“effect of interest and inflation rates on the economy”

8/22/2019 EFFECT OF INTEREST AND INFLATION RATES ON THE ECONOMY

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A Final Project Report

On

EFFECT OF INTEREST AND INFLATION RATES ON THE

ECONOMY

A Report submitted in partial fulfillment of

the requirements of

BBA Program

Submitted to:- Submitted by:-

Mr. Roshan Kkumar Harinder Kumar

Roll no. 94532451189


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ACKNOWLEDGEMENT

Surpassing milestones towards a mission sometimes gives us such degree of jubilance

that we tend to forfeit the precious guidance and help extended by the people to whom

the success of mission is solely dedicated.

It is my pleasure to thank all people, who directly or indirectly contributed in the

development of this work.

I would also like to thank my faculty guide Lecturer Roshan Kumar, Faculty GNA-IMT

Phagwara who has been a source of constant inspiration, stimulating me to learn and

making my learning process an enlightening experience.

Lastly, it gives me immense gratification to place on records my profound gratitude and

sincere appreciation to each and every one of those who have helped me in this endeavor.


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TABLE OF CONTENT

Contents:- Page no.

Acknowledgement

Abstract

1. Introduction 5-19

i. Measures of inflationii. Effects of inflation

iii. Reasons for interest rate changesiv. Economyv. Growth of industry

vi. Economic liberalization in India

2. Types of Inflation 19-203. History of inflation in India 21-314. History of inflation in the developed economies 32-385. Interconnection b/w different world economies 38-396. Effect of interest rate changes on the economy 39-41

over a period of time7. Research Methodology 41-45

i. Objectivesii. Research Design

iii. Data collectioniv. Data analysisv. Limitations of the study

8. Facts and Findings 469. Recommendations 4710. Limitations of Study 4811. Conclusion 49

Bibliography 50


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ABSTRACT

Inflation & Interest rates are interconnected with each other. Like in a country like India the aim

of the government is to increase the rate of economic growth. Government through RBI

increases or reduces the interest rates for affecting the supply of money into the system which

directly affects the rate of inflation.

The Purpose of the project is to measure the effect of changes in inflation and interest rates on

the economic growth of India. Various measures for controlling the interest rates and inflationrates.

The interest rates and Inflation is controlled by the government and RBI.In the project the tools

and policies will be covered which are used by the government and the RBI for controlling

inflation as well as interest rates.

All the tools like repo rate, reverse repo rate, SLR, bank rate, crr will be discussed in detail.

Study of the effect of inflation as well as interest rates on various industries and common man

will be a part of the project.

Effect of inflation during recessionary as well as periods when economy is on boom. Striking a

balance between pace of economy, inflation as well as interest rates.

An analysis of variation in interest and inflation rates over a period of time will be done and their

relationship with each other will be checked. Comparison between Indian economic growth

(w.r.t variation in interest and inflation rates) and economic Growth of developed country like

USA will be included in the research project.


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INTRODUCTION

Inflation: In economics, inflation is a rise in the general level of prices of goods and services in

an economy over a period of time. When the general price level rises, each unit of currency buys

fewer goods and services. Consequently, inflation also reflects erosion in the purchasing of

money a loss of real value in the internal medium of exchange and unit of account in the

economy.

Measures of Inflation

Producer price indices: (PPIs) which measures average changes in prices received by domestic

producers for their output. This differs from the CPI in that price subsidization, profits, and taxes

may cause the amount received by the producer to differ from what the consumer paid. There is

also typically a delay between an increase in the PPI and any eventual increase in the CPI.

Producer price index measures the pressure being put on producers by the costs of their raw

materials. This could be "passed on" to consumers, or it could be absorbed by profits, or offset

by increasing productivity. In India and the United States, an earlier version of the PPI was

called the Wholesale Price Index.

Commodity price indices: which measure the price of a selection of commodities? In the

present commodity price indices are weighted by the relative importance of the components to

the "all in" cost of an employee.

Core price indices:because food and oil prices can change quickly due to changes in supply and

demand conditions in the food and oil markets, it can be difficult to detect the long run trend in

price levels when those prices are included.

Therefore most statistical agencies also report a measure of 'core inflation', which removes the

most volatile components (such as food and oil) from a broad price index like the CPI. Because

core inflation is less affected by short run supply and demand conditions in specific
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markets, central banks rely on it to better measure the inflationary impact of current monetary

policy.

Other common measures of inflation are:

GDP deflator: is a measure of the price of all the goods and services included in Gross

Domestic Product (GDP). The US Commerce Department publishes a deflator series for US

GDP, defined as its nominal GDP measure divided by its real GDP measure.

Regional inflation The Bureau of Labor Statistics breaks down CPI-U calculations down to

different regions of the US.

Historical inflation: before collecting consistent econometric data became standard for

governments, and for the purpose of comparing absolute, rather than relative standards of living,

various economists have calculated imputed inflation figures.

Most inflation data before the early 20th century is imputed based on the known costs of goods,

rather than compiled at the time. It is also used to adjust for the differences in real standard of

living for the presence of technology.

Asset price inflation: is an undue increase in the prices of real or financial assets, such

as stock (equity) and real estate. While there is no widely accepted index of this type, some

central bankers have suggested that it would be better to aim at stabilizing a wider general price

level inflation measure that includes some asset prices, instead of stabilizing CPI or core

inflation only.

The reason is that by raising interest rates when stock prices or real estate prices rise, and

lowering them when these asset prices fall, central banks might be more successful inavoiding bubbles and crashes in asset prices.


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Effects of Inflation:

General

An increase in the general level of prices implies a decrease in the purchasing power of the

currency. That is, when the general level of prices rises, each monetary unit buys fewer goods

and services.

The effect of inflation is not distributed evenly in the economy, and as a consequence there are

hidden costs to some and benefits to others from this decrease in the purchasing power of money.

For example, with inflation, lenders or depositors who are paid a fixed rate of interest on loans or

deposits will lose purchasing power from their interest earnings, while their borrowers benefit.

Individuals or institutions with cash assets will experience a decline in the purchasing power of

their holdings. Increases in payments to workers and pensioners often lag behind inflation,

especially for those with fixed payments.

Increases in the price level (inflation) erode the real value of money (the functional currency)

and other items with an underlying monetary nature (e.g. loans and bonds). However, inflation

has no effect on the real value of non-monetary items, (e.g. goods and commodities, gold, real

estate).

Debtors who have debts with a fixed nominal rate of interest will see a reduction in the "real"

interest rate as the inflation rate rises. The real interest on a loan is the nominal rate minus the

inflation rate (approximately).

For example if you take a loan where the stated interest rate is 6% and the inflation rate is at 3%,

the real interest rate that you are paying for the loan is 3%.

It would also hold true that if you had a loan at a fixed interest rate of 6% and the inflation rate

jumped to 20% you would have a real interest rate of -14%. Banks and other lenders adjust for


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this inflation risk either by including an inflation premium in the costs of lending the money by

creating a higher initial stated interest rate or by setting the interest at a variable rate.

As the rate of inflation decreases, this has the opposite (negative) effect on borrowers.

Negative

High or unpredictable inflation rates are regarded as harmful to an overall economy. They add

inefficiencies in the market, and make it difficult for companies to budget or plan long-term.

Inflation can act as a drag on productivity as companies are forced to shift resources away from

products and services in order to focus on profit and losses from currency inflation.

Uncertainty about the future purchasing power of money discourages investment and saving and

inflation can impose hidden tax increases, as inflated earnings push taxpayers into higher income

tax rates unless the tax brackets are indexed to inflation.

With high inflation, purchasing power is redistributed from those on fixed nominal incomes,

such as some pensioners whose pensions are not indexed to the price level, towards those with

variable incomes whose earnings may better keep pace with the inflation. This redistribution of

purchasing power will also occur between international trading partners.

Where fixed exchange rates are imposed, higher inflation in one economy than another willcause the first economy's exports to become more expensive and affect the balance of trade.

There can also be negative impacts to trade from an increased instability in currency exchange

prices caused by unpredictable inflation.

Cost-push inflation:

High inflation can prompt employees to demand rapid wage increases, to keep up with consumer

prices. In the cost-push theory of inflation, rising wages in turn can help fuel inflation. In the

case of collective bargaining, wage growth will be set as a function of inflationary expectations,

which will be higher when inflation is high.

This can cause a wage spiral. In a sense, inflation begets further inflationary expectations, which

beget further inflation.


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Hoarding

People buy durable and/or non-perishable commodities and other goods as stores of wealth, to

avoid the losses expected from the declining purchasing power of money, creating shortages of

the hoarded goods.

Hyperinflation

If inflation gets totally out of control (in the upward direction), it can grossly interfere with the

normal workings of the economy, hurting its ability to supply goods. Hyperinflation can lead to

the abandonment of the use of the country's currency, leading to the inefficiencies.

Allocative efficiency

A change in the supply or demand for a good will normally cause its relative price to change,

signaling to buyers and sellers that they should re-allocate resources in response to the new

market conditions. But when prices are constantly changing due to inflation, price changes due to

genuine relative price signals are difficult to distinguish from price changes due to general

inflation, so agents are slow to respond to them. The result is a loss of allocative efficiency.

Shoe leather cost

High inflation increases the opportunity cost of holding cash balances and can induce people to

hold a greater portion of their assets in interest paying accounts. However, since cash is still

needed in order to carry out transactions this means that more "trips to the bank" are necessary in

order to make withdrawals, proverbially wearing out the "shoe leather" with each trip.

Menu costs

With high inflation, firms must change their prices often in order to keep up with economy-wide

changes. But often changing prices is itself a costly activity whether explicitly, as with the need

to print new menus, or implicitly.
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Business cycles

According to the Austrian Business Cycle Theory, inflation sets off the business cycle. Austrian

economists hold this to be the most damaging effect of inflation. According to Austrian theory,

artificially low interest rates and the associated increase in the money supply lead to reckless,

speculative borrowing, resulting in clusters of malinvestments, which eventually have to be

liquidated as they become unsustainable.

Positive

Labor-market adjustments

Keynesians believe that nominal wages are slow to adjust downwards. This can lead to

prolonged disequilibrium and high unemployment in the labor market. Since inflation would

lower the real wage if nominal wages are kept constant, Keynesians argue that some inflation is

good for the economy, as it would allow labor markets to reach equilibrium faster.

Room to maneuver

The primary tools for controlling the money supply are the ability to set the discount rate, the

rate at which banks can borrow from the central bank, and open market operations which are the

central bank's interventions into the bonds market with the aim of affecting the nominal interest

rate.

If an economy finds itself in a recession with already low, or even zero, nominal interest rates,

then the bank cannot cut these rates further (since negative nominal interest rates are impossible)

in order to stimulate the economy - this situation is known as a liquidity trap.

A moderate level of inflation tends to ensure that nominal interest rates stay sufficiently above

zero so that if the need arises the bank can cut the nominal interest rate.
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Tobin effect

The Nobel Prize winning economist James Tobin at one point argued that a moderate level of

inflation can increase investment in an economy leading to faster growth or at least a higher

steady state level of income.

This is because inflation lowers the real return on monetary assets relative to real assets, such

as physical capital. To avoid this effect of inflation, investors would switch from holding their

assets as money (or a similar, susceptible-to-inflation, form) to investing in real capital projects

Keynesian view

Keynesian economic theory proposes that changes in money supply do not directly affect prices,

and that visible inflation is the result of pressures in the economy expressing themselves in

prices. The supply of money is a major, but not the only, cause of inflation.

There are three major types of inflation:

Demand-pull inflation is caused by increases in aggregate demand due to increased private and

government spending, etc. Demand inflation is constructive to a faster rate of economic growth

since the excess demand and favorable market conditions will stimulate investment and

expansion.

Cost-push inflation also called "supply shock inflation," is caused by a drop in aggregate supply

(potential output). This may be due to natural disasters, or increased prices of inputs. For

example, a sudden decrease in the supply of oil, leading to increased oil prices, can cause cost-

push inflation. Producers for whom oil is a part of their costs could then pass this on to

consumers in the form of increased prices.

Built-in inflation is induced by adaptive expectations, and is often linked to the "price/wage

spiral". It involves workers trying to keep their wages up with prices (above the rate of inflation),
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and firms passing these higher labor costs on to their customers as higher prices, leading to a

'vicious circle'. Built-in inflation reflects events in the past, and so might be seen as hangover

inflation

Interest Rates: An interest rate is the rate at which interest is paid by a borrower for the use

ofmoney that they borrow from a lender. For example, a small company borrows capital from a

bank to buy new assets for their business, and in return the lender receives interest at a

predetermined interest rate for deferring the use of funds and instead lending it to the borrower.

Interests rates are fundamental to a capitalist society. Interest rates are normally expressed as

apercentagerate over the period of one year.

Reasons for interest rate change:

Political short-term gain: Lowering interest rates can give the economy a short-run boost.

Under normal conditions, most economists think a cut in interest rates will only give a short term

gain in economic activity that will soon be offset by inflation. The quick boost can influence

elections. Most economists advocate independent central banks to limit the influence of politics

on interest rates.

Deferred consumption: When money is loaned the lender delays spending the moneyon consumption goods. Since according to time theory people prefer goods now to goods later, in

a free market there will be a positive interest rate.

Inflationary expectations: Most economies generally exhibit inflation, meaning a given amount

of money buys fewer goods in the future than it will now. The borrower needs to compensate the

lender for this.

Alternative investments: The lender has a choice between using his money in different

investments. If he chooses one, he forgoes the returns from all the others. Different investments

effectively compete for funds.
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Risks of investment: There is always a risk that the borrower will gobankrupt, abscond, die, or

otherwise default on the loan. This means that a lender generally charges a risk premium to

ensure that, across his investments, he is compensated for those that fail.

Liquidity preference: People prefer to have their resources available in a form that can

immediately be exchanged, rather than a form that takes time or money to realize.

Taxes: Because some of the gains from interest may be subject to taxes, the lender may insist on

a higher rate to make up for this loss.

Economy

An economy consists of the economic system of a country orotherarea, thelabor, capital

andlandresources, and the economic agents that socially participate in the production,

exchange, distribution and consumption ofgoods and services of that area.

A given economy is the end result of a process that involves itstechnological

evolution,history and social organization, as well as its geography,natural resource endowment,

andecology, as main factors. These factors give context, content, and set the conditions and

parameters in which an economy functions.

Economy of India:

The economy of India is the eleventh largest economy in the world by nominal GDP and

the fourth largest by purchasing power parity (PPP).Following strong economic reforms from the

socialist inspired economy of a post-independence Indian nation, the country began to develop a

fast-paced economic, as free market principles were initiated in 1990 for internationalcompetition and foreign investment. Economists predict that by 2020, India will be among the

leading economies of the world.

India was under social democratic-based policies from 1947 to 1991. The economy was

characterized by extensive regulation, protectionism, public ownership, pervasive
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corruption and slow growth. Since 1991, continuing economic liberalization has moved the

country toward a market-based economy.

Recent trends in Indian Economy

The growth in IIP for the period April to August 2010-11 stood at 10.6 percent and this was

higher than the growth posted during the five month period of the previous fiscal. The overall

mood of the industry looked promising, however growth in August decelerated to 5.6 per cent as

compared to 10 percent plus in the previous year, which was slightly disappointing.

The high growth oriented manufacturing sectors which accounts for the majority share has been

the backbone of the rising Industrial growth numbers.

Coming to the use-based classification one can say that the capital goods which include the plant

and machinery grew by a phenomenal number, with average growth for April- August being 29

per cent as against 3.4 percent increase in the previous year.

Nevertheless, capital goods shows volatility when we look at the monthly numbers as it turnsnegative for the second time this year in August 2010 after a positive movement. Output in the

basic and intermediate goods rose but not as much as seen in the previous year.

The consumer goods cumulatively for the five-month period have also shown acceleration in

growth, it rose by 8.6 percent as against the increase of 3.6 percent seen in the previous year. The

rise was however, seen to mainly come from the consumer durables goods category.

Acceleration in growth was observed in food products, cotton textiles, jute products, paper

Products, rubber products, basic metals, metal products machinery and transport equipments

during the period from April to August as compared to the corresponding growth numbers of the

previous year.


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Growth of industry: Recent Trends (in percentage)

Growth in 17 industry sectors


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Trends in Inflation

Inflation in September 2010 has been brought fewer than 10 per cent. The inflation was 8.62

percent in September 2010 on a Y-o-Y basis; this has been brought down from 9.55 percent in

August this year. The buildup in the wholesale price index in September over March has been

3.9 percent compared to the build of 5.4 percent in the previous year.


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Economic Liberalization in India

The economic liberalization in India refers to ongoing economic reforms in India that started in1991. After Independence in 1947, India adhered to socialistpolicies. In the 1980s, Prime

MinisterRajiv Gandhi initiated some reforms. In 1991, after India sold 67 tons of gold to

the International Monetary Fund (IMF), the government ofP. V. Narasimha Rao and his finance

ministerManmohan Singhstarted breakthrough reforms.
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The new neo-liberalpolicies included opening for international trade and

investment, deregulation, initiation ofprivatization, tax reforms, and inflation-controlling

measures.

The overall direction of liberalization has since remained the same, irrespective of the ruling

party, although no party has yet tried to take on powerful lobbies such as the trade unions and

farmers, or contentious issues such as reforming labor laws and reducing agricultural subsidies.

The main objective of the government was to transform the economic

system from socialism to capitalism so as to achieve high economic growth and industrialize the

nation for the well-being of Indian citizens. Today India is mainly characterized as a market

economy.

As of 2009, about 300 million peopleequivalent to the entire population of the United States

have poverty. The fruits of liberalization reached their peak in 2007, when India recorded its

highest GDP growth rate of 9%.With this; India became the second fastest growing major

economy in the world, next only to China.

An Organization for Economic Co-operation and Development (OECD) report states that the

average growth rates 7.5% will double the average income in a decade and more reforms would

speed up the pace.

Indian government coalitions have been advised to continue liberalisation. India grows at slower

pace than China, which has beenliberalising its economy since 1978.McKinsey states that

removing main obstacles "would free Indias economy to grow as fast as Chinas, at 10 percent a

year".

For 2010, India was ranked 124th among 179th countries in Index of Economic Freedom World

Rankings, which is an improvement from the preceding year.

Exchange rate & its effect on the economy
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In finance, the exchange rates (also known as the foreign-exchange rate, forex rate or FX rate)

between two currencies specify how much one currency is worth in terms of the other. It is the

value of a foreign nations currency in terms of the home nations currency.

For example an exchange rate of 91 Japanese yen (JPY, ) to the United States dollar (USD, $)means that JPY 91 is worth the same as USD 1.

The foreign exchange market is one of the largest markets in the world. By some estimates,

about 3.2 trillion USD worth of currency changes hands every day. The spot exchange rate refers

to the current exchange rate. The forward exchange rate refers to an exchange rate that is quoted

and traded today but for delivery and payment on a specific future date.

Exchanges rates affect economy in a huge way. Like if value of rupee is increasing against the

dollar than it will affect the exports in a negative way & if its reducing than it will help in

increasing the exports.

Future Prospects

Emerging strong even during the scariest phase of global financial meltdown, India has become

one of the favorite investment destinations for the foreign investors across the globe. The

investment scenario in India is getting better and better with each passing day due to high

confidence level of the investors.

Today, India is considered the 4th biggest economy in the world. Its impressive GDP rate,

especially in the field of purchasing power, has catapulted it to second position among all the

developing nations.

According to forecasts, Indian economy will grow to become 60% in size of the economy of US.It will also witness macro-level stability in economic conditions. Behind all this, investment can

be said to be the key player.

Types of Inflation


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There are four main types ofinflation. The various types of inflation are briefed below.

Wage Inflation: Wage inflation is also called as demand-pull or excess demand inflation. This

type of inflation occurs when total demand for goods and services in an economy exceeds the

supply of the same. When the supply is less, the prices of these goods and services would rise,

leading to a situation called as demand-pull inflation. This type of inflation affects the market

economy adversely during the wartime.

Cost-push Inflation: As the name suggests, if there is increase in the cost of production of

goods and services, there is likely to be a forceful increase in the prices of finished goods and

services. For instance, a rise in the wages of laborers would raise the unit costs of production and

this would lead to rise in prices for the related end product. This type of inflation may or may not

occur in conjunction with demand-pull inflation.

Pricing Power Inflation: Pricing power inflation is more often called as administered price

inflation. This type of inflation occurs when the business houses and industries decide to increase

the price of their respective goods and services to increase their profit margins. A point

noteworthy is pricing power inflation does not occur at the time of financial crisesand economic

depression, or when there is a downturn in the economy. This type of inflation is also called as

oligopolistic inflation because oligopolies have the power ofpricing their goods and services.

Sectoral Inflation: This is the fourth major type of inflation. The sectoral inflation takes place

when there is an increase in the price of the goods and services produced by a certain sector of

industries. For instance, an increase in the cost of crude oil would directly affect all the other

sectors, which are directly related to the oil industry.

Thus, the ever-increasing price of fuel has become an important issue related to the economy all

over the world. Take the example of aviation industry. When the price of oil increases, the ticket

fares would also go up. This would lead to a widespread inflation throughout the economy, even

though it had originated in one basic sector. If this situation occurs when there is a recession in
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the economy, there would be layoffs and it would adversely affect the work force and the

economy in turn.

Other Types of Inflation

Fiscal Inflation: Fiscal Inflation occurs when there is excess government spending. This occurs

when there is a deficit budget. For instance, Fiscal inflation originated in the US in 1960s at the

time President Lydon Baines Johnson. America is also facing fiscal type of inflation under the

president ship of George W. Bush due to excess spending in the defense sector.

Hyperinflation: Hyperinflation is also known as runaway inflation or galloping inflation. This

type of inflation occurs during or soon after a war. This can usually lead to the complete

breakdown of a countrys monetary system. However, this type of inflation is short-lived. In

1923, in Germany, inflation rate touched approximately 322 percent per month with October

being the month of highest inflation.

To sum up, any type of inflation could affect the economy of a country badly.

History of Inflation in India

Inflation is the gravest economic concern which has gripped India into its jagged

tentacles. Inflation can be defined as the rise in overall price level in the economy, i.e.

rise in prices of all the goods and services.

When prices rise, each rupee buys less goods and services than it had been before, consequently

eroding the purchasing power of money. It is measured through inflation rate- the annualized


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percentage change in a general price index (Consumer Price Index and Wholesale Price Index)

over time.

India has been plagued by the disease of inflation since the 1950s but it has started showing its

prominently harmful symptoms and ill effects since 1991, post liberalization. Kick started by the

fiscal crisis of 1991, marked by deficits in government finances and devaluation of the rupee, a

whopping inflation of 13.66 per cent took its toll on the Indian economy.

Though later controlled, average inflation rate has been stubborn at a 9.3 per cent per year till the

end of the 19th century. Since last years global meltdown somewhat crippling the Indian

economy, the inflation rate has been steadily rising to surpass the double digits. At present, it is

around 11 per cent.

Causal Factors:

The puzzle haunting the Indian economists is simply this- Why is inflation rate in India so high

as compared to the other emerging and overheating market economies, like China, Korea and

Indonesia where inflation just touches a mere 3 per cent?

Firstly, India has been very much underinvested as compared to China whose rate ofinvestment

for the year 2009 was 45 per cent as compared to Indias 37 per cent. This has been the key to

Chinas development, (currently fastest in the world) free from all scars ofinflationary pressure.

India has always been subject to uncertainty ofthe monsoons, particularly last year, which led to

a sharp fall in agricultural produce, declining supply and thus shooting up the prices. This is

called the Supply shock factor or the cost push inflation.

Another reason, intuitively named as the Policy Shock is responsible for inflation. Hike in fuel

prices, subject to the discretion ofOPEC, increases the manufacturing cost ofa

numberofindustries, which in turn shoots up the prices oftheir respective commodities.

Apart from the above, there is another explanation, namely overheating: the supply capacity falls

short ofdemand.


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Now, overheating in India is a serious cause ofworry because it certainly implies that the

economys current growth rate of8.4 per cent surpasses its potential or trend growth rate. In this

scenario, how can anyone in India dream of China-type-double-figure growth rates unless and

until infrastructure development is given some serious thought?

Microeconomic distortions causing an increase in land prices accompanied by various

macroeconomic factors such as surging capital inflows in the real estate and housing sector are

very much responsible for the rising cost of production in the economy. Apart from agriculture

and manufacturing, service sector which contributes the highest (54 per cent for 2009-2010) also

bears dire consequences of galloping prices of land.

Excess of short-term borrowings and speculative activities are majorly responsible for a

steady inflation in the Indian economy. Highly volatile, these short term borrowings lead to a

vicious cycle of speculation, which ends up causing serious depression in the economy,

sometimes insolvency. Increase in speculative activities leads to a rise in domestic price, thus

making the exports expensive.

This ensues in the deficit in the balance of payments which forces the government to

pump in money into the economy by printing currency notes. This, along with the

adjustment of the BOP, plays havoc with the demand capacity of the economy. Since people own

more money now, their demand for goods and services accelerates like anything and this further

leads to a rise in prices.

Consequences

The dire consequences of this phenomenon are levied upon the aam admi. Of course somebody

like you and me, or someone less well off than us cannot be considered as aam aadmi. Aam


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aadmi clan is that 70 per cent of the population of India who spend less than Rs 20 on themselves

every day.

Right from the ricks hawallas in Delhi, to the daily wage earners in Bihar, these people struggle

to make ends meet. Prices of food items like vegetables, fruits, pulses, oil, wheat, rice, etc,

conveyance, education and healthcare have soared up to no extent, thus causing the cost of living

to increase.

The RBI has been implementing the only monetary strategy it knows, increasing the interest

rates to squeeze liquidity. According to the forecasts of the Bloomerag News survey, the RBI

will increase both the repurchase and the reverse repurchase rates by a quarter points each. This

has led to an upsurge in agitation among the opposition parties who are stubborn against any

rise in interest rates.

However, the government needs be careful lest it ends up hampering the growth of the economy

with such a tight credit policy. A balance needs to be maintained between the credit liberty for

growth on one hand and tightening liquidity for tackling inflation on the other.

Wages, in the country are on a high rise these days. World leading mobile phone supplier Nokia

Pvt Limited and IT companies such as Wipro and Infosys have taken a step ahead and raised the

wages of their employees to retain them.

Future Predictions:

The RBI predicts that it will be able to pull down inflation rate up to 6 per cent by the end of this

year. If in future inflation is not curbed, it will not only deprive the aam admi of basic amenities

but along with it, also deprive the Indian economy of its growth of all the sectors.

Indus Valley Civilization


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The Indus Valley civilization, the first known permanent and predominantly urban settlement

that flourished between 2800 BC to 1800 BC boasted of an advanced and thriving economic

system. Its citizens practiced agriculture, domesticated animals, made sharp tools and weapons

from copper,bronze and tin and traded with other cities.

Evidence of well laid streets, layouts, drainage system and water supply in the valley's major

cities, Harappa, Lothal,Mohenjo-daro and Rakhigarhi reveals their knowledge of urban

planning. One of the theories about their end is that they eventually overused their resources, and

slowly died out.

Ancient & Medieval Characteristics

Though ancient India had a significant urban population, much of India's population resided

in villages, whose economy was largely isolated and self-sustaining. Agriculture was the

predominant occupation of the populace and satisfied a village's food requirements besides

providing raw materials for hand based industries like textile, food processing and crafts. Besides

farmers, other classes of people were barbers, carpenters, doctors (Ayurvedic

practitioners), goldsmiths, weavers etc.

Religion

Religion, especially Hinduism, played an influential role in shaping economic activities. The

Indian caste system castes and sub-castes functioned much like medieval European guilds,

ensuring division of labour and provided for training of apprentices. The caste system restrictedpeople from changing one's occupation and aspiring to an upper caste's lifestyle.

Thus, a barber could not become a goldsmith and even a highly skilled carpenter could not

aspire to the lifestyle or privileges enjoyed by a Kshatriya (person from a warrior class). This

barrier to mobility on labour restricted economic prosperity to a few castes.
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Pilgrimage towns like Allahabad, Benares, Nasik and Puri, mostly centered around rivers,

developed into centres of trade and commerce. Religious functions, festivals and the practice of

taking a pilgrimage resulted in a flourishingpilgrimage economy.

Family business

In the joint family system, members of a family pooled their resources to maintain the family and

invest in business ventures. The system ensured younger members were trained and employed in

the family business and the older and disabled persons would be supported by the family.

The system, by preventing the agricultural land from being split ensured higher yield because of

the benefits of scale. The system curbed members from taking initiative because of the support

system and family or work.

Organizational entities

Along with the family-run business and individually owned business enterprises, ancient India

possessed a number of other forms of engaging in business or collective activity, including

the gana, pani, puga, vrata, sangha, nigama and sreni. Nigama, pani and sreni refer most often to

economic organizations of merchants, craftspeople and artisans, and perhaps even para-military

entities.

In particular, the sreni was a complex organizational entity that shares many similarities with

modern corporations, which were being used in India from around the 8th century BC until

around the 10th century AD. The use of such entities in ancient India was widespread including

virtually every kind of business, political and municipal activity.

The sreni was a separate legal entity which had the ability to hold property separately from its

owners, construct its own rules for governing the behavior of its members, and for it to contract,

sue and be sued in its own name. Some ancient sources such asLaws of Manu VIII

and Chanakya'sArthashastra have rules for lawsuits between two or more sreni and some
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sources make reference to a government official (Bhandagarika) who worked as an arbitrator for

disputes amongst sreni from at least the 6th century BC onwards.

There were between 18 to 150 sreni at various times in ancient India covering both trading and

craft activities. This level of specialization of occupations is indicative of a developed economyin which the sreni played a critical role. Some sreni could have over 1000 members as there were

apparently no upper limits on the number of members.

The sreni had a considerable degree of centralised management. The headman of the sreni

represented the interests of the sreni in the kings court and in many official business matters.

The headman could also bind the sreni in contracts, set the conditions of work within the sreni,

often received a higher salary, and was the administrative authority within the sreni.

The headman was often selected via an election by the members of the sreni, who could also be

removed from power by the general assembly. The headman often ran the enterprise with two to

five executive officers, who were also elected by the assembly.

Coinage

Punch marked silver ingots, in circulation around the 5th century BC and the first

metallic coins were minted around 6th century BC by the Mahajanapadas of the Gangetic

plains were the earliest traces of coinage in India. While India's many kingdoms and rulers issued

coins, barter was still widely prevalent.
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Villages paid a portion of their agricultural produce as revenue while its craftsmen received a

stipend out of the crops at harvest time for their services. Each village, as an economic unit, was

mostly self-sufficient.

Exports

Surplus of Indian manufactures, like the muslin ofDacca, calicos ofBengal, shawls ofKashmir,

steel and iron works, silk, and other textiles and handicrafts, agricultural products

likepepper, cinnamon, opium and indigo were exported to Europe, the Middle East and South

East Asia in return for gold and silver.

GDP estimate

According to economic historian Angus Maddison in his bookThe World Economy: A

Millennial Perspective, India had the world's largest economy from the first to 11th century, and

in the 18th century, with a (32.9%) share of world GDP in the 1st century to (28.9%) in 1000

AD, and in 1700 AD with (24.4%).

Early Modern Period

1725 - 1750
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During this period, Mughals were replaced by the the Maratha Empire in much of India. While

the other small regional states who were mostly late Mughal tributary states such as

theNawabs in the north and the Nizam in south India remained.

However, the Mughal tax administration system was left largely intact. China was the world's

largest economy followed by India and France. The gross domestic product of India in 1750 was

estimated at about 80 per cent that of China.

1750 - 1775

During this period, tax administration system in India was collected by officers of the Maratha

empire which expanded to almost 2.8 million km. While the Nizam's remained prosperous in

the Deccan. China was the world's largest economy followed by India and France. The gross

domestic product of India in 1775 was estimated at about 70 per cent that of China. Nevertheless,

a devastating famine broke out in the eastern coast in early 1770s killing 5 per cent of the

national population.

The fall of the Rupee

After its victory in the Franco-Prussian War(187071), Germany extracted a huge indemnity

from France of 200,000,000, and then moved to join Britain on a gold standard for currency.

France, the US and other industrializing countries followed Germany in adopting a gold standard

throughout the 1870s.

At the same time, countries, such as Japan, which did not have the necessary access to gold or

those, such as India, which were subject to imperial policies that determined that they did not

move to a gold standard, remained mostly on a silver standard. A huge divide between silver-

based and gold-based economies resulted. The worst affected were economies with a silver

standard that traded mainly with economies with a gold standard.
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With discovery of more and more silver reserves, those currencies based on gold continued to

rise in value and those based on silver were declining due to demonetization of silver. For India

which carried out most of its trade with gold based countries, especially Britain, the impact of

this shift was profound. As the price of silver continued to fall, so too did the exchange value of

the rupee, when measured against sterling.

Price of Silver - Rate of Exchange: 1871-72 to 1892-93

Period

Price of Silver

(inpence per Troy

ounce)

Rupee exchange rate

(in pence)

18711872 60 23

18751876 56 21

18791880 51 20

18831884 50 19

18871888 44 18

18901951 47 11/16 18

18911892 45 16

18921893 39 15

Source: B.E. Dadachanji.History of Indian Currency and Exchange, 3rd enlarged ed.

(Bombay: D.B. Taraporevala Sons & Co, 1934), p. 15.

1975 2000:

Economic liberalization in India in the 1990s and first decade of the 21st century led to large

changes in the economy.
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This is a chart of trend of gross domestic product and foreign trade of India at market

prices estimated byMinistry of Statistics and Programme Implementation with figures in

millions of Indian Rupees. See also the IMF database.

2000 - Present

The gross domestic product of India in 2007 was estimated at about 8 per cent that of the USA.

National Democratic Alliance led by Bharatiya Janata Party (BJP), was in helm of economic

affairs from 1998-2004. During this period there were two finance ministers, viz., Yashwant

Sinha (19982003) and Jaswant Singh (20032004).

The main economic achievement of the government was the universal license in

telecommunication field, which allows CDMA license holders to provide GSM services and vice

versa. NDA started off the Golden Quadrilateral road network connecting main metros

ofDelhi, Chennai, Mumbai and Kolkata.

The project, still under construction, was one of the most ambitious infrastructure projects of

independent India. Simultaneously, North-South and East-West highway projects were planned

and construction was started.

The top 3 per cent of the population still contribute 50 per cent of the GDP and benefits of

economic growth have not trickled down. Education for all is still an unrealized dream in India.

This was made a fundamental right by amending the constitution of India and huge amount of

money was pumped into the project under the name ofSarva Shiksha Abhiyan.

This project met with limited success. Graduate unemployment was estimated at 34 million

nationwide.

Currently, the economic activity in India has taken on a dynamic character which is at once

curtailed by creaky infrastructure, for example dilapidated roads and severe shortages of

electricity, and cumbersome justice system yet at the same time accelerated by the sheer

enthusiasm and ambition of industrialists and the populace.

The upward economic cycle in India is expected in short time to effectively address the short

comings and bottlenecks of the infrastructure. The fast changing, seemingly chaotic and
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unsettled situation is much more hopeful and reassuring than the socialist morass that was the

Nehru and Indira Gandhi legacy.

.

For purchasing power parity comparisons, the US Dollar is exchanged at 9.46 Rupees only.

Despite steady growth and continuous reforms since the Nineties, Indian economy is still mired

in bureaucratic hurdles from coast to coast. This was confirmed by a World Bank report

published in late 2006 ranking Pakistan (at 74th) well ahead of India (at 134th) based on ease of

doing business.

The Union government treasury reported annual revenue of 51-52 billion in 2005 thus

registering an average annual growth of almost 22 per cent since 2000. India imported about 85

per cent of oil and 22 per cent of gas consumption by 2003.

History of Inflation in Developed Economies:

US


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The economic history of the United States has its roots in European colonization in the 16th,

17th, and 18th centuries. Marginal colonial economies grew into 13 small, independent farming

economies, which joined together in 1776 to form the United States of America. In 230 years the

United States grew to a huge, integrated, industrialized economy that makes up nearly a quarter

of the world economy.

The main causes were a large unified market, a supportive political-legal system, vast areas of

highly productive farmlands, vast natural resources (especially timber, coal, iron, and oil), and an

entrepreneurial spirit and commitment to investing in material and human capital. The economy

has maintained high wages, attracting immigrants by the millions from all over the

world. Technological and industrial factors played a major role.

Inflation Woes: 1970,s

i. The postwar boom ended with a number of events in the early 1970s

ii. The collapse of the Bretton Woods system in 1971

iii. The growing influx of imported manufacturing goods, such as automobiles and

electronics

iv. The 1973 oil crisis,

v. The 19731974 stock market crash,

vi. The ensuing 1970s recession, and

vii. The ensuing displacement ofKeynesian economics by monetarist economics, especially

by the free-market Chicago School of Economics, led by conservative theorist Milton. at

the same time, the consensus among experts moved against New-Deal-style regulation, in

favor of deregulation.

viii. In the late 1960s it was apparent to some that this juggernaut of economic growth was

slowing down, and it began to become visibly apparent in the early 1970s. The United

States grew increasingly dependent on oil importation from OPEC afterpeaking

production in 1970, resulting in oil supply shocks in 1973 and 1979.
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ix. Stagflation gripped the nation, and the government experimented with wage and price

controls underPresident Nixon. The Bretton Woods Agreement collapsed in 19711972,

and President Nixon closed the gold window at the Federal Reserve, taking the United

States entirely off the gold standard. President Gerald Ford introduced the slogan, "Whip

Inflation Now" (WIN). In 1974, productivity shrunk by 1.5%, though this soon

recovered. In 1976, Jimmy Carterwon the Presidency.

x. Carter would later take much of the blame for the even more turbulent economic times to

come, though some say circumstances were outside his control. Inflation continued to

climb skyward. Productivity growth was small, when not negative. Interest rates

remained high, with the prime reaching 20% in January 1981; Art Buchwald quipped that

1980 would go down in history as the year when it was cheaper to borrow money from

the Mafia than the local bank.

xi. Unemployment dropped mostly steadily from 1975 to 1979, although it then began to rise

sharply. This period also saw the increased rise of the environmental and consumer

movements, and the government established new regulations and regulatory agencies

such as Occupational Safety and Health Administration, the Consumer Product Safety

Commission , theNuclear Regulatory Commission, and others.

Deregulation & Regulations: 1974 1992

The deregulation movement began when Nixon left office and was a bipartisan operation under

Ford, Carter and Reagan. Most important were the removals of New Deal regulations from

energy, communications, transportation and banking. The hasty removal of some regulations of

Savings and Loans while keeping federal insurance led to the Savings and Loan crisis which cost

the government an estimated $160 billion.

In 1981, Ronald Reagan introduced Reaganomics. That is, fiscally-expansive economic policies,

cutting marginal federal income tax rates by 25%. Inflation dropped dramatically from 13.5%
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annually in 1980 to just 3% annually in 1983 due to a short recession and the Federal

Reserve Chairman Paul Volcker's tighter control of the money supply and interest rates.

Real GDP began to grow after contracting in 1980 and 1982. The unemployment rate continued

to rise to a peak of 10.8% by late 1982, but dropped to 5.4% unemployment at the end ofReagan's presidency in January 1989.

Critics of the Reagan Administration often point to the fact that the gap between those in the

upper socioeconomic levels and those in the lower socioeconomic levels increased during

Reagan's presidency; they also note that the federal debt spawned by his policies tripled (from

$930 billion in 1981 to $2.6 trillion in 1988), reaching record levels.

Though debt almost always increased under every president in the latter half of the 20th century,

it declined as a percentage of GDP under all Presidents after 1950 and prior to Reagan. In

addition to the fiscal deficits, the U.S. started to have large trade deficits. Also it was during his

second term that the Tax Reform Act of 1986 was passed.

Vice President George H. W. Bush was elected to succeed Reagan in 1988. The early Bush

Presidency's economic policies were sometimes seen as a continuation of Reagan's policies, but

in the early 1990s, Bush went back on a promise and increased taxes in a compromise with

Congressional Democrats.

He ended his presidency on a moderate note, signing regulatory bills such as the Americans with

Disabilities Act, and negotiating the North American Free Trade Agreement. In 1992, Bush and

third-party candidate Ross Perot lost to Democrat Bill Clinton.

The advent of deindustrialization in the late 1960s and early 1970s saw income inequality

increase dramatically to levels never seen before, but at the same time never before in the United

States could consumers buy so many goods even with the inflation of the 1970s. In 1968, the

U.S. Gini coefficient was 0.386, about equivalent to Japan (.381), though still above that of the

United Kingdom (.368) and Canada (.331).

However, in the years since, increased free trade, globalization and high corporate taxes have

caused U.S. companies to begin to shift their manufacturing and heavy industrial operations to

second- and third-world countries with lower labor costs, income inequality in the U.S. has risen
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dramatically. In 2005, the American Gini coefficient had reached 0.469, similar to that of

Malaysia and the Philippines, both at .461, and well-ahead of China (.440).

Critics of economic policies favored by Republican and Democratic administrations since the

1960s, particularly those expanding "free trade" and "open markets" say that these policies,though benefiting trading as well as the cost of products in the U.S., could have taken their own

on the prosperity of the American middle-class. But in this period, consumers were buying as

never before with so many products and goods at such low costs and in high quantities.

The New Economy: 1990 2007

During the 1990s, the national debt increased by 75%, GDP rose by 69%, and the stock market

as measured by the S&P 500 grew more than threefold.

From 1994 to 2000 real output increased, inflation was manageable and unemployment dropped

to below 5%, resulting in a soaring stock market known as the Dot-com boom. The second half

of the 1990s was characterized by well-publicized Initial Public Offerings of High-tech and "dot-

com" companies.

By 2000, however, it was evident a bubble in stock valuations hadoccurred, such that beginning

in March 2000, the market would give back some 50% to 75% of the growth of the 1990s. The

economy worsened in 2001 with output increasing only 0.3% and unemployment and business

failures rising substantially, and triggering a recession that is often blamed on the September 11,

2001 Terrorist Attacks.

An additional factor in the fall of the US markets and in investor confidence included numerous

corporate scandals. See the wikipedia list of corporate scandals.

Through 2001 to 2007, the red-hot housing market across the United States fueled a false sense

of security regarding the strength of the U.S. economy.
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Germany

Nazi Economy

During the Hitler era (1933-45), the economy developed a hothouse prosperity, supported with

high government subsidies to those sectors that tended to give Germany military power and

economic autarky, that is, economic independence from the global economy.

During the war itself the German economy was sustained by the exploitation of conquered

territories and peoples. With the loss of the war, the country entered into the period known

as Stunde Null ("Zero Hour"), when Germany lay in ruins and the society had to be rebuilt from

scratch.

Post World War 2

The first several years after World War II were years of bitter penury for the Germans. Seven

million forced laborers left for their own land, but about 14 million Germans came in from the

East, living for years in dismal camps.

It took neatly a decade for all the German POWs to return. In the West, farm production fell,

food supplies were cut off from eastern Germany (controlled by the Soviets) and food shipments

extorted from conquered lands ended.
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The standard of living fell to levels not seen in a century, and food was always in short supply.

High inflation made savings (and debts) lost 99% of their value, while the black market distorted

the economy. In the East, the Soviets crushed dissent and imposed another police state, often

employing ex-Nazis in the dreaded Stasi. The Soviets extracted about 23% of the East German

GNP for reparations, while in the West reparations were a minor factor.

The man who took full advantage of Germany's postwar opportunity was Ludwig Erhard, who

was determined to shape a new and different kind of German economy. He was given his chance

by United States officials, who found him working inNuremberg and who saw that many of his

ideas coincided with their own. A PhD in economics, he was influenced by the Austrian School.

Erhard's first step was currency reform: the abolition of the Reichsmarkand the creation of a new

currency, the Deutsche Mark. He carried out that reform on 21 June 1948, installing the new

currency with the concurrence of the Western Allies but also taking advantage of the opportunity

to abolish most Nazi and occupation rules and regulations in order to establish the genesis of a

free economy.

The currency reform, whose purpose was to provide a respected store of value and a widely

accepted legal tender, succeeded brilliantly. It established the foundations of the West German

economy and of the West German state.

German Reunification & its Aftermath

Germany invested over $2 trillion marks in the rehabilitation of the former East Germany

helping it TO transition to a market economy, and cleaning up the environmental degradation.

By 2011 the results were mixed, with continued to slow economic development in the East, in

sharp contrast to the rapid economic growth in both area and southern Germany.

Unemployment was much higher in the East, often over 15%. Economists Snower and Merkl

(2006) suggests that the malaise was prolonged by all the social and economic help from the

German government, pointing especially to bargaining by proxy, high unemployment benefits

and welfare entitlements, and generous job security provisions.
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The old industrial centers of the Rhineland and North Germany lagged as well, as the coal and

steel industries faded in importance. The economic policies were heavily oriented toward the

world market, and the export sector continued very strong.

Interconnection b/w different world economies

Economic relations

The United States is also one of India's largest direct investors. From 1991 to 2004, the stock of

FDI inflow has increased from USD $11.3 million to $344.4 million, totaling $4.13 billion. This

is a compound rate increase of 57.5% annually.

Indian direct investments abroad were started in 1992. Indian corporations and registeredpartnership firms are allowed to invest in businesses up to 100% of their net worth. India's

largest outgoing investments are manufacturing, which account for 54.8% of the country's

foreign investments. The second largest are non-financial services (software development),

which accounts for 35.4% of investments.

The United States is one of India's largest trading partners. In 2007, the United States exported

$17.24 billion worth goods to India and imported $24.02 billion worth of Indian goods. Major

items exported by India to the U.S.

include InformationTechnology Services, textiles,machinery, ITeS,gems and diamonds, chemic

als, iron and steel products, coffee, tea, and other edible food products. Major American items

imported by India include aircraft, fertilizers, computer hardware, scrap metal and medical

equipment.

Both India and China hold more or less same positions in the global economic scenario. This in

turn has further enhanced the economic relations between the two countries. In 2003, Bangkok

Agreement was signed between the two countries. Under this agreement both China and India

offered some trade preferences to each other.

India provided concessions on 188 products exported from China. On the other hand, China

provided preferences on tariff for 217 products exported from India. The economic relations
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between the two nations is expected to improve aided by the flourishing IT and ITES sector,

biotechnology industry, health sector, and financial sector.

The bilateral trade between the two countries is expected to reach 20 billion US dollars by the

year 2008. The projected figure for 2010 is 30 billion US dollars.

Effect of interest rate changes on the economy

Interest Rate Theories - Affecting Demand - How does the interest rate affect demand?

The key to using the interest rate to help economic management is the effect that interest rates

have on demand. If the Bank of England feel that inflationary pressures are rising in the

economy then they will increase the rate of interest to dampen down the growth of aggregate

demand.

Demand falls when interest rates are raised through their effect on the components of aggregate

demand.Aggregate demandis made up of the following types of spending:

Consumption + Investment + Government expenditure + (Exports - Imports)

Of these, the first two in particular will be affected by interest rate changes.

Consumption

Consumption will fall when interest rates are raised. This happens for two reasons. The first is

that it is now more expensive to borrow money. This will put people off borrowing, and lower

borrowing means lower spending. However, it is not just new borrowing that is affected, but also

people who are still paying off existing borrowing.

For many people their main investment is their house. To buy this they are quite likely to have

taken out a mortgage and higher interest rates means higher mortgage payments. These reduce

theirdisposable income and so leave them with less money each month to spend. The same will

be true for people who have borrowed to buy other things as well.


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Investment

To invest many firms will, like people, have to borrow. They will borrow if they think that the

rate of return on their investment is greater than interest rates. If interest rates rise then fewer

investment projects are likely to be viable, because with the higher cost of borrowing they are

now less profitable. The rise in interest rates will therefore reduce the level of investment. The

amount investment falls by depends on the interest elasticity of demand for investment.

Firms take interest rates into account when deciding whether or not they go ahead with new

capital investment spending. A fall in interest rates should help to increase business

confidence and raise the level of planned fixed investment. See the pages on investment theory

and the discussion of the marginal efficiency of capital.


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RESEARCH METHODOLOGY

Objectives:

To study the trends in inflation rates and interest rates over a period of time.

To analyze relationship among inflation and interest rates.

To understand the effect of inflation and interest rates on the economy.

To know how the government controls inflation and interest rates.

Study of Indian economy in comparison to developed economies

Research Design:

Exploratory research design will be u

“effect of interest and inflation rates on the economy”

Documents