TYPES OF ECONOMY :Open, closed, traditional ,CAPITALIST, SOCIALIST, MIXED, Anarcho Capitalism,FORMAL vs INFORMAL

 

TYPES OF ECONOMY :

There can be various parameters for classification of an economy .More prominently an Economy can be classified upon the following  parameters:

1. How economy is interacting  with the  global economy.
2. How demand and supply defines mode of economy.

Closed Economy :

• These Economies neither export goods and services from foreign countries nor it import goods and services from the foreign countries. 
• It does not borrow money from abroad nor it lends to other countries. 
• Neither residents of a closed economy don’t go for other countries to work nor foreigners are not allowed to work in a closed economy.

Open  Economy:

• These Economies export  goods and services from foreign countries and imports goods and services from the foreign countries as well. 
• It borrows money from abroad as well as it lends to other countries. 
• Residents of an open economy  go for other countries to work and Foreigners are allowed to work in an open economy

Other classification can be based on demands and supply within an economy, parameters on this basis to classify the economy are:

1. What goods and services should be produced in the country?
2. How should the goods and services be produced? Whether methods of production should be labour intensive or capital intensive.
3. How should these produced goods and services be distributed among people?

Traditional Economy: 

• A traditional economy is an original and primitive economic system. 
• The traditions, customs, and belief system of the economy define the nature of   the goods and the services to be produced in an economy, as well as the rules and manner of their distribution. 
• Example: Tribal Communities.

CAPITALIST ECONOMY:

• The purchasing power /desire /demand /wants rather than the basic needs of the people decides what goods are to be  produced and  distributed among people .
• As the control is in the hands of industrialist ,then methods of production will always be selected in the manner in which it is more and more profitable to the businessmen. 
• The produced goods and services are distributed as per the demand /purchasing power of the people.
• Most of the countries in today’s world are moving towards Capitalist mode of Economies.
• Ex. Cheaper housing  for the poor is the basic need of the masses but this demand don’t create demand in the market sense because the poor do not have the purchasing power to support the demand. 

SOCIALIST ECONOMY:

• In a socialist society , the government which decides what goods are to be produced. 
• The decision is  in accordance with the needs rather than the demands  of the society. 
• It is assumed that the government knows what is good for the people of the country and so it takes care of the needs of the people and the desires of individual consumers are not given much importance.
• Ideally, a socialist society has no private property since everything is owned by the state. 
• The methods used for production are labour intensive creating more and more of the jobs.
• In principle, distribution under socialism is supposed to be based on what people need and not on what they can afford to purchase. 
• Example: The then USSR and China of 1990,s and Cuba.

MIXED ECONOMY:

• In the mixed Economy, both the government and the market together answer the three questions of what to produce, how to produce and how to distribute what is produced.
•  In a mixed economy, the market will provide whatever goods and services it can produce well and it is concerned about the demand /desires/purchasing power  of the society. 
• On the other hand, the government will provide essential goods and services which the market fails to do. 
• India is the classic case of mixed Economy.

Anarcho Capitalism : 

• A radical concept of Political state which advocates for demolition of state and talks of police and legal services to be provided by  the private sector .
• Javier Milei ,the rpesident of Argentina is of this ideology and considered to be the ultra right.

INFORMAL ECONOMY: 

• The informal sector, informal economy, or grey economy is the part of an economy that is not part of the formal system ie it is neither taxed, nor accounted in government records. 
• Unlike the formal economy, activities of the informal economy are not included in Gross Domestic Product (GDP).
• Ex. any nearby shop from which you make purchases without any bill.

FORMAL ECONOMY:

• All the activities of an economy which pay taxes to the government and are accounted in the government records. 
• This economy constitutes a part of Gross Domestic Product (GDP). 
• Example: All the purchases from any mall in which you receive the bill.

Functions of money, Evolution of Money,Transaction demand, Precautionary demand, Asset motive/speculative demand

 

MONEY:

• Money is an economic liquid asset used for economic transactions 
• It is recognized as a medium of exchange for transactional purposes in an economy like buying goods and services.
• Currency is the basis of Economy in the sense that its movement in the economy is the barometer of the health of Economy.

Functions of money: 

There are primary and secondary functions of money.

Primary functions include:

•  Money as a means of Exchange avoiding the inefficiencies of a barter system
•  Money as a unit of account as a standard numerical unit of measurement

Secondary functions include:

• Money as a means to settle debt - a unit in which debts are denominated.
• Money as a store of value that can be used as a standard measure and common denomination of trade

EVOLUTION OF MONEY:

                                     Barter system 

                                            ↓

                         Goods like fur, salt ,rice and wheat  used as currency.

                                            ↓

                         Metallic standard (Gold standard and silver standard)

                                            ↓

                                   Paper currency 

                                            ↓

                                   Plastic currency 

                                            ↓

                                   Crypto Currency

DEMAND FOR MONEY:

• The demand for money refers to liquidity preference of individuals. 
• It means that how much assets an individuals wish to hold in the form of liquid money (as opposed to illiquid physical assets).
• The demand for money is dependent upon  economic as well as non economic factors.

In his book "The General Theory of Employment, Interest and Money " John Maynard Keynes talked about three type of demands:

Transaction demand – 

It is that part of the money which we need to purchase goods and services in day to day life.

Precautionary demand:

This demand occurs when we require money for unexpected purchases or emergencies. eg. for medical emergencies.

Asset motive/speculative demand: 

The speculative motive for demanding money comes into play when the individual is having a choice to invest the money in investment or to hold it in the form of cash.

In the situation of liquidity trap, the demand for money is infinitely elastic. Increasing the money supply is ineffective in boosting demand.

Qualitative Tools of Monetary Policy :Fixing Margin,Publicity,Credit Rationing,Moral Suasion,Direct Action,FORWARD GUIDANCE

 

                           

Qualitative Measure of the RBI:

• Tools which define the direction of credit in the economy ie where the money will be channelized in the economy as per the requirement of the economy.
• Most of the measures are of advisory nature rather than mandate or compulsion to be followed by the bank.
• The objective is to encourage credit supply for the needy sector and discourage it for other non-necessary sectors.

Fixing Margin Requirements:

• It is that part of a loan which a borrower has to raise at its own in order to get finance for any purpose. 
• This portion of the loan is not financed by the bank.
• A change in a margin implies a change in the loan size. 
• Increasing margin for the non-necessary sectors will reduce the allocation of funds by banks to that particular sector .
• Example, If the RBI feels that less credit supply should be allocated to Real Estate sector, then it will increase the margin. 
• Reducing margin for the necessary sectors will increase the allocation of funds by banks to that particular sector. 
• Example, If the RBI feels that more credit supply should be allocated to agriculture sector, then it will reduce the margin and even 85-90 percent loan can be given. 
• Apart from this,margin money ensures motivation of the investor as certain amount of his money is also invested.

Publicity:

• The Central Bank (RBI) publishes various reports stating what is good and what is bad in the system. 
• This published information can help commercial banks to direct credit supply in the desired sectors.

Credit Rationing: 

• Central Bank fixes credit amount to be granted / rationed by limiting the amount available for sectors in the form of loans by commercial bank. 
• It  helps in lowering banks credit exposure to unwanted sectors.
• Ex. Rationing of credit during demonetization and Targeted Long term REPO operation (TLTRO)

Moral Suasion / Control Through Directives:

• Directives, Guidelines and  Suggestions issued by the RBI to persuade the Indian banking system 
• These are in the form of advisory without any strict action for non-compliance of the rules. 

Direct Action:

If certain banks are not adhering to the RBI’s directives, the RBI can impose an action against a bank. 

FORWARD GUIDANCE:

• Communication from central banks to the public about the state of the economy and likely future course of the monetary policy. 
• It influences the financial decisions of households, businesses and investors by providing guidance for the expected path of interest rates.
• Forward guidance attempts to prevent surprises that might disrupt the markets and cause significant fluctuations in asset prices.

 

Variable Reserve Ratios,Cash Reserve Ratio ,Statutory Liquidity Ratio

Net Demand and Time Liabilities:

Demand Liabilities:

Liabilities of a bank which are payable on demand like saving accounts, demand draft.

Time Liabilities:

Time Liabilities of a bank are those which are payable otherwise than on demand like Fixed deposits.

Other Demand and Time Liabilities (ODTL):

It includes interest accrued on deposits, bills payable, unpaid dividends, suspense account.

The Net Demand and Time Liabilities or NDTL shows the difference between the sum of demand and time liabilities (deposits) with a bank and the deposits of bank in the form of assets held by the other bank.

Bank’s NDTL = Demand and time liabilities (deposits) +ODTL – deposits with other banks

Example:

Total demand and time liabilities of a bank X (including the other bank deposit) :10,000. 

Interbank deposits of the bank X: 1000 with the other bank 

NDTL:  9,000 (10,000-1,000).

Variable Reserve Ratios (VRR):

Monetary policy tool which controls money supply by maintaining different types of assets like cash , gold , government securities as reserves. Ex: Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio  (SLR).

VRR is used to control credit in the market. By changing the ratio of reserves, the RBI influences the volume of credit that banks can advance. There are two components of VRR:

• Cash reserve ratio (CRR) and 
• Statutory liquidity ratio (SLR). 

Cash Reserve Ratio (CRR):-

• The average daily balance that a bank is required to maintain with the Reserve Bank of India to operate risk free.
• CRR is calculated on fortnightly basis and is calculated in terms of percentage of NDTL, notified by RBI from time to time .
• As per the RBI Act 1934, all Scheduled Commercial Banks are required to maintain a cash balance on average with the RBI on a fortnightly basis to cater to the CRR requirement.

DYNAMICS OF CRR:

The main purpose of CRR is to regulate money circulation in the economy to drive overall liquidity. It enables banks to keep a minimum cash reserve with RBI, so as to deal with any emergency situation. It helps keep inflation under control as the RBI use it as a tool to regulate liquidity in the economy.As on Nov 2024, CRR is 4.5 %.

 If CRR increases, Liquidity with banks decreases, leading to less inflation in the market.

 If CRR decreases, Liquidity with banks   increases, leading to high liquidity in the market 

****** The CRR limits were in the range of 3 -20 % prior to 2006 but 2006 onwards, the limits has been removed.

Statutory Liquidity Ratio (SLR):

The share of NDTL that all Scheduled Commercial Banks is required to maintain in safe and liquid assets, such as, government securities, cash and gold. The SLR is to be maintained with the bank itself.

 DYNAMICS OF SLR :

• Changes in SLR often influence the availability of resources in the banking system for lending to the private sector and hence affect the liquidity in the economy.
• SLR has helped the government to sell its securities or debt instruments to banks. 
• Most of the banks will be keeping their SLR in the form of government securities as it will earn them an interest income.
• Traditionally the amount to be held thus was stipulated to be no lower than 25 percent and not exceeding 40 percent of the bank’s total NDTL. SLR was 38.5 % during 1990’s while CRR was 15 % during 1990’s.

If SLR increases, Liquidity with banks decreases , leading to less inflation in the market.

If SLR decreases, Liquidity with banks   increases, leading to high liquidity in the market .

**********From January-2007 the floor of 25 percent on the SLR was removed following an amendment of the Banking Regulation Act, 1949.

VRRR Rationale:

• CRR causes a huge strain on the financial resources of a bank as there is a huge opportunity cost as the money set aside for deposits with the RBI can be utilized by other sectors creating growth in the economy. Emerging economy like India cant afford to keep this money lying idle with RBI.
• The RBI does not pay any interest on the cash reserve it holds and it is a major lost opportunity for the Banks. 
• Statutory Liquidity Ratio (SLR) is already in place and an instrument for the RBI to contain speculative spending by banks, indiscriminate lending and excess cash. 
• CRR in addition to SLR is like taxing the bank for public deposits it has secured by sound banking practices. Additionally the CRR as a policy tool to control inflation in the economy has not also yielded the desired results. Price rise has always been an economic issue and will continue to be a cause of concern. Cash supply in the economy is not the sole cause of price rise but supply side factors are a major contributing factor.
• On the positive side, CRR along with SLR provide a buffer to banks so as to avoid aggression in providing loan and avoid any situation which is disastrous for a bank like bank run. Banks in India could survive crisis of 2008 due to VRR.

 

POTENTIAL GDP:

• The highest market value of goods and services that can be produced in an economy by utilizing the whole potential of the economy over a period of time is referred to  as potential GDP.
•  Like GDP, potential GDP represents the market value of goods and services, but rather than capturing the current status  of a nation’s economic activity, potential GDP attempts to estimate the highest level of output an economy can sustain over a period of time.
• It assumes that an economy has achieved full employment and that aggregate demand does not exceed aggregate supply.
• When GDP falls short of that natural limit, it means the country is failing to live up to its economic potential.

Determinants of potential GDP are Inflation, Recession, Factory output, productivity, Currency depreciation, foreign capital Reserves, Infrastructure

OUTPUT GAP:

The difference between potential and real GDP is called the output gap.

POSITIVE OUTPUT GAP /INFLATIONARY GAP:

• If the real GDP exceeds potential GDP, then the output gap is positive.
• This is also referred to as inflationary gap.
• An inflationary gap endures when the demand for goods and services exceeds production above its sustainable limits, and that aggregate demand is outstripping aggregate supply. 
• This situation is marked by higher overall employment levels, increased trade, or high government expenditure.
• The inflationary gap depicts the point in business cycle when the economy is growing.

NEGATIVE OUTPUT GAP /DEFLATIONARY GAP :

• When the potential GDP is higher than the real GDP,then the output gap is negative.
•  This gap is also referred to as a deflationary gap. 
• In the scenario of negative output gap, demand for goods and services is weak. 
• It’s a sign that the economy may not be at full employment.

 

Wholesale Price Index vs Consumer Price Index, Producer Price Index

 

PRICE INDEX:

• The price index is an indicator of the average price movement of a fixed basket of goods and services over time . The basket of goods and services is decided considering whether the changes are to be measured in retail, wholesale, or producer prices etc.
• The basket will also vary for economy-wide, regional, or sector specific series.
• The weights of various items in CPI basket are assigned as per the expenditure by the consumers on different items and these weights remain fixed for next 5/6 years.
• So, this time basket revision is due since 2011-12 but we have not been able to change weights since 2011-12 due to demonetization, GST, Covid.

At present, separate series of index numbers are compiled to capture the price movements at retail and wholesale level in India.

Wholesale Price Index:

• WPI represents the price of goods at a wholesale stage i.e. goods that are sold in bulk and traded between organizations instead of consumers. 
• It is released on a monthly basis by Office of the Economic Advisor, in Department of Industrial Policy and Promotion (DIPP) ,Ministry of Commerce &Industry.
• The index basket of the present 2011-12 series has a total of 697 items.
• It includes only goods and not the services.
• The commodities are chosen based on their significance in the region.
• The constituents of WPI in decreasing trend are: manufacturing (64 %) ,(23 %) and (13 %).
• Food index in WPI comprises of 24.38 % constituting food articles from primary and food products from manufacturing indexes.
• WPI is the basis of GDP Deflator.

CONSUMER PRICE INDEX (CPI)---

A consumer price index (CPI) measures changes in the price level of a market basket of consumer goods and services purchased by households.

The CPI is released on a monthly basis on 12th of every month by National Statistical  Office (NSO),Ministry of Statistics and Programme Implementation (MOSPI).

Initially,CPI is compiled for the following:

1. Industrial Workers (IW) (base 2001)

2. Agricultural Labourer (AL) (base 1986-87) 

3. Rural Labourer (RL) (base 1986-87)

4. Urban Non-Manual Employees (UNME) (base 1984-85),

• The first three indices  are compiled by the Labour Bureau in the Ministry of Labour and  Employment.
• The first three are still compiled by The GOI while the fourth index compiled by National Statistical Organisation (NSO) has been discontinued.
• AICPI (IW) is used in calculating the central government Dearness allowance on a   quarterly basis.

NEED FOR NEW CPI SERIES:

• These four CPIs reflect the effect of price fluctuations of various goods and services consumed by specific segments of population in the country. 
• These indices did not encompass all the segments of the population and thus, did not reflect the true picture of the price behaviour in the country as a whole.  

Hence, New Series of CPI was started in 2012.

• The new series, with 2010 as the base year, also includes services, which is not the case with the WPI series.
• Basket comprises of 448 items for rural and 460 items for urban.
• For all India, basket comprises of 299 items.
• Thus, now Central Statistics Office (CSO) of the Ministry of Statistics and Programme Implementation has started compiling a new series of CPI for the :

(a) CPI for the entire urban population viz CPI (Urban);

(b) CPI for the entire rural population viz CPI (Rural)

(c) Consolidated CPI for Urban + Rural will also be compiled based on above two CPIs

Why CPI is better than WPI? :

• CPI reflects price rise driven by potential consumer demand and available supply—is a better indicator of inflation for guiding monetary policy decisions than WPI inflation.
• WPI excludes prices of services such as education, healthcare, and rents. However, services now account for nearly 60 per cent of GDP and a vast majority of these services are not traded with other countries. 
• Conversely, the new CPI measure assigns nearly 36% weightage on services and includes price changes in housing, education, healthcare, transport and communication, personal care and entertainment

Producer Price Index (PPI) :

• PPI measures the average change in prices received by the producer and excludes any indirect taxes.
• PPI weights are derived from Supply Use tables covering both goods and services.
• Producer Price Index has replaced Wholesale Price Index in most countries.
• In 2019, GOI constituted a working group for revision of the current series of WPI that has 2011-12 as its base year.
• PPI globally tracks price movements in both goods and services.
• PPI is considered conceptually more consistent with the System of National Accounts for use as deflator.