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Knowledge Corner

Economics & Financial Markets – 2

Basic roles of the financial markets
In a very simple economy, there are two sets of economic agents: households and firms. Households save and the firms invest. It is the role of the financial sector to ensure that the savings of the household sector reaches the firms, which need the resources for investment. In reality the economy is of course much more complex than this overly simplified system. In a real economy, savers include not only households but also firms and government. Similarly, investments can be made by not only firms, but also households and the government.
However, even in a more complex economy, the main function of the financial system essentially involves the mobilization of resources from those who have surplus and allocation of these resources to those who face deficit. In other words, the financial sector plays the role of an intermediary by ensuring smooth flow of resources from those who have surplus funds to those who have a shortage of funds. Let us look at the savers’ side. People differ from each other in their risk appetite as well as their expectations of return and liquidity of their savings. The financing system provides a menu of saving vehicles with differing risk, return and liquidity characteristics.
A more efficient financing system, catering better to the needs of those with surplus funds, can generate higher savings. Now, let us look at the investors’ side. The financing system also helps in allocation of savings to those in need of funds (namely, investors). Investors have differing needs too. An efficient financial system allocates savings efficiently and increases the productivity of investment. In other words, for a given level of saving, more efficient financial intermediation increases the productivity of investment. It thus seems obvious that the more efficient the financial system, the more rapid the growth rate. The second important role of the financial system is that of risk management. Every business enterprise involves risk. The financial institutions provide a framework for evaluating these risks. The financial market allows sharing, trading and transferring of risk among different economic agents.
For example, when an innovative high-technology firm sells its equity in the financial market, it is sharing the risk of the new technology with its shareholders. In absence of a financial market, such firms will tend to go for projects which are safer and may be less innovative. Financial markets, by allowing the sharing of risk, encourage future structural changes essential for maintaining a country’s long-term growth potential. Given rapid technological progress and increased role of innovation in growth performance, the role of financial market becomes crucial. The third role of the financial markets is to pool and communicate information efficiently, so that market prices reflect available information. All these roles put the financial system at the centre of modern macroeconomics.
What is Inflation
Inflation denotes a rise in general level of prices. More specifically, inflation refers to the rate of general price increase over a period of one year. For example, if we say that the current inflation is 8 percent, it means the general price level has increased by 8 percent over the last one year. It has been observed that inflation the world over has generally remained in the positive territory, implying that the general price level typically rises. There have however been exceptions, when there have been sustained decline in the price level of goods and services. This phenomenon is called deflation. For example, if we say that the current deflation rate is 4 percent, it means that the inflation is (–) 4 percent.
In other words, the general price level has fallen by 4 percent over the last one year. Japan suffered from deflation for almost a decade in 1990s.
Exchange Rate
Persistently higher inflation in a country (say Country A) relative to the inflation in another country (say Country B) generally leads to depreciation of a currency in country A. Depreciation of the currency of country A means decrease in the value of the currency of country A relative to the currencies of country B. In other words, if country A Persistently experiences higher inflation than country B, in exchange for the same number of units of Currency A, the residents of country A will get fewer units of currency B than before.
Exports and Imports
As stated in the preceding paragraph, relatively higher inflation in a country leads to the depreciation of its currency vis-à-vis that of the country with a lower inflation. If the two countries happen to be trading partners, then the commodities produced by the higher inflation country will lose some of their price competitiveness and hence will experience lesser exports to the country with lower inflation. A currency depreciation resulting from relatively higher inflation leads not only to lower exports but also to higher imports.
Interest Rates
When the price level rises, each unit of currency can buy fewer goods and services than before, implying a reduction in the purchasing power of the currency. So, people with surplus funds demand higher interest rates, as they want to protect the returns of their investment against the adverse impact of higher inflation. As a result, with rising Inflation, interest rates tend to rise. The opposite happens when inflation declines.
Unemployment
There is an inverse relationship between the rate of unemployment and the rate of inflation in an economy. It has been observed that there is a stable short run tradeoff between unemployment and inflation. This inverse relationship between unemployment and inflation is called the Phillip’s Curve . When an economy is witnessing higher growth rates, unless it is a case of stagflation, it typically accompanies a higher rate of inflation as well. However, the surging growth in total output also creates more job opportunities and hence, reduces the overall unemployment level in the economy. On the flip side, if the headline inflation 15 breaches the comfort level of the respective economy, then suitable fiscal and monetary measures follow to douse the surging inflationary pressure. In such a scenario, a reduction in the inflation level also pushes up the unemployment level in the economy.
Interest Rates
Interest rate is the price demanded by the lender from the borrower for the use of borrowed money. In other words, interest is a fee paid by the borrower to the lender on borrowed cash as a compensation for forgoing the opportunity of earning income from other investments that could have been made with the loaned cash. Thus, from the lender’s perspective, interest can be thought of as an “opportunity cost’ or “rent of money” and interest rate as the rate at which interest (or ‘opportunity cost’) accumulates over a period of time. The longer the period for which money is borrowed, the larger is the interest (or the opportunity cost). The amount lent is called the principal. Interest rate is typically expressed as percentage of the principal and in annualized terms. From a borrower’s perspective, interest rate is the cost of capital. In other words, it is the cost that a borrower has to incur to have access to funds.
Factors affecting the level of Interest Rate
Interest rates are typically determined by the supply of and demand for money in the economy. If at any given interest rate, the demand for funds is higher than supply of funds, interest rates tend to rise and vice versa. Theoretically speaking, this continues to happen as interest rates move freely until equilibrium is reached in terms of a match between demand for and supply of funds. In practice, however, interest rates do not move freely. The monetary authorities in the country (that is the central bank of the country) tend to influence interest rates by increasing or reducing the liquidity in the system. This has been discussed later. Broadly the following factors affect the interest rates in an economy.
Monetary Policy
The central bank of a country controls money supply in the economy through its monetary policy. In India, the RBI’s monetary policy primarily aims at price stability and economic growth. If the RBI loosens the monetary policy (i.e., expands money supply or liquidity in the economy), interest rates tend to get reduced and economic growth gets spurred; at the same time, it leads to higher inflation. On the other hand, if the RBI tightens the monetary policy, interest rates rise leading to lower economic growth; but at the same time, inflation gets curbed. So, the RBI often has to do a balancing act. The key policy rate the RBI uses to inject (or reduce) liquidity from the monetary system is the repo rates (or reverse repo rates). 3 Changes in repo rates influence other interest rates in the economy too.
Growth in the economy
If the economic growth of an economy picks up momentum, then the demand for money tends to go up, putting upward pressure on interest rates.
Inflation
Inflation is a rise in the general price level of goods and services in an economy over a period of time. When the price level rises, each unit of currency can buy fewer goods and services than before, implying a reduction in the purchasing power of the currency. So, people with surplus funds demand higher interest rates, as they want to protect the returns of their investment against the adverse impact of higher inflation. As a result, with rising inflation, interest rates tend to rise. The opposite happens when inflation declines.
Global liquidity
If global liquidity is high, then there is a strong chance that the domestic liquidity of any country will also be high, which would put a downward pressure on interest rates.
Uncertainty
If the future of economic growth is unpredictable, the lenders tend to cut down on their lending or demand higher interest rates from individuals or companies borrowing from them as compensation for the higher default risks that arise at the time of uncertainties or do both. Thus, interest rates generally tend to rise at times of uncertainty. Of course, if the borrower is the Government of India, then the lenders have little to worry, as the government of a country can hardly default on its loan taken in domestic currency.
Impact of interest rates
There are individuals, companies, banks and even governments, who have to borrow funds for various investment and consumption purposes. At the same time, there are entities that have surplus funds. They use their surplus funds to purchase bonds or Money Market instruments. Alternatively, they can deposit their surplus funds with borrowers in the form of fixed deposits/ wholesale deposits. Interest rates receive a lot of attention in the media and play an important role in formulation of Government policy. Changes in the rate of interest can have significant impact on the way individuals or other entities behave as investors and savers. These changes in investment and saving behavior subsequently impact the economic activity in a country. For example, if interest rates rise, some individuals may stop taking home loans, while others may take smaller loans than what they would have taken otherwise, because of the rising cost of servicing the loan. This will negatively impact home prices as demand for homes will come down. Also, if interest rates rise, a company planning an expansion will have to pay higher amounts on the borrowed funds than Otherwise. Thus the profitability of the company would be affected. So, when interest rates rise, companies tend to borrow less and invest less. As the demand for investment and consumption in the economy declines with rising interest, the economic growth slows down. On the other hand, a decline in interest rates spurs investment spending and consumption spending activities and the economy tends to grow faster.
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