Demand For Money Factor of Inflation

Money is a narrowly defined term which includes things like paper currency, travellers checks, and savings accounts. It doesn't include things like stocks and bonds, or forms of wealth like homes, paintings, and cars. Since money is only one of many forms of wealth, it has plenty of substitutes. The interaction between money and its substitutes explain why the demand for money changes.

We'll look at a few factors which can cause the demand for money to change.

1. Interest Rates

Two of the more important stores of wealth are bonds and money. These two items are substitutes, as money is used to purchase bonds and bonds are redeemed for money. The two differ in a few key ways. Money generally pays very little interest (and in the case of paper currency, none at all) but it can be used to purchase goods and services. Bonds do pay interest, but cannot be used to make purchases, as the bonds must first be converted into money. If bonds paid the same interest rate as money, nobody would purchase bonds as they are less convenient than money. Since bonds pay interest, people will use some of their money to purchase bonds. The higher the interest rate, the more attractive bonds become. So a rise in the interest rate causes the demand for bonds to rise and the demand for money to fall since money is being exchanged for bonds. So a fall in interest rates cause the demand for money to rise.

2. Consumer Spending

This is directly related to the fourth factor, "Demand for goods goes up". During periods of higher consumer spending, such as the month before Christmas, people often cash in other forms of wealth like stocks and bonds, and exchange them for money. They want money in order to purchase goods and services, like Christmas presents. So if the demand for consumer spending increases, so will the demand for money.

3. Precautionary Motives

If people think that they will suddenly need to buy things in the immediate future (say it's 1999 and they're worried about Y2K), they will sell bonds and stocks and hold onto money, so the demand for money will go up. If people think that there will be an opportunity to purchase an asset in the immediate future at a very low cost, they will also prefer to hold money.

4. Transaction Costs for Stocks and Bonds

If it becomes difficult or expensive to quickly buy and sell stocks and bonds, they will be less desirable. People will want to hold more of their wealth in the form of money, so the demand for money will rise.

5. Change in the General Level of Prices

If we have inflation, goods become more expensive, so the demand for money rises. Interestingly enough, the level of money holdings tends to rise at the same rate as prices. So while the nominal demand for money rises, the real demand stays precisely the same.

6. International Factors

Usually when we discuss the demand for money, we're implicitly talking about the demand for a particularly nation's money. Since Canadian money is a substitute for American money, international factors will influence the demand for money. The following factors can cause the demand for a currency to rise:

1. An increase in the demand of that country's goods abroad.
2. An increase in the demand for domestic investment by foreigners.
3. The belief that the value of the currency will rise in the future.
4. A central banking wanting to increase its holdings of that currency.

Demand for Money Wrap Up

The demand for money is not at all constant. There are quite a few factors which influence the demand for money.

Factors Which Increase the Demand for Money

1. A reduction in the interest rate.
2. A rise in the demand for consumer spending.
3. A rise in uncertainty about the future and future opportunities.
4. A rise in transaction costs to buy and sell stocks and bonds.
5. A rise in inflation causes a rise in the nominal money demand but real money demand stays constant.
6. A rise in the demand for a country's goods abroad.
7. A rise in the demand for domestic investment by foreigners.
8. A rise in the belief of the future value of the currency.
9. A rise in the demand for a currency by central banks (both domestic and foreign).

Cost-Push Inflation vs Demand-Pull Inflation

Definition of Cost-Push Inflation

Inflation can result from a decrease in aggregate supply. The two main sources of decrease in aggregate supply are

• An increase in wage rates
• An increase in the prices of raw materials

These sources of a decrease in aggregate supply operate by increasing costs, and the resulting inflation is called cost-push inflation

Other things remaining the same, the higher the cost of production, the smaller is the amount produced. At a given price level, rising wage rates or rising prices of raw materials such as oil lead firms to decrease the quantity of labor employed and to cut production.

Definition of Demand-Pull Inflation

The inflation resulting from an increase in aggregate demand is called demand-pull inflation. Such an inflation may arise from any individual factor that increases aggregate demand, but the main ones that generate ongoing increases in aggregate demand are

1. Increases in the money supply
2. Increases in government purchases
3. Increases in the price level in the rest of the world.

The three most likely causes of an increase in aggregate demand will also tend to increase inflation:

1. Increases in the money supply This is simply factor 1 inflation.

2. Increases in government purchases The increased demand for goods by the government causes factor 4 inflation.

3. Increases in the price level in the rest of the world Suppose you are living in the United States. If the price of gum rises in Canada, we should expect to see less Americans buy gum from Canadians and more Canadians purchase the cheaper gum from American sources. From the American perspective the demand for gum has risen causing a price rise in gum; a factor 4 inflation.

What is Inflation??

To understand inflation, we first must understand what the word means. The Economics Glossary defines Inflation as:
Inflation is an increase in the price of a basket of goods and services that is representative of the economy as a whole.

Because inflation is a rise in the general level of prices, it is intrinsically linked to money, as captured by the often heard refrain "Inflation is too many dollars chasing too few goods".

To understand how this works, imagine a world that only has two commodities: Oranges picked from orange trees, and paper money printed by the government. In a year where there is a drought and oranges are scarce, we'd expect to see the price of oranges rise, as there will be quite a few dollars chasing very few oranges. Conversely, if there's a record crop or oranges, we'd expect to see the price of oranges fall, as orange sellers will need to reduce their prices in order to clear their inventory. These scenarios are inflation and deflation, respectively, though in the real world inflation and deflation are changes in the average price of all goods and services, not just one.

We can also have inflation and deflation by changing the amount of money in the system. If the government decides to print a lot of money, then dollars will become plentiful relative to oranges, just as in our drought situation. Thus inflation is caused by the amount of dollars rising relative to the amount of oranges (goods and services), and deflation is caused by the amount of dollars falling relative to the amount of oranges.

Thus, Inflation is caused by a combination of four factors:

1. The supply of money goes up.
2. The supply of other goods goes down.
3. Demand for money goes down.
4. Demand for other goods goes up.

Fiscal Deficit & GDP

The fiscal deficit is the difference between the government's total expenditure and its total receipts (excluding borrowing). The elements of the fiscal deficit are (a) the revenue deficit, which is the difference between the government’s current (or revenue) expenditure and total current receipts (that is, excluding borrowing) and (b) capital expenditure. The fiscal deficit can be financed by borrowing from the Reserve Bank of India (which is also called deficit financing or money creation) and market borrowing (from the money market, that is, mainly from banks).

Nominal GDP Growth vs. Real GDP Growth

GDP, or Gross Domestic Product is the value of all the goods and services produced in a country. The Nominal Gross Domestic Product measures the value of all the goods and services produced expressed in current prices. On the other hand, Real Gross Domestic Product measures the value of all the goods and services produced expressed in the prices of some base year. An example:
Suppose in the year 2000, the economy of a country produced $100 billion worth of goods and services based on year 2000 prices. Since we're using 2000 as a basis year, the nominal and real GDP are the same. In the year 2001, the economy produced $110B worth of goods and services based on year 2001 prices. Those same goods and services are instead valued at $105B if year 2000 prices are used. Then:
Year 2000 Nominal GDP = $100B, Real GDP = $100B
Year 2001 Nominal GDP = $110B, Real GDP = $105B
Nominal GDP Growth Rate = 10%
Real GDP Growth Rate = 5%

Similar is the case for Interest. General rates as we understand are nominal interest rates (quoted by Banks and all) but we adjust the inflation then remaining part is the real interest rates.

GDP is an indicator of size/growth for a country's economy. Its not purchasing power, nor cash reserves, nor net profit or any other term.
GDP = Consumption + Govt Exp + Investments + (Export - Imports)

Increase/Decrease in Imports do not have any effect on GDP. An increase in import would result in increase in consumption too, hence it nullifies the entire thing. GDP would remain constant. However surplus in production could mean increase in exports (depending on the global demand of the product and assuming that the consumption is same) and hence increase in GDP.

Now lets say a product has been manufactured at a cost of $1500. If this product is not sold and kept as inventory, as of now it is added in investment at $1500 but the moment it is sold the selling price is added in consumption and $1500 is taken out from investment. If selling price of this item is only$1 then net effect of this product will still be $1 and not the cost of raw material and labor put to creat this product. In case the product is not sold then at some time it may be scrapped and that year it will be taken out of investment.

Opportunity Cost

In economics, Opportunity cost(economic cost) is the cost of something in terms of an oportunity forgone (and the benefits that could be received from that opportunity), or the most valuable forgone alternative, i.e. the second best alternative.

For Eg: If a city decides to build a hospital on the vacant land that it owns, the opportunity cost is some other thing that might have been done with the land and construction funds instead. In building the hospital, the city has forgone the opportunity to build a sporting center on that land, or a parking lot, or the ability to sell the land to reduce the city's debt, and so on.

Opportunity cost need not be assessed in monetary terms, but rather can be assessed in terms of anything that is of value to the person or persons doing the assessing. For example, a person who chooses to watch, or to record, a television program cannot watch (or record) any other at the same time. (The rule still applies if the recording device can simultaneously record multiple programs; there is going to be a limit, and if the number of desired programs exceeds the capacity of the recorder, some of them will not be saved, and thus cannot be seen.) In any case, at the time the person chooses to watch a program, either live or on a recording, they cannot watch something else, and if they are not able to record another program showing at the same time, the opportunity to view it is lost (presuming the particular program is not repeated). Or another example, someone having a video game can choose to watch a program or play the video game on the TV; they can't do both simultaneously. Whichever one they choose is a lost opportunity to experience the other.

Assessing opportunity costs is fundamental to assessing the true cost of any course of action. In the case where there is no explicit accounting or monetary the land for a parking lot, or the money that could have been made from selling the land, or the loss of any of the various other possible uses -- but not all of these in aggregate, because the land cannot be used for more than one of these purposes.

However, most opportunities are difficult to compare. Opportunity cost has been seen as the foundation of the marginal theory of the value.

Pitfalls in the calculation of Opportunity Costs: Hidden Costs

One has to be careful in calculating the opportunity cost of any course of action. There are two pitfalls in the way of such a calculation: some relevant costs may be ignored in the calculation or some costs that should not be included may be included. For example: Sunk Costs should not be included in opportunity costs because once that cost is incurred, sunk costs are not part of the firm's alternatives because they cannot be put to alternative use.

In a brief summary, an opportunity cost is the benefit lost from making one choice over another.

Globalization

Any economic phenomena emerges after the failure of government practices simultaneously in many areas within a country and in many countries. The failure could be because of many reasons but fundamentally all of them come under one broad 'reason' prevalent in that particular era. The seeds of Gloabalisation were sown at the beginning of post-colonial era. All the under developed nations were similar in that they were latecomers to industrialisation and wanted to catch up with the developed nations. So, they thought the best way to move forward was to protect their industries from foreign competition and the pursuit of industrialisation in most of the developing nations came to be based on the practice which we now know as Import Substitution. Here, the nations followed inward-looking policies and believed that the best way to make progress was to make everything on their own; from a safety pin to an aeroplane ..... everythng by them and for them. Nothing shall be imported and they would be completely self-sufficient. But the policy makers cudnt be more myopic in their views than this . This was one of the biggest blunder commited by India as well . Under Nehru, immediately after independence, we undertook a massive industrialisation programme which was totally based on Import Substitution. And it took us 40 years (until 1991) to realise what gr8 mistake we have been committing. All those big industries are either closed or running in red now (with few doing well aftr 1991 policy changes). Our policy makers missed out on the basic facts and importance of globalisation. Thus aftr years of backwardness , we finally strtd off with the policies focussed on Export Promotion.

Globalisation is a direct off-shoot of these Export Promotion policies. These policies along with the forward and backward linkages withing the country, in the form of Social Overhead Capital and Directly Productive Activities, led to the modernisation and globalisation of most of the nations. And soon the nations from being called less developed countries derisively, were addressed as Developing Countries . So much to pacify emotions !!


The sociologist, Anthony Giddens, defines globalisation as a decoupling of space and time, emphasizing that with instantaneous communications, knowledge and culture can be shared around the world.

Source : Chango on PaGaLGuY

Increase in sensex index - What do they mean?

The index movements reflect the changing expectations of the stock market about future dividends of the corporate sector. The index goes up if the stock market thinks that the perspective dividends in the future will be better than previously thought. When the prospects of dividends in the future becomes pessimistic, the index drops. The ideal index gives us instant readings about how the stock market perceives the future of corporate sector. Every stock broadly moves due to two resons; news about the compnay or news about the economy (budget, etc.)

The job of an index is to purely capture the second part, the movements in the economy. This is achieved by averaging. Each stock contains a mixture of two elements - stock news and index news. When we take an average of returns on many stocks , the individual stock news tend to cancel out and the only thing left is news that is common to all stocks. The news that is common to all stocks is news about the economy. That is what a good index captures. The correct method of averaging is that of taking a weighted average, giving each stock a weight proportional to its market capitalization.

For eg. : Suppose an index XYZ contains 2 stocks, A and B. A has a market cap of Rs. 1000 cr. and B has a mkt. cap. of Rs. 3000 cr. Then we attach a weight of 1/4 th to movements in A and 3/4 to movements in B.

Similarly in Sensex, the 30 stocks have their assigned wightages.

So you see its a very dynamic process. At times you will hear .... Sensex has fallen by 9 % ( if its 10 % then there would be a 1 hr. market halt if the movement is before 1 : 00 pm. etc ... Its a market-wide circuit breaker ..... wont get into all that now) but say any other share has risen by 9 % .... u might get flummoxed ..... but the simple reason behind this is that those shares are not part of the Sensex and may rise despite the negative feeling of the traders ... there was no trickle down effect on this particular stock and it managed to rise by 9 % . It could be because of any reason ..... like the sale of various mill lands few months back in Mumbai led to the unbelievable intra day rise of share prices of Bombay Dyeing, IndiaBulls (which are not part of Sensex ) and other cos. which held a stake in these lands ...... over the months also few of the sectors which have shown a sharp increase in share prices despite the fluctuations in the SENSEX is sugar space (like Renuka, Ponni, Oudh, Bajaj (handled by Shishir Bajaj whose uncle Rahul is the Founder of Bajaj Auto but Shishir got the sugar industry aftr the separation between the brothers i.e rahul and Shishir's father), Auto space, IT sector , etc. Due to the tremendous performance of the BSE SENSEX ... more and more companies are filing for IPO ( Initial Public Offerings ) though it has slowed down a bit since the SENSEX crossed 10,000 and cos. became a bit more risk averse at high figures. IPO at a high SENSEX and at a time when the normal Indian had cash to invest , is a good idea. Many companies during this period stepped in ..... like NDTV whose IPO price was Rs. 100 but today is trading at around Rs. 220 mark ... then there is Reliance Communication (formerly owned by Mukesh but now by Anil) which opened at Rs. 200 and now trading at Rs. 440 + ...... and the list just goes on and on .... pyramid retail , INOX , and many other construction and entertainment cos (primarily).

But now rather than going for individual shares, smart investors are investing in mutual finds. SIPs (systematic investment plans) are the in thing right now. You have funds with hardly any entry or exit load and every other day some or the other co. used to come out with its own mutual fund ( dont tell me u missed the amazing marketing extravaganza at the launch of Reliance Mutual Fund) till a few months back. The future lies in the next step and that is ETFs (Exchange Traded Funds) .... these are mutual funds which shall be traded on the share market just as any other share and will still hav NAV (Net Asset Value) just like a normal mutual fund. US has many successful ETFs like SPDRs, QQQs, etc. will talk about mutual funds in detail some other time.

But as far as FIIs are concerned .... we are still a long way to go till we even reach to a 'visible distance' of where China is right now. Too much of talk goes on about India being close and all that .... but a long way to go ... yeah we are moving in the right direction but not fast enough. And whatever progress we have made hass been in the past 15 years since the famous Economic Liberalisation process of 1991. It was Manmohan Singh , under the PMship of Narsimha Rao who changed the picture of the Indian Economy. Today the fact that i am typing this post is coz Manmohan Singh the economist showed us the way. If he would not have taken those steps, the license raj would have continued and there would not have been any competition. Its because of the competition in each and every sector, because of the entry of foreign players that the local industries are improving. Its because Airtel was allowed to start mobile services, Hutch, TATA, Reliance and others were allowed that the state owned MTNL and BSNL woke up from years of sleep and strtd gud services such as broadband and triband. You need to shake up the system to see any kind of progress. You need to be as innovative as Grameen Bank in B'desh which had the belief that micro finance can change the rural system. It is these visions which win Nobel prize.

Source: Chango on PaGaLGuY.com