Expectations play a major role in determining the reality. Specifically, expectations have a significant role in the occurrence of economics events. Various economic events are just the reflection of its expectations.

The theory of rational expectations tells that the expectations formed by using all the relevant information drives the whole economy and indicates what the future state of economy would be.

Sometimes it is the expectations itself that leads to the actual happening of that event. To get a clear view, think about the share prices in the capital markets.

Share prices

Prices in stock market vary according to the changes in the forces of demand and supply. But what changes the demand and supply is the expectations prevailing in the market. If a share is expected to give higher returns, its demand will increase. This increase in demand causes the share price to rise eventually. Thus returns are increased by trading the share. It is ‘self fulfilling expectation’.

Generally, share prices are rather dependent on irrational expectations. And that is what accounts for the losses from trading in stock market. People usually engage in herd behavioral trading. Blindfolded, influenced by others and without using rational information they end up incurring losses.

Inflation

The same phenomenon applies to inflation. Inflationary expectations are one of the factors that lead to the actual inflation. Expectation of high prices in future tends the agents to increase the wages (so that real wage is unaffected), raising the expenses and thus raising prices. Here just an expectation of high inflation causes it to actually happen.    

We can see the pre-monsoon inflation situation on similar notes. The revised forecast by Meteorological department indicated a poor monsoon. Risk of drought was dwelling over several parts of the country. There was expectation of rise in food inflation in the near future. Moreover, the recent cut in the repo rate by 0.25% was expected to stimulate spending in the economy and will result in increase in inflation to a bit. Using the relevant information, economic agents formed rational expectations. The RBI too raised the inflation forecast of January 2016 from 5.8% to 6%.

Aggregate Demand

Consumption and aggregate demand are also affected by how the expectations are formed. An expectation of increase in income in the future increases the current consumption. If everyone believes the same then, this will lead to an increase in the aggregate demand for goods and services in the economy. Thus production will rise and national income will increase fulfilling the expectation of increased income.

*****

Expectations strongly influence the reality. They help in forming current decisions based on future predictions.

Also, it is not always the same as predicted and should not be confused with exact replica of expectations, rather it is considered an important determinant of uncertain future. Hence it is important that economic agents make rational expectations using all required information and take decisions accordingly.

It is rightly said that “Failing to plan is planning to fail”.

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The recent speech by Shashi Tharoor at the Oxford University was highly appreciated and praised. His arguments about the economic and social conditions of India during the British raj were very well placed. And he concluded by proving that Indeed, Britain owes India a lot. So, let’s understand the economic scenario of India during the colonial rule. Following are the facts that reveal the effect of colonial rule on the economy of India:

• Sectors of economy: During the pre colonial period and also during the colonial period, Indian economy was dominated by agriculture sector. The major part of the GDP came through the agricultural contribution. After the British invasion as well, the agriculture sector grew. Any change in the agriculture sector was clearly reflected on the GDP. But the composition of agricultural produce changed drastically. Earlier India exported finished goods and imported raw materials. After the changes in the agricultural policies, which were directed to grow specific crops, India became the importer of finished goods and exporter of raw materials mainly to Britain. After the World War I there was a global agricultural crisis.

Contribution of Industry to the national income was very low. Indian cotton textile Industry suffered a lot. After the industrial revolution in the Europe, production of cloth with the help of machines gave a stiff competition to the Indian cotton textiles. India not only lost its export market but also its internal demand. This critically affected the small scale industrial sector of Indian economy.

• Employment structure: There was stagnation in the composition of occupation in various sectors. Employment in agriculture was the highest with around 75%; Industry had around 10% and 15% in services. The tax system was aimed at extracting the maximum benefits out of the income of people. The zamindari system is one example. People employed were forced to pay high taxes irrespective of their agricultural produce. In order to pay the taxes people used to take loans and never come out of the payment cycles. The per capita income was very low. Slavery was highly popular in those days. During the World War I around 1,780,000 Indian men were sent from India to be a part of the British army. Among them 74,187 died and 67,000 were wounded.
• Growth: During pre world war period, the growth rate of national income was around 2%. The rate of growth of the per capita income was also positive. But, after the year 1921, i.e. when the world was moving towards the great depression, the growth was nearly 1%. And there was no growth in the per capita income. During the inter war period there was a downturn of the Indian economy. The British adopted a contractionary monetary policy during the great depression. This is a perverse behavior as during crisis, economies opt for an expansionary monetary policy. Thus British policies aimed at deterioration of the Indian economy.

These are a few indicators of British rule’s impact on Indian economy. Not only economically, but also socially British rule was a black phase for India. Lives of many people lost because of the poverty, starvation persistent in those days. Truly, Britain owes India a lot which cannot be paid in monetary terms.

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The central bank is the apex institution which facilitates the working of commercial banks and regulates the monetary decisions for the economy. The central bank controls money supply and interest rates by using the monetary policies. Central bank is the bank of the commercial banks. It is the lender of the last resort. For a developing country, central bank is a significant body which accelerates the growth of the economy. Here are a few important roles played by the central bank in a developing country:

• Money Control: Any change in the money supply affects the price level of the economy. If the money supply is increased, there will be an increase in the price level and vice-versa. Hence, central bank has a major role in maintaining the equilibrium between the demand and supply of money. Central bank directly controls the supply of money and can influence the demand for money for various purposes by using appropriate monetary policy.
• Interest rate: Interest rates are an important determinant of the investment demand in the economy. Central bank by regulating the money supply, can change the interest rates and thus can stimulate investment. For example, if the central bank wants to increase the investment demand it will increase the money supply. An increase in the money supply will reduce the interest rate and borrowings will be cheaper. People will borrow and invest these funds. Therefore investment in the economy has been increased.
• Balance of payments: The central bank controls the foreign exchange reserves and helps to solve the balance of payments problem faced by the government. When the imports exceeds the exports i.e. expenditure exceeds the income, central bank uses its foreign currency reserves to pay the balance. The central bank also maintains the stability of the domestic currency. It avoids fluctuations in the currency by a process of buying and selling of foreign reserves.
• Economic growth: Central bank facilitates the working of the commercial banks and encourages new banks to come up. It helps in rural development by extending the commercial bank branches to rural areas. It helps in the establishment of various financial institutions which helps in the country’s growth.

By performing all the above stated roles, central bank aims at the economic development of the country. In situations of economic difficulties it is the central bank which tries to stabilize the economy. Central bank is the apex institution of economic growth in the country.

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Black money, as you all must know, is the money earned in the parallel economy or generated through illegal activities and for which the tax has not being paid. Black money and money laundering is a major concern in India. According to some reports, Indians have $500 billion of black money in foreign countries which are tax havens. India loses a lot of amount on which the tax is unpaid and this is restricting growth potential of India. But, now suppose the government is able to bring back the black money. What will be the impact of black money back in India?

There are both positive and negative impacts of such a situation. Let’s begin with the positive effects:

• Increase in Foreign reserves: Because $500 billion money would be back in the form of dollars, the forex reserves in India will increase. This will help in the strengthening of the Indian national rupee. Imports will be cheaper. Oil imports and other imports could increase. As the food inflation is also determined by the cost of oil import, inflation will fall.
• Development projects: India can complete various development projects which are currently being halted due to lack of funds. A huge population of India is still poverty stricken. Availability of large funds will enable the government to speedily remove the gap between the rich and the poor. As world class infrastructure will be build up, growth opportunities in the country will increase. Development will thus increase the standard of living of the people. There is a possibility of per head increase in the income.
• Debt repayment: India can easily meet the foreign loan obligations and can allow balance of payments equilibrium. Credit rating of the country will also increase. The burden of the budget deficit will be reduced.

We should also be aware of the possible negative effects of bringing black money back in the country:

• Increase in Inflation: The income of all the individual in the country will increase. Thus there will be a sudden increase in the aggregate demand. Due to the tendency of people to spend more, prices of goods and services in the domestic currency will increase. Rise in inflation can have its own negative effects which will be adequate to affect the economy.
• Misallocation of funds: For getting maximum benefits these funds must be invested in appropriate resources. There is a possibility of misallocation of resources by the government due to their inability to frame significant policies. Moreover, instances of corruption within the government framework may also increase.

These are some of the expected impacts of a sudden increase in the government funds. Benefits are more and the negative impacts could be easily avoided. Thus for a developing country which is still struggling with poverty, starvation and poor health & education, bringing back the country’s own money is vital. But, nobody knows whether the day when all the black money is brought back will ever come or not.

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There has been a sudden drop in the gold prices in India and other Asian countries. The gold price dropped drastically on 20^th July 2015. The price plunged to rupees 25,250 in India, which is a two year low level and the biggest fall in the current fiscal. In the international market the gold price fell to $1089 which is the lowest in the five years. But, people are wondering what is causing the gold prices to plummet so massively? Here are a few reasons which are responsible for the sudden drop:

• Dollar strengthening: There is an inverse relationship between the U.S. Dollar and the gold prices. For example, when the dollar loses its value, gold becomes cheaper to invest and its demand increases. As a result, gold prices increase when dollar falls. Recently, the Federal Reserve Bank has announced the possibility of interest rate hike in the September. Due to the expectations of increase in interest rates, investors are willing to invest in dollar for earning better returns. This increase in demand for dollars is shooting its price up. Hence, the gold prices are plummeting. In the previous month, dollar price touched a three month high value against currencies of some other countries. This makes the gold more expensive to buy and therefore its demand is reduced.
• Chinese markets: The gold reserves in china accounts for 1.65% of the total foreign exchange reserves. But in 2009 the reserves were about 1.8% of the total reserves. There has been a decline in the demand for gold from china which was, on the other hand, expected to invest more in the gold reserves. Moreover, there has been massive selling of gold in the Chinese market on Monday. Around 33 tons of gold has been sold in the shanghai market. This has led to the drastic fall in the gold price.
• Policies against gold import: Recent development made by both the government and the Reserve Bank of India in the import policies for gold is also one of the reasons for this fall. Some measures have been taken to reduce gold imports in order to induce investment demand in other equities. Due to lack of demand, the price of gold has fallen.
• Uncertainty in the international market: Due to the Greek crises and the recent trends of slowdown in the world economy, there is uncertainty and fear in the minds of investors. They are moving towards investment in a safer commodity rather than an unfavorable one. Because dollar is considered the safest, there has been a shift from speculative commodities to safer commodities.

These are some of the reasons responsible for the sudden fall. Market watchers and policymakers are keenly watching the trends and are hopeful that the situation will be changed. They believe that this is a sudden impact but the prices will stabilize soon.

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After reading the title of the article everyone must be thinking- negative interest rates, really? We all are familiar with the term ‘interest rates’. It means the additional amount that a borrower has to repay along with the principle lending amount or it means the additional amount earned on lending money to someone. But what would a negative interest rate mean? Yes you are right! Negative interest rate implies that the borrower gets additional amount as interest on the amount it borrows. For example if the interest rate on a sum of $100 is -2%, it means that the borrower, along with the amount $100, will get an interest of $2 instead of paying interest to the lender.

The main purpose of such negative interest rates is to encourage borrowings and stimulate investment in the economy. When a central bank charges negative interest rate it means that people will need to pay interest in order to deposit their cash in the banks. This is done to encourage people to spend their money and increase the aggregate consumption. This increase in aggregate demand will lead an increase in the national income and hence will be beneficial for the economy. Central bank implements such interest rates by its monetary policy.

The euro zone is first to adapt a negative interest rate policy. The European Central bank (ECB) set the depository rates at -0.2% in the month of September 2014. The reason behind this stern move is the deflationary pressures in European economies. This is done in order to stimulate the economy towards spending so that inflation is increased and concerns about deflation are removed. Lack of spending implies lower national income, thus lower investment, lower employment, and it indicates falling of an economy. European countries like Sweden, Denmark, and Switzerland etc. have lowered the interest rates below zero with an aim of encouraging inflation. The European countries are coming to grips with Unemployment and stagnation.

Another reason why ECB is setting negative interest rates is to lower the currency value. As investors will move away from the country due to lower returns, the value of Euro will fall. This will result in increased competitiveness of European goods in the world market and hence increased exports. Now this increase in demand will help them to recover. For them supply is no problem but demand is.

Policymakers in Europe are immensely worried about the deflationary spiral and negative interest rate is one of the indications. They are trying to avoid any crisis and therefore, hoping an increase in inflation with such interest rates policies. But there is no surety that negative interest rate will definitely work. Sometimes such policies may backfire. One problematic situation could be the moment when the banks stop lending at such lower rates or even negative rates in an attempt to reduce their losses. Also, even after getting enough money, people may not spend at current prices with an anticipation of lower prices in future.

It’s very strange that such policies have been implemented and are considered with all the hope to avoid harsh times like financial crises. European policymakers are just giving it a try!

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Foreign exchange reserves is defined as the reserves of foreign currency kept as assets with the central bank. The quantity of the reserves can be affected by the monetary policies introduced by the central bank. The purpose of keeping foreign reserves is to import foreign goods and services and is primarily used to maintain a steady exchange rate by the central bank.

The foreign exchange in India has reached great heights and is said to be sufficient for funding 11 months imports. In the last month, the foreign exchange reserves touched a lifetime high of $355.46 billion. There had been a small dip in the reserves in the first week of July and currently the reserves are $354.5 billion. India has become one of the top nine foreign reserves holders in the world. In the words of S S Mudra, the deputy governor of the RBI – “Our reserves are at a reasonable level now”. In the last financial year the central bank had added $1.4 billion reserves whereas within the two months of the current fiscal the level has reached to $8 billion. It is therefore assured that India won’t be much affected by the Greek crisis or the crash of Chinese stock exchange.

Here are the benefits and purpose of keeping large amounts of foreign exchange reserves:

• Stabilize exchange rate: Central bank uses the foreign exchange reserves to stabilize the exchange rate. This is done in the form of buying and selling domestic currency in exchange of foreign currency in the world market. Suppose the dollar to rupee exchange rate is 1$ = 80 and the central bank want to revalue the rate, then, central bank will buy the domestic currency in exchange of the foreign currency ( from the reserves it holds) so that the supply of dollar is increased in the rest of the world and hence its price falls. If there will be no foreign reserves, then a central bank cannot influence the exchange rate. Therefore, having high reserves of foreign exchange implies exchange rate stability.
• Imports funding: Domestic country would be able to buy foreign goods if the forex reserves are adequate. It is used to meet all payment obligations in the rest of the world. The country will be able pay all its dues and achieve a balance of payment equilibrium. As the country will pay foreign debt easily, its credit rating will increase and hence better growth prospects. Adequacy of foreign exchange reserves is considered when it is sufficient to meet imports for three months and external debts becoming due in the near future.
• Precautionary holdings: In situations of financial crises, countries having low reserves suffer a lot. One example is the Asian crises. Countries like Malaysia, South Korea, Indonesia, Thailand etc. ran out of foreign exchange and the economies suffered a lot. Therefore, central banks keep foreign exchange reserves for precautionary purpose as well.

India is the leader of the growth in Asian economies in the current fiscal. No doubt, it is an epoch of development and growth for Indian economy.

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In the article ‘tragedy of the commons’ I have explained the importance of property rights and optimal utilization of resources. (In case you missed it check it here). The essence of the article was that property rights must be well defined. Failure to define the property rights might lead to externalities and economic inefficiencies. Now, if the property rights are well defined then does the distribution of property rights affect the economic outcome?

This answer was given by Ronald Coase by his famous theorem known as ‘the coase theorem.’ The theorem states that the optimal amount of the good involved in the externality is independent of the distribution of the property rights. It means that it doesn’t matter who has the property rights, the outcome will be efficient in all the cases. This arises because the parties will bargain with each other and it will lead to a Pareto optimal allocation. Let’s understand it by an example.

Suppose there are two roommates A and B. A likes to listen loud music but B doesn’t and hence externality arises. In the first case let person A has been allotted property rights to listen to loud music. In such a situation person B will suffer. In the absence of trade, the outcome is not efficient as both A and B could be made better off by trade. Therefore, Person A would like to sell some of his property rights to B and can receive money or any desirable good in return. This trade will result in a Pareto efficient allocation. Now think from the opposite end, suppose B has the legal right to noise free environment. In this case B can trade his property rights in order to get valuable things in return. Again the outcome will be optimal. Hence, as long as transaction costs are low, parties can bargain and trade their rights to achieve a mutually beneficial outcome, which is regardless of whom the property rights were allotted. There can be difference in the payments made in each case, but the efficient level of the good will remain the same.

This theorem is useful in many government decisions regarding property rights and externalities. One real life example is – Caithness Energy, a company in Oregon, offered $5000 to the households residing near the turbines of the company so that, they do not complaint about the loud noise the turbines create.

The coase theorem is an important contribution to the modern economics and is highly used in resolving legal issues relating to externalities. Because of his great work, in 1991, Ronald Coase was awarded with a Nobel Memorial Prize in Economic Sciences.

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A government budget comprises of expected revenue and expenditure during a fiscal year. There are two parts in a budget- Revenue budget and capital budget. A budget is said to be in surplus if the revenue is greater than the expenditure. But if the expenditure exceeds the revenue then there exists budget deficit. In simple words, a deficit occurs when the government spends more than it earns in the form of taxes and other sources. The excess expenditure is financed by either borrowing from capital markets or from the central bank.

There are different types of budget deficits depending upon the type of revenue and expenditure. The three forms of deficit are:

• Revenue deficit: Revenue deficit occurs when the total revenue expenditure exceeds total revenue receipts. The revenue receipts consists of tax revenue and non tax revenue like fees, fines etc. The revenue expenditure, on the other hand, means expenditure which doesn’t create any assets like salaries of employees, subsidies etc. Revenue deficit is an indication that the government is not able to meet its own expenditure from the revenue receipts. The revenue has to be met by borrowing. High Revenue deficit is considered dangerous as it implies a higher repayment debt. In order to avoid the deficit, a government should either curtail its expenditure or increase the taxes.

Revenue deficit =Total revenue expenditure –Total revenue receipts 

• Fiscal deficit: Fiscal deficit refers to the excess of total expenditure over total receipts excluding borrowings during a fiscal year. It is the amount of borrowings that the government needs to meet its expenditure. A higher fiscal deficit implies a higher borrowings and hence, a higher payment obligation. It is recommended that fiscal deficit must be less than 5% of the GDP, otherwise as the borrowing increases, the government’s liability increase not only for the loan repayment but also for the interest payment. A high fiscal deficit may also lead to inflationary pressure.

 Fiscal deficit =Total expenditure –Revenue receipts –Capital receipts(excluding borrowings)

• Primary deficit: Primary deficit refers to the excess of total expenditure over total receipts excluding borrowings and interest payments. In other words it is fiscal deficit minus interest payments. It tells how much the government needs to borrow to meet its current year’s expenditure. It doesn’t include the interest payments. If primary deficit is zero then, fiscal deficit is equal to interest payments on earlier loans. Therefore, it implies that the government has borrowed just to pay its interest.

 Primary deficit =Fiscal deficit –Interest payments

Although the existence of primary deficit and revenue deficit are considered dangerous, a safe limit of fiscal deficit (within 5%) is a sign of growing economy. If the fiscal deficit occurs as a result of increased capital expenditure i.e. expenditure on building infrastructure or on fixed assets, then it is advantageous for the country.

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“World Bank and international monetary fund aren’t they the same? They both ensure the economic stability of the world economy, then what’s the difference?”- This is a common reply when people are asked about the difference between the World Bank and IMF. Most people tend to get confused between the two because they both concentrate on economic issues and help their member countries whenever required. The difference lies in their purposes and functions. IMF and the World Bank are collectively known as the Bretton Woods Institutions and were established in the year 1945.

World Bank: The primary purpose of the World Bank is to help its member nations in their economic development. The World Bank finances the major development projects of any country in order to help in its growth prospects. It is a development institution which offers loans to the poorer nations and the developing nations with the aim of increasing the standard of living of the people living in those countries. The initial work of the World Bank after its launch was focused on rebuilding the infrastructure of the countries affected by the World War II. The major organizations that come under World Bank are: international bank for reconstruction and development (IBRD) and International development association (IDA).

• IBRD: It gives loans for the commercial projects or profitable projects if a country like building of world class infrastructure like dams, highways etc. It charges a higher rate of interest and has a fixed no. of years for repayment of the loan.
• IDA: It generally gives loans for the social infrastructure programs like health, education etc. Here interest is not charged and longer periods of repayment are provided.

International Monetary Fund: The primary purpose of IMF is maintaining international monetary cooperation among its member countries. It oversees the monetary policies and exchange rate policies of its members. It aims at supervising economic policies that affect the balance of payments of countries, thereby providing suggestions in case of any potential problem. It also provides monetary assistance to the countries whenever they face a crisis. IMF gives loans to the countries in serious crises which are unable to meet its foreign payment obligations and suffer from balance of payment deficit. The loans are given under certain terms and conditions which the recipient country must follow. The member nations contribute some amount at the time of joining which along with the contribution of other members is used for giving financial assistance whenever needed in future. IMF is the lender of the last resort.

“World Bank is a development institution while International Monetary Fund (IMF) is cooperative institution”

World Bank is a bank and obtains its funding from investors around the world and from that, gives loans to the governments of poor nations for development projects. Whereas IMF is a fund, which uses the pooled money, obtained by the member countries (182) at the time of joining, and uses that for assisting nations with economic crisis.

These institutions may differ in their functions and purposes but, they share the same objective of economic growth and welfare of the member countries.

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