Digital Marketing Minus the Marketing

Digital Marketing is the new buzzword. Every second resume floating around the jobosphere claims Digital Marketing skills. Colleges and Institutes are cashing in and offering courses with fancy names.

A few weeks D, one of our alumni was conducting interviews for a Digital Marketing positioning for a well-funded startup. Around 100 candidates applied for the position and about 40 were shortlisted for interviews, all claiming 2-5 years of Digital Marketing experience. After a frustrated week of interviewing he nearly gave up….

So what is the problem? In a nutshell, trying to ‘do’ digital marketing without a clue about marketing. One candidate stared blankly when asked what was the audience segment he was targeting! Another had never heard of positioning!

Digital Marketing is simply marketing in a Digital world. Digital Media offers great power and flexibility to someone who understands marketing. Everyone else is a monkey with a new toy.

Let me illustrate. One of the core concepts of marketing is STP: Segmenting, Targeting and Positioning.

It starts with the idea that all consumers are not the same and that their needs and aspirations are different. So one carefully defines that segment of the audience that wants to target. Today, availability of data and analytical tools allow us to segment the audience more efficiently and effectively than before. GPS tells us where they are (and have been). App data tells us what they browse, buy and when.

And then we see how we can specifically target that segment of the audience with a customized message. Here again Digital Marketing is way more powerful than traditional marketing. Say, you are marketing a lipstick. You look at media that has women audiences, like say TV Soaps, Women’s magazines etc. But it is inefficient. Not all women like soaps and many women don’t read women’s magazines. On the flipside, there are women who read sports magazines and watch News on TV (both considered to be largely male audiences).

Enter Google and Facebook. Click a few buttons and you can ensure exactly who watches your ad. Women, Age 15 to 45, Metro and small town etc. You can even make a special 25% birthday promotion and show the ad only to those who have birthdays in the coming week. Fb has 150+ parameters on which you can target
a specific audience.

The other beautiful thing is that you can create and target tailored ads for each segment of the audience. Digital Ads are cheap and easy to produce. And unlike traditional ads you can quickly get an idea of what works and what doesn’t? CTR or click through rate is the percentage of people who click on an Ad. So you can take two different ads, run them for a few hours and check which one has a higher CTR (called A/B testing).

So what’s the takeaway. Digital Marketing is an exciting field, which is revolutionizing marketing across the world. And yes, you can build a great career in it. But, you need a strong foundation in marketing.

4 votes, 4.25 avg. rating (83% score)

Our Agricultural crisis – A managers viewpoint

Our Agricultural crisis: A manager’s viewpoint

Much has been said about the crisis in agriculture. Newspaper and Digital columns have been written, TV anchors and their guests have screamed at each other, politicians have called each other anti farmer, experts (sic) have pontificated endlessly. However much has also been left unsaid. Today I want to bring in a managers viewpoint? Before we start, let me assure you those simplistic solutions like farm loan waivers and raising MSPs are NOT the solution.

So what is so unique about a manager’s viewpoint?

  1. A manager is guided by facts and data. In the words of one of my mentors. I trust my wife. For everything else show me data.
  2. A good manager is not driven by ideology, he is driven by a desire to solve problems
  3. Lastly, a manager, unlike politicians or bureaucrats, uses incentives and persuasion to solve problems, not rules and bans.

So let’s start with the key facts

Agriculture and allied services contribute about 14% to India’s GDP. In simplified terms, if all Indians together earn Rs 100, then all the farmers together earn Rs 14.

The problem is the number of people who have to share this Rs 14. The total number of people dependent on farming is about 60%. So again in simple terms, if India’s population is taken as 100, then 60 of them are dependent on agriculture and are sharing that 14% of Income.

Now our per capita income is Rs 1 lakh. So per capita income of farmers is 1/4th the national, i.e. Rs 25,000 per year. Not surprisingly most farmers also have other sources of income including small retail, construction wages etc. In fact, on an average farming accounts for 60% of farmer’s income.

So key takeaway. Too many people are sharing too little income.

Let’s as a manager, two possible approaches to a solution

  1. Increase the income from agriculture, i.e. grow the numerator.
  2. Decrease number of people dependent on agriculture, i.e. reduce the denominator

Increasing Agricultural Income

At its simplest, agricultural income equals Production Qty X Price. (less expenses)

I) Raising prices:

So the simplest way to increase agricultural income is to raise the price. Please note the clamor for a rise in MSP or minimum support price (Trust politicians to focus on the easy wrong answer for every problem). Unfortunately, raising MSP has many disadvantages

  • It raises the cost of food for Indian poor, i.e food inflation. And since the poor are in many cases daily wagers, it raises wages, including farm wages, creating an inflationary spiral.
  • MSPs only work if a government agency buys substantial quantities of agri produce. So, FCI buys wheat and rice and hence is able to implement an MSP. But for most other products there is no agency, which buys agri produce.
  • A simple demand and supply graph shows that to sustain higher MSP’s agencies like FCI have to buy larger quantities of food grains. And hence when MSP’s are set based on politics rather than economics,  we see overflowing godowns and wastage due to pests, spoilage etc.
  • Lastly, an MSP creates a false demand for products and hence distorts price signals. For example, say there is an oversupply of Rice. Market economics would see a drop in price, which would signal farmers to reduce supply in the next crop. But a high MSP would encourage more rice farming and hence create a greater oversupply next year.

Key takeaway: MSPs for all agri crops is not feasible. Nor can MSPs be raised independent of laws of supply and demand.

II) Increasing productivity:

Obviously increasing productivity is a win-win situation. A farmer can get more income without a rise in price, which will hurt the consumer. And clearly, there are many crops where Indian farms have lower per hectare yield compared to global standards.

The key problems here

  1. Fragmented landholdings: Like almost all productive operations, farming is also subject to economies of scale. Average landholding in India is far too low to generate economies of scale and sufficient income for farmers.
  2. Scientific Irrigation: The easiest way to generate more productivity is to convert single crop land into multi crop land. That requires a fundamental rethink of irrigation: from large multi purpose projects to small sustainable projects, from government operated to farmer operated and maintained through user fees, from flood irrigation to drip irrigation. We also need scientific crop selection suitable for the land. For example, the stupidity of growing sugar cane in water scarce Marathwada needs to stop.
  3. Risk of oversupply and falling prices: A higher productivity in many cases leads to a steep fall in prices. This happens because most agri products (esp perishable ones) tend to be price inelastic. Demand is fairly constant and hence a small change in supply can lead to drastic changes in price. Onions and Tomatoes are prime examples. There are only two broad ways to avoid such price fluctuation: One, is to address the perishable nature of such crops, so create cold storage facilities and connect to international markets using imports and exports to balance local supply fluctuations. The second is financial insurance against price fluctuations, which involves hedging against prices.
  4. GM Crops: While activists have demonized GM crops, let me assure you that scientific evidence on harmful effects of GM crops is Zilch, Zero. Americans and Canadians have been consuming GM food for ages and there has been no connection between GM food and health risks. Please note that the US is a lawsuit happy nation, If there was any evidence, there would have been million dollar lawsuits. In a nation where thousands of farmers commit suicide, preventing a technology that can greatly benefit farmer lives with a minuscule risk is a tragedy.

Decreasing the workforce in farming

All the other options notwithstanding, this is an inevitable option. Farming is not viable at the levels of landholdings and the labor-intensive methods that we use. And this is not an opinion. There is not ONE country in the world, which has a high standard of living and a high percentage of people working in agriculture. Not ONE. All developed nations have between 5 to 15% of the population working in agriculture, and even those farmers are subsidized. The benefits of a transition to farm labor to Industry and urban work are clear and obvious.

  • Greater land holding size for remaining farmers and hence a greater income
  • Greater scope for mechanization, scientific farming, investments in technology and economies of scale
Country Per capita Income % age Population in Agriculture
USA $ 57,436 1.6%
France $ 38, 128 2.8%
South Korea $ 27,539 4.9%
New Zealand $ 39,427 6.5%

Before people accuse me of planning a large scale forced takeover of farmer land, let me assure you that I am talking of voluntary migration, as has happened in every developed nation in history . It must be noted that farmers across India would love to have the option of giving up farming and in many cases that is almost every farmer’s dream for their children.

What do we need to catalyze such a move?

  • Manufacturing: Manufacturing allows for the easiest transition from agriculture to jobs. Of course, despite Make in India program, progress has been slow. Reasons include global environment, ease of doing business, labor laws and infrastructural bottlenecks.
  • Allow those who want to exit farming an easy exit. Allow a simple land leasing model, which allows a farmer who gets a job to lease out his/her land to other farmers: a win-win option that supplements his income as well as makes his neighbor’s farming viable.
  • Remove restrictions on the sale of land and allow bank finance for purchase of agricultural land. This allows for farmers to scale up to a viable farm size while allowing a clean exit to farmers who want out. Today, you need to be certified by government as a farmer to buy farm land. Google search for Amitabh Bachan labelling himself as a farmer to buy land in UP.
  • Above all: education and skill development for next generation of rural youth to get employment rather than be forced into farming out of lack of choice.

In conclusion, we Indians have an oversupply of opinions and judgments and ideologies and a serious shortage of data and logical analysis. Certain mega trends are inevitable and cannot be fought. Second, it’s not for you and me to decide what is good for farmers. They will decide for themselves. We just need to see that they have decent alternatives to choose from.

A movement away from farming and into higher skilled jobs is one such inevitability. It would be accompanied by greater urbanization, which again is a good thing. Urbanization creates conditions for knowledge sharing, trade, and business, scale-based efficiencies in all areas. Rather than fight these trends we need to find a way to manage these transitions. For example, we cannot send back people migrating to cities, but we can definitely help provide a better quality of life for them.

1 vote, 5.00 avg. rating (89% score)

POS is as much about Appearance as it is Functionality

I’m sure we have all experienced the frustration of trying to get down a store aisle that was too narrow, knocking things off shelves, as we tried to squeeze by another shopper’s cart; or experienced the confusion of trying to find something after walking into a store with randomly placed stacks of boxes as displays and mismarked aisles. The frustration of finding things, struggling through cluttered aisles and looking for pricing can make it enough to simply walk out of the store and go someplace else. This is why appearance and functionality are an important element in positive POS.

If customers cannot locate what they are looking for due to cluttered and congested aisles, they will choose to shop someplace where they can shop without obstructions. This is a vital item to consider when placing endcap displays, seasonal, or sale displays. Look at your space and plot display units accordingly. Don’t use stacks of case boxes with the tops cut off in the middle or at the end of a row as display units. This may be a cheap and quick method of display, but it looks cheap as well. Stacked boxes also increase chances of a customer accidentally knocking a display over on themself or someone else and getting injured creating a liability issue for your business. Another problem with stacked boxes is once the top case is empty, how does the customer get to the product in the closed cases below? If all the cases are opened before being stacked you risk increased spoils from crushed boxes or broken containers. These are just a few of the reasons why it makes more sense to use actual display units located in traffic friendly locations when promoting your sale and seasonal items.

Clearly and accurately marked aisles and directories are also critical. There is nothing more frustrating to a customer in a hurry than going from one end of a store to the other and back again looking for an item because the aisles and directories are inaccurate or out of date. Place signage at both ends of the aisle that contains a list of each category that is on that aisle. Making it easy for your customer to find what they are looking for will not only make your customer happy, but it will increase your sales since not all consumers like to ask for help if they can’t find something.

Have easy to understand pricing posted on the shelves with the item it belongs with. Consumers like to know what they are being asked to pay for something before they reach the register in order to make an informed decision. Make sure sales prices are accurate and visible. Don’t give your customer an unfriendly surprise at checkout when the price is higher than they were expecting to pay.

Besides having an organized customer friendly appearance, having clutter free aisles, easy to read aisle signs and directories, and accurately priced items and shelves creates a good first impression for your customers making them want to become a repeat shopper. Manage your business’ appearance as part of your POS and you’ll see results in your bottom line.

8 votes, 3.75 avg. rating (75% score)

Doctors pursuing Management Courses for better career prospects

There are many doctors around the world who are seeking admission into management courses. They are applying for different management programmes from various reputed institutes. The various universities are there in order to gain the professional and personal expertise which is most needed when it come to treating a patient.

This course simply enables the doctors to behave more professionally. It is not required to say that doctor’s professional attitude is only about getting personal with the patients. They can understand patients and can build a rapport with them. It will help them treating well and healing their pain and get them cured. Doctors really need to be caring towards their patients so that they can treat them well.

There are many executive programs related to management which are formulated for doctors and for them who are practicing this medical profession. Many doctors have pursued these programs and got benefit out of this and today they are doing their work with more proficiency and with more professionalism.

When we are thinking of any doctor doing MBA, it may feel us very astonished and we might again think how stupid the person is! What is the requirement of doing so? Because this is not sound to us a very conventional thing. Today in the reality it has enough implications. Doctors need to know many more skills which they can simply gain by doing a MBA course.

There are many things required to run a firm including health care one. Hence to manage well you need to have managerial skills so that you earn profit in your business. After all money always matter. To run a successful health care firm requires knowledge in finance and accenting as well along with planning and execution.

Specialists have a mixture of alternatives in concentrating on administration courses. They can select to utilize the customary and more regular self-study and at work preparing choices. They could additionally go to gatherings, workshops, and preparing projects offered by restorative affiliations and organizations. Short-course, Continuing Medical Education programs on business and administration are additionally accessible.

To test sufficiency in managerial parts, medical practitioners could first expect low maintenance. Basic regulatory obligations are in their individual healing facilities or centers. They can also uncover their specialty in performing administration obligations. They could proceed onward and take part in transient workshops or classes led by doctor’s facilities, medicinal associations, schools or colleges, and business or administration firms and schools. A while later, specialists could then study administration courses or consume formal instruction in a school or college of their decision, then again graduate studies program. These degrees or courses could be acquired full-time on-yard, low maintenance on-grounds, or in an official arrangement wherein people have a set number of classes for every month. After completing the management course a doctor easily go for their own business. He may associate with a hospital besides he can run his own business with more profit. This can happen only by the knowledge of management course.

4 votes, 4.00 avg. rating (79% score)

Industrial Requirements for MBA

MBA is course which can be done from regular basis as well part time or correspondence. There are many entrance exam or tests you need to qualify for entering into this programme. The criteria are changing every year as the study process is evolving and adding new requirements in to the system.

There are lots of benefits for MBAs in industries and it’s not only that MBAs get benefit in industries but also industries are benefitted from MBAs. It’s a two way process. We have outlined few benefits which are mentioned below:

  1. MBAs have a great impact on the salary band of industries. If a person is MBA qualified, it is certain that the person will definitely get good packages where other may find it hard and struggling.
  2. Industries are looking for MBAs because they are more professional and knows the nuances of all managerial skills and hence can apply to every field irrespective of technical and non technical.
  3. MBAs know how to plan and execute, hence can add a lot of value addition and produce more results in Industries.

In case you are an aspiring MBA and currently working in any industry then we must say you are absolutely thinking right as MBA simply will enhance your skills further and you will be adorned in your field with more offerings in terms of salary, perks, bonus and other fringe benefits as well. After a market survey regarding the industrial requirements of MBA it has been noticed there is huge response. This information are tailored under and mentioned for your better understanding.MBA is not a very easy course to understand, it has lot of Industrial Requirements.

The MBA gives you the chance to view the money related parts of business from a worldwide and a key point of view. The programme sets business operations into the setting of maintainable and dependable fates. A MBA is an essential part in the abilities set of tomorrow’s business experts. It furnishes the worldwide point of view, money related information and discriminating thinking aptitudes needed for you to turn into a senior pioneer in industry.

The MBA programme gives you a chance to improve the fiscal ability. It also helps to increase the aptitudes applicable to senior administration capacities inside private, open and philanthropy divisions from a worldwide point of view. It is intended to furnish a powerful and thorough dissection of administration action in the budgetary circle. It is conceivable to finish the quickened programme in one year.

Organization must think about the future. They are putting resources into their staff to be better ready for business tests of what’s to come. MBA is very rich professional study. Every people want to study the subjects. Because this subjects has a huge facilities. People could gain a huge knowledge about the market of any business. People developed many business ideas by this study. If you want to grow in your career life you should go for a MBA course. After completing, you can easily get into the industry with high package.

4 votes, 3.50 avg. rating (71% score)

New Specifications for MBA 2014

MBA which is abbreviation of Master of Business Administration is a master’s degree regarding business administration which is attracting students and professionals from a wide range of academic disciplines as well from different corporate. The MBA degree originated in the United States in the late 19th century as the country industrialized and companies wanted scientific approaches to management. The main courses in an MBA program introduce the various areas of business such as accounting, marketing, finance, human resources and operations management; many programs include elective courses.

Now a day MBA is most aspiring course for everyone due to its huge demand in corporate. There are many students who are applying for this from various reputed institutes and universities.

MBA is course which can be done from regular as well part time or correspondence. There are many entrance exam or tests you need to qualify for entering into this programme. There are new eligibility criteria which are changing every year as the study process is evolving and adding new requirements in to the system.

In the year 2014, if you want to join MBA program you have to adhere to the new specifications of it. There are many institutes which will guide you to perform well in the test and also guide you regarding the New Specifications for MBA 2014 which is mentioned below:

  1. The candidate should be a graduate from an accredited university in any stream.
  2. The candidate should have 50% or more than 50% in his graduation.
  3. In the case of applicants whose first language is not English, then IELTS 6.0 (or equivalent) is necessary. International qualifications will be checked for appropriate matriculation to UK Higher Education postgraduate programmes.
  4. Candidates who are working and applying for an executive programme should have a minimum of 3 years relevant work experience.

In the case of applicants whose first language is not English, then IELTS 6.0 (or equivalent) is obligatory. International education will be verified for appropriate matriculation to UK Higher Education postgraduate programmes.

Last month we have done a survey regarding the new specifications of MBA and gathered so much of responses and views about it. These information are tailored under and mentioned for your better understanding.

Affirmation to the Management courses for 2014 will be made on the preface of Cat-2013 score (Common Admission Test) headed by Indian Institutes of Management joined by gathering talk and singular gathering. The Cat-2013 scores will have 85% weightage, Group Discussion 7.5% weightage and Personal Interview 7.5% weightage in determination of seekers. Procurement is completed on the web, regardless of the way that charges must be submitted separated from the net. To ask for concession, fill in the key online selection structure. After extraordinary fulfill a Login Id, Password and bank slip will be made.

You just keep an eye on the announcement of the new specification for the MBA courses. You can search in the internet. After getting all the knowledge then you can proceed further.

2 votes, 5.00 avg. rating (93% score)

Which Managerial Skills are high on the wish list of the Industries?

MBA is certainly a course which enables you to become a manger on first place. It gives you theoretical aspect so that you gain knowledge and master the subject to perform well in the industries.

Managers are needed to have more than just one skill to prove themselves and do their job of managing things and people. There are many skill set you must be aware about and possess some of them to become a successful manager and to enjoy a successful career.

Now a day MBA is most aspiring course for everyone due to its huge demand in corporate. There are many students who are applying for this from various reputed institutes and universities. There are some outlined few managerial skills which are high on wish list of industries and their benefits as well.

The most important skill is nothing but humanness. The most valuable qualities you can develop within yourself as a manager are kindness, patience, and consideration for other people. Although machines don’t care whether you scream and curse at them, people do and these are the ones who actually adds value to the organization and leads towards growth.

A kind of skill which is high on wish list is Conceptual Skill which is the ability to envisage the organization as one. It is summation of Analytical, Creative and Initiative skills. It certainly supports the manager to identify the causes and nature of problems and also enables to counter them.The demand of skill set in different industries varies according to their particular requirement for particular job.

There is a survey done to know which Managerial Skills are high on the wish list of the Industries and gathered so much of responses and views about it. These information are tailored under and mentioned for your better understanding.

People are now a day encouraged by the course of MBA. Because teach people. People know about the time management. People also know about the personality development. People will learn a lot on the managerial skill. This helps understudies to apply their studying essentially and in this way set their brain to work in greatly intense corporate world. There are various kinds of MBA programme available in the market. This program is like the MBA course yet the project span is year and a half. Compelling and tightly pressed classes separate this from the consistent MBA course. This program gives exceptionally less down time between semesters; generally, classes are directed throughout summer and winter holidays. Distance Learning Program – Like low maintenance course, this program is useful for working experts. They can go to classes online and can listen to movie classes sent by the particular colleges.Part Time MBA – As the name suggests, individuals can seek after MBA low maintenance. This program is greatly famous around working proficient as it permits them to go to classes throughout their helpful time.

By looking at all these responses from big shots of different industries we must say it is not easy to know exactly which Managerial Skills are high on the wish list of the Industries but it is always easy to groom yourself to keep pace with the rising requirements.

2 votes, 3.00 avg. rating (66% score)

Summer Internship Program Opportunities for MBA Aspirants (2012-2013)

The summer Internship program which resolute in parallel with our Final placements has became a huge success. 29 organizations attended the Summer Internship program and made 81 offers for the batch of 62 students.

The emphasize of this season’s Summer Internship Program has been the fact that Companies typically known to visit only top level B-Schools like CRISIL, Powerhouse, ITC provided internships to first year students at Vanguard.

Other big names that attended the Summer Internship programs include Media firm Radio Mirchi, Outdoor Advertising major Clear Channel Outdoor, Telecom majors like Tata Communications and Vodafone as well as the Delhi based FMCG major Faces Cosmetics. The Murugappa Group also offered various Market Research profiles across group locations. In what has clearly been a difficult positioning pattern Vanguard Business School has handled to entice an amazing mix of new interviewers on university while we look ahead to ongoing our powerful connection with current interviewers in the future.

Click Here to Read Detailed Report.

4 votes, 3.75 avg. rating (75% score)

The Coal Pricing Dispute between NTPC and Coal India – The real issue

This video sheds some light on an interesting issue that is playing out in the real world. The simple question at the heart of this complex discussion is

“How should the correct price of coal be determined?”

Another issue underlying the ongoing search (as illustrated in the video discussion linked above) for an answer to this important question is that the correct price depends on the quality of the coal being supplied. As seen in the linked video, the dispute between Coal India Limited (CIL) and NTPC fundamentally focuses on the correct way to determine the quality of the coal being supplied as a means to determining the correct price of the coal being supplied by CIL to NTPC.

What I am not going to do in this article

I am not going to analyse the arguments given by NTPC, CIL and the different experts weighing in on the matter and come up with my own wise formula for the pricing of coal.

Why I am not going to do that

Simply put, attempting to come up with my own wise formula for the price of coal would be rather presumptuous on my part. I would actually have to pretend that such a formula makes sense. The truth is that any such attempt is fundamentally unwise and is therefore bound to be incorrect.

What I am going to do

I am going to use the very existence of this dispute to highlight a fundamental and very important economic point – that the market process is the only correct way of discovering the correct price of any good and that any attempt at coming up with a number that is supposed to denote the correct price is necessarily going to be arbitrary and that there is no way of knowing whether the number so identified is the correct one. I am also going to use this understanding to identify what would be a sensible solution to situations of the kind that NTPC and CIL find themselves in.

What is price?

Price is the ratio of the quantities in which the two goods that constitute an exchange are exchanged. If 3 horses are exchanged for 267 barrels of fish, the price of a horse is

Phorse    =    Number of barrels of fish/Number of horses
             =    267/3 barrels of fish per horse
             =    89 barrels of fish per horse

If 3 horses are exchanged for Rs. 6 lakh, then the price of a horse is

Phorse    =    Number of units of money/Number of horses
             =    Rs. 6 lakh/3 horses
             =    Rs. 2 lakh per horse

What determines the price of a good?

The price of any good is determined by the subjective valuations of all the individuals who participate voluntarily in the market process. Every individual enters the market with a value scale on which different goods and multiple units of the same good are ranked. The immediate outcome of this is that for every unit of a good, every buyer has a certain maximum buying price above which he does not have a demand for that unit of the good while every seller has a minimum selling price below which he is not ready to supply that unit of the good. This combined with the Law of One Price translates into saying that at every hypothetical price that one may take up, every buyer demands a certain quantity of the good in question while every seller is ready to supply a certain quantity of the good.

This array of quantity demanded or supplied by an individual at every hypothetical price is what we understand as the individual demand or supply schedule. Since the individual demand and supply schedules only specify the quantity of a good that that individual demands or is ready to supply at every hypothetical price, it is both possible and meaningful to add the individual quantities demanded and supplied by every individual at every hypothetical price into what we may call a market demand and supply schedule for the good. The market demand and supply schedules tell us the total quantity that all the individuals who participate in the voluntary market process put together demand or are ready to supply at every hypothetical price.

Economic reasoning helps us identify two very fundamental laws that help us understand a basic feature of these market demand and supply schedules – The Law of Demand and The Law of Supply. These may be stated and understood as below.

  • The Law of Demand – At a higher hypothetical price, the total quantity demanded will be the same or lower. Conversely, at a lower hypothetical price, the total quantity demanded will be the same or higher.
  • The Law of Supply – At a higher hypothetical price, the total quantity supplied will be the same or higher. Conversely, at a lower hypothetical price, the total quantity supplied will be the same or lower.
  • From these laws, we see that at sufficiently low hypothetical prices, total quantity demanded would be more than total quantity supplied while at sufficiently high hypothetical prices, total quantity demanded would be less than total quantity supplied. At some price in between, demand will be equal to supply and the market is said to be cleared. This hypothetical price which emerges through a market process is called the market clearing price. At any price other than the market clearing price, mismatch between quantity demanded and supplied would drive the price back towards the market clearing price, which is therefore also understood as an equilibrium price.

    Thus we see that individual valuations work through a complex market process to ensure that a particular price emerges or is discovered for each good. These individual valuations cannot be known to any individual or data collection mechanism. They are known only through the preferences demonstrated by individuals in actual voluntary exchange. Therefore, the correct price of a good cannot be known to any individual. No amount of experience, expertise or computational capability can replace the market process and come up with a correct price.

    The additional complexity in the discovery of prices of producers’ goods

    The process described above explains the discovery of the prices of consumers’ goods, i.e., goods that immediately and directly satisfy human ends. Producers’ goods, however, are a more complex affair as they are valued not for their own immediate usefulness in satisfying human ends but for their usefulness in eventually churning out consumers’ goods. For instance, coal is valued not for its immediate usefulness but for its usefulness in operating thermal power plants which produce electricity which is in turn valued because it may be further transmitted and distributed for consumption either in further production or in running appliances like bulbs, fans, air-conditioners, televisions, microwave ovens, mixers, grinders and a whole host of home appliances that immediately and directly satisfy human ends.

    Producers’ goods are valued by producers. A producer produces to further exchange his output for monetary revenue, which in turn would help him obtain consumers’ goods to satisfy his own ends. Economic theory explains that the valuation of producers’ goods in done by every producer based on his estimate of the contribution of the marginal unit of a given supply of a producers’ good to his revenue. This concept, called the Marginal Value Product or MVP is imputed backwards by the producer based on his subjective assessment of the quantitative relationship between the marginal unit of the supply of the producers’ good and the revenue obtainable from the sale of the final consumers’ good (called the production function).

    Economic theory demonstrates that every producer whose subjective imputed assessment or MVP of a given supply of a producers’ good is greater than a hypothetical price would have a demand for the producers’ good at that hypothetical price. A fundamental economic law known as The Law of Returns demonstrates that the relationship between the MVP and the quantity of any producers’ good would take the form of a downward sloping curve. In other words, it establishes that the Law of Demand as defined for consumers’ goods works just as well for producers’ goods, i.e., at higher hypothetical MVP, quantity demanded of any producers’ good would be lower while at lower hypothetical MVP, quantity demanded of any producers’ good would be higher. The downward sloping MVP curve thus becomes the downward sloping demand curve for the producers’ good.

    Economic reasoning further establishes that the opportunity cost of supplying a produced producers’ good is zero, which would result in a vertical supply curve for the producers’ good. The interaction of the downward sloping demand curve and the vertical supply curve establishes the market price of the producers’ good.

    Summarising the complexity in discovering the prices of producers’ goods

    Prices of producers’ goods are also eventually determined by the subjective valuations of all the individuals who constitute the market. Their valuations as consumers determine the market prices of consumers’ goods. Their valuations as producers based on their subjective assessment of the demand schedules of consumers’ goods further determine the prices of producers’ goods. So we see that a complex but strong and robust market process based on valuations that cannot all be known to any individual drives the determination of the market price of any producers’ good.

    Why is this process failing to work in the coal market and why are NTPC and CIL engaged in a tussle?

    The reason is very simple. The market process has been disrupted by the establishment of two massive monopolies on the two sides of the coal exchange market. CIL and NTPC are both government entities with a monopoly on the supply of coal and the production of coal-based thermal power respectively. There is therefore no real free market in coal. In the absence of a free market for coal, there cannot be a market process for the discovery of the price of coal. The act of creating these two monopolies is a direct subversion of the market process. Problems related to the pricing of coal are an inevitable outcome of such subversion.

    Citing, as the Chairman of NTPC does in the video, that NTPC is working as per the regulations of the CERC (Central Electricity Regulatory Commission) does not constitute an answer. It is only an example of bureaucratic washing-my-hands-off-the-matter. The claim that pricing should be according to calorific value is also a very poor answer because it is a technocratic solution, not a market solution. A bunch of technical experts sitting together and systematically analysing reams of data does not constitute a market process of price discovery. It still remains a technocratic solution that will necessarily end up as arbitrary number fixing with no connection to the complex market processes that would otherwise determine the price. Government getting in and mediating the discussion will only transform the price that emerges thus from a technocratic solution to a political solution, not an improvement in any sense.

    What would constitute a real solution?

    The real solution would require breaking the monopoly of NTPC and CIL over their respective product markets. It will, in all probability, involve breaking the huge monoliths into multiple smaller pieces and completely privatising their ownership and operations. It would involve government completely renouncing its claims over the underlying resources by transferring them in their entirety to private hands and letting the new owners decide how to operate their individual facilities. It would involve further privatising the entire mechanism of transmission and distribution of power, thus letting the market decide what is the proper price of every factor of production including coal. Clearly, this solution is very challenging and there is bound to be a lot of political opposition to its implementation. That, however, does not take away from the fact that absent a free market in power, pricing of goods like coal will continue to attract controversy and remain a festering problem periodically inviting technocratic and political intervention to throw up inappropriate solutions.

    Related articles:
    Key Concepts in Economics – 3 – Subjective Value to Exchange and Price discovery

    4 votes, 4.50 avg. rating (87% score)

    Follow-up on the CAD question – Value of a currency, gold reserves and FRB

    In response to my previous article, Aditya Sood had asked the following question.

    Sir, I have a question. From what I understand, the value of a currency of a country used to be linked to its gold reserves in the past. The fractional reserve is a new thing. So who decided that value of a currency should be de-linked from an underlying commodity? Was it that all countries saw some flaws in that system and decided to shift to a new one ? Or is it that one particular country/group of people enforced it upon the rest ? If yes, how did they manage to convince all the countries about shifting to a new system?

    Also, when this delinking took place, did anyone (economists etc.) see any alarm bells ringing?

    Aditya’s question contains so many clues to the kind of misunderstanding that exists among ordinary people and the extent to which education is required to enable ordinary people to understand the varying grotesqueries of the prevailing system of money and banking.

    Misunderstanding No. 1

    Aditya asks

    From what I understand, the value of a currency of a country used to be linked to its gold reserves in the past.

    The important point to understand is that in the not too distant past, commodities like gold and silver were money. There was no such thing as a currency independent of coins of these precious metals and there was therefore no question of the value of a currency being linked to its gold (or silver) reserves.

    The clue to understanding these lies in understanding how some of the important modern currencies got their name. Take the British Pound, for instance. Ever wondered why it is called the Pound, or more specifically the Pound Sterling? Simply because the unit of money in England in the 1600’s was 1 lb (by weight) of Sterling Silver. 1 lb being a large weight (453.592 gms to be precise), there were other smaller units such as the shilling and the pence that served as the unit of money in smaller value exchanges. Each of these units stood for a definite weight of the same money commodity – Sterling Silver.

    The concept of monetary unit is important to understand while we understand money. The monetary unit is a conveniently chosen quantity of the underlying money commodity. Money is a good like any other good and is one of the commodities exchanged in any trade transaction, it being the generally accepted medium of exchange. Every good in every exchange is exchanged in a certain quantity and so is money. The concept of the monetary unit is a method to specify and identify the quantity of the money commodity involved in an exchange. When the price of a good is quoted as 10 shillings, it means the quantity of sterling silver contained in, say, 10 coins marked 1 shilling each. In this sense, the monetary unit is similar to the unit of measurements like the metre, the kilogram and the litre.

    So, in response to Aditya’s question, it is not that the value of the Pound Sterling was fixed as 1 pound of sterling silver. It was simply that the Pound Sterling was defined as 1 pound (by weight) of sterling silver.

    Misunderstanding No. 2

    Taking the same part of Aditya’s question

    From what I understand, the value of a currency of a country used to be linked to its gold reserves in the past.

    the second important misunderstanding that is visible is that there was no such thing as the currency of a country. There was money, which was largely coins of specific weight and purity of metals like gold and silver, and there were different such units, each of a specific weight and purity and minted at a particular mint. In any economy, multiple forms of money were simultaneously in circulation and there even existed exchange rates among the different currencies depending on their defined weight and purity, the age of the coins and their wear and tear, and, last but not the least, the reputation of the mint itself.

    In America in the 1700’s, for instance, Spanish silver coins were the most popular form of money. The most popular coins of all were the thalers. The name thaler is a shortened form of the longer Joachimsthaler which in turn stood for coins minted at the mint of a Count Schlick from the Joachimsthal or Joachim’s Valley region of Bohemia (modern day Czechoslovakia). These coins flowed into America thanks to the robust trade with Spain, what with large tracts of America then being Spanish colonies (Does The Mask of Zorro remind you of something related?). The reliability of these coins soon made them the most popular coins in trade. Even the Joachimsthaler was later to be upstaged by the even more reliable Maria Teresa Thaler. At the time of American Independence, a choice had to be made as to the unit of money of the newly independent States of America. The unanimous choice was the already prevailing thaler renamed as the Dollar.

    The thaler stood for 371 ¾ grains of pure silver and the dollar too was chosen to stand for the same quantity of the same metal. In effect, it was just a formal acknowledgement of what was already the market’s choice of the money commodity and the monetary unit.

    In addressing Aditya’s question, what we therefore see is that different regions ended up using different monetary units of one or the other of precious metals like silver and gold and that in each region one of these monetary units ended up being predominant due to various market factors.

    Misunderstanding No. 3

    I apologise for quoting the same bit from Aditya again, but it is interesting to note how many misunderstandings are revealed by just 1 sentence. He asked

    From what I understand, the value of a currency of a country used to be linked to its gold reserves in the past.

    The notion of gold reserves being linked to the amount of money in circulation is an outcome of certain banking practices that started becoming prevalent in the late 17th and early 18th centuries. I am referring primarily to the emergence of paper money and demand deposits a money substitutes. The point is simple – paper money as we know it is a relatively recent phenomenon. For a large part of history, gold and silver coins served as the money.

    Paper money emerged in the form of receipts issued by warehouses that stored money proper (gold and silver coins). Over time, these receipts started circulating in lieu of the money proper, the coins in storage. This evolved further into the concept of savings banks which accepted deposits of coins against which they issued bank notes. Savings banks, like their predecessors, the warehouses, charged their clients for the storage of the coins.

    By the 16th and 17th centuries, these bank notes had become widely accepted as money substitutes that could, on demand, be redeemed in the money proper. However, savings banks observed that only a small fraction of their bank notes actually returned for redemption at any point in time. This served as a great temptation for the savings banks to in a practice that is today known as Fractional Reserve Banking.

    Banks started issuing bank notes of cumulative face value far greater than the actual number of units of money proper in storage. The actual reserves of money proper they held was a fraction of the total face value of their own bank notes that they had put into circulation. This is the concept of the fractional reserve underlying the concept of Fractional Reserve Banking.

    Operationally, every Fractional Reserve Bank is fundamentally insolvent. It has made promises that it just does not have the ability to keep. If a bank has a reserve ratio of 10%, any number more than 10% of the total notes emitted coming in for redemption at a time means that the bank has to make public its insolvency and shut down.

    But why did banks risk such insolvency? The reason was that the money could be loaned out at interest and the bank could earn an actual profit in money proper. Basically, banks were getting to earn easy money by lending out other people’s property that had been given to them for safekeeping.

    This system of Fractional Reserve Banking, while temporarily profitable, is not without its consequences. Bank notes emitted thus were offered as loans to producers. Thus, they were injected into the production system as credit expanded beyond the actual pool of available real savings. This was, as is to be expected, accompanied by interest rate depression below the free-market level. In simple terms, as explained out here, this is precisely how the inflationary boom is created. However, as explained by ABCT, the seeds of the inevitable economic depression are sown during the inflationary boom. The economic depression would start with a spate of bank runs, leading to widespread closure pressures on highly inflationary fractional reserve banks.

    Unfortunately, the Fractional Reserve Banking system was also a convenient way for governments to raise resources for their ever-burgeoning spending plans. Fractional reserve banks were therefore able to lobby governments to protect them from the effects of their own irresponsibility. This close, symbiotic relationship between governments and the banking system grew ever stronger through a series of boom-bust cycles throughout the 18th and 19th centuries eventually leading to a system of governments taking control of the system of money by instituting Central Banks and conferring on them a monopoly over the issue of the fiat money and control over the banking system.

    The biggest step in this process was the setting up of the Federal Reserve Bank of the US in 1913 with a monopoly over the issue of US Dollars. The inflationary practices of the banking system under the Federal Reserve’s watch led to the Crash of 1929 and the Great Depression of 1929-1945. Under the pretext of the Great Depression, the US government moved the monetary system further from a linkage to real money such as gold through policies such as outright gold confiscation and devaluing the dollar from 1/20.6 oz of gold to 1/35 oz of gold. The argument cited was that the demand to hold gold was responsible for the Depression. The reality was that the government wanted to put an end to the commodity-based monetary system and free itself from the strict limits imposed on government spending by the laws of economics.

    The US thus moved from a gold standard to a notional gold exchange standard where US citizens could not redeem dollars in gold but foreigners and their governments could. By 1971, however, the situation worsened on account of further inflationary fractional reserve banking and the US was about default on its obligation to redeem dollars in gold to foreigners. That was when the then President Nixon repudiated all obligations of the US government to redeem dollars in gold, thus putting the entire world on a pure fiat standard. The UK had already done so in 1931 leaving the Dollar as the sole global currency.

    This, in short, is how the monetary system of the world transformed from a pure commodity-based monetary system to a pure fiat monetary system controlled by governments through Central Banks and the rest of the banking system. Basically, the banking system followed practices that landed them in trouble and created economic depressions. The blame was steadily and repeatedly placed on precious metals, especially their scarcity, eventually leading to a government takeover of the system of money and the banishment of silver and gold from their market anointed role as money proper.

    What do we learn from this deviation into history?

    It is incorrect to make statements like value of a currency being linked to the reserves held by the government or a monetary authority like a Central Bank. The monetary system of today is essentially the outcome of a systematic though protracted government takeover of a market determined system of money.

    Addressing the rest of Aditya’s questions

    Aditya then asks

    The fractional reserve is a new thing.

    It evolved basically as a way to earn money from nothing and grew by lobbying support from governments that benefited from FRB.

    So who decided that value of a currency should be de-linked from an underlying commodity?

    If one person or entity should be blamed, it is the US government. At a more general level, it is the banking system, Central Banks and governments that, through their machinations, moved the monetary system off a commodity base into a pure fiat system.

    Was it that all countries saw some flaws in that system and decided to shift to a new one?

    No. The commodity-based system of money had no major flaws. In fact, it is precisely the scarcity of precious metals that makes them good monetary materials. Rather, it was that governments and the banking system the world over saw a commodity-backed monetary system as a serious limitation on their inflationary and extravagant ways and foisted an FRB system on the markets. When their system failed (as it is expected to), they blamed the failure on the commodity and used it as an excuse to take control of the monetary system and change it to something that was more beneficial to them.

    Or is it that one particular country/group of people enforced it upon the rest ?

    Not exactly, various governments, in their own ways, encouraged, fostered and finally acted to enforce a pure fiat monetary system.

    If yes, how did they manage to convince all the countries about shifting to a new system ?

    No one had to convince any one. Every government and every fractional reserve bank wanted this system. Since governments were ready to use the power in their hands to make this happen, they did.

    Also, when this delinking took place, did anyone (economists etc.) see any alarm bells ringing?

    There were economists of the Austrian School like Ludwig von Mises who cautioned against these moves but they were largely ignored.

    What we can learn from this

    Most of us carry a number of misconceptions that distort our view of the working of the world. A lot of what we hear from most common sources needs to be questioned if we are to make sense of what is happening in the world around us. History shows us that those who are in charge of the system of money and banking are themselves responsible for the key monetary and economic problems of the day. Unless we grasp this fundamental issue, we will find it very difficult to comprehend true and lasting solutions to serious economic challenges.

    6 votes, 4.00 avg. rating (79% score)

    What sense do we make of bad news?

    It seems to be the season of bad news. Here, here, here, here and here with some honourable exceptions here and here, various sectors of industry led by the automobile sector seem to be facing slow or negative growth in the last financial year. What sense do we make of these disparate bits of data coming from different corners of the market?

    Why are auto sales falling?

    Before answering this question, it is important to understand that what we are witnessing is a broadbased fall in sales across the automobile industry, not just in one or two firms. This means that people have, in general, chosen not to buy new automobiles, which in turn means that they have chosen to retain their existing mode of transportation, which could be private or public transportation.

    Second, a significant proportion of automobile purchases (2 and 4 wheelers) in India happens with a bank financing the purchase, usually paying a large chunk (70-80%) of the price. The buyer of the automobile pays for it on a 3-5 year EMI schedule. That people are not ready to borrow in order to finance automobile purchases indicates that either funding is not available as easily as before or has become too costly, or the borrowers perceive greater uncertainty regarding their future income and are therefore reluctant to take up the responsibility of paying for a new vehicle under a scheme of EMIs.

    So, if automobile sales are indeed falling, it must be a combination of these factors
    1. People choosing to retain existing modes of transportation
    2. Funding not as easily available as before
    3. People not ready to borrow now and pay EMI later due to fundamental uncertainty over their own income
    that underlies the problem. But then that raises the further question of why such an outcome should occur, that too across the entire automobile industry after so many years of spectacular, non-stop growth? The answer lies not in an analysis of the automobile industry and its markets but in understanding the broader economic climate in which the auto industry currently operates.

    The economic climate

    Since 2007, the global economy and the Indian economy along with it have been muddling through what is today called The Great Recession and is being recognised as one of the longest periods of economic growth challenges since the Great Depression. On paper, the recession started in December of 2007 and while there are debates about the official end date, the problems that started in 2007 are far from over. Every now and then, a new crisis pops up and there is a mad scramble to contain it. It was Greece a few months ago and it is Cyprus now. Heaven knows what it will be in the near and distant future.

    Like any depression, The Great Recession is just a period of correction that consists of identification of a cluster of entrepreneurial error. In simple terms, a large number of businesses suddenly and surprisingly find that they are and have been producing things that people do not need and are therefore staring at deep losses and capital erosion. As Austrian Business Cycle Theory explains, this cluster of errors is created during the preceding inflationary boom (in this case by the boom of 2001-2007) and is caused by a combination of misleading interest rate signals given to producers, credit injection into the production system and monetary inflation, causing intertemporal discoordination, i.e., a mismatch between consumers’ consumption decisions and producers’ corresponding production decisions.

    That producers en masse suddenly find far fewer takers for their goods, as automobile manufacturers currently do, is a result of this intertemporal discoordination. When this happens, what a sensible producer should do is to understand the economic climate, try to develop a better forecast of what the future, medium and long-term, is likely to look like and adjust production decisions accordingly. This could mean, in some cases, producing less of the good. It could even mean completely ending certain lines of production, i.e., shutting down certain businesses.

    Such decisions are usually accompanied by a lot of pain as many people are put out of employment and, in many cases, will need to reskill themselves to the requirements of the new production structure. This puts further strain on many already struggling businesses leading to more business failures and more people being out of unemployment. While this sounds painful, it is just the market’s way of clearing past production decisions that are not in line with consumer preferences.

    This process goes on till the market clears out all such poor decisions and leaves the production system in sync with consumer preferences. Capital is taken out of the hands of those who made poor forecasts of the future into the hands of better forecasters, i.e., from failed entrepreneurs to successful entrepreneurs. This is the proper point of economic recovery. Further economic expansion would, under a free market, be triggered by fresh decisions to save and add to the capital available to be advanced for production for a more distant future.

    An alternative, equally or more likely in today’s FRB system, is that the banking system interrupts the market’s cleaning up process and initiates a fresh round of interest rate depression through credit expansion and monetary inflation, thus flooding the market with cheap money and cheap loans. This time, however, one would also have to contend with the possibility that such measures are not guaranteed to work like they have in the past. Experiments in the Western world indicate that such attempts have not really led to an economic recovery this time round.


    What the auto industry is going through today could very well be one of the manifestations of the bursting of the bubble created from 2001 to 2007. If people are not buying as many cars as they are producing, it is probably because they do not wish to see producers produce as many cars as they are producing. It is possible that the market is crying for a correction and that producers need to cut-back production to the level customers are ready to support. This is clearly one of the possibilities for any producer. Alternately, producers could place their bets on the RBI, through the banking system, inflating a new bubble through a fresh round of credit expansion and monetary inflation. In this case, they need to hold their horses for the recovery to happen while being prepared to profit the most by being at the vanguard of the recovery.

    Clearly, therefore, each entrepreneur will have to decide which scenario is likely to play out and what is the most appropriate course of action for him. It’s not easy, but no one ever said that operating a business in an environment of uncertainty created by endless meddling in the market would be easy. The times sure are challenging and let’s hope many entrepreneurs do make their way heroically through this economic fog to do what they do best – meet customer needs in the best possible way.

    What we need to take home, and what this article seeks to emphasise, is the point that in many circumstances, having sound economic understanding can help us understand business situations far better than those economically uninformed or ill-informed can. We can also see that cutting through the fog and making sense of complex situations is made possible by a good grasp of sound economic principles. The situation created by falling sales of the automobile industry in India only highlights the point that learning sound economics is a critical prerequisite for any aspiring business manager seeking to create a career out of making effective business decisions in a complex economic environment.

    1 vote, 5.00 avg. rating (89% score)

    Understanding the impact of RBI’s Repo and Reverse Repo Rate Cut

    It has happened as expected. RBI has announced a 25 basis point cut in the Repo and Reverse Repo rates. For the less exposed, this means that the Repo Rate has fallen from 7.75% to 7.5% while Reverse Repo Rate has fallen from 6.75% to 6.5%. What does this mean to different people? The segments we cover in this article are Banks, Industry, ordinary people and the broader economy.

    Impact on Banks

    To understand the impact of a cut in Repo and Reverse Repo Rates on banks, it is important to understand the role they play in banking. Repo and Reverse Repo are basically instruments used by the RBI to influence the total monetary base of banks.

    To get a grip on this, it is important to understand how banks work and what the term monetary base means. Banks engage in a practice called Fractional Reserve Banking (FRB). As explained in the linked article, under FRB, a bank lends many multiples of the actual cash in hand. This cash they have is what I mean by monetary base. Clearly, any addition to the monetary base adds to the bank’s ability to make loans by creating money from nothing (as explained in the linked article).

    In India, banks’ monetary base takes 2 forms – CRR (Cash Reserve Ratio) and SLR (Statutory Liquidity Ratio). CRR is the amount of actual cash that banks need to hold with the RBI. SLR refers to the amount (by value) of approved securities (government bonds, gold and approved, privately issued financial instruments) that banks are mandated to hold. Currently, CRR is 4% and SLR is 23%. Together, they constitute the monetary base of the Indian banking system.

    However, what CRR and SLR do not cover is the extent to which the RBI can lend to banks. That is covered under the Repo and Reverse Repo. In a Repo or a repurchase agreement, the Repo seller (the bank) sells an approved security to the RBI with the understanding that at a certain date in the future, the bank will buy the security back from the RBI. The bank gets cash and the RBI the security.

    One would expect that this would not influence the monetary base because while the bank gets cash and adds to its CRR base, it loses possession of the security and falls behind on its SLR base and can therefore not lend more. The interesting part is that this problem in the way of expanding bank lending is eliminated by the way the Repo system works.

    Very interestingly, during the term of the Repo, the bank is allowed to count the security thus sold to the RBI as part of its investments to fulfil the SLR requirement. So, the net effect of a Repo transaction is an addition to the bank’s cash reserves without falling behind on SLR requirements. With this, the bank can now engage in much more lending.

    At the end of the term of a Repo, the bank buys the security back from the RBI at a price higher than the original sale price. The difference expressed as a percentage of the original sale price is the Repo Rate. Thus, Repo Rate is used to calculate the price at which the security is bought back by the bank. It is the equivalent of an interest paid by the bank to RBI.

    It might seem that at the time the bank buys the security back, its cash reserve falls. However, the bank can then enter into a fresh Repo transaction and sell the security back to the RBI, bringing the cash reserve back to the higher level. In this manner, Repo becomes a means for the RBI to maintain a steady level of lending to banks.

    But all this additional lending would mean more purchases of securities to meet SLR requirements. This would mean the need to deploy cash for the same. That cash would go outside the system of lending and reduce the system’s lending potential. This problem is solved by what is called the Reverse Repo.

    In a Reverse Repo, the RBI sells an approved security to the bank with the understanding that it will buy it back at a future date at a higher price. The difference between the 2 prices expressed as a percentage of the original selling price (per annum) is called the Reverse Repo Rate. The Reverse Repo Rate thus becomes the interest rate received by the bank for lending cash to the RBI.

    The important point for us to note is that a bank may show securities bought from the RBI through the Reverse Repo window as part of its SLR commitments. Further, as in the case of the Repo, at the end of the term of the Reverse Repo, the bank can enter into a fresh Reverse Repo with the RBI.

    Summarising the understanding

    Bank XYZ hits its lending limit based on its CRR and SLR. It sees potential for more lending. It offers RBI a portion of the securities it holds as part of a Repo transaction and gets cash. It deploys 23% of this new cash to obtain securities under the Reverse Repo window from the RBI, thus keeping the cash within the system. The bank now gets to create new money amounting to 1/(CRR+SLR) times the money borrowed under the Repo window and lend it out at interest. The Repo window thus becomes a cheap source of borrowing for banks.

    The impact of a cut in Repo and Reverse Repo Rates

    A cut in Repo and Reverse Repo rates basically reduces the bank’s cost of borrowing from the RBI to add to its reserves. It enables banks to either increase the interest rate spread on loans made by the bank or offer borrowers lower rates of interest without eating into its own interest rate spread. Thus, a cut in Repo and Reverse Repo Rates increases the banking system’s potential by expanding more loans in a profitable manner.

    Impact on Industry

    With lower repo and reverse repo rates, industry gets to borrow more and even gets to pay lower interest rates on its borrowing. Therefore, those businesses that are in a position to secure additional lending from the banking system will benefit from lower repo and reverse repo rates.

    Impact on ordinary people

    The impact on ordinary people can be felt in 2 ways. In the nearer term, greater lending to businesses will lead to more business investment and employment opportunities. In the medium and longer term, however, the dominant factor influencing ordinary people will be the increased money supply (inflation), which will send prices of consumers’ goods soaring, resulting in future pressure to raise interest rates thus forcing the pricking of the inflationary bubble and the onset of the depression.

    Impact on the broader economy

    In the long-run, reducing Repo and Reverse Repo rates is harmful for the economy as it is just a means to lend reserves to banks, enabling them to engage in far bigger inflation to undertake much more credit expansion through FRB. While this lending will have some short-term positive effects, in the long-run, it creates and worsens the inflationary boom of the familiar boom-bust cycle. It also sets the conditions for the inevitable raising of interest rates thus pricking the inflationary bubble and triggering the depression.


    Thus we see that the policy of reducing Repo and Reverse Repo rates is essentially bad for the economy in the long-run because it greatly aids the creation of the business cycle. It also hurts ordinary people by sending prices soaring. Industry and the banking system, however, benefit in the short run. This explains why a policy of lowering repo and reverse repo rates finds fairly broad-based support from the banking industry and general industry as well.

    25 votes, 4.40 avg. rating (87% score)

    The hidden side of RBI’s push for more electronic payments

    In this article, the RBI is cited to be pushing for electronic payments as a replacement for cheques for loan repayments. The obvious explanation is that ECS will eliminate all the time and effort involved in collecting, depositing cheques and then getting them cleared. This is supposed to leave the banking system more efficient.

    What is not stated is the deeper reason for the move – to make people more accustomed to making electronic payments for everything to eventually make the move to eliminating cash.

    Now, cash is a bothersome thing. As long as people have a concept of cash and want it for various purposes, the banking system has to keep some cash. This is the reasoning behind having reserve ratios like CRR and SLR. With these, the bank is supposedly in a position to comfortably meet demand for cash.

    Why does people having a demand for cash make it bothersome?

    If people did not have a demand for cash, there is no operational limit to how much money the central bank and the entire banking system can create. We will then land in Inflationist Utopia where money creation and credit expansion can go on unbridled. That also means that all limits on government spending are eliminated.

    Is it possible that this Inflationist Utopia is RBI’s goal?

    3 votes, 4.67 avg. rating (89% score)

    Is MNREGS a significant cause of rapidly rising prices?

    The Financial Express reports thus – ‘Rural wage hike pushing inflation, posing challenge for RBI’. It goes on to quote an Assocham spokesperson thus.

    “Near 20 per cent annual increase in the wage inflation in rural areas is building up price pressures on food articles like cereals, rice and wheat, and is posing a big challenge for the Reserve Bank which is being called upon to cut the policy interest rates on Tuesday,” industry body Assocham said.

    So what sense are we to make of this? Why would rural wages shoot through the roof in this manner? As far as I understand, there are two possible reasons. The first is that agriculture has seen such a tremendous productivity increase that marginal value product of a unit of labour has really gone up 20%. Alternately, as I explained out here, a steady rise in prices is possible only if inflationary policies greatly and steadily increase money supply.

    And over the last couple of years, the Government of India, through various State governments, has really been flooding the rural markets with money through the MNREGS. So should we be surprised that rural wages have increased as much and as rapidly as they have? If we are, then it is time to revise our economics fundamentals. That such an outcome is inevitable could have been known right at the time of conceiving of a scheme like MNREGS. Why then are such policies being pushed? These and many other such tough questions are what we should be asking policy makers, but only an economically literate population can do so.

    3 votes, 3.00 avg. rating (64% score)

    Cantillon Effects and the “strange” divergence between CPI and WPI

    This article focuses on a certain divergence between two popularly used measures of price inflation – WPI and CPI – to explain the limited room available to the RBI in cutting interest rates as demanded by many sections of industry. My article seeks to explain that such a divergence is not unusual and in fact normal in an economy driven as much by credit injection through monetary inflation as the economy of today is.

    In economic theory, the term Cantillon Effects refers to the asymmetric distortionary effect of inflation (defined in the Classical tradition as an increase in the money supply) on the prices of goods. In simple terms, an increase in money supply does not lead to a uniform rise in the prices of all goods and services. Some prices rise more while some others may rise less, stay stable or even fall in the face of inflation.

    Why would there be Cantillon Effects of inflation?

    The important point is that money always and everywhere exchanges for particular goods and not for all goods, definitely not for a basket of goods like the ones for WPI and CPI calculations. A good way to understand this is to imagine for a moment that the good Angel Gabriel decides to double the money stock of some good people (while they are asleep) in a certain society. The next morning, this economy sure has greater money supply but the additional money supply is in the hands of particular individuals only.

    The additional stock of money immediately influences the value scales of the particular individuals alone to begin with. The marginal unit of money becomes less valued to these people and therefore a certain number of units of particular goods that were earlier considered less valuable than the marginal unit of money may suddenly appear more valuable than the marginal unit of money. So, these people step out and buy these goods. In economic terms, the demand schedules of these buyers have been influenced and their demand curves have been shifted rightward. The demand curves for the particular goods see a rightward shift as well.

    However, the value scales of suppliers of these goods do not see any change as nothing has changed for the suppliers. This results in an unchanged supply curve, which, in conjunction with a rightward shifted demand curve, will lead to a higher equilibrium price for the particular goods that these people buy.

    In the meantime, demand and supply schedules of other goods remain unaffected and their prices remain unaffected as well. Thus, we see that injecting money into the hands of particular people can raise the prices of some goods while having no influence whatsoever on the prices of other goods. This phenomenon is what we understand in Economics as Cantillon Effects.

    The “strange” divergence between WPI and CPI

    Let us first remind ourselves that we are right now at the end-stage of a previous round of inflation created by an out-of-control fractional reserve banking system. During any such inflationary period, there will be Cantillon Effects of the inflation. In the early stages of such an inflation, the money injected by the banking system into the production structure will necessarily be spent first on buying factors of production including capital goods, land and labour. This spending works its way through the system of production till it lands in the hands of the owners of land, labour and capital as rent, wages and interest respectively.

    Therefore, the immediate effect of the initial inflation is necessarily to raise the prices of producers’ goods, which in turn will cause an index like the WPI to rise while leaving the prices of consumers’ goods relatively unchanged, thus leaving an index like CPI relatively unchanged as well. It is only in the late stages of the inflationary process when the land and labour factor owners and capitalists spend their income on consumers’ goods that their prices and hence CPI go up. At that stage, we may very well witness a rise in CPI being accompanied by a much smaller rise in WPI.

    The kind of move that the article cited above speaks of is therefore nothing unusual and is in fact to be expected in an economy driven by inflationary credit expansion by a fractional reserve banking system.

    Policy implications

    Actually, there are few or no policy implications. Any attempt by the RBI to push money supply up by dropping rates is likely to lead to greater credit expansion through inflationary banking or money injection into the system of production. Therefore, the first effects are once again likely to be on the prices of producers’ goods, i.e., on the WPI. It is only in the future that the effect on consumers’ goods prices will become visible and the CPI goes up again.

    Unless the banking system is completely broken and has no avenues into which credit can be injected, it is certainly possible for the banking system to inject newly created money into the production system. There is therefore little to fear and no reason to argue that the RBI has little headroom in tinkering with interest rates, especially once it has, as has every central bank, chosen the path of inflationary banking.

    1 vote, 5.00 avg. rating (89% score)

    How many regulations is too many?

    This article quoting the economist Raghuram Rajan (now tipped by some to be the next RBI Governor) brings up an important issue – that of regulation. Unlike Mr. Raghuram Rajan, I would argue in much simpler terms. The number of regulations is too many if their number exceeds zero. In simpler terms, every regulation is one too many.

    What is regulation

    The word regulation is one of these new-age words that had crept into our vocabulary in a rather insidious fashion. Today, most people look upon regulation as something necessary without which unbridled greed will result in undesirable outcomes. “Some regulation is necessary”, argue most people.

    But what IS regulation? Very simply, it is a set of mandates or restrictions imposed by government on particular sets of citizens. Depending on the particular regulation, the set could become large enough to encompass all citizens. However, the important point to note that every regulation is an act of coercing one or more citizens with the aim of making them follow particular courses of action or preventing them from following particular courses of action.

    So, regulation is coercion. Economically speaking, it is a form of violent exchange. From the perspective of economics, violent exchange lowers overall well-being. The victim of the violent exchange is forced to give up a more valued good for a less valued good or nothing at all. The recipient of the violent exchange clearly benefits, but the impossibility of comparing value across people leaves us with only one certainty. There is loss of utility and well-being to the person being coerced. The rest of it is plain wishful thinking.

    Regulation and the labour market

    This is especially true in the labour market where capitalists can only offer any factor of production its discounted marginal value product, i.e., the present value of its future marginal contribution to revenue. If capitalists are forced to pay more, they will employ less of the factor until the factor price equals its DMVP once again. The result of regulations in the labour market is, therefore, chronic unemployment.

    All forms of labour regulation – minimum wages, mandatory contributions, gratuity, firing restrictions, child labour laws, etc. – raise the costs of employment. Therefore, they are all retrogressive. So, the only real solution is to repeal ALL these retrogressive regulations in the labour market. The only hurdle is the political one. The rest is just playing with words.

    4 votes, 4.00 avg. rating (79% score)

    Why are cereal prices high?

    This is priceless. ROFL stuff. Article 1 says that the Central Government is not allowing export prices of wheat to fall below a certain level. That level, incidentally, would make their minimum support price look ridiculous by placing a huge subsidy (that only means much bigger than the current one) burden on government, but that’s my observation, not the article’s. As per the article, it is ministers of the Central Government who are refusing to allow wheat export prices to fall below the prices at which the Central Government sells wheat to biscuit manufacturers.

    And then there is Article 2 that blames State governments for prices not falling and for stocks piling up and rotting in godowns. It even cites economic theory by mentioning that record stocks should send prices crashing down and ends by saying that the fact that they are not must be because of hoarding.

    Ah! There it comes!!! The evil hoarder is responsible for all the miseries of the common man and government is the saviour. Let the crackdown start and let’s have punitive punishment meted out to the greedy people who are ready to watch millions starve.

    Yes! Repeat after me until you really believe it!! Government manipulation of the money supply and its tampering with the price mechanism have nothing to do with high and ever rising prices. If you repeat it enough times, it will become the truth. So repeat it blindly without thinking.

    2 votes, 3.00 avg. rating (66% score)

    Economic science is in dire straits

    This article brings out quite well and rather unintentionally a lot of what’s wrong with Economic science in India (and frankly, the entire world) today. Particular points in the article are especially revealing. Take this segment, for instance, where the author gives you a mental image of the typical macroeconomist.

    …. he’ll tell you that he actually studies the impact of soft coal prices in the Ruhr on the velocity of the money supply in West Germany in the 1970s and something else you will never learn because you suddenly hear your phone ring.

    So what IS the macroeconomist doing? He is building a model. A model is a mathematical framework that gives us the values of certain output variables for different combinations of input variables. The model does this by assuming certain mathematical relationships between the input and output quantities.

    Why is the macroeconomist trying to build a model? The primary purpose of modelling is to be able to predict outcomes of actions and choices. To do this, a model first tries to explain observed correlations between the same input and output variables in one or more historical circumstances. The more the number of such instances in which the model makes accurate predictions and the lower the error, the more robust the model is said to be.

    Where would such models be used? One key use of such models is in policy formulation and evaluation. The term policy in particular refers to the particular approach that government would take to the broader economy or a specific segment thereof, which in turn translates to the manner in which government chooses to intervene in the economy or a particular segment of it. Thus, we see that models are primarily used in shaping and evaluating government interventions in the economy.

    Another key use is to help businesses in making better economic forecasts and therefore in making better business decisions.

    What is the problem with this approach?

    The problem is very fundamental. Model building is based on assumptions that are absolutely unsuited to the study of Economics. Every model assumes certain constant quantitative causal relationships between the input and output variables. As a social science that may be defined as the study of exchange, sound economic theory cannot assume any such constant quantitative causal relationships between variables.

    Unlike in the natural sciences where twice the volume of water flowing into a leak-free pipe will mean twice the water flowing out as well, in Economics, the subject of the study is man. The singular trait of man is his unpredictability. No two human beings may be assumed to behave the same way in the same circumstances. The same human being may not behave the same way in the same circumstances at different points in time.

    What this translates to is this – In the natural sciences, if a stone thrown up today falls back to the ground, a stone thrown up in identical fashion tomorrow will fall back to the ground as well. In economics, however, such automatic repetitive and repeatable behaviour cannot be expected because we are talking of people, not stones.

    What models end up doing, therefore, is that they make unreal assumptions about human behaviour in order to make their predictions fit observations at some point in time. The problem in doing so is that past robustness of a model in explaining is no indication of its correctness or its future accuracy. People change, and with that change economic outcomes. Models cannot predict the manner in which people can change.

    Modelling in economics is little different from voodoo. Personally, I like to call it the virgins in the volcano method of economics. In simple terms,

    The model says that there is a strong correlation between the number of virgins that fell down the volcano and the amount of rain that fell every year. So in order to improve rainfall this year, let’s throw a couple more virgins down that volcano right away.

    What we learn is that the very attempt at creating economic models is fundamentally and deeply flawed. What do we say about economics education when modelling is the core of the development of economic science? May I say “Heaven help us”?

    2 votes, 3.00 avg. rating (66% score)

    The sad state of the policy on FDI in retail

    [Update: An alternate interpretation of the real estate issue has been added]

    This was a good wake up call back to reality after all the dreaming about the possibility of 100% FDI going all the way to convertibility on the capital account. No! The Indian government is not going to do the economically sensible thing. It will insist on putting spokes in the wheel and hurdles in the path of the eager investor.

    It will burden the capitalist with burdens so big that he will begin to wonder if all the hoopla about the humongous Indian market is worth it at all. It will get down to telling the capitalist how to run his business and where to put his money. It will dictate what goods he may sell, where he may source his goods from and therefore at what cost, thus throwing all business strategies of the capitalist out of the window.

    The simple case of mandatory investment in real estate

    This is from the newspaper article cited today.

    Senior executives and representatives of these companies met government officials in New Delhi this week to lobby for concessions. These included relaxing the local sourcing conditions, making investment in real estate part of the mandatory $50-million investment that foreign retail companies have to make in back-end infrastructure, as well as lowering the minimum investment figure itself.

    The hallmark of a real estate bubble is that property prices go completely out of sync with rental prices of the same property. For instance, when a plot of vacant land that would get a bare rental price of Rs. 3 lakh p.a. has a market price of Rs. 1 crore or more, the market is betting that the prevailing expectation on interest rates is around 3%. This is simply because the market price of the land is nothing more than the discounted present value of all future rental income flows against that property. Given that land rentals are best seen as rentals in perpetuity, the discounted present value of all future rental income flows is nothing but the sum to infinity of a Geometric Progression with
    • initial term (a) = Rental Price of land/(1+i/100) (Year 1 rental comes at the end of the year in the basic model)
    • common factor (r) = 1/(1+i/100)

    Market price of land = {Rental Price/(1+i/100)}/{1–(1/1+i/100) or

    Market price of land = Rental Price/(i/100)

    So a market price of Rs. 1 crore given a rental price of Rs. 3 lakh implies an expectation that

    i = (3 lakh/1 crore)*100 or 3%

    A 3% nominal rate of interest when price inflation is estimated anywhere from 6% (based on WPI) to 11% (based on CPI) means negative expectation on real interest rate. If ever you could say B-U-B-B-L-E, it is under such circumstances.

    So, given that there is indeed a bubble in real estate, it is eminently possible that a multinational that specialises in the business of retail and is focused on keeping costs as low as possible as part of its business strategy would clearly have reasons to prefer leasing to buying, especially if it can get the requisite security of tenure. If, on the other hand, it is forced to invest in Real Estate, there is clearly less capital left to invest in other aspects of the business. In this manner, government actually gets to tell the retail chain where to put their capital.

    A company whose core competence is running a chain of retail supermarkets through leased real estate would hardly consider it its core competence to make profits through real estate plays. By forcing the retail chain to play the real estate game, government is actually dictating their business strategy. Someone tell me what sense this makes!

    [Update] – It may also be interpreted that these retail chains are asking to be allowed to include their real estate investments as part of the mandatory $50 million that they have to invest in back end infrastructure. If this interpretation were correct, then all they are trying to do is to free themselves from other mandatory investments and leave themselves free to make the rest of the investments most in keeping with their business plans. Not allowing them to do so, however, will still remain another way of dictating investment terms to the investing capitalist. I fail to see how this makes sense at all.[Update ends]

    30% mandatory local sourcing hurts the Indian consumer

    The policy on FDI in retail includes a mandatory requirement of 30% local sourcing. If the retailer prefers to source from suppliers in other countries, it implies that suppliers in this country are overall less efficient and involve greater cost for the retailer. Protecting local industry in this manner automatically implies hurting the local consumer burdening him with higher costs. In the name of protecting the Indian manufacturer, this policy hurts the Indian consumer.

    To make matters worse, it is a classic case of Bastiat’s dictum of the seen vs the unseen. The employment that is created in the lines of production favoured by the policy is very visible and is seen. The employment destroyed in the industries that are disfavoured because the consumer now has less disposable income and is therefore unable to spend on those is unseen and can never be known or estimated, though it is very real.

    The most one can say is that the spending caused by the policy is forced upon the consumer while the unseen spending that the customer would have engaged in would have been volitional and would hence have left him better off. That he would be better off is a logical necessity as the very use of force indicates that the option being forced is valued less by the consumer for if it weren’t, the force wouldn’t be needed in the first place. Thus, in economic terms, the policy of forced local sourcing leaves the Indian consumer worse off.

    Time to review the policy

    If the government wants to do something good for Indians in general, it needs to reconsider its policy on FDI in retail and allow foreign capitalists to invest as they wish to and stop dictating terms to them.

    2 votes, 4.50 avg. rating (86% score)

    An economic depression is not a bad thing

    Most people I speak to think that an economic depression is a problem that needs to be solved. Take a look at this article, for instance. This notion is far from correct. An economic depression is a period of necessary correction. An economic depression is necessarily and always preceded by an inflationary boom.

    The real problem is the inflationary boom for which the bust is the cure

    During the boom, policies targeted at interest rate depression allow the banking system to expand credit way beyond the available pool of real savings. This results in massive investments into projects that never would have been invested in on the free market. At the very least, new investments would need to be accompanied by
    1. additional net saving by consumers
    2. movement of capital from lines of production of other less preferred goods
    These prevent the possibility of an inflationary boom. These conditions are a logical necessity for the new investment to happen.

    However, an inflationary boom creates malinvestments. The process of creating the inflationary boom necessarily also includes the pins required to prick the bubble at some unexpected point in time. When this happens, the market reassesses all the investments made and sorts them into good and bad investments. This is done through the profit/loss mechanism and made explicit through the phenomenon of business bankruptcy. While this process involves pain, without it, the market cannot realign investments to be in line with consumer preferences, especially across time periods.

    Economists would say that the boom causes intertemporal discoordination while the bust corrects those errors and brings about the highly necessary intertemporal coordination once again.

    The free market is capable of keeping the inflationary boom in check

    Even if the banking industry or a segment of it were to engage in fractional reserve banking by emitting far more paper, plastic and electronic forms of money than the real money commodity that they have on hand, the free market has a built-in mechanism to keep this under check. This is called bank failures.

    Let us take, for instance, a region that uses dollars defined as a 1 ounce coin made of sterling silver as the unit of money. If a bank with $1 million in real dollars issues $10 million in paper dollars, the over-supply of paper dollars can easily be identified by the market. Further, the fact that on this market, every bank’s notes would be clearly identified with the bank (they would be printed as XYZ bank notes) and the market would easily be able to establish different rates of discounts for notes issued by different banks.

    A more inflationary bank’s notes would be more deeply discounted than the notes of a less inflationary bank. Prices of goods might be quoted in dollars but one would have to fork out more $1 notes of an inflationary bank than the quoted dollar price. For instance, if an inflationary bank’s notes faced a discount of 50% on the market, a customer wishing to buy a good priced at $50 by paying in notes of the inflationary bank will need to fork out notes of $100 face value. If the discount were 75% because the bank is perceived as highly inflationary, he will need to fork out notes of $200 face value. Thus, the greater the inflationary condition that the market sees in a bank, the less valuable would be the money substitutes emitted by the bank.

    Further, the more inflationary a bank is assessed to be, the more likely it is to be brought down by note and deposit holders walking into the bank’s branches and asking for real money in exchange. While this could be due to a loss of trust in the bank, it could also be because a trusting customer has issued a cheque to the customer of another bank that is asking the inflationary bank to pay in real dollars (which it does not have).

    Such failures of fractional reserve banks would lead to a more cautious public wary of inflationary fractional reserve banks. Fractional reserve banks would then have to incentivise people to place money in their accounts, which in turn would raise the cost of their funds available for loans. In addition, being rated as a non-inflationary bank would make a bank more attractive to a public seeking greater safety of their money. In this process, the very service of getting rated on inflationary practices would become a valuable service that could be offered by rating agencies. Thus, we see that on the free-market, there exist many possibilities of mechanisms to keep fractional reserve banking in check.

    If fractional reserve banking is in check, so is the inflationary boom. Thus, we see that an inflationary boom of the kind that we see today is impossible on the free market and that it is only fractional reserve banking with no market controls that causes the inflationary boom.

    When we will encounter massive inflationary booms

    Massive inflationary booms necessarily require massive interventions that prevent the functioning of market mechanisms. These typically take the form of government action aimed at protecting the inflationary segments of the banking industry. Today, these take the following forms
    1. Central Banking with a monopoly on money issue and bank licensing
    2. Central Banking as a source of lending of last resort to failing banks
    3. Deposit insurance that is politically motivated and priced
    4. Legal tender laws that force acceptance of inflated money substitutes at par
    5. Capital gains taxes on alternate forms of money
    In the absence of these forms of protection, it is impossible for a fractional reserve banking system to become as prevalent as it has become today.

    The conclusion

    We need to stop fearing or hating the economic depression. What we really need to be wary of is the inflationary boom that forces the pain of the bust on people at large. We also need to fear all the interventions that make the inflationary boom possible and the periodic pain of the depression a “necessary” feature of our lives.

    2 votes, 4.50 avg. rating (86% score)

    How inflationary banking creates economic depressions and recessions

    In response to my post of yesterday , a student of mine, Sankalp, had asked this question to which I responded thus. Sankalp raised an important point that I am sure a lot of people believe. With a little elaboration from my side, his question becomes this

    What is the problem in banks being inflationary by nature if by engaging in such inflation, they will be able to lend much more and a lot more investment can happen? Would not an economy where lending is constrained by the actual amount of cash experience highly hampered growth in comparison?

    Ordinary people see no problem in this state of affairs. Those with an exposure to mainstream economics would in fact jump to a fierce defence of this system and argue that growth would become highly constrained if the banking system were to allow cash to sit idle in the bank’s vaults while thousands of investment-worthy projects gather dust and go to rust.

    The Austrian School of Economics in the tradition of Carl Menger, Böhm Bawerk, Ludwig von Mises, Friedrich Hayek and Murray Rothbard takes a radically different view of this situation. Austrian School economists explain that the much dreaded economic depression (including its modern semantic avatars, the economic recession, slowdown, downturn or whatever you wish to call it) is caused by the inflationary banking system.

    The explanation, known by the name Austrian Business Cycle Theory, originated in the work of Ludwig von Mises in his book, The Theory of Money and Credit (1912) and was further developed by his student, Friedrich Hayek, in his books Monetary Theory and the Trade Cycle and Prices and Production. In fact, Friedrich Hayek went on to win the Nobel Prize in Economics in 1974 for his Business Cycle Theory, the only Austrian School economist to do so till date.

    The brief version of Austrian Business Cycle Theory

    In an earlier post, I had presented a stylised representation of a production system in which the original means of production, labour and land, are applied across various stages of production and eventually transformed into consumers’ goods. We saw in that case that the consumers’ goods output worth 100 oz was made possible and supported by a total capitalist saving of 318 oz.

    What would happen if consumers were to decide to save 20 oz? Two things happen.
    1. Consumption now falls to 80 oz
    2. Capitalist savings go up to 338 oz
    But what is the use of greater saving being available from capitalists when people have decided to consume less? The trick is to recognise that saving is a deferral of consumption, not permanent abstinence from consumption. In simpler terms, the saving is intended as future consumption. Saving is a decision to change the time of consumption.

    This decision by consumers gets communicated to producers through a fall in the rate of interest. Producers take a cue and decide to rejig their production for a more distant future. In doing so, the production system becomes longer, with more stages of production. Hayek presented this in a highly stylised form using what are today known as Hayekian triangles as shown below.

    Fig 1 - Hayekian Triangles representing the effect of new capitalist saving on the structure of production

    Originally, a total saving of 160 oz churned out an output of 80 oz worth consumers’ goods. Now, a total saving of 180 oz churns out an output of 60 oz worth consumers’ goods. In our 6-stage production structure, a similar outcome would occur with a corresponding increase in the number of stages of production.

    Many outcomes result. The immediate fall in demand for consumers’ goods leads to a fall in their prices. This is transmitted up the production structure, but the lower consumption does not put factors out of employment. The lower interest rate causes remoter stage capital goods prices to rise on account of much lower discounting (lower interest rates) of their imputed future contribution to revenue (called their discounted marginal value product). In the long run, greater availability of savings results in increased demand for factors in remoter stages of production.

    The addition of stages implies greater specialisation and division of labour implying more efficient production thus leading to greater volume of consumers’ goods output in the future. This leads to a further fall in consumers’ goods prices in the future. However, when the greater output of consumers’ goods hit the market, the saved funds are now available to support their consumption. For the same 60 oz of spending, consumers get to consume the greater output of the longer and hence more efficient production system. This is the normal process by which an economy advances and standard of living improves.

    Inflationary credit expansion and the production structure

    When the banking system inflates money supply, it does so by injecting credit into the production system in the form of loans made to producers. This injection, however, takes place without saving by consumers. An injection of 80 oz of credit makes the production structure as long as in the earlier case with the 80 oz of consumers’ goods output being supported by a total apparent capitalist saving of 240 oz.

    Fig 2 - Hayekian Triangles representing the effect of credit injection through monetary inflation on the structure of production

    To achieve this credit expansion, the banking system will need to depress the interest rate. This lowered interest rate raises the prices of remoter stage capital goods as in the case of real savings, shifting factors of production there. However, the greater availability of capital without a fall in the demand for consumers’ goods results in a rise in the prices of factors of production. When the greater income is spent on consumers’ goods, their prices start going up as well, though after the prices of capital goods and their factors of production go up.

    A general feeling of prosperity is created all around as capital goods prices, consumers’ goods prices, wages and rents go up and profits emerge in the economy. This is the inflationary boom like the one we experienced from 2001 to 2007.

    However, inflationary pressures soon catch up and the system is forced to raise interest rates. Production processes that started in the reduced interest rate regime suddenly become impossible to continue further. To make matters worse, when the greater output of the more efficient, longer production structure hits the market, savings are not available to be spent on them. Unsold inventory piles up and businesses rack up huge losses.

    The result is widespread business failure including failure of financial institutions that made loans to borrowers who end up defaulting. This is what we understand as the bust, commonly known as an economic depression or recession.

    What we see

    The lengthening of the production structure caused by genuine saving was stable and sustainable in the long run. Lengthening fuelled by credit expansion, however, is unstable as the manner in which it is done creates pressures that force an untimely increase in interest rates resulting in the depression stage of the business cycle. We see that once the inflationary boom is triggered by credit expansion through monetary inflation by the banking system, the bust is inevitable.

    Thus, Austrian Business Cycle Theory helps us understand that it is the inflationary banking system that is the primary cause of all the misery created by the phenomenon of economic depressions. The key question now is

    Are these boom-bust cycles inherent to the capitalist system of production or are they a result of intervention in the economy? Is it at all possible to eliminate the business cycle?

    These important questions shall be the subject of another post on another day.

    0 votes, 0.00 avg. rating (0% score)

    Fixing Inflation

    This article raises an issue very relevant to the times we live in – fixing inflation. Summarising what Mr. Subbarao says, inflation is a supply side problem. That means that according to him, inability of the system of production to keep up with the ever-rising demand for goods and services is responsible for steadily rising prices. This inability, he implies, is due to fiscal policy failures and a slow pace of reform dragging economic growth down. The responsibility for fixing the problem, as per Mr. Subbarao, lies with the government. In his opinion, there is precious little that the RBI can do to stimulate growth without stoking the fires of inflation.

    Mr. Chidambaram, on the other hand, believes that he has done what he could and was expected to do, i.e., keep fiscal deficit under control, to keep inflation under control, and that the ball is now in the RBI’s court. He believes it is time for the RBI to cut interest rates and tinker with other parameters in its control (like CRR and SLR) to boost growth.

    What do we, as ordinary people, make of this debate happening in rarefied environs? Let me make a beginning by focusing, in this article, on inflation.

    What is inflation?

    The commonly accepted definition of inflation is the steady rise in prices, which is measured through price indices like WPI and CPI. The Classical (Original) definition of inflation, however, is the increase in money supply. This might come as a surprise to many of you because all you may have heard is the commonly accepted definition given above. So here, here, here and here are some links that confirm what I am saying.

    Which of these is meaningful and useful?

    Only the Classical definition of inflation is meaningful and helps us understand real world phenomena like ever-rising prices while the commonly accepted definition is utterly useless.

    Why is the Classical definition meaningful and useful?

    Money is a commodity like any other. It has a price too. That price is determined, like it is for all other commodities, by the forces of supply and demand. When money supply increases, the price of money falls. When the price of money falls, the prices of goods and services denominated in that money rise. A steady rise in the supply of money causes a steady rise in prices. Thus, the Classical definition of inflation helps us understand the real world phenomenon of rising prices from fundamentals and is therefore meaningful.

    Why is the commonly accepted definition of inflation useless?

    Defining inflation as the steady rise in prices tells us nothing about what caused prices to rise in the first place. Explanations like the demand-pull and cost-push theories, and structural/built-in inflation are based on elementary economic fallacies and errors. For instance, if we say that prices are rising because demand is rising, what caused the demand to rise in the first place? If we say prices rise because costs rise, aren’t costs prices themselves? Are we then not bound to explain what caused THOSE prices to rise first? If we do not, would we not be guilty of engaging in circular reasoning by saying that rising prices cause prices to rise? And is saying that some price rise is “built-in” not a negation of economic theory itself, especially price theory, which seeks to explain prices from fundamentals?

    A small point of caution while using the Classical definition of Inflation

    It often happens that productivity improvements send supply of goods and services up so rapidly that we do not see rising prices but stable or even mildly falling prices. In such cases, it is important to bear in mind that in the absence of inflation, prices of these goods and services would have been much lower than they currently are. So, merely observing stable, slowly rising or mildly falling prices in the face of increase in money supply does not negate the Classical definition of inflation.

    What causes money supply to increase steadily?

    As explained in my previous post, the banking system that we live with is the fundamental and most proximate cause of inflation. Fractional Reserve Banking is based on creating money many multiples of the monetary base we start with. A banking system with a 10% reserve ratio can multiply every Re. 1 into Rs. 10. The Rs. 9 is addition of money supply by the banking system.

    Central Banks (like RBI) make matters worse. They have reserve ratios of their own based on which they lend reserves to banks. The US Fed, for instance, has a reserve ratio of 35%. This means that the Fed multiplies the banking system’s monetary base by 1/0.35 or 2.9 times. Combined with the banking system’s reserve ratio, every $1 can be multiplied into $29. The inflationary potential of the banking system is thus magnified by Central Banks.

    Government spending draws resources from the private sector through taxation and borrowing. All this leads to a pressure to keep increasing money supply.

    It is these 3 factors – the Banking System, Central Banks and Government – that are responsible for causing inflation (as per the Classical definition).

    What does this help us do?

    At the very least, it helps us pin the blame for the phenomenon of ever-rising prices. At a deeper level, it gives a solution to the problem. All it takes to solve the problem of inflation is for the triumvirate identified above to stop engaging in inflation (as per the Classical definition).

    The question is, would they? And if they would not, why is it so? These are important questions that we will find answers to in subsequent posts.

    2 votes, 3.00 avg. rating (66% score)

    Why the SBI Chairman is calling for rate cuts

    I just chanced upon this article and thought it would be helpful to explain why representatives of the banking industry frequently make such demands. This is meant as a primer for those with little introduction to banking and finance.

    Here’s how the banking system works. It is called a system of Fractional Reserve Banking. Unlike ordinary people, banks can lend many times the amount of money that they actually have on hand. If you have Rs. 1000 on hand, the maximum amount you can lend to someone is Rs. 1000. A bank, however, gets to lend many multiples of Rs.1000 depending on the regulatory regime, i.e., the reserve requirements imposed by the central bank (the RBI in India).

    This is made possible by a simple accounting trick. Imagine a bank with the following balance sheet

    Table 1 - Balance Sheet of a Hypothetical Bank upon launch

    One would expect that the bank will be able to lend a maximum of 1,000,000 and end up with a balance sheet that looks like this.

    Table 2 - Expected Balance Sheet of a fully loaned up bank

    We think that the bank has 1,000,000 in cash to pay all deposit holders if need be. However, under fractional reserve banking, a bank needs to keep only a fraction of the total deposits as cash in reserve. This fraction is called the reserve ratio. These days, it is usually set by the central bank of each country though prior to central banking, banks used to set their own reserve ratios.

    A bank with a 10% reserve ratio needs to keep only 100,000 as reserve against deposits of 1,000,000. Conversely, a cash base of 1,000,000 can support a deposit base of 10,000,000. This means that the bank’s balance sheet can look like this.

    Table 3 - Balance Sheet of a fully loaned up Fractional Reserve Bank with a 10% Reserve Ratio

    Thus, we see that fractional reserve banking enables banks to lend far in excess of their actual cash holdings. They do this by adding units of money to the total money supply by adding it into new or existing deposit accounts. This is reflected in the jump in deposits held in bank from 1,000,000 to 10,000,000.

    Basic arithmetic tells us that if a bank gets to borrow 1,000,000 at 8% and lend 10,000,000 at 12%, it must be enormously profitable. So, there is phenomenal incentive for banks to borrow to add to their cash base and grow by increasing the total amount they have loaned out. In order to do this, banks need a source of near unlimited lending. That source is the central bank (the RBI in India).

    The Repo window of the RBI is basically a means for banks to augment their cash reserves through sale of bonds to the RBI (repo) or borrowing reserves from the RBI (reverse repo). Interest rates (Update: Please note that interest rate here stands for repo/reverse repo rates) determine how much a bank can add to its cash base through this window. Higher interest (Update: repo/reverse) rates mean lower addition to the cash base while lower interest (Update: repo/reverse repo) rates mean higher addition to the cash base. Therefore, it must be obvious that banks would prefer lower interest (Update: repo/reverse repo) rates all the time.

    Lowering the reserve ratio has a dramatic effect on how much the banking system can lend out on the same cash base. A drop in the reserve ratio from 10% to 9% will leave our hypothetical bank’s balance sheet looking like this.

    Table 4 - Balance Sheet of fully loaned up Fractional Reserve Bank after cut in Reserve ratio to 9%

    The banking system thus gets to lend out an additional amount greater than its actual cash base. While the actual additional amount of lending possible depends on the original reserve ratio and the extent of the cut, the simple arithmetical point is that it a cut in the reserve ratio necessarily means additional lending possibilities for banks. Combined with a cut in repo and reverse repo rates, it can indeed add significantly to the banking system’s ability to create new loans.

    Thus, it becomes clear why the banking industry is perpetually calling for lower interest rates and lower reserve ratios. The economic consequences of these are, of course, an entirely different matter and I shall tackle them some other time.

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