Economy : Understanding and its evolution, Economics vs Economy, Sectors of Economy

 

The Evolution of "Economy":

• The word economy is a Greek word which means "household management." 
• Economics as an area of study was touched on by philosophers in ancient Greece, notably Aristotle, but the modern study of economics began in 18th century Europe and the  Scottish philosopher Adam Smith, who in 1776 wrote the famous economic treatise The Wealth of Nations, was thought of in his own time as a moral philosopher. 
• He and his contemporaries, believed that economies evolved from pre-historic bartering systems to money and eventually credit-based economies.

UNDERSTANDING THE ECONOMY----

Production, exchange and consumption of goods and services are the basic economic activities. There are three basic questions in an economy ie

• What is produced and in what quantities
• How are these goods produced 
• For whom are these goods produced

In the course of these basic economic activities, every society has to face scarcity of resources and it is the scarcity of resources that gives rise to the problem of choice. 

Eg India have 2.4 % of land area in world while it has 18 % of world population. 

ECONOMICS VS ECONOMY :

• Economics is about the optimum decisions about the choices to use its scarce resources in the given economic system to meet the needs of the population.
• Economics aims to comprehend and explain how choices are made in the face of scarce  resources by evaluating the behaviour of different agents in the economy.I
• It digs into the concepts, theories, and frameworks that support production, distribution, and consumption decision-making processes.

                                                                        while 

• Economy represents the large set of inter-related production and consumption activities and  real-world implementation of economic principles and systems. 
• The economy encompasses  everyone from individuals to entities such as corporations and governments.

SECTORS OF ECONOMY:

For better understanding of the functioning of an  economy, an economy can be classified in various sectors. Basically it can be classified as primary ,secondary and tertiary sectors. Now a days tertiary sector can further be classified as Quaternary sector and quinary sector.

PRIMARY SECTOR—

• As the primary means “the basis ”,so this sector is the basis of all other sectors.
• All the subsequent  activities /sectors are dependent upon this sector. 
• This sector includes all the activities  having a direct connection to the environment or in which goods are produced by exploiting natural resources . 
• Since most of the natural products we get are from agriculture, dairy, fishing, forestry, this sector is also called agriculture and related sector along with Mining (extraction of buried material below the surface) and quarrying (Anything extracted from above the surface of earth) which includes oil extraction, coal mining etc. 
• People involved in the primary activities of an economy are also termed as red collar workers due to their association with activities of outdoor nature.

SECONDARY SECTOR--

• The secondary sector is subsequent to the primary sector.
•  It covers all the activities in which natural products are changed into other forms through ways of manufacturing processes. 
• Such processes are  associated with industrial activity. 
• People involved in the secondary sectors of the economy are termed as blue collar workers of the economy.

TERTIARY SECTOR—

• Activities of this sector don’t produce a good at their own. 
• Rather these activities  help in the development  of the primary and secondary sectors. 
• This sector produces intangible goods and are referred to as services.

QUATERNARY SECTOR--- 

Tertiary sector can further be classified into The quaternary and Quinary  sector of the economy .

It refers to describe a knowledge based part of the economy - which typically includes services such as information technology, information-generation and -sharing, media ,research and as well as knowledge-based services like consultation, education, financial planning etc.

QUINARY SECTOR: 

• Part of economy that is involved in decision making eg all the top executives involved in decision making like bureaucrats .  
• Professional under this category often referred as 'gold collar' professionals.

Financial vs Real Economy : 

Economy can also be classified as financial and Real sector .

Financial sector comprises of those aspects of the economy that deals purely with the transaction of money and other financial assets .

                                                                            while 

Real sector encompasses all non-financial enterprises related to production, purchase of goods and services .

Sunrise Industry:

• Sunrise industry is a term used for a sector that is just in its infancy but shows promise of a rapid boom. 
• The industry is typically characterized by high growth rates, high degree of innovation and generally has plenty of public awareness about the sector and investors get attracted to its long-term growth prospects.
• Examples
  
  : Information Technology, Telecom Sector, Healthcare, Infrastructure Sector, Retail Sector and Food Processing Industries.

Evolution of Economic system :Liberalism,Mercantilism,Laissez Faire ,Keynesian,Neo Liberalism ,Monetarism

 CLASSICAL LIBERALISM:

Politico-economic theory that developed in mid of 17^th century and advocate for civil liberties under rule of law with emphasis on individual autonomy, limited government, economic freedom, political freedom and freedom of speech .

MERCANTILISM: 

• Politico -economic system that prevailed during 16^th -18^th century in Europe .
• The theory focused on economic nationalisation advocating for more and more exports and less of less imports so as to become economically strong.
• It advocated for a strong government with maximum interference in the economic affairs .
• This theory promoted colonisation as it provided markets for exports and maximum benefits for ruling countries. 
• Its a coincidence that Adam Smith coined this term mercantilism and opposed this while advocating for Laissez Faire.

Economic Liberalism: 

• In contrast to mercantilism, Classical liberalism when applied in the realm of Economy strongly supports limited state regulation , market economy, private property in the means of production. 
• Free trade, deregulation of the economy, lower taxes and privatization are often hallmarks of economic liberalism.

Laissez Faire Economic System: 

• Politico-Economic theory, rooted in classical liberalism   developed in 18^th century and reached to its peak in 19^th century during industrial revolution. 
• The theory assumes that individual is the basic unit in society and enjoys a natural right to freedom. 
• It advocated for free market capitalism, no intervention of government in businesses and giving space to market .

KEYNESIAN ECONOMICS : 

• John Maynard Keynes popularly known as Keynes is the most influential Economist of the modern times .
• Classicals believe that free markets would automatically provide full employment—that is, that everyone who wanted a job would have one as long as workers were flexible in their wage demands but  Keynes was of the view that  free markets have no self-balancing mechanisms  leading to full employment.
• Classical economists could not avert the Great depression and yielded to Keynesian economics. 
• Keynesian is a demand side theory that focusses on increasing the demand by increasing the investments in the market preferably through active monetary and fiscal policies.
• Keynesian economists justify government intervention through public policies that aim to achieve full employment and price stability. 
• This theory was popularised till 1970’s and monetarists came thereafter but the Keynesian have relevance during 2008 and corona .

Animal Spirit :

The 'animal spirit' is a term coined by the famous British economist, John Maynard Keynes, to describe how people arrive at financial decisions, including buying and selling securities, in times of economic stress or uncertainty.

Neo Liberalism:

• Principles of Classical liberalism / Laissez Faire  emerges as neo liberalism in 19^th century and during 1970’s onwards in the contemporary times. 
• Neo liberalism is about promoting the free markets, recommending for  limiting the government subsidies, reforming tax regulations to increase the tax base, decreasing deficit spending, and limiting protectionism. 
• Thatcherism, Reaganism and LPG reforms in India are examples of Neo liberalism .

MONETARISM: 

• The idea advocated by Freidman  in 1970-80’s was in fact revival of neo classical Quantity theory of money. 
• The argument was that it is not demand but the supply of money in the economy that defines the economic activity in the economy. 
• The monetarism believes that the government should avoid counter cyclical policies and should only regulate the money supply in the economy  . 

Money supply and inflation is governed by the relationship M x V = Px T. where,

 M = the money supply,

V = the velocity of money,

 P = average price level, and

T = Output in the economy or the volume of transactions occurring in the economy.

Monetarists believe that the causation is from left to right ie An increase (or decrease) in the supply of money will affects production, demand, employment  depending upon the variable factor in the equation.

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.