The Economy Thread Part 1

I have been thinking of writing this one for a long long time, and yet i have not got it complete yet. This topic is one of the countless that fascinate me, the science behind the economy and factors that influence it. This is the first post in a series on Economy. It is arranged in terms for simple Q and A for easier understanding!

How can the central bank cool the economy?

It does by increasing the bank rate and the CRR rate primarily. Bank rate(discount rate) is the rate of interest at which central bank gives loans to banks. This is used to change the money supply. CRR on the other hand is the minimum reserves that each bank needs to park with the central bank. This is an important instrument in money supply. What is money supply? Suppose bank has Rs. 100 and it lends Rs. 90 as loan(10% being the CRR). The total max money supply is Rs. 1000 (How? - if bank has Rs 100, it loans you Rs 90, you deposit the Rs 90 back in bank, then bank again loans out 90% of it i.e. Rs 81 and this goes on. The total amount would be Rs 1000 like this). If central bank feels that money supply is too much it can raise CRR to 20% and the max money supply now would come down to 100+80+64.. to 500. Hence this reduces money creation and maintains purchasing power. But how can money supply maintain purchasing power??

Suppose there are 100 rupees chasing 10 items in the market, and the increased money supply leads to 110 rupees in the same market for those original 10 products. In short, there are Rs. 11 to buy the same item. Now, the prices will rise. This is a very simple analogy of a complex science, but that is pretty much the way it works.

What about interest rate? Does not that matter? Yes it matters. Lower interest rate means that borrowing is easier for individuals to buy stuff like cars, houses and for companies so they create new capacities and increase employment. The increased spending by individuals also in-turn boosts the economy as it produces demand for goods. On the other hand a runaway growth leads to hardening of interest rates as most of the money is being spent on consumption or creating new capacity leading to bank deposits running low, thereby curbing new loans. In those cases banks increase deposit rates and loan rates to induce people to save and make it harder for companies to borrow. Runaway growth also leads to inflation as wages rise causes more money to chase fewer items in the market, besides the increased money supply in the system is also a factor in increased inflation as there is a higher demand for credit.

How can the central bank induce growth in the economy?

To induce economy, the easiest is to lower the rate of interest so that it is easier to burrow and increase consumption. Also lower the CRR, so that money supply in the system increases that causes more money at bank's disposal.The other form of stimulus is increased government spending like government agreeing to make 8-lane all 4-lane highways in the country. The spin-off of such spending is increased jobs and consumption of goods therefore kick starting the economy. But it has a trade-off, since this government spending is financed by borrowing, this increases debt causing interest rate to rise as borrowing created a higher demand for credit. since most money is put on government debt, less money on consumption so this may negate the effects of the stimulus.
Another way to induce growth is to qualitative easing (which is done when interest rates are near zero, so there is not much scope to reduce rates.) In this the central bank prints money and buys back the government bonds previously issued to the bank so that money supply is increased in the system and this excess liquidity is used to loan money to individuals and companies to induce growth.

What is T-bills?

The US has a huge budget deficit, so it has more dollars going out, then coming in. It manages this by issuing out T-bills or bonds or notes. All these instruments are different, and have varying yields and maturity time. This is government debt. Why does countries like China buy them? Because it a an ultra-safe investment for there trade surplus dollars besides it buys a certain influence in Washington. What if China one day decides to sell it T-instruments one day. Probably the sky will not fall, as there are other buyers in the market who will chip in.

Why US/Japan is not failing despite this much debt?

The reason US is not going to go under despite the massive deficit, is due to the fact that its currency, the dollar is the world's reserve currency and most of the trade in gold, oil is dollar denominated. In short the buyers for dollar are always there. As for Japan, since about 95 percent of Japan’s debt is held domestically, there’s no risk of capital flight. Japan borrows from its companies and people, an arrangement that’s roughly the mirror image of the U.S.

Next week on stagflation, credit swaps, foreign exchange and bonds.

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