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‘Inflation’ ला मराठीमधे काय म्हणाल?

Source: Flickr

Source: Flickr

महागाई चलनवाढ असे अनेक शब्द आपण रोजच्या वर्तमानपत्रात वाचत असतो. पण ह्यांचा नक्की अर्थ काय आहे? महागाईसाठी कोणाला दोष द्यायचा हे ठरवण्याआधी ती नक्की कशामुळे निर्माण होते ते पाहूया. महागाई दोन कारणांमुळे होऊ शकते. पहिलं अगदी सोपं आहे. एखादी गोष्ट बनवायला जो कच्चा माल लागतो तो जर महाग झाला तर त्या गोष्टीची किंमत पण आपसूकच वाढणार. जर आंतरराष्ट्रीय बाजारात तेलाची किंवा धातूंची किंमत वाढली तर प्लास्टिक स्टील इत्यादी गोष्टींची किंमत पण वाढणार. आपल्याला असे वाटते की आधी महागाई वाढते आणि मग आपला पगार वाढतो पण उत्पादनातला एक महत्वाचा घटक म्हणजे कामगार असतो. म्हणून पगारवाढ हे पण महागाईचं एक कारण असू शकतं. ह्याला अर्थाशात्रात ‘cost push inflation’ म्हणतात.

महागाईचं दुसरं कारण सहसा लक्षात न येणारं आहे. कुठल्याही गोष्टीची किंमत फक्त त्याच्या निर्मितीला लागलेल्या खर्चावर ठरत नाही. बहुतेकदा त्या गोष्टीची किती मागणी आहे आणि किती पुरवठा शक्य आहे ह्या वर त्याची किंमत ठरते. म्हणजे जरी ती गोष्ट बनवायला निश्चित खर्च आला असेल तरी त्याची विकण्याची किंमत अनिश्चित असू शकते. कांद्याचे भाव हे ह्याचं उत्तम उदाहरण आहे. कधी ते १० रुपये किलो असतात तर कधी १०० रुपये किलो. उत्पादनाची किंमत तर बदलत नाही मग काय बदलतं? कांदे अशी गोष्ट आहे की ज्याच्या मागणीत फारसा बदल होत नाही पण पुरवठ्यामधे खूप तफावत दिसते. पुरवठा जास्त झाला की किंमती पडतात आणि कमी झाला की किंमती वाढतात. ह्या उलट हॉटेलमधे राहण्याचा खर्च बघा. इथे पुरवठा बऱ्यापैकी स्थिर असतो पण मागणी वर खाली होत असते. म्हणून सुट्टीच्या दिवशी बुकिंग महाग पडते. ह्याला ‘demand pull inflation’ म्हणतात.

पण फक्त कांदे किंवा हॉटेल बुकिंग महाग झालं तर त्याला तुम्ही महागाई म्हणाल का? महागाई म्हणजे सरसकट सगळ्या गोष्टींची किंमत वाढणे. बरेच वेळा चलनवाढ हे महागाईचे कारण असू शकते. जेव्हा RBI जास्त नोटा छापते तेव्हा देशातला एकूण पैसा वाढतो. जर त्या प्रमाणात पुरवठा वाढला नाही तर आहेत त्याच गोष्टी जास्त किंमतीला विकल्या जाऊ लागतात आणि महागाई वाढते.

आता ह्या ‘Inflation’ ला चांगला मराठी शब्द सुचवा.

 

Siddarth Gore is a Research Scholar at the Takshashila Institution and he tweets @siddhya

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‘Information Asymmetry’ ला मराठीमधे काय म्हणाल?

सध्या फॅशनमधे असलेली टेराकोटाची कानातली बाजारात २५० च्या खाली मिळणार नाहीत. पण तुम्हाला हे माहिती आहे का की त्या कारागीराला ह्यामधले फक्त १० रुपये मिळतात? बिहारची प्रसिद्ध मधुबनी चित्र घ्यायला गेलात तर ३००० च्या खाली मिळणार नाहीत. पण त्या चित्रकाराला प्रति चित्र फक्त ८० ते १०० रुपये मिळतात. हि इतकी विषमता कशी निर्माण होते?

 

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आपल्याला सहसा लक्षात येत नाही पण बाजारात विकल्या जाणाऱ्या  प्रत्येक गोष्टीला ३ किंमती असतात. एक जी ग्राहकाच्या मनात असते , एक विक्रेत्याच्या मनातली आणि तिसरी म्हणजे ज्या किंमतीला सौदा पक्का होतो ती. आपण अगोदर पाहिले आहे की सौदा तेव्हाच शक्य असतो जेव्हा ग्राहकासाठीचं मूल्य (मनातली किंमत) हे विक्रेत्याच्या मूल्यापेक्षा जास्ती असतं. तुम्ही जेव्हा घासाघीस करता तेव्हा खरंतर तुम्ही एकमेकांच्या मनातली किंमत शोधायचा प्रयत्न करत असता. हे गिऱ्हाईक जास्तीतजास्त कितीला गटवता येईल हे विक्रेता शोधत असतो आणि किंमत कमीतकमी किती करता येईल हे गिऱ्हाईक हुडकत असतं. जो हि माहिती अचूक मिळवतो त्याला व्यवहार जास्त फायद्याचा ठरतो. ह्या माहितीच्या तफावतीला अर्थशास्त्रात ‘Information Asymmtery’ असं म्हणतात.

काही प्रकारच्या व्यवहारांमध्ये हि खूप बघायला मिळते. जसं की डॉक्टर आणि रुग्ण. रुग्णाला काय झालंय हे त्याच्यापेक्षा डॉक्टरला खूप जास्त कळत असतं. ठरवलं तर तो त्याचा गैरवापर करू शकतो. म्हणूनच तर आपण डॉक्टर रुग्ण संबंधात विश्वासाला खूप महत्व देतो. वर पाहिलेल्या उदाहरणात कारागीराला त्याच्या कलाकृतीच्या किंमतीचा (विकत घेणाऱ्याच्या मनातली) अंदाज नाही म्हणून त्याचा फायदा कमी होतो. जर ती माहिती त्याच्यापर्यंत पोहोचली तर हि विषमता नक्कीच कमी होऊ शकते.

आता ‘Information Asymmetry’ ला चांगला मराठी शब्द सुचवा.

Siddarth Gore is a Research Scholar at the Takshashila Institution and he tweets @siddhya

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Demonetising a currency

Adopting another currency or introducing a new currency does not solve the economic crises, unless it is followed by massive corrections in the macroeconomic fundamentals.

 The Central Bank of Zimbabwe announced that it would officially demonetise the Zimbabwean dollar with effect from 15th June 2015. Any bank account in the country which holds between zero and 175 quadrillion Zimbabwean dollars will get a flat amount of US $5. This, in effect sets the exchange rate at US$1 = Z$ 35,000,000,000,000,000

Demonetisation is the process whereby a currency of a country officially loses its status as legal tender. The Zimbabwean dollar’s usage was effectively abandoned in April 2009 itself, but was still recognised as legal tender. Legal tender or fiat money is the official status given to a currency by the central bank, whereby all citizens of that country are obliged to accept it as a means of exchange.

Demonetisation has often happened in the past. Germany has demonetised at least thrice in recent history – from Papiermark to RentenMark; from Reichsmark to Deutchemark to finally from Deutchemark to the Euro.

The process of demonetisation was seen when several European countries abandoned their national currencies to be replaced by the Euro. The other big event of demonetisation process happened with regard to gold, when the US officially closed the gold window in 1973, thereby ending the decades long gold exchange standard/Bretton Woods system.

Apart from these one-off occurrences, the process of demonetisation usually happens after a country goes through a process of hyperinflation and the currency becomes worthless. Zimbabwe’s episode of hyperinflation in 2008, where inflation rates were as high as 231 million percent, caused the Zimbabwean dollar to collapse in value. It was impossible for normal trade to occur with the national currency, as a loaf of bread cost Z$1.6 trillion at one point. As a result, currencies such as the US dollar, the South African rand and the euro were widely circulated and used in Zimbabwe.

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A hundred trillion Zimbabwean dollar note

 

Demonetistion is usually the last step in the fight against hyperinflation. It is the official acceptance from the central bank and the government that its currency is of little or no value and acknowledgements of its failure. Thus, demonetisation is undertaken only at severely extenuating circumstances. Countries usually try to redenominate the currency first. Redenomination is the fixing of a new value for the existing currency. Operationally, it is the equivalent of knocking of a few zeroes from the value of the currency. For example, Zimbabwe tried redenomination four times since 2006. In the first redenomination Zimbabwe removed three zeroes from the value, 13 zeroes in the second redenomination and a further 12 zeroes in the third redenomination. However, bad macroeconomic fundamentals and a bad fiscal and monetary policy framework ensured Zimbabwe’s journey further into hyperinflation.

Once a currency is demonetized, the country has two options left: 1) Dollarization/Adoption of a foreign currency – This is when the country adopts the currency of another country as its own, which effectively translates into abandoning independence in monetary policy. The monetary policy of the adopted currency become applicable and binding on the country adopting it. Usually, the dollar is adopted, but not necessarily so always. 2) Introduction of a new currency – Eventually, the country might choose to introduce another of its own currency and have a preset exchange rate with the old currency/dollars. This is done to regain independence in monetary policy.

In the final analysis, adopting another currency or introducing a new currency does not solve the economic crises, unless it is followed by large scale corrections in the macroeconomic fundamentals.

Anupam Manur is a Policy Analyst at Takshashila Institution. He tweets @anupammanur

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Potential Output – Importance and Estimation

Potential output is of vital importance in macroeconomic policy making, despite imperfections in its estimation.

In order to have an effective monetary and fiscal policy, policy makers need to gauge the level of economic activity in the economy and whether this level is consistent with the potential level. In economic terms, policy makers look at the real output and its deviation from potential output, called the output gap. Potential output – the trend growth in the productive capacity of an economy – is an estimate of the level of GDP attainable when the economy is operating at a high rate of resource use.  This is not a technical ceiling on the maximum level of output attainable. Rather, it is an estimate of maximum sustainable output – output that can be sustained in the long run without leading to macroeconomic instability.

While this may seem like a purely academic and statistical exercise, in reality, understanding and proper estimation of potential output has grave consequences for the economy. If actual output is lower than potential output, that is, if the output gap is negative, then the economy is performing below its potential – resources and capacity are underutilized and unemployment is higher than what it should be. On the other hand if the output gap is positive (actual output is higher than potential output), the economy is overheated, demand exceeds supply and inflationary pressures on the economy is high. As is self-evident, neither state is desirable. The manifestation of the output gap is usually through inflation in the economy. A positive output gap results in higher inflation and a negative output gap results in deflation.

For policy makers, therefore, understanding potential output and the output gap is of crucial importance. Negative output gap should ideally be followed by an expansionary fiscal and monetary policy, so as to increase spending and demand in the economy, which will result in actual output converging towards potential output. A contractionary monetary and fiscal policy is required in the case of a positive output gap to reduce the demand in the economy and to provide liquidity to the suppliers to increase their production.

Many central bankers around the world indeed use the concept of potential output in determining the rate of interest. In deciding the policy rate, central bankers use a popular rule of thumb called the Taylor rule, which reduces the complexities in choosing the interest rate to a formula that incorporates the difference between the actual and targeted inflation rate and the difference between the actual and potential GDP[1].

Figure 1: Showing the Real potential GDP and Real GDP for the US economy on the left scale and the rate of inflation on the right scale for the period 1995-2015.

Figure 1: Showing the Real potential GDP and Real GDP for the US economy on the left scale and the rate of inflation on the right scale for the period 1995-2015.

As can be seen from the graph, real GDP has exceeded potential GDP during the boom years in the late 1990s and has significantly fallen below the potential GDP after the recession off 2007. It can also be seen that inflation reacts to the output gap. Inflation is above the targeted rate of 2% when output gap is positive and vice versa.

Estimating Potential Output

Despite its overwhelming importance to policy making, there seems to be no consensus amongst economists regarding the best method to estimate potential output. Different countries and organizations use different methods based on country specific circumstances. However, no method has been able to provide consistently robust estimates and each method has its own set of lacunae.

The various methods of estimating potential GDP can be broadly classified into two categories: the production function approach and the statistical approach. The first approach, followed by the Congressional Budget Office, USA, relates the level of output to level of technology and factor inputs, namely capital and labour. Potential Output, thus, would be the output if both labour and capital are fully utilized in an efficient manner. This manner would also require certain assumptions regarding the specific form of the production to be made. Usually, a constant returns to scale production function, such as the Cobb-Douglas production function, is used.

However, for emerging market economies, where reliable data on labour and capital is unavailable, time-series statistical techniques have become quite popular. A widely used approach in the Indian context is the Hodrick-Prescott filter, which decomposes the actual real GDP into two components – a trend and a cyclical component – and potential output is proxied by the trend component.  In other words, the GDP growth rate has an underlying structural component (trend) and another component that is seemingly random due to natural variations in the business cycles and external demand and supply shocks (cyclical). The purpose of the statistical tools is to remove the cyclical part and project the long run potential GDP based on the trend growth rate.

Figure 2: Estimates of output gap in India. Source: Monetary Policy Report, April 2015, RBI publications.

Figure 2: Estimates of output gap in India. Source: Monetary Policy Report, April 2015, RBI publications.

The graph below shows the estimates of output gap for India using various statistical techniques. While there are differences between the different techniques, broad generalizations can be derived: the economy was overheated for a prolonged period between 2005 and 2012 and has been in slack ever since.

Irrespective of which method is used, it is important to understand the shortcomings in these approaches. However, the presence of short-comings should not be a reason to undermine the immense importance of the concept of potential output in determining macroeconomic policies.

Anupam Manur is a policy analyst at Takshashila Institution. He can be found on twitter @anupammanur

 

[1] Specifically, it is: it = i* + α (πt – π*) + β (yt – y*), where it is the policy rate; πt and π* are the actual and targeted inflation rates, respectively; yt and yt* are actual and potential output, respectively; and i* is the federal funds rate consistent with on-target inflation and output.

 

 

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Bond Markets – a primer

Markets catering to sale and purchase of financial items such as stocks, commodities, bonds, currencies, etc. are called financial markets. While financial markets can be of various types, two of the most common financial markets are money markets and capital markets. Both these markets are used to manage liquidity and risk for companies, governments and individuals. However, they differ from each other in the risk involved (and hence the returns) and the time horizon for which an investor remains invested in these markets. Money markets are low-risk and are accessed with a short-term view, but the buying and selling of financial assets in capital markets involves higher risk and is done for a medium to long-term period. While some financial markets can be very small involving just a few participants, others like the New York Stock Exchange are very big with daily trade volumes in the order of trillions of dollars.

Capital markets, in particular, are vital to the functioning of an economy and act as proxies for a general condition of the world market. These markets are used to channel financial investments between suppliers of capital such as retail and institutional investors, and users of capital such as governments, businesses, and individuals. Capital markets are accessed in order to raise capital for long-term purposes such as mergers & acquisitions, entering into a new line of business, large government projects, etc. Capital markets typically involve issuing financial instruments like equity (stock) and debt (bond).

Bond markets

A bond is essentially a loan that an investor makes to corporations or governments who want to raise money. Bonds fetch investors periodic interest payments (coupons) over a fixed period of time (until maturity). At the end of maturity the investor is guaranteed his principal amount back. Maturity periods of bonds range from 3 months to 30 years. The most common long-term bond has the maturity period of 10 years.

A bond market (also called the debt market) primarily includes government issued securities and corporate debt securities. The roots of bond markets can be traced back to the Italian Renaissance, when governments compelled wealthy citizens to loan money for the financing of wars against the Ottoman Empire. In return, these citizens were paid a compensation fee as interest. In fact, even during the two world wars bond markets played a crucial role in financing military operations of various nations.

Corporations issue bonds to finance their long-term corporate operations. The largest, oldest and most developed corporate bond market is the US Dollar corporate bond market, followed by the Euro denominated corporate bonds. Corporates bonds are listed and traded in exchanges and are considered riskier than government bonds.

The biggest players in the bond markets are governments which sell debt to fund theircountries’ operations. Governments borrow/lend money from/to other governments and banks and often purchase debt from other countries if they have excess reserves of that country’s money (arising out of trade between these two countries). For instance, Japan is a major holder of US government debt. As of 2009, the size of the worldwide bond market is estimated at $82.2 trillion with US alone accounting for 44% of this market with the average daily trading volume in U.S. Treasuries was $409.8 billion in 2009. Government bonds are traded directly between two parties without the involvement of an exchange.

US 30 year bond

Price of a bond vs. the yield – Yield of a bond is the return that an investor gets on the bond and is calculated as coupon amount/price. For a bond bought at its face value, the yield is equal to the interest rate. However, just like other publicly traded securities, the prices of bonds and hence their yields change on a regular basis. The price of a bond and its yield have an inverse relationship with each other, i.e. when a bond’s price rises then its yield falls and vice versa. For example, if you buy a bond with a 10% coupon atits $1,000 par value, the yield is 10% ($100/$1,000). However, if the price goes down to $800, then the yield goes up to 12.5% because you are getting the same guaranteed $100 on an asset that is worth $800 ($100/$800). Conversely, if the bond goes up in price to $1,200, the yield shrinks to 8.33% ($100/$1,200).

The natural question that follows is why does the price of a bond change. While the issuance price of a bond is usually set at par, the actual market price depends on a number of factors including the credit worthiness of the issuer, time until maturity of the bond, the demand for a bond, and the prevailing interest rates in the economy. Bonds that have already been issued and continue to be traded in the secondary market must therefore continually readjust their prices to be in line with current interest rates.

When interest rates in an economy rise, then the prices of the bonds in the market fall. This leads to an increase in the yield of older bonds thereby making them comparable with new bonds with higher coupon (interest) rates. Similarly, when the interest rates decline, the prices of bonds goes up thereby reducing the yield on older bonds and making them comparable with new bonds that have low coupon rates.

Capital markets, especially the bond markets, play an important role in the smooth functioning and growth of an economy. In fact, the importance of bond markets (primarily the Government bond markets) can be gauged from the fact that they are the biggest source of influence in setting the long-term interest rates for the economy as a whole.

Nidhi Gupta is a Social Policy graduate from the London School of Economics and manages outreach and business development at the Takshashila Institution. She is on twitter @nidhi1902

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Why is the Dollar the World’s Reserve Currency?

By Anupam Manur and Varun Ramachandra

Strength, stability, universal acceptability, and a lack of a viable alternative to the dollar makes it the global reserve currency. 

Global trade and businesses function best when there is a currency that is widely accepted. This doesn’t imply a common currency, instead, it refers to the usage of a widely acceptable currency for international transactions. Such a currency reduces the transaction costs of converting one currency to another and enables easy invoicing of traded goods and services. This common currency is referred to as the reserve currency.

The brief history of reserve currencies:

Historically, a reserve currency implied a currency that was in wide circulation even outside the issuing state’s borders. Currently, the US dollar is the world’s reserve currency but this hasn’t been the case forever. The silver Drachma issued by the ancient Athens was probably the first reserve currency. The Roman Aureus and Denarious coins, the Byzantine Solidius coins, the Arabian Dinar, the Florence Fiorino, and the Dutch Gulden have at various points had the status of being the world’s reserve currency.

History of money

 

In 1717, Britain adopted the gold standard – a system where central banks had to back each paper currency note they printed with an equal or proportional amount of gold — and simultaneously built a vast empire. At the height of its power, more than 60% of world trade was invoiced in pounds and this led to the pound sterling becoming the world’s reserve currency. At around the end of the 19th century, America’s economic significance rose and this resulted in the US dollar toppling the pound as the most sought-after currency. Today, more than two-thirds of foreign exchange reserves held by central banks around the world are in US dollars (see figure).

COFER

 

Why do central banks maintain reserves?

Two important reasons for holding reserves are as follows:

First, safety. Reserves act as savings, and central banks can benefit from this in hours of need. When a country faces a balance of payments crisis or some other form of financial crisis, the central bank can use its reserves to alleviate the situation. Typically, central banks manage enough reserves to cover for three months’ worth of imports to maintain continuity of trade in times of crises. Reserves also act as positive assurance to debtors.

Second, reserves are maintained to manage a country’s exchange rate policy (the previous post explored this aspect). Whenever a country’s currency appreciates or depreciates, and moves away from the target exchange rate set, the central bank steps in and uses its reserves to maintain exchange rate stability. The Reserve Bank of India has done this on numerous occasions when the rupee has appreciated or depreciated.

Why is the US dollar the reserve currency?

Since the United States boasts of the world’s largest economy (around $18 trillion) and has a stable political environment, most international trade is invoiced in dollars and about 50-60% of US dollars circulate outside US borders. Since there has been no default or major devaluation of the dollar in the past few decades, the USD and the US government’s treasury bonds are thought of as the safest assets in the world; this inherent stability and risk-free nature of the dollar is attractive to investors and has therefore ensured that the US dollar is the world’s reserve currency.

According to economist Ewe-Ghee Lim, there are five factors that facilitate international currency’s status: a large economic size, the existence of a well-developed financial system, confidence in the currency’s value, political stability, and network externalities. Additional features for currencies that assume reserve status are large-scale current account and financial account convertibility, an independent central bank, a high degree of capital mobility, surveillance of economic policies, and cooperation of monetary policymaking at regional and multilateral levels. The dollar checks almost all of these boxes.

The rise of China since the 80s has made the Chinese Yuan an important world currency, but since the Yuan has been deliberately undervalued to aid exports, the real exchange rate of Yuan is unknown. Japan and Britain are waning economic powers, the emerging markets are too volatile, the Euro has many internal problems, and gold is too static a commodity to be held as the reserve currency. This leaves the dollar as the only viable option for the time being, and probably for some more time to come.

Anupam Manur is a Policy Analyst at Takshashila Institution  and tweets @anupammanur

Varun Ramachandra is a Policy Analyst at Takshashila Institution and tweets   @_quale

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The Murky Connections between Trade and Exchange Rate

A positive trade balance should result in appreciation of the currency. However, it is in the interest of countries that export large volumes of goods to have a weaker currency.

By Shobitha Cherian and Anupam Manur

The relationship between the strength of an economy and the strength of the currency was discussed in a previous post. The aim of this post is to discuss the conditions under which economies would want to have a weaker currency. Generally, it is in the interest of countries that export large volumes of goods to have a weaker currency.

The exchange rate of a particular currency is determined mainly by the demand and supply of the said currency. By this logic, countries which export large volumes of goods, or which have higher international demand for their goods, would have stronger currencies, or would have a higher value when compared to the reserve currency or the U.S Dollar. This is due to the fact that since their goods are high in demand, so will be their currency. However, in actual practice, one can see that it is favourable for certain countries to have weaker currencies.

Table showing the relationship between trade balance and exchange rates

Table showing the relationship between trade balance and exchange rates

Source: Calculations based on data from World trade organisation and the International monetary fund database.  Note: Since the countries belonging to the Euro zone use a common currency, they have been eliminated from this analysis.

The above set of countries shows the volume of exports as a percentage share of total world exports, the current account balance (difference between exports and imports) and their exchange rate with respect to the US$. The chosen countries are amongst the top 20 exporters.

From the above data set, it is apparent that countries with a significant share of the world export market have currencies that are weaker than the dollar, i.e., more of that currency is required to buy one dollar. The Korean Won and more so the Indonesia rupiah stand out; around 12800 rupiah is required to buy 1US$.

However, merely looking at export data and the exchange rate gives an incomplete picture. Since the exchange rate is determined by a country’s exports and imports, the relevant data to look at is the trade balance (second column). Further, the strength of a currency has to be looked at in terms of changes. The third column gives the percentage change in the value of the currency since 2010 (a positive number reflects appreciation and a negative number means that the currency has depreciated/weakened).

The table above shows the rather murky lines between economic principles and reality. As explained above, a positive trade balance should result in a currency appreciation and vice versa. Only five of ten countries (highlighted in green) follow this rule. Saudi Arabia and the UAE have fixed exchange rate regimes and thus, show no change in the five years despite having a positive trade balance. Japan, Russia and South Korea have very strong trade surpluses, yet their currencies have depreciated during this period. The Russian rouble has depreciated by over 175%.

Why is this so?

The regulatory authorities of a country may actively keep their currency weak in order to boost exports; if the currency is weaker, the goods produced domestically for export become cheaper for the rest of the world, and by the simple principle of demand and supply, the demand for its goods increases.

Monetary authorities achieve this using a variety of instruments at their disposal. It can impose foreign exchange controls – artificially restrict the movement of the currency. The central banks also participate in the foreign exchange markets to keep the currency at the desired level. For example, if the rupee begins to appreciate against the dollar, RBI steps in, sells rupees and buy dollars, which will devalue the rupee.

Devaluation is sometimes used deliberately as a policy action in times of contraction, where the country would want to get back to the growth path through exports. However, continued devaluation can be seen as a manipulative path of action which seeks to keep a currency artificially weak and will usually face outrage by the international community. This might also result in a competitive devaluation amongst competitors, which can have grave consequences for global financial stability.

Shobitha Cherian is an intern at Takshashila Institution and studies B.Sc economics at Christ University

Anupam Manur is a policy analyst at Takshashila Institution and tweets @anupammanur

 

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Information Asymmetry in the Information Age

Why the impact of new technologies on markets requires governments to revise their regulatory policies

In their interesting article, Alex Tabarrok and Tyer Cowen discuss the declining relevance of asymmetric information. Information asymmetry occurs when one party has more knowledge about the transaction than the other. Usually this grants that party an undue advantage in the transaction whereas the other faces a higher risk. Taborrok and Cowen explain how various new technologies have provided enough avenues to minimise information asymmetry within the economy. They go on to conclude that this change deserves a re-examination of regulatory policy as most of the theories relating to information asymmetry are now obsolete. This post shows how this conclusion is equally relevant in the Indian context through the following scenarios.

 The Ordeals of a Family Vacation

Till recently, a typical middle income family in India would spend lots of time, effort and money planning their itinerary for their yearly holiday. Better off families would opt for travel agents who could reduce the amount of time and effort required, i.e. the transaction cost. However, the monetary cost would probably increase considerably as travel agents often exploit their customers’ poor knowledge of ticket prices and regulations to increase their profits.

This entire set-up changed dramatically with the advent of online travel booking sites. The entry of sites such as Yatra, TravelGuru, and MakeMyTrip into the market reduced the transaction costs of travel as booking a ticket was now just a click away. Furthermore, these sites supplied travellers with data they could use to make more informed choices. Such data would range from information about weather conditions and popular tourist sites to customer reviews containing user-uploaded photos. The most important contribution of these sites was to reduce the information asymmetry by removing the middle men. By providing limitless options for travel and accommodation, and the option of online payment they enabled middle income families to plan their holidays in hours.

 The Maid Market in India

Information asymmetry can increase the risk of buyers making uneconomic decisions because it often leads to a decline in the quality of products offered in the market. This decline induces buyers to reduce the amount they are willing to pay for the product and can eventually force sellers of costlier and higher quality products out of the market. This creates a market which is dominated by sellers of low quality goods. In economics this is referred to as adverse selection; a good everyday example would be house maids.

With the rise in the incomes and aspirations of middle income India, a larger number of families have started looking for house maids who comply with their living standards. Such families are increasingly looking for maids who understand English, care for hygiene, can cook continental food, handle hi-tech home appliances and are neatly dressed. However, the market for house maids suffers from an asymmetry of information. Households are usually at the losing end of the bargain as each maid has more knowledge of her expertise than the house owner. House owners would try to reduce their risk by initially paying a low wage to the maids. This would price out higher quality maids who value their service at a higher rate and would leave only low quality maids in the market.

This problem has been solved by home maid agencies. These agencies recruit domestic workers or people interested in domestic work and train them according to changing demands within the market. These agencies help domestic workers in finding better opportunities by guaranteeing a higher quality of service provision to house owners.

 The GPS Tracking of Garbage

The principal-agent problem occurs when a person (the principal) hires someone (the agent) to perform certain tasks. However, in most cases the incentives of the agent differ significantly from the principal as the costs incurred are borne only by the principal. The textbook solution is to create incentives for the agent such that it is in his or her self interest to follow the principal’s directions. One such incentive is to share the risk. For example, companies like Infosys pay their CEOs with stock options as a compensation for relatively low salaries. Another method would be to increase the cost of disobedience by monitoring the agents more. An example of the latter method is the use of GPS fitted garbage trucks in Delhi.

Garbage trucks are owned by private garbage disposal services or by municipal corporations. These trucks collect garbage from all across the city and dump it at a particular location. However, the drivers of the trucks have various incentives that interfere with this role. These include profits from reselling the garbage or alternate uses of the truck. In 2013, the Delhi government fitted GPS devices to garbage trucks to track their movements and monitor their work performance. These monitoring systems reduced the information asymmetry between the drivers of garbage trucks and owner of the garbage disposal services.

 Uber: the Escrow Agent

Asymmetry of information can often create distrust between the parties to a transaction. In such cases, escrow agents act as a trusted third party that ensure that parties maintain the standards of performance set by the contract. A simple example of this would be Uber, an international company which operates a mobile app that allows customers to book taxis.

Uber’s legal page describes the company as an intermediary for taxi drivers and people interested in availing their services. This role allows Uber to guarantee that there will be no bargains over fares for customers as well as a regular stream of income for drivers. In doing this, Uber reduces the information asymmetry by providing details about the driver ranging from his current location to his basic profile. This has helped in reducing the transaction costs of cab rides and has empowered customers trying to narrow the information gap.

 In Conclusion

The advent of new technologies has mended multiple market failures by narrowing the information gaps in various economic exchanges. In doing so they have also changed the very fabric of transactions and have thus rendered many theories from the past obsolete. As many regulatory policies were designed on the basis of those theories the onus is on political systems to revise these regulations. When they do so, they must keep in mind the ways in which new technologies have affected information asymmetries. In order to maintain pace with innovations, these policies would have to be time bound and adaptable to the needs of the time.

Tabarrok and Cowen succinctly summarise the challenges of such reforms in their piece:

 These changes cast new light on the costs of a political system that produces many new regulations but repeals very few old ones.

Devika Kher is a Research Associate at Takshashila Institution. Her twitter handle is @DevikaKher

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Does a strong currency mean a strong economy?

by Anupam Manur & Varun Ramachandra

Exchange rates have negligible connection with the strength of an economy. Instead, it is determined by trade performance, capital inflows or an arbitrary number chosen by the central bank.

In their book The Dollar Crisis, Paul Simon and Ross Perot famously said that “A weak currency is the sign of a weak economy, and a weak economy leads to a weak nation”. The quote was mentioned in the larger context of American military and economic might, but the feelings espoused in the quote are shared by many. For instance, this article in the Economist describes the feeling of despair amongst the citizens of Hong Kong when the value of their currency (Hong Kong dollar) slipped below that of Mainland China (Yuan). Politicians, central bankers, economists, and policy makers often share the ‘blame’ for a weak currency. But is a ‘weak’ currency truly an indicator of a ‘weak’ economy? Consequently does a ‘strong’ currency necessarily imply a ‘strong’ economy? This post aims to answer these questions.

The strength of a currency, in economic terms, implies the price (or the exchange rate) of one currency in terms of another foreign currency; this is usually measured with respect to the US Dollar, which is considered as the world’s reserve currency. (We will discuss why the US dollar is the world’s reserve currency in our next post). An exchange rate higher than one implies that the currency is stronger than the dollar and an exchange rate lesser than one implies that it is weaker.

The strength of an economy is measured by various means and the most used measure is the value of its Gross Domestic Product (or GDP).  The GDP measures the level of economic activity within a country and is the final monetary value of all the finished goods and services produced. It is a comprehensive measure of economic strength of a country[1]. The table below illustrates the metrics discussed thus far.

ExchangeRateGDP

Source: GDP, GDP per capita and the ranks from IMF database. Exchange rate is obtained from IMF and XE.com

Note on exchange rate rank:  It is obtained by sorting, in ascending order, the dollar value of domestic currencies. This is a metric derived purely for understanding the ideas discussed in this post and is not a robust measure.

Note on US$, per unit: This number indicates the number of US dollars that can be bought using the domestic currency. Example, exchange rate of 0.0160 for India means that one Indian rupee can buy 0.016 US dollars.

It is clear from the table that China, India and Japan are the second, third and fourth largest economies in the world, but their currencies are relatively weak. In fact, the per-capita GDP and exchange rates are also not comparable variables.

EXCHANGE RATE DETERMINATION

According to economics textbooks, the exchange rate is determined by the demand and supply for a currency relative to another foreign currency. This exchange rate arises out of three major factors:

First, the demand for a currency comes from people acquiring more of a particular currency to pay for foreign goods that they wish to buy (imports). Therefore, the exchange rate is determined by the volume of exports and imports of a country. If a country exports more than it imports, the demand for the exporter country’s currency and its exchange rate rises. Generally, an exporting country would want all or some of its payments made to it in its local currency, which would increase the demand for its currency.

Second, the demand for currencies arises from the financial markets and interest rate regimes. London is the one of the biggest financial centres — measured in terms of the volume of foreign exchange turnover– in the world and hence there is high demand for the Pound Sterling, as is the case with Swiss Francs. Further, countries with higher interest rates normally tend to have stronger currencies, as investors hope to get higher returns on their investments. A high interest regime encourages conversion into these local currencies and helps attain larger returns.

Third, it is in the interest of certain countries to have a weaker currency. A weaker currency will make exports cheaper and imports expensive giving these countries a competitive edge in the world market. Thus, the central banks and governments of different countries deliberately try to have a weaker currency.

The three factors discussed are not comprehensive and do not possess equal weightage; the eventual exchange rate dynamics depends on several other parameters.

Market determination of exchange rate does completely explain the exchange rate determination. There are more exceptions to this than adherents. For example, the Bahamian Dollar is exactly on par with the US dollar, despite playing a negligible role in world trade. This is due to the fact that the central bank of Bahamas has artificially pegged its currency 1:1 with the US dollar. That is even an infinitesimal change in the US dollar is directly reflected in the Bahamian dollar. Currency pegging (either 1:1 or some other predetermined ratio) is done by many countries to maintain stability. For example, Nepal and Bhutan have pegged their currency to the Indian rupee.

In conclusion, it is flippant to estimate the strength of an economy solely through the value of a currency. The strength of an economy is dependent on several variables that exhibit multi-causal relationship amongst themselves. Exchange rate have negligible connection with the strength of an economy. Instead, it is determined by trade performance, capital inflows or an arbitrary number chosen by the central bank.

 

[1] For simplicity, this post considers the GDP as the measure of strength of economy; to eliminate large country/ population bias we must consider the per-capita GDP (total GDP divided by the population) to arrive at a precise figure. Countries like India rank high in terms of GDP but, thanks to its population, rank much lower in per-capita GDP. Kuwait, on the other hand, ranks high in terms of per-capita GDP.

Anupam Manur is a Policy Analyst at Takshashila Institution  and can be found on twitter @anupammanur

Varun Ramachandra is a Policy Analyst at Takshashila Institution and can be found on twitter  @_quale

 

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