Economics is the study of the choices consumers, business managers, and

government officials make to attain their goals, given their scarce

resources

Economics can be broadly

divided into two areas
Macroeconomics
Microeconomics
Economics gives a better understanding of the environment in which all businesses operate

Business leaders are constantly asking themselves questions like :

• Will the economy pick up next year?

• What is the potential threat of a new producer entering the market?
• Is the Central Bank going to change the interest rate?
• How much will the currency exchange rate fluctuate?
• What will be the effect on my business due to the changes in global economic scenario?

These are all few questions that an understanding of the economics will help to answer
The area of study in the field of economics that deals with the market behaviour of
individual consumers and firms. It focuses on the patterns of supply and demand
and the determination of price and output in individual markets.
For example,
The following questions would be covered under the ambit of microeconomics –
• Why does the price of an airline ticket keep changing till the date of travel ?
• Why does the OPEC have a huge say in determining the crude oil prices ?
• Why are diamonds so costly ? Are they really rare ?
• What is the importance of a regulatory body like the CCI ?
The area of study in the field of economics that deals with the behaviour and
performance of an economy as a whole. It focuses on the aggregate changes in the
economy such as unemployment, growth rate, gross domestic product and inflation.
Governments use macroeconomic models in formulation of economic policies and
strategy.
For example,
The following questions would be covered under the ambit of macroeconomics –
• What is the relationship between inflation and interest rate set by the Central Bank ?
• Why does China hold a huge amount of securities issued by the United States?
• What is the distinction between the different measures of Gross Domestic Product ?
• How does the Volkswagen scandal cause a downside risk to the German economy ?
It is the means by which a government adjusts its spending levels and tax rates to
influence the aggregate demand and the level of economic activity in the country.
Spending
One of the largest consumers of goods and services in a country is the government
itself. The government spends money under heads such as national defence,
infrastructure, subsidies, entitlement programs and discretionary spending that ranges
from purchasing paper clips to funding scientific research. This in turn pumps a
tremendous amount of money into the hands of private businesses when it purchases
goods and services ranging from pens to multi-billion dollar aircraft carriers. All this
economic activity helps grow the economy and create jobs and thereby improve the
lives of citizens.

Government spending is also an important tool used to drive the economy out of high
unemployment, recessions and depressions. The Chinese economic stimulus program
post the global financial crisis in 2008 is one such example.
Taxation
The government expenditure is funded mainly through taxation and borrowings. Taxes
can be generated from income, sales , property and several other sources. When there
is an economic slowdown , unemployment levels are up and consumer spending is down
the government might decide to fuel the economy by decreasing taxation that gives
consumers more money to spend. On the other hand when the inflation is too strong
the economy may need a slowdown wherein the government can increase the taxes to
suck money out of the economy.

Another source of funding for the government are the borrowings obtained by issuing
bonds like treasury bills and other securities.

The objectives of fiscal policy such as economic development and price stability can be
achieved only if the tools of policy like Public Expenditure, Taxation and Borrowing are
effectively used.
It is the macroeconomic policy laid down by the central bank that involves management
of money supply and interest rate and is the demand side economic policy used by the
government to achieve macroeconomic objectives like inflation, consumption, growth
and liquidity.
In India, the RBI implements the monetary policy through a set of Quantitative and
Qualitative tools.

Quantitative Tools Qualitative Tools

• Reserve ratios (SLR, CRR)
• Open Market Operation
• Policy Rate (Repo Rate)
• Margin requirements/LTV
• Consumer credit regulation
• Selective credit control
• Moral suasion
• Rationing of credit
• Direct Action
Quantitative Tools

• Reserve ratios (CRR and SLR)

Cash Reserve Ratio
CRR is the minimum proportion of a bank’s deposit to be held with the RBI in the
form of cash.
Statutory Liquidity Ratio
SLR is the minimum percentage of deposits that a bank has to maintain in the form
of gold, cash or other approved securities. It is the ratio of liquid assets (cash and
approved securities) to the demand and term liabilities / deposits.
For example, if a bank has a total deposit of 100 crores and the CRR is 4 per cent and
SLR is 21.5 per cent then the money left with the bank to lend is 74.5 crores.
If the bank were to achieve a profit of 1 crore by lending 100 crores at a particular
interest rate. Now after imposing the CRR and SLR constraints the bank will have to
lend the lesser amount at a higher interest rate in order to obtain the same profit.
This way as the value of CRR and SLR increases the interest rate increases thereby
reducing the money supply in the economy which in turn helps to curb inflation.
Quantitative Tools
• Open Market Operations
The buying and selling of government securities in the open market by the central
bank in order to expand or contract the amount of money in the banking system.

If the economy has an inflationary trend then the RBI may decide to start selling
government securities in the open market which reduces the liquidity in the system.
On the other hand if RBI wants to infuse liquidity into the system it may decide to
buy the government securities thereby increasing liquidity.

• Liquidity Adjustment Facility (LAF)

A tool used in monetary policy that allows banks to borrow money through
repurchase agreements. LAF assists banks in resolving short-term cash shortages
during periods of economic instability or any other stress.
The two important tools under the LAF are – repo rate and reverse repo rate.
Reverse repo rate = Repo rate – 1 %
 Quantitative Tools
• Marginal Standing Facility (MSF)
It was introduced with the same objective as the Repo rate but for some differences
as shown below :
Banks find MSF route useful to borrow funds when they do not have excess securities
beyond the SLR limit.
LAF (Repo) MSF
Minimum Rs.5 crores Minimum Rs.1 crore
•Not all clients welcome here
All clients are welcome i.e.
•Only scheduled commercial banks can borrow under this
•Central and state governments
window. SBI, PNB, BoB, ICICI etc.
•Banks – be it commercial bank or RRB or cooperative bank
•This MSF facility is specially created to help them solve
•Non-banking financial institutions.
short-term cash shortages
Bankers cannot pledge securities from SLR quota to borrow
Can use securities from SLR quota
from this window
No limit. Can borrow as much as you want(as long as you
Maximum 2 % of NTDL
have government securities to pledge)
RBI decides Repo rate MSF = Repo Rate +1%
Summary
Policy dear money cheap money
Tool To fight inflation To fight deflation
Reserve Ratio (CRR, SLR) Increase them. Decrease them.
Open Market Operation (OMO) RBI sell securities RBI buy securities
Bank Rate increase it decrease it
Repo rate increase it decrease it
it’s value is linked with Repo, hence cannot be increased/decreased
Reverse Repo
independently.
it’s value is linked with Repo, hence cannot be increased/decreased
Marginal Standing Facility
independently. Besides MSF= temporary