household saving rate has improved marginally.

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The Ninth plan period ended with a growth rate of 5.70%. The Tenth five year plan aimed to transform the country into the fastest growing economy of the world. Year 2002-03 saw a growth rate of 3.88%. Investment and GDS shared 24.6 and 25.4% of the GDP respectively. 2003-04 registered a growth rate of 7.97%. Capital formation constituted 26.9% of GDP and 28.7% was shared by Gross Domestic Savings. India’s real GDP growth rate was 7.05% in the year 2004-05. Investment constituted 32.82% and GDS 32.41% of the GDP. Year 2005-06 saw a steep increase in the GDP growth rate, 9.48%. The share of investment and GDS was 34.65% and 33.44% respectively. 9.57% GDP growth rate was recorded in the year 2006-07. 35.66% of GDP was shared by Investments and 34.60% by GDS. Finally, the Tenth five year plan resulted in an average GDP growth rate of 7.59%. The Internal balance indicators stood at 31.08%, GDS and 30.76% Gross Domestic Capital Formation (% of GDP, 2004-05 series)

9.32% Growth rate was seen in 2007-08. Capital formation constituted 38.11% and savings constituted 36.82% of the GDP. Year 2008-09 saw a sharp decline in the GDP growth rate, 6.72%. During this period, the investment stood at 34.30% and GDS at 32.02% of GDP. GDP growth rate recovered to 8.59% in the year 2009-10. Investment constituted 36.30% and savings constituted 33.69% of the GDP. Year 2010-11 saw real GDP growth rate of 8.91%. 36.5% of GDP was shared by capital formation and 33.68% GDS. In the financial year 2011-12, again a steep decline in real GDP growth rate was seen, 6.69%. During this time, 36.4% and 31.35% of GDP was constituted by Investment and Gross domestic savings respectively. Hence, the Eleventh Five Year Plan recorded an average of 8.046%. The Internal balance indicators were 33.51% and 36.56% for GDS and Investment respectively.

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In a developing country like India, savings have generated a topic of discussion among policy makers and economists. In spite of other macroeconomic factors like inflation, consumption, etc being there, savings have always been a major determinant in the growth of the country. The neo-classical growth theory also states that savings are an integral part of the economic process of a country. Growth is an integral part of a country’s development. Since the growth in some of these economies is often considered resource intensive rather than technology intensive, savings are likely to play a very important role in promoting real growth. According to a number of studies undertaken, savings in most cases have a positive effect in the growth of a nation.

Growth models emphasizing capital accumulation (Solow and AK models), tell us that higher savings rates lead to growth because higher savings imply higher capital investment. Though, the endogenous growth theory states that the growth of the economy also depends on endogenous factors like innovation, human capital and knowledge. Talking about personal savings, according to the life cycle hypothesis, savings are a major part of an individual’s life cycle.

According to, Franco Modigliani people save—accumulate assets—to finance their retirement, and they dis-save—spend their assets—during retirement. The more young savers there are relative to old dis-savers, the greater will be a nation’s saving rate. The life cycle hypothesis stated that a higher rate of growth means higher level of savings, indicating a bi-directional relationship. According to studies, we gathered that countries with higher saving or investment rates have tended to have higher growth rates (see Levine and Renelt, 1992, for a review). This finding has been interpreted as being consistent with either the traditional Solow (1956) growth model, in which higher saving leads to higher level of income per capita in steady state (and thus to higher growth rates on the transition path), or with the “new growth models” of Romer (1987) and others in which higher saving leads to a permanently higher rate of growth. Government policies are also a major determinant of the savings and growth in a country. It is the policymakers who have to ensure a steady level of savings for the growth of the country’s economy. The growth of a country is in the hands of its people, but the government has to ensure that the growth remains steady and that the people save enough to make the country economically better.

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Uncertain Payoffs: Risky choices often have financial consequences, also known as payoffs. Payoffs can be either positive (gains) or negative (losses). To evaluate a choice we need to know the likelihood of each possible payoff occurring. Like other consequences, payoffs depend on unfolding events, in other words, on the state of nature. As long as we know the probability of each possible state of nature, we can determine the probability of each possible payoff.

To evaluate a choice with risky financial prospects, we usually begin with two simple questions. First, what do we expect to gain or lose, on average? Second, do we expect the actual gain or loss to be close to that average or far from it?

Expected Variability: To determine the average gain or loss from a risk financial choice, we can calculate it’s expected payoff. The expected payoff is a weighted average of all the possible payoffs, using the probability of each payoff as its weight.

Variability: Economists gauge financial risk by measuring the variability of gains and losses. Roughly speaking, variability is low when range of likely payoffs is narrow, and high when the range is wide.  With little variability, the actual payoff is almost always close to the expected payoff.  Histograms can help us visualize variability.

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Risk exists whenever the consequences of a decision are uncertain. While analyzing risks and gauging their magnitude, the following concepts are involved.

Possibilities: The consequences of any risky decision depend on events outside the decision makers control. Usually, events can unfold in many different ways. Each possible unfolding of events is refered to as a state of nature.

For example, suppose that Rohit is trying to decide whether to buy tickets to a baseball game. His enjoyment of the game will depend on two uncertain events that are beyond his control: whether it rains and whether his team wins. He will be happiest if it does not rain and his team wins. That is one possible state of nature.

To analyze a risky decision, economists begin by describing every possible state of nature. In the above example, there are four possible states of nature. Try answering?

Probability: Some states of nature are more likely than others. Probability is a measure of the likelihood that a state of nature will occur. It’s usually written either as a number between 0 and 1 or as a percentage. A probability of 0 means that a state is impossible, a probability of 1 means taht it is certain. A probability of 3/4 means that the odds of the state in question occurring are three out of four. The probabilities of all states of nature always add up to 1, because it is certain that something will happen.

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David Hume and his contemporaries suggested that economic variables should be divided into two groups.

The first group consists of nominal variables – variables measured in monetary units. The second group consists of real variables – variables measured in physical units.

For example, the income of corn farmers is a nominal variable because it is measured in rupees, whereas the quantity of corn the produce is a real variable because it is measured in bushels. Nominal GDP is nominal variable because it measures the rupee value of economy’s output of goods and services; real GDP is a real variable because it measures the total quantity of goods and services produced and is not influenced by current prices of those goods and services. The separation of real and nominal variables is called the classical dichotomy.

Most prices are quoted in units of money and, therefore, are nominal variables. When we say that the  price of corn is Rs. 2 a bushel or that price of wheat is Re. 1 a bushel, both prices are nominal variables. But we can also say that the price of a bushel of corn is 2 bushels of wheat. This is relative price, it is not measured in terms of money. Hence, relative prices are real variables.

The classical dichotomy is useful because different forces influence real and nominal variables. According to classical analysis, nominal variables are influenced by developments in economy’s monetary system, whereas money is largely irrelevant for explaining real variables.

Changes in the supply of money, according to classical analysis, affect nominal variables but not real ones. When the central bank doubles the money supply, the price level doubles, the rupee wage doubles, and all other rupee values double. Real variables, such as production, employment, real wages, and real interest rates, are unchanged.

The irrelevance of monetary changes for real variables is called monetary neutrality.

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How Credit Cards and Debit Cards fit into the monetary system??

Many people use credit or debit cards to make purchases. Because money is the medium of exchange, one might naturally wonder how these cards fit into the measurement and analysis of money.

Let’s start with credit cards. Although one might guess that credit cards are part of economy’s stock of money, in fact measures of quantity of money do not take credit cards into account. Credit cards are not really a method of payment but a method of deferring payment. When you buy an item with credit card, the bank that issued the card pays the store what is due. Later, you will have to repay the bank. When the time comes to pay your credit card bill, you will likely do so by writing a cheque against your account. The balance in this account is part of economy’s stock of money.

The story is different with debit cards, which automatically withdraw funds from a bank account to pay for items brought. Rather than allowing users to postpone payment for their purchases, a debit card allows users immediate access to deposits in their bank accounts. Using a debit card is similar to writing a cheque. The account balances that lie behind debit cards are included in measures of the quantity of money.

Even though credit cards are not a form of money, they are still important for analyzing the monetary system. Because people with credit cards can pay many of their bills all at once at the end of the month, rather than sporadically as they make purchases, they may hold less money on average than people without credit cards. Thus, the increased popularity of credit cards may reduce the amount of money that people choose to hold. In other words, credit cards are not part of the supply of money, but they may affect the demand for money.

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EFFECT

(noun)

• A change which is a result or consequence of an action or other cause.
• Cause (something) to happen; bring about.

AFFECT

(verb)

• to have an effect on; make a difference to.
• touch the feeling of.

There is often confusion over the words effect and affect. In order to understand which to use, one must know the difference between a noun and a verb. Effect is a noun. Affect is a verb.

Trick to spot Effect

The word effect can mean outcome, consequence, or appearance. Try using one of these instead of effect. If the sentence still makes sense, then effect is almost certainly correct because, effect is a noun, just like the words outcome, consequence, and appearance.

Example:

The effects of the Tylenol should be felt within twenty minutes.

(Try substituting the noun effect with the noun consequence. “The consequences of the Tylenol should be felt within twenty minutes.” < sounds ok; hence, effect is correct)

White paint will give the effect that the room is very large.

(Try substituting the noun effect with the noun appearance. “White paint will give the appearance that the room is very large.” < sounds ok; therefore, effect is correct)

Trick to spot Affect

The word affect can mean transform. Try using the verb to transform (transforming, transformed, transforms) instead of effect. If the sentence still makes sense, then affect is almost certainly correct.

Example:

His speech affected my outlook towards life.

(Try substituting the verb affected with verb transformed. “His speech transformed my outlook towards life.” <makes sense; hence, affect is correct)

The price of gasoline affects the economy.

(Try substituting the verb affects with the verb transforms. “The price of gasoline transforms the economy.” <sounds ok; hence, affect is correct)

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