CURRENC-I PRIMER

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GAURIKA | GAYATRI | SAYLEE | SUYASH

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 About the Club

About the Club

The Economics and International Business Club of IIM Indore, aims to strengthen the understanding of
economics amongst the students such that they are able to better appreciate its applications across the
fields of management in global business. We conduct several competitions and quizzes all year round which
act as a platform for the students to exchange ideas using economics concepts in micro and macro
environment business conditions. Macroscan, our bi-monthly digital magazine reflects our conscious effort
to keep Planet-I updated with the latest happenings in the world of economics and business news.

Currenc-I in association with NISM (National Institute of Securities Markets) also arranges workshops and
certification exams on campus, giving the participants an opportunity to expand their knowledge on topics
such as Investment Advisory, Securities Market etc.

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 Events

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Prepared
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in association with
with thethe Placement
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Indore
 Economics Basics

• Demand is the quantity wanted to be purchased by consumers at

different price levels
• Supply is the quantity supplied by the industry at different price levels
• As the price of good increases, demand falls (consumers do not prefer the good due to high price). Hence demand
curve is a downward sloping curve
• As the price of good increases, supply increases
(manufacturers gets more revenue due to increased price).
Hence supply curve is an upward sloping curve
• Equilibrium level is given by the point of intersection
and the corresponding price is equilibrium price

Elasticity measures the degree of responsiveness of quantity demanded(or supplied) to change in price of the good
• Price Elasticity- Measures change in quantity demanded(or supplied) in response to change in price of the good
Price Elasticity = ΔQ (%age Change in Demand) / ΔP (%age change in Price)
When Price elasticity= 0, demand is said to be perfectly inelastic; demand does not change when price changes
Eg: Demand for Salt (although in reality no demand is perfectly inelastic)
When Price elasticity= Infinity, demand is said to be perfectly elastic; small change in price of a product causes a major
change in its demand
Eg: Demand for a luxurious good
• Income Elasticity- Measures percentage change in quantity demanded(or supplied) due to change in income
Income Elasticity = ΔQ(%age Change in Demand) / ΔI(%age change in Income)

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 Economics Basics

Consumer surplus
Law of diminishing marginal utility

The law states that every additional unit of input It refers to the value that consumers derive from
provides lesser utility than the previous unit consumed purchasing a good. For example, if you would be willing
by individual. to spend $10 on a good, but you are able to purchase it
Example: Consuming one candy bar may satisfy a for just $7, your consumer surplus from the transaction
person’s sweet tooth. If a second candy bar is is $3. You’re getting $3 more value from
consumed, the satisfaction of eating that second bar the good than it cost you.
will be less than the satisfaction gained from eating the
first. If a third is eaten, the satisfaction will be even Producer surplus
less. It refers to the value that producers derive from
transactions.
For example, if a producer would be willing to sell a good
• In businesses, Law of DMU applies to the number of
for $4, but he is able
labor you employ for production to sell it for$10, he achieves
• In all types of market, the firm maximizes the
producer surplus of $6.The
profit by increasing the factors of production to
total producer
that limit where additional benefit is just equal to the surplus achieved would be
cost of production
represented by the dotted area
in the chart.

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 Types of Markets

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 Key Economic Parameters

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 Key Economic Parameters

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 Interest Rate
Short term interest rate:
Short-term interest rates are the rates at
which short-term borrowings are effected between
financial institutions or the rate at which short-term
government paper is issued or traded in the market
Long term interest rate:
Long-term interest rates refer to government
bonds maturing in ten years. Rates are mainly determined
by the price charged by the lender, the risk from the
borrower and the fall in the capital value. Long-term
interest rates are generally averages of daily rates,
measured as a percentage.
Real vs Nominal rate:
The difference between the two is inflation.
A real interest rate is the adjusted rate after factoring out
inflation, reflecting the real cost to the lender.
Relationship between interest rate and bond price:
The bond price and interest rates have an
inverse relationship (i.e. at higher levels of interest, the
bond prices fall )This is because, for a bond, the difference
between the buy price and the sell price is the income the
investor earns and can be viewed as a proxy for interest.
Given that the price at which the bond will be redeemed is
fixed, the current price of the bond has to fall, for the
investor to earn a higher interest.
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Factors affecting interest rate
• Inflation: At higher levels of inflation, interest rates
are expected to increase to control inflation. The
central bank attempts to increase the cost of
borrowing, further lenders also seek higher return as
their purchasing power decreases in the future.
• Economic growth: With a thriving economy, the
demand for credit increase, as do the interest rates.
• Govt spending: The government also goes to the
debt market, when their spending exceeds revenue.
The increased demand for debt, raises the cost of
borrowing for all.
• Risk free rate of the economy: Interest rates are a
function of the risk free rate and the various risk
premiums. A higher risk free rate will have a direct
impact on the interest rates.
• Uncertain economic future: Under volatile
conditions, such as elections, new government,
changing government policies, etc., lenders secure
themselves against the uncertain future by increasing
interest rates.
 Interest Rate

Impact of interest rates:

Investment: Long-term interest rates are one of the determinants of business

investment.
High long-term interest rates discourages investment in new equipment. This in turn
slows down corporate growth and makes it less attractive for investors to hold
shares of the company. The ripple effect is felt in the stock market, as share prices
fall.

Consumer spending: Spending is inversely related to interest rates. As borrowing

becomes affordable, consumer borrow to spend on housing, education etc. The
corollary is higher interest rates encourage consumers to save more, postpone
future purchases and provide funds for investment.

Currency: Higher interest rates increase the value of country's currency by attracting
foreign investment and thereby increasing its demand.

Economy: The benefit of having high or low interest rates depends on the state of
the economy. When the economy is weak; low interest rates encourage people to
spend which increases the demand for goods and services. High interest rates are
necessary at other times. With limited resources, a persistent increase in demand
leads to high inflation. Increased spending also raises our import bill and puts
pressure on foreign reserve levels. In such a situation, higher interest rates can help India’s long term interest rate
the economy by discouraging people from excessive spending, which would help (Total, % per annum, Aug 2012
cool the economy and bring it back to normality – Feb 2019)

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 Balance of Payments
 In an ideal scenario, the BOP should be zero.
However, in reality, a country faces either of the
two situations- surplus or deficit.
Components of BOP
• Current account: Includes the flow of funds from
the import and export of goods (visible items) and
services (invisible items). A trade deficit occurs
when the import of goods and services exceeds
exports while the reverse gives rise to a trade
surplus. Unilateral transfers to and from abroad,
for instance, donations and gifts. Also includes
factor payments and receipts in the form of rent,
interest and profit.
• Capital account: The capital account is used to
finance the deficit in the current account or absorb
the surplus in the current account. All the loans
(both private sector and public sector) given to and
received from abroad. Includes investments made
by non-residents in shares in the home country or
investment in real estate in any other country. Also
includes the foreign exchange reserves maintained
by the central bank to influence the exchange rate
and to balance the BOP.
• Current account deficit is financed by a surplus in
the capital account and vice versa.
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Implication of the status of BoP:
• Deficit: A country with a deficit will
have to borrow from other countries
to pay for its imports. In the short run, this fuels the
country’s economic growth. In the long run however,
debt repayment obligation will divert funds from
being invested in future growth.
• Surplus: A country with a surplus has enough savings
to lend to countries that buy its products. The
increased demand will be matched with increased
production and increased employment. In the long
run however, the country can get dependent on
export driven growth.
Importance of BoP:
• Provides a picture of the power dynamics that exist
between countries.
• The data on the BOP shows whether the country’s
currency is appreciating or depreciating in
comparison with other countries.
• Businesses use BOP to analyse the market potential
of a country, especially in the short term. A country
with a large trade deficit is not as likely to import as
much as a country with a trade surplus. If there is a
large trade deficit, the government may adopt a
policy of trade restrictions such as quota or tariffs.
 Foreign Exchange Market
Nominal Exchange Rate: The nominal exchange rate E is
defined as the number of units of the domestic currency
that can purchase a unit of a given foreign currency. A
decrease in this variable is termed nominal appreciation
of the currency. An increase in this variable is termed
nominal depreciation of the currency.
Real Exchange Rate: The real exchange rate R is defined
as the ratio of the price level abroad and the domestic
price level, where the foreign price level is converted into
domestic currency units via the current nominal
exchange rate.
Currency Impact on the Economy
A currency’s level has a direct impact on the following
aspects of the economy:
• Merchandise trade: In general terms, a weaker
currency will stimulate exports and make imports
more expensive, thereby decreasing a nation’s trade
deficit over time.
• Capital Flows: A nation needs to have a relatively
stable currency to attract investment capital from
foreign investors.
• Inflation: A devalued currency can result in
“imported” inflation for countries that are substantial
importers.
• Interest Rates: A strong domestic currency exerts a
drag on the economy, achieving the same end result
as tighter monetary policy (i.e., higher interest rates).
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Major factors affecting exchange rate
• Differentials in Inflation: In general,
a country with a consistently lower
inflation rate exhibits a rising currency value, as its
purchasing power increases relative to other
currencies.
• Differentials in Interest Rates: By manipulating
interest rates, central banks exert influence over
both inflation and exchange rates. Higher interest
rates offer lenders a higher return relative to other
countries. Hence, if other factors are ignored, a
higher interest rate leads to appreciation in
currency.
• Current-Account Deficits: A higher deficit causes the
currency to depreciate relative to the trading
partner.
• Speculation: If a country's currency value is
expected to rise, investors will demand more of that
currency in order to make a profit in the near future.
As a result, the value of the currency will rise due to
the increase in demand.
• Recession: When a country experiences a recession,
its interest rates are likely to fall, decreasing its
chances to acquire foreign capital. As a result, its
currency weakens in comparison to that of other
countries, therefore lowering the exchange rate.
 Foreign Exchange Market
Foreign Exchange Reserves:

Interest Rate Parity Theorem:

• Foreign exchange reserves are assets held on
reserve by a central bank in foreign currencies,
which can include bonds, treasury bills and other
government securities.
• Most foreign exchange reserves are held in U.S.
dollars, with China being the largest foreign
currency reserve holder in the world.
• Economists suggest that it’s best to hold foreign
exchange reserves in a currency that is not directly
connected to the country’s own currency.
Importance of foreign reserves
1. It increases the confidence in the monetary and
exchange rate policies of the government.
2. It enhances the capacity of the central bank of the
country to intervene in the foreign exchange market and
control any adverse movement and stabilize the foreign
exchange rates to provide a more favorable economic
environment for the progress of the country.
3. During time of any crisis foreign exchange reserves
come to the rescue of any country so as to absorb the
distress related to such crisis.
4. It also adds to the comfort of market participants that
domestic currency is backed by external assets and
hence it also helps the equity markets of the country.
Interest rate parity (IRP) is a theory in
which the interest rate differential between two
countries is equal to the differential between the
forward exchange rate and the spot exchange rate.
Interest rate parity plays an essential role in foreign
exchange markets, connecting interest rates, spot
exchange rates and foreign exchange rates.
F0 is the forward
rate.
S0 is the spot rate.
ic is the interest
rate in country c.
ib is the interest
rate in country b.
Letter Of Credit:
A letter of credit is a letter from a bank guaranteeing
that a buyer's payment to a seller will be received on
time and for the correct amount. In the event that the
buyer is unable to make payment on the purchase, the
bank will be required to cover the full or remaining
amount of the purchase.

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 Assignment

You are required to send in a one page writeup on any one of the following problem statements.

1. Uncertainty around Brexit has deterred investment and slowed the UK economy. Many firms
have even decided to relocate their operations and staff from Britain to the EU. As the Chancellor
of the Exchequer draft a policy that could help revive investor sentiment and protect jobs.

2. You are a member of the economic policy framing committee in Iran. You will be attending a high
profile meeting to discuss the strategic measures which must be employed in light of the recent
US sanctions. What policy suggestions would you make to reduce the impact of sanctions on the
weakening economy? Delineate with respect to short and long term view.

3. As a member of the Congress Working Committee, draft a resolution on how the party plans to
make the NYAY scheme fiscally viable. You may use the 2018 budget for reference.

 Send in your entries with subject “Primer submission” to currenci@iimidr.ac.in

 The writeup needs to be submitted in the form of a published newsletter, creative
submissions are welcome
 Naming convention “Full name_CAT ID”
 Submissions will be checked for plagiarism and shall be evaluated on the quality of content
and originality.
 Deadline: as per SAC E-mail
 Candidates with the best submissions will be given direct access to the interview round of
the club Prepared in association with the Placement Preparation Committee, IIM Indore