Measuring the Cost of Living

P G K Murthy
Consumer Price Index
 Is a measure of the overall cost of the goods and services bought by a typical
consumer .
How the price index is computed ?
 Fix the basket : Determine which prices are important to the typical
consumer
 Find the prices : Find the prices of each of goods and services in the basket
for each point in time .
 Compute the basket cost : Use the data on prices to calculate the cost of the
basket of goods and services at different times .
 Choose a base year and compute the index : Designate one year as base year
which is the bench mark against other years are compared .

 Consumer Price Index =

 Price of basket of goods and services x 100

 Price of basket in base year

Example
 Fix the basket : 4 Hot Dogs 2 hamburgers
 Find the prices : Hot Dogs Hamburgers
 2005 1 2
 2006 2 3
 2007 3 4
 Compute the basket cost :
 Choose 2005 as base year and compute the index :
Compute Inflation
 Use the consumer price index to calculate the inflation rate which is the
percentage change in the price index from the preceding period .
 CPI in year 2 – CPI in year 1
 Inflation rate in year 2 = ----------------------------
 CPI in Year 1

Produce Price Index

 Measures the cost of basket of goods and services bought by firms rather
than consumers .
Problems in Measuring the Cost of Living
 1. Substitution bias : When prices change from one year to the next , they do not
change proportionately . Prices of some articles rise more than that of others . Consumers
may substitute a costlier product by a cheaper product . Thus , it ignore consumers’
substitution effect .
 2.Introduction of new goods : Consumers preferences change .
 3.Unmeasured quality change : If the quality of a good deteriorates from one
year to the next , the vaLUE OF RUPEE FALLS .

GDP Deflator versus the Consumer Price Index

 GDP Deflator reflects the prices of all goods and services produced domestically
whereas the consumer price index reflects the prices of all goods and services bought by
consumers .
 Prices of Aero planes have an impact on GDP but not on CPI.
 CPI compares the price of a fixed basket of goodfs and services to the price of the
basjet in the base year . GDP deflator compares the price of currently produced goods
and services in the base year .
Correcting Economic Variables for the effects of Inflation

 Amount in today’s prices (Rs) =

 Price Level Today
 Amount in year T in rupees x -----------------
 Price Level in year T
Real versus Nominal Interest Rates

 Real Interest Rate = Nominal Rate of Inflation – Rate of Inflation
Open Economy – Macro Economics : Basic Concepts
P G K MURTHY
Types of Economies
 Closed Economy : An economy that does not interact with other economies of
the world .
 Open Economy : Interacts with other economies in two ways . It buys and sells
goods and services in world product markets .
 It buys and sells capital assets such as stocks and bonds in world financial markets
.

Certain Concepts
 Exports : goods and services that are produced domestically and sold abroad .
 Imports : goods and services that are produced abroad and sold domestically .
 Net exports : the value a nation’s exports minus the value of its imports also
called trade balance .
 Trade surplus : exports in excess of imports .
 Trade deficit : exports less than imports .
 Balance trade where exports are equal to imports .
Net Capital Outflows
 The purchase of foreign assets by domestic residents minus the purchase of
domestic assets by foreigners
Equality of Net Exports and Net Capital Outflow
 Net Exports measures an imbalance between exports and imports . Net capital
outflow measures an imbalance between the amount of foreign assets bought by
domestic residents and the amount of domestic assets by foreigners .
 NCO = NX
Nominal and Real Exchange Rates
 Nominal exchange rate is the rate at which a person can trade the currency one
country for the currency of the other .
 Appreciation : an increase in the value of a currency as measured by the amount
of foreign currency it can buy .
 Depreciation : a decrease in the value of a currency as mentioned by the amount
of foreign currency it can buy .
 Real Exchange Rate : the rate at which a person can trade the goods and services
of one country for the goods and services of another:
 Real Exchange Rate =
 Nominal Exchange Rate x Domestic Price
 Foreign Price
 Thus real exchange rate depends on the nominal exchange rate and on the prices
of the goodsin the two countries measured in the local currencies .

Purchasing Power Parity (PPP)

 A theory of exchange rates whereby a unit of any given currency should be able
to buy the same quantity of goods in all countries .
 This law asserts that a good must sell for the same price in all locations .
 The process of taking advantage of differences in prices for the same item in
different markets is called arbitrage .
 Parity refers to equality and purchasing power refers to value of money in terms
of goods it can buy .
 It tells us that the nominal exchange rate between the currencies of two countries
depends on price levels in those countries .
Limitations of PPP
 Theory of PPP is not complete . Many goods are not easily traded .
 It does not always hold is that even tradable goods are not always perfect
substitutes when they are produced in different countries .
 For these reasons , real exchange rates fluctuate over time .
Saving Investment and the Financial System
P G K Murthy
Financial System
• Consists of those institutions in the economy that help to match one person’s
saving with another person’s investment .
Financial Markets
• Are the institutions through which a person who wants to save can directly
supply funds to a person who wants to borrow .
Bond and Bond Market
• Bond is a certificate of indebtedness that specifies the obligations of the
borrower to the holder of the bond .
• Bond identifies the time at which the loan will be repaid , called the date of
maturity .
• Coupon rate is the rate of interest that will be paid periodically . ( annually )
• The buyer of the bond is known as principal who may hold bond till maturity or
transfer to any one after lock in period if any .

Characteristics of Bond
• 1.Bond’s term : the length of time until bond matures .Normally , terms are 3
yrs , 5 yrs, 7 yrs etc. A bond that never matures is known as perpetuity . This bond pays
interest for ever but principal is ver repaid .
• 2. Credit Risk – the probability that the borrower will fail to pay some of the
interest or principal .
• 3. Tax treatment - the way the tax laws treat interest earned . Normally it is
taxable in the hands of recipient .

Stock Market
• Stock represents ownership in a firm and is therefore a claim to the profits that
the firm makes .
• The sale of stock to raise money is called equity finance whereas the sale of
bonds is called debt finance .
• Stocks of public limited companies are traded on stock exchanges .

Financial Intermediaries
• Are those through which savers can indirectly provide funds to borrowers .
• Major Financial Intermediaries are :
• 1. Banks : Primary job of Banks is take in deposits from people who want to
save and use these deposits to make loans to people who wants to borrow . Banks pay
depositors interest on their deposits and charge interest on their loans .
Financial Intermediaries
• 2. Mutual Fund is an institution that sells shares to the public and uses the
proceeds to buy a selection , or portfolio , of various types of stocks , bonds , or both
stocks and bonds .
• Primary advantage of mutual funds is that they allow people with small
amounts of money to diversify . Secondary advantage is that mutual funds give
ordinary people access to the skills of professional maney managers .
• Index funds which buy all stocks in a given index , perform better than others .

Savings and Investment in National Savings

• Y = C+I+G + NX
• In a closed economy , NX = 0 then
• Y = C+I+G
• Therefore , I = Y – C – G
• National savings is the total income in the economy that remains after paying for
consumption and government purchases .
• Savings equals to investment .

Modifications to formula
• T denote the amount that the Government collects from households in taxes minus
the amount it pays back to households in the form of transfer payments ( such as Social
Security and Welfare ) .
• S= Y-C-G
• S= (Y – T- C ) + ( T- G)
• (Y – T- C ) = PRIVATE SAVING :
• T- G = PUBLIC SAVING
• Investment refers to the purchase of new capital such as equipment or buildings .
Market for Loanable funds
• Is the market in which those who want to save supply funds and those who want
to borrow to invest demand funds .
• Savings is the source of the supply of loanable funds .
• Investment is the source of the demand for loanable funds .
Interest Rates and Demand and Supply of Loanable funds
• Graph : rate of interest on y axis and loanable funds on x axis .
• Nominal rate of interest is the rate reported .
• Real rate of interest is the one adjusted for inflation .

Policy Shifts
• 1. Savings Incentives
• 2.Investment incentives
• 3.Government budget deficits and surpluses .
The Monetary System
P G K Murthy
Meaning of Money
• Money is the set of assets in the economy that people regularly use , to buy
goods and services from other people .
Functions of Management
• Medium of Exchange :an item that buyers give to sellers when they want to
purchase goods and services .
• Unit of account : the yard stick people use to post prices and record debts .
• Store of value : an item that people can use to transfer purchasing power from the
present to future .
• Liquidity : the ease with which an asset can be converted into the economy’s
medium of exchange .:
Kinds of money
• Commodity money : When money takes the form of a commodity , with intrinsic
value , it is called commodity money ex.Gold , silver or any commodity which has
exchange value .
• Fiat money : Money without intrinsic value is called fiat money e.g. .A fiat is
simply an order or decree , and fiat money is stablished as money by government
decree .the acceptance of fiat money depends as much as much on expectations and
social convention as a government decree .

Money in Indian Economy

• The quantity of money circulating in the economy called the money stock has a
powerful influence on many economic variables .
• Currency – the paper bills and coins in the hands of public .
• Demand deposits : balances in the bank accounts that depositors can access on
demand simply by writing a cheque .
Banks and Money Supply
• Reserve Deposits : Deposits that Banks have received but have not loaned out
are called reserves .
• Assets and Liabilities sides of Banks
• If banks hold all deposits in reserve , banks do not influence the supply of
money .
• The fraction of total deposits that a bank holds a reserve is called the reserve ratio
.
• Fractional reserve banking :
• CRR : 5.00 % SLR : 25.00 %
• Banks releases loans money supply increases .

The Money Multiplier

• An initial deposit of Rs.1000 with a reserve ratio of 10 % ,can add up in the
following manner :
• 1000 – 100 = 900
• 900-90 = 810
• 810-81 = 729
• 729-73 = 656
• 656- 66 = 590
• 590-59 = 531
• The amount of monery the banking system generates with each dollar of reserves
is called the money multiplier .5216 created out of 1000 . Money Multiplier is 5.27 .
Higher reserve ratio , lower loanable funds and lower the money multiplier .

Tools of Money Control

• Open Market Operations : the purchase and sale of Government bonds
• Reserve Requirements : CRR and SLR
• Repos and Reverse Repos of RBI ;
• Bill Discounting Rate
RBI
• The Reserve Bank of India was established on April 1, 1935 in accordance with
the provisions of the Reserve Bank of India Act, 1934.
• Preamble
• The Preamble of the Reserve Bank of India describes the basic functions of the
Reserve Bank as:
• "...to regulate the issue of Bank Notes and keeping of reserves with a view to
securing monetary stability in India and generally to operate the currency and credit
system of the country to its advantage."
Central Board

• The Reserve Bank's affairs are governed by a central board of directors. The
board is appointed by the Government of India in keeping with the Reserve Bank of India
Act.
• Appointed/nominated for a period of four years
• Constitution:
– Official Directors
• Full-time : Governor and not more than four Deputy Governors
– Non-Official Directors
• Nominated by Government: ten Directors from various fields and one government
Official
• Others: four Directors - one each from four local boards

• Objective
• Primary objective of BFS is to undertake consolidated supervision of the financial
sector comprising commercial banks, financial institutions and non-banking finance
companies.
• Constitution
• The Board is constituted by co-opting four Directors from the Central Board as
members for a term of two years and is chaired by the Governor. The Deputy Governors
of the Reserve Bank are ex-officio members. One Deputy Governor, usually, the Deputy
Governor in charge of banking regulation and supervision, is nominated as the Vice-
Chairman of the Board.

• Main Functions
• Monetary Authority:
• Formulates, implements and monitors the monetary policy.
• Objective: maintaining price stability and ensuring adequate flow of credit to
productive sectors.
• Regulator and supervisor of the financial system:
• Prescribes broad parameters of banking operations within which the country's
banking and financial system functions.
• Objective: maintain public confidence in the system, protect depositors' interest
and provide cost-effective banking services to the public.
• Manager of Foreign Exchange
• Manages the Foreign Exchange Management Act, 1999.
• Objective: to facilitate external trade and payment and promote orderly
development and maintenance of foreign exchange market in India.
• Issuer of currency:
• Issues and exchanges or destroys currency and coins not fit for circulation.
• Objective: to give the public adequate quantity of supplies of currency notes and
coins and in good quality.
• Developmental role
• Performs a wide range of promotional functions to support national objectives.

Problems in Controlling Money Supply

• RBI can not control the amount of money that households chhose to hold as
deposits in Banks .
• RBI can not control fully the amount that banks decide to lend . In some
countries like USA , Fed can not control at all .
Money Growth and Inflation
P G K Murthy
Money supply , Monet Demand and Money Equilibrium
 Money supply is determined by RBI through supply of currency and coins ,
allowing Banks to give loans against reduced reserve ratios , repayment of Govt loans ,
RBI loans ( bonds ) etc.
 Money demand is also determined by RBI through market operations .
 At the equilibrium , , the quantity of money demanded balances the quantity of
money supplied .
Quantity Theory of Money
 A theory asserting that the quantity of money available determines the price level
and that the growth rate in the quantity of money available determines the inflation rate .
Classical Dichotomy and Monetary Neutrality
 Nominal variables : variables measured in monetary units .
 Real variables : : variables measured in physical units .
 Classical dichotomy : the theoretical separation of nominal and real variables .
 Monetary neutrality : the proposition that changes in the money supply that do
not effect real variables .In the short run , money supply will have effect real variables
too .
Velocity and the Quantity Equation
 Velocity of money : the rate at which money changes hands :
 V=(PXY)/M
 Where V – Velocity : P = Price level ( deflator ) : Y = GDP at real prices : M:
Money supply
Necessary elements for the equilibrium price level
 1. Velocity of money is relatively stable over time .
 2.Velocity is stable when the Central bank changes the quantity of money (M)., it
causes proportionate changes in the nominal value of output .
 3.The economy’s output of goods and services is primarily determined by factor
supplies ( labour , physical capital , human capital and technology .
 4.With output (Y) determined by factor supplies and technology , when the
Central Bank alters the money supply and induces proportional changes in the nominal
value of output , these changes are reflected in price level .
 5.Therefore , when , Central Bank increases supply of money , the result is high
inflation .Fs
Inflation Tax
 When the government raises revenue by printing money , it is said to levy
inflation tax .
 When the Government prints money , price level increases and rupees in banks
and in hand are less valuable . Thus , the inflation tax is like a tax on every one who
holds money .
Fisher effect
 Fisher effect the one –for-one- adjustment of the nominal interest rate to the
inflation rate .
 The Fisher effect does not hold in the short run to the extent that inflation is
unanticipated .
 Inflation fallacy to mean that inflation itself does not reduce purchasing power of
people but purchasing power of rupee .
 Shoe leather costs are resources wasted when inflation encourages people to
reduce their money holdings .
 Costs price adjustments are called menu costs .