A1

What is macroeconomics?

 the study of the economy as a whole, and the variables that control the macro-economy.
 the study of government policy meant to control and stabilize the economy over time, that is,
to reduce fluctuations in the economy.
 the study of monetary policy, fiscal policy, and supply-side economics.

A2 What is exogenous variable

An exogenous variable is a variable that is not affected by other variables in the system. For example,
take a simple causal system like farming. Variables like weather, farmer skill, pests, and availability of
seed are all exogenous to crop production. Exogenous comes from the Greek Exo, meaning “outside”
and gignomai, meaning “to produce.” In contrast, an endogenous variable is one that is influenced by
other factors in the system. In this example, flower growth is affected by sunlight and is therefore
endogenous.

In Simultaneous Equations
An endogenous variable is one that is explained by a model. So if you have a set of simultaneous
equations, those equations (the simultaneous equation model) should explain the behavior of any
endogenous variable. On the other hand, if the model doesn’t explain the behavior of certain variable,
then those variables are exogenous. The following example (from this Yale University post) explains
the difference with an example. Equations 1, 2, and 3 are a simple multiplier model with several
variables:
1. A composition function: Ct = a1 + a2Yt + et
2. An investment function: It = b1 + b2rt + ut
3. Income identity function: Yt = Ct + It + Gt
Where “t” is time and the variables are:

 Consumption (Ct)
 Investment (It)
 Total income/GDP (Yt)
 Government Spending (Gt)
 Interest Rate (Rt)
Ct, It, and Yt are endogenous as they are explained by the model.

A3 How Economic Factors Affect Business

Environment
Table of Contents
 Definition
 Economic Factors Affecting Business Environment
o Demand and Supply
o Marginal and Total Utility
o Money and Banking
 o Economic Growth and Development
o Income and Employment
o General Price Level
o Trade Cycles
o Inflation
o Recession

Definition
All businesses, whether domestic or international, are affected by the
dynamic economic environment conditions prevalent in the market. Among
many economic factors affecting business some are; interest rates, demand
and supply, recession, inflation, etc. Let us take a look at such economic
factors.
All businesses want to maximize on their profits. All this can be achieved
by analysis of demands of consumers, provision of appropriate supplies to
them and the maintenance of high quality of goods and services. As simple
as this operation is, many factors affect it. The sales, production and
procurement processes of a business are greatly impacted by these
economic elements. Below is a list of economic factors that affects
businesses. Consider, all of them are interconnected.
I recommend you to read Pestle Analysis.
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Economic Factors Affecting Business

Environment
Demand and Supply
There are two great economic factors affecting business models work – demand
and supply. Demand is how willing and able a consumer is to purchasing
what a business offers and supply is how able the business is to make
available what the consumer needs. For example, when a mobile phone
infused with the latest technology is introduced to the market, it fetches a
higher price due to the high demand in markets, and the prices remain high if
the demand is more than the supply.
Here is another example. Bad weather in 2000 messed the sugar crop in
Brazil, arguably the largest producer of sugar in the world. Because of this,
there was a decrease in the supply of sugar globally, and so the prices of
sugar rose steeply. This led to other suppliers capitalising in opportunity
and increasing the supplies which brought the cost down.
Marginal and Total Utility
The amount of satisfaction that is derived by consumers from the amount of goods
they have is referred to Utility. After continuous and successive
consumption of units of same goods, the fulfilment that is experienced by
the consumer starts depreciating. This results in short-term or long-term
fall in sales of the business. Most Organization prepare for the launch of a
different brand before the collapse in utility and sales is experienced. The
hurl of a new brand ensures that the revenue trend of business does not
drop down. The fall down of utility is one of the economic factors affecting
businesses.
Such is, when we purchase a pizza, the first few pieces give us great
satisfaction. Nonetheless, there is a down fall in the satisfaction levels
when we continue eating the rest of the pizza. Suppose, the marginal utility
derived on consuming the first slice was 90%. Nonetheless, due to the
dwindling of utility, the second piece had the score of 80% and the third
piece had 70%. The satisfaction derived on consumption will be in a
deteriorating order.
Money and Banking
Banking facilitates monetary and fiscal policies that affect business and
the economic environment also the consumers of business. Money in
circulation dictates the demand of the consumers. On the contrary, banking
facility dictates the borrowing capacity of individuals as well as the
business. Banking polices play a crucial role in affecting the prices of
goods and interest rates together with assets prices and investments.
The economic environment activities and inflation are influenced by the
monetary policies of a particular country. This whole dynamic situation is
also known as monetary policy transmission mechanism.
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Economic Growth and Development

The amount of money that is being invested into channels of long-term
upgradation and the finances of the people living in the society at large in a
particular country is decreed by the economic growth of a country. Among
all the economic factors that are affecting business, development is the upmost
important one. As a business needs to cater for the demands of an economic
environment potent society.eg, The luxury brands perform hearty during an
economic upswing, much more than the organizations which their outcome
is essential offerings.
Income and Employment
Another crucial aspects of the economy that affects a business operation, are the
rate of income and employment varsity in a particular country. The density
of employment determines the rate of demand in a company and even the
country including the purchasing power of individuals.
Example
During an economic upswing, opportunities for work are available to enable
people to generate income and have a stronger purchasing power.
Nonetheless, the purchasing power of most people goes down, as
employment density and the rate of income goes up during the recession
period in a given economic environment.
General Price Level
General price levels of commodities is also a key economic factor affecting
businesses and plays a huge part in its growth. You could talk about the cost
of raw materials for the production of commodities in any economic
environment, the paying power of potential clients, the cost of production
and transportation rates as some of the most important elements that end
up contributing to the retail price, thereby lowering the profits generated by
a business.
Example
In most economic environments, when prices go up, the total revenue
generated has a high chance to go down because there might be a
decrease in demand. Assuming consumers have bought sixteen pizzas for
the price of $4. But because of increase in price of the pizzas, the
consumers may only be able to afford 8 pizzas for a higher cost of $6.
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Trade Cycles
This too plays an integral part in the fluctuation of cost of goods and
services sold by a business. The cycles include but are not limited to;
depression, recession, recovery, prosperity. These are all phases that make
up a business cycle that dictates the demand and supply of all goods and
services and general prices of all commodities, whether essential or non-
essential.
Inflation
Inflation usually occurs when the supply of money is too much in
the economic environment market while not equally supported by a similar
availably of goods and services. Now, there is a lot floating around in this
situation. The prices of goods have to increase one way or the other, in
order to sustain the businesses. And so there is an increase in the cost of
raw materials needed for production. This upsurge in the cost of raw
materials obviously translates to the retail price.
Let’s break this down. The buying power of consumers decreases, their
incomes remain constant, but the prices of products and services shoots
up. This will definitely affect the businesses in that, the demand for the
goods is directly dependent on its availability and its price.
Example
In 2008, the worst case of inflation affected the central African nation,
Zimbabwe. This proved very disastrous for its economy leading to the
country adopting a foreign currency as a way of solving the crises.

Recession
Companies usually make great losses and face dips in sales and profits
during recession. And in order to reduce their costs most of them usually
resort to staff cuts, retrenchment and firing, reducing capital
expenditure, advertising budgets, research and development activities, and so
on. Of course this affects companies and organizations of all sizes
regardless of the economic environments they are in.

National Income BOOK

Models of Income Determination with emphasis on Keynesian
Model

PPT +
Figure-3 represents the graphical representation of
national income determination in the two-sector
economy:
In Figure-3, while drawing AS schedule it is assumed that the total
income and total expenditure are equal. Therefore, the numerical
value of AS schedule is one. AD schedule is prepared by adding the
schedule of C and I. The aggregate demand and aggregate supply
intersect each other at point E, which is termed as equilibrium
point.

The income level at point E is Rs. 200 billion, which represents the
national income of the economy. The schedule curve after point E
represents that the AS is greater than AD (AS > AD). In such a
situation, the products and services are costing more than Rs. 200
billion; therefore, households are not willing to buy them.

Therefore, the supply of products and services exceeds their

demand. As a result, businesses would have a pile of unsold stocks.
For example, in Table-1, when the income or aggregate supply is at
Rs. 300 then the aggregate demand or expenditure is Rs. 250,
which is less than the aggregate supply.

The equilibrium condition of national income

determination can be expressed as follows:
Aggregate demand = Aggregate supply

C + I = C-HS

Therefore, I = S

Thus, the national income can be determined by using either

aggregate demand and aggregate supply schedules or investment
and savings schedules. These two methods of income determination
are classified as income-expenditure approach and saving-
investment approach.

Therefore, the AD can be represented by the following

formula:
AD = C + I

Therefore, AD schedule is also termed as C+I schedule. According

to Keynes theory of national income determination in short-run
investment (I) remains constant throughout the AD schedule, while
consumption (C) keeps on changing. Therefore, consumption (C)
acts as the major determinant or function of income (Y).

The consumption function can be expressed as follows:

ADVERTISEMENTS:

C = a + bY

Where, a = constant (representing consumption when income is

zero)

b = proportion of income consumed = ∆C/∆Y

By substituting the value of consumption in the equation of AD, we

get:

AD = a + bY + I

Let us prepare an AD schedule by assuming that the

investment is Rs. 50 billion and consumption function of a
product is:
ADVERTISEMENTS:

C = 50 + 0.5 Y

Therefore, aggregate demand would be:

AD = a +b Y + I

AD = 50 + 0.5 Y + 50

AD= 100 + 0.5 Y

What Is Investment Multiplier?
The term investment multiplier refers to the concept that any increase in public
or private investment spending has a more than proportionate positive impact
on aggregate income and the general economy. It is rooted in the economic
theories of John Maynard Keynes.

The multiplier attempted to quantify the additional effects of investment

spending beyond those immediately measurable. The larger an investment’s
multiplier, the more efficient it is in creating and distributing wealth throughout
the economy.

KEY TAKEAWAYS

 The investment multiplier refers to the stimulative effects of public or

private investments.
 It is rooted in the economic theories of John Maynard Keynes.
 The extent of the investment multiplier depends on two factors: the
marginal propensity to consume (MPC) and the marginal propensity to
save (MPS).
 A higher investment multiplier suggests that the investment will have a
larger stimulative effect on the economy.
Understanding the Investment Multiplier
The investment multiplier tries to determine the economic impact of public or
private investment. For instance, extra government spending on roads can
increase the income of construction works, as well as the income of materials
suppliers. These people may spend the extra income in the retail, consumer
goods, or service industries, boosting the income of the workers in those
sectors.

As you can see, this cycle can repeat itself through several iterations; what
began as an investment in roads quickly multiplied into an economic
stimulus benefiting workers across a wide range of industries.

Mathematically, the investment multiplier is a function of two main factors:

the marginal propensity to consume (MPC) and the marginal propensity to
save (MPS).

Real World Example of the Investment Multiplier

Consider the road construction workers in our previous example. If the
average worker has an MPC of 70%, that means they consume $0.70 out of
every dollar they earn, on average. In practice, they might spend that $0.70 on
items such as rent, gasoline, groceries, and entertainment. If that same
worker has an MPS of 30%, that means they would save $0.30 out of every
dollar earned, on average.

These concepts also apply to businesses. Like individuals, businesses must

“consume” a significant portion of their income by paying for expenditures
such as employees’ wages, facilities’ rents, and the leases and repairs of
equipment. A typical company might consume 90% of their income on such
payments, meaning that its MPS—the profits earned by its shareholders—
would be only 10%.

The formula for calculating the investment multiplier of a project is simply:

1 / (1 - MPC)1/(1−MPC)
Therefore, in our above examples, the investment multipliers would be 3.33
and 10 for the workers and the businesses, respectively. The reason the
businesses are associated with a higher investment multiple is that their MPC
is higher than that of the workers. In other words, they spend a greater
percentage of their income on other parts of the economy, thereby spreading
the economic stimulus caused by the initial investment more widely.

Factors Affecting Consumption

Functions: (Subjective and Objective
Factor) {STRUCTURAL NAHI MILA}

Factors Affecting Consumption Functions: Subjective and

Objective Factor!
According to Keynes, two types of factors influence the
consumption function: subjective and objective. The subjective
factors are endogenous or internal to the economic system itself.
The subjective factors relate to psychological characteristics of
human nature, social structure, social institutions and social
practices.
These are likely to remain more or less stable during the short
period. Established behaviour pattern undergoes material change
only over long periods. These factors fundamentally determine the
form of the consumption function (i.e., slope and position of the
propensity to consume, the С curve).

The objective factors affecting the consumption function are

exogenous, or external to the economy itself. These factors may at
times undergo rapid changes. Thus, objective factors may cause a
shift in the consumption function.

Subjective Factors:
Subjective factors basically underlie and determine the form of the
consumption function (i.e., its slope and position).

The subjective factors concerned are:

(1) behaviour patterns fixed by the psychology of human nature

(2) the institutional arrangements of the modern social order, and

social practices relating to the behaviour patterns of business firms
with respect to wage and dividend payments and retained earnings,
and the institution controlling the distribution of income.

Human behaviour regarding consumption and savings out of

increased income depends on psychological motives.

First, there are motives which “lead individuals to refrain from

spending out of their incomes.”

Keynes enlists eight such motives:

1. The Motive of Precaution:
The desire to build up a reserve against unforeseen contingencies.

2. The Motive of Foresight:

The desire to provide for anticipated future needs, e.g., in relation to
old age, family education, etc.

3. The Motive of Calculation:

The desire to enjoy interest and appreciation, because a larger real
consumption, at a later date, is preferred to a smaller immediate
consumption.

4. The Motive of Improvement:

The desire to enjoy a gradually increasing expenditure since it
gratifies the common instinct to look forward to a gradually
improving standard of life rather than otherwise.

5. The Motive of Independence:

The desire to enjoy a sense of independence and the power to do
things.

6. The Motive of Enterprise:

The desire to secure a mass de manoeuvre to carry on speculation or
establish business projects.

7. The Motive of Pride:

The desire to possess or to bequeath a fortune.

8. The Motive of Avarice:

The desire to satisfy pure miserliness, i.e., unreasonable, but
insistent abstinence from expenditure as such.
To this, Keynes adds a corresponding list of motives on
consumption such as enjoyment, short-sightedness, generosity,
miscalculation, ostentation and extravagance.

Subjective motivations also apply to the behaviour patterns of

business corporations and governmental bodies. In this respect,
Keynes listed the following motives for accumulation:

(a) The Motive of Enterprise:

The desire to do big things, to expand, to secure resources to carry

out further capital investment.

(b) The Motive of Liquidity:

The desire to face emergencies and difficulties successfully.

(c) The Motive of Improvement:

The desire to secure a rising income and to demonstrate successful

management.

(d) The Motive of Financial Prudence:

The desire to ensure adequate financial provision against
depreciation and obsolescence and to discharge debts.

Keynes maintains that the strength of all these motives may vary
considerably according to the institution and the organisation of the
economic society. Since economic and social institutions and
organisations are formed by habits, race, education, morals, present
hopes and past experiences, techniques of capital equipment and
the prevailing distribution of wealth and established standard of life
— all these factors are unlikely to vary in the short run. They,
therefore, affect secular progress only very gradually. In other
words, these factors, subject to slow change and over a long period,
may be considered as given or stable.

Objective Factors:
Objective factors, subject to rapid changes and causing
violent shifts in the consumption function, are considered
below:
1. Windfall Gains or Losses:
When windfall gains or losses accrue to people their consumption
level may change suddenly. For instance, the post-war windfall
gains in stock exchanges seem to have raised the consumption
spending of rich people in the U.S.A., and to that extent, the
consumption function was shifted upward.

2. Fiscal Policy:

The propensity to consume is also affected by variations in fiscal

policy of the government. For instance, imposition of heavy taxes
tends to reduce the disposable real income of the community; so its
level of consumption may adversely change. Similarly, withdrawal
of certain taxes may cause an upward shift of consumption function.

3. Change in Expectations:
The propensity to consume is also affected by expectations
regarding future changes. For instance, an expected war
considerably influences consumption by creating fears about future
scarcity and rising prices. This leads people to buy more than they
immediately need, i.e., to hoard. Thus, the ratio of consumption to
current income will rise, which means that the consumption
function will be shifted upward.

4. The Rate of Interest:

In the long run, substantial changes in the market rate of interest
may also influence consumption. A significant rise in the rate of
interest may induce people to reduce their consumption at each
income level, because people will save more in order to take
advantage of the high interest rate.

Moreover, if the rate of interest rises, then the lending of the

present saving (realised by consuming less) will enable one to
obtain an even larger quantity of consumption goods in the future.
Keynes, thus, argues that “Over a long period, substantial changes
in the rate of interest probably tend to modify social habits
considerably.”

In addition to these four factors, Keynes also mentioned changes in

the wage level, in accounting practices with respect to depreciation
(indicating the difference between income and net income), as the
objective factors affecting the consumption function.

Keynes’ disciples, however, considered his list of objective

factors inadequate and have listed others which we
consider below:

1. The Distribution of Income:

With the given level of income, aggregate consumption will vary if
income is distributed in different ways among the people. A
community with a greatly unequal distribution of income tends to
have a low propensity to consume on the whole, while a community
with a high degree of equality of income will have a high propensity
to consume in general.

Thus, redistribution of income through fiscal measures of the State

will affect the propensity to consume. Joan Robinson explicitly
states that “the most important influence on the demand for
consumption goods is the distribution of income.” It may be noted
here that Keynes does not specify income distribution as an
objective factor but includes it under the common heading of fiscal
policy.

2. Holding of Saving — Liquid Assets:

According to Kurihara another factor affecting the consumption
function is the volume of accumulated savings by the people. The
larger the amount of such savings (i.e., holding of liquid assets, like
cash balances, savings accounts and government bonds), the more
likely people will tend to spend out of their current income, because
the holding of savings in the form of liquid assets, will give them a
greater sense of security. A change in the real value of such assets
held by them, owing to general price changes, might also affect the
consumption function.

3. Corporate Financial Policies:

Kurihara observes that business policies of corporations with

respect to income retention, dividend payments, and re-
investments, produce some effect on the propensity of equity
holders to consume. A cautious dividend policy followed by
corporations and corporate savings will reduce the consumption
function by reducing the residual disposable income of the
shareholders (who are consumers, in a way).

All the above-mentioned factors will affect the consumption

function in one direction or another. However, all of them are
relatively unchanging in the normal short run and, therefore,
cannot explain the changes in total consumption during the short-
run period. Income is the only variable which will change
considerably in the short run and affect consumption. Thus, it may
be asserted that consumption varies only in the level of income.

Demand for and Supply of Money –

Discussed!
Article Shared by Tushar Seth

It will be useful to have an idea of the demand for and the supply of
money.

The modern notion about the aspects of money is different from the
traditional one. Let us analyze demand for and supply of money
separately.

Demand for Money:

The old idea about the demand for money was that money was
demanded for completing the business transactions. In other words,
the demand for money depended on the volume of trade or
transactions. As such the demand for money increased during boom
period or when the trade was brisk and it decreased during
depression or slackening of trade.
The modern idea about the demand for money was put forward by
the late Lord Keynes, the famous English economist, who gave birth
to what has been called the Keynesian Economics. According to
Keynes, the demand for money, or liquidity preference as he called
it, means the demand for money to hold.

Broadly speaking, there are three main motives on

account of which money is wanted by the people by the
people, viz:
(i) Transactions motive

(ii) Precautionary motive

(iii) Speculative motive

Now a word about each one of them.

(i) Transactions Motive:
This motive can be looked at:
(a) From the point of consumers who want income to meet the
household expenditure which may be termed the income motive,
and

(b) From the point of view of the businessmen, who require money
and want to hold it in order to carry on their business, i.e., the
business motive.

(a) Income Motive:
The transactions motive relates to the demand for money or the
need for cash for the current transactions of individual and business
exchanges. Individuals hold cash in order “to bridge the interval
between the receipt of income and its expenditure.” This is called
the income Motive’.

Most of the people receive their incomes by the week or the month,
while the expenditure goes on day by day. A certain amount of ready
money, therefore, is kept in hand to make current payments. This
amount will depend upon the size of the individual’s income, the
interval at which the income is received and the methods of
payments current in the locality.
(b) Business Motive:
The businessmen and the entrepreneurs also have to keep a
proportion of their resources in ready cash in order to meet current
needs of various kinds. They need money all the time in order to pay
for raw materials and transport, to pay wages and salaries and to
meet all other current expenses incurred by any business of
exchange.

Keynes calls it the ‘Business Motive’ for keeping money. It is clear

that the amount of money held, under this business motive, will
depend to a very large extent on the turnover (i.e., the volume of
trade of the firm in question). The larger the turnover, the larger in
general, will be the amount of money needed to cover current
expenses.

(ii) Precautionary Motive:
Precautionary motive for holding money refers to the desire of the
people to hold cash balances for unforeseen contingencies People
hold a certain amount of money to provide tor the risk of unemploy-
ment, sickness, accidents and other more uncertain perils. The
amount of money held under this motive will depend on the nature
of the individual and on the conditions in which he lives.

(iii) Speculative Motive:

The speculative motive relates to the desire to hold one’s resources
in liquid form in order to take advantage of market movements
regarding the future changes in the rate of interest (or bond-prices).
The notion of holding money for speculative motive is a new
typically keynesian idea. Money held under the speculative motive
serves as a store of value as money held under the precautionary
motive does. But it is a store of money meant for a different
purpose.

The cash held under this motive is used to make speculative gains
by dealing in bonds whose prices fluctuate. If bond prices are
expected to rise, which in other words means that the rate of
interest is expected to fall, businessmen will buy bonds to sell when
the price actually rises.
If however, bond prices are expected to fall, i.e., the rate of interest
is expected to rise, businessmen will sell bonds to avoid capital
losses. Nothing being certain in this dynamic world, where guesses
about the future course of events are made on precarious bases,
businessmen keep cash to speculate on the probable further
changes in bond prices (or the rate of interest) with a view to
making profits.

Given the expectations about the changes in the rate of interest in

future, less money will be held under the speculative motive at a
higher current or prevailing rate of interest and more money will be
held under this motive at a lower current rate of interest.

The reason for this inverse correlation between money held for
speculative motive and the prevailing rate of interest is that at a
lower rate of interest less is lost by not lending money or investing
it, that is by holding on to money; while at a higher rate, holders of
cash balances would lose more by not lending or investing.

Conclusion:
Thus, the amount of money required to be held under the various
motives constitutes the demand for money. It may be borne in mind
that, in economic analysis, demand for money is the demand for the
existing stock of money which is available to be held. It is stock of
money not a flow of it over time.

Liquidity Preference Theory

By JAMES CHEN

 Reviewed By GORDON SCOTT 

 Updated Dec 28, 2020

What Is Liquidity Preference Theory?

Liquidity Preference Theory is a model that suggests that an investor should
demand a higher interest rate or premium on securities with long-
term maturities that carry greater risk because, all other factors being equal,
investors prefer cash or other highly liquid holdings.

Liquidity Preference Theory

How Does Liquidity Preference Theory Work?
Liquidity Preference Theory suggests that investors demand progressively
higher premiums on medium and long-term securities as opposed to short-
term securities. According to the theory, which was developed by John
Maynard Keynes in support of his idea that the demand for liquidity holds
speculative power, liquid investments are easier to cash in for full value.

Cash is commonly accepted as the most liquid asset. According to the liquidity
preference theory, interest rates on short-term securities are lower because
investors are not sacrificing liquidity for greater time frames than medium or
longer-term securities. 

Special Considerations
Keynes introduced Liquidity Preference Theory in his book The General
Theory of Employment, Interest and Money. Keynes describes the theory in
terms of three motives that determine the demand for liquidity:

1. The transactions motive states that individuals have a preference for

liquidity to guarantee having sufficient cash on hand for basic day-to-
day needs. In other words, stakeholders have a high demand for
liquidity to cover their short-term obligations, such as buying groceries
and paying the rent or mortgage. Higher costs of living mean a higher
demand for cash/liquidity to meet those day-to-day needs. 
2. The precautionary motive relates to an individual's preference for
additional liquidity if an unexpected problem or cost arises that requires
a substantial outlay of cash. These events include unforeseen costs like
house or car repairs.
3. Stakeholders may also have a speculative motive. When interest rates
are low, demand for cash is high and they may prefer to hold assets
until interest rates rise. The speculative motive refers to an investor's
reluctance to tying up investment capital for fear of missing out on a
better opportunity in the future.

When higher interest rates are offered, investors give up liquidity in exchange
for higher rates. As an example, if interest rates are rising and bond prices are
falling, an investor may sell their low paying bonds and buy higher-paying
bonds or hold onto the cash and wait for an even better rate of return.

Example of Liquidity Preference Theory

A three-year Treasury note might pay a 2% interest rate, a 10-year treasury
note might pay a 4% interest rate and a 30-year treasury bond might pay a 6%
interest rate. For the investor to sacrifice liquidity, they must receive a higher
rate of return in exchange for agreeing to have the cash tied up for a longer
period of time.

Supply of Money:
We have described the demand for money as the demand for the
stock (not flow) of money to be held. The flow is over a period of
time and not at a given moment. In the case of commodity, it is a
flow. Goods are being continually produced and disposed of. This is
the essential difference between the demand for money and the
demand for a commodity.

Similarly, the supply of money conforms to the ‘stock’ concept and

not the ‘flow’ concept. Just as the demand for money is the demand
for money to hold, similarly, the supply of money means the supply
of money to hold. Money must always be held by someone,
otherwise it cannot exist. Hence, the supply of money means the
sum total of all the forms of money which are held by a community
at any given moment.

The stock of money, which constitutes the supply of it, consists of

(a) metallic money or coins, (b) currency notes issued by the
currency authority of the country whether the Central bank or the
government, and (chequable bank deposits. In old times, the coins
formed the bulk of money supply of the country. Later, the currency
notes eclipsed the metallic currency and now the bank deposits in
current account withdraw-able by cheques have overwhelmed all
other forms of money.

Thus, money supply means total volume of monetary media of

exchange available to the community for use in connection with the
economic activity of the country. Broadly speaking, money supply in
a country is composed of two main elements, viz., (a) currency with
the public; and (b) deposit money with the public.

In order to arrive at the total amount of currency with the public, we

add: (i) currency notes in circulation; (ii) circulation of rupee notes
and coins; and (iii) circulation of small coins; and from the total
deduct- ‘Cash in hand with banks’ The bulk of the currency with the
public (over 95 per cent) is in the form of currency notes issued by
the Reserve Bank of India. Next in importance are the rupee notes
issued by the Government of India.
Besides currency, money supply with the public includes the deposit
money, i.e., the bank balances held in current accounts of the banks.
In underdeveloped countries, the currency, and not the bank
deposits, occupies a dominant position, because in such countries
the bulk of commercial dealings are done through cash as a medium
of exchange and not through cheques as in advanced countries.
Deposit money with the public in India consists of two items, viz.,
net demand deposits of bank and ‘other deposits’ with the Reserve
Bank of India.

By adding total currency with the public and the total demand
deposits, we get the total money supply with the public.

It is also worth nothing here that in India the deposit money with
the public has now come to exceed, albeit slightly, the total currency
money with the public. Compare with it the position in 1950-51,
when deposit money with the public was not even one-half of the
currency in circulation among the public.

This shows that the banking habit has steadily been growing in the
country and the time will not be far off when deposit money will far
outstrip the currency money.

The total amount of bank deposits in the country is determined by

the monetary policy of the central bank of the country. When the
central bank wants to give a boost to the economy of the country, it
follows a cheap money policy, lowers the bank rate, which is
followed by lower rates of interest charged by the commercial
banks, thus helping credit creation by the banks.

There are times, however, when in the interest of economic stability,

the central bank follows a policy of credit squeeze by raising the
bank rate and purchasing securities through open market
operations and adopting other credit control measures.

Conclusion:
Thus, the supply of money in a country, by and large, depends on
the credit control policies pursued by the banking system of the
country.
The term “business cycle” (or economic cycle or boom-bust cycle) refers to
economy-wide fluctuations in production, trade, and general economic activity. From
a conceptual perspective, the business cycle is the upward and downward
movements of levels of GDP (gross domestic product) and refers to the period of
expansions and contractions in the level of economic activities (business
fluctuations) around a long-term growth trend.

Figure 1. Business Cycles: The phases of a business cycle follow a wave-like pattern over time with regard
to GDP, with expansion leading to a peak and then followed by contraction.

Business Cycle Phases

Business cycles are identified as having four distinct phases: expansion, peak,
contraction, and trough.

An expansion is characterized by increasing employment, economic growth, and

upward pressure on prices. A peak is the highest point of the business cycle, when
the economy is producing at maximum allowable output, employment is at or above
full employment, and inflationary pressures on prices are evident. Following a peak,
the economy typically enters into a correction which is characterized by
a contraction where growth slows, employment declines (unemployment
increases), and pricing pressures subside.  The slowing ceases at the trough and at
this point the economy has hit a bottom from which the next phase of expansion and
contraction will emerge.

Business Cycle Fluctuations

Business cycle fluctuations occur around a long-term growth trend and are usually
measured in terms of the growth rate of real gross domestic product.

In the United States, it is generally accepted that the National Bureau of Economic
Research (NBER) is the final arbiter of the dates of the peaks and troughs of the
business cycle. An expansion is the period from a trough to a peak, and
a recession as the period from a peak to a trough. The NBER identifies a recession
as “a significant decline in economic activity spread across the economy, lasting
more than a few months, normally visible in real GDP, real income, employment,
industrial production. ” This is significantly different from the commonly cited
definition of a recession being signaled by two consecutive quarters of decline in real
GDP.  If the economy does not begin to expand again then the economy may be
considered to be in a state of depression.

Impact on Business Operations

How the business cycle affects business operations may be best explained by

looking at how one business responds to these cycles. Normal Maintenance is a
small business that provides a variety of construction services to homeowners. They
specialize in roofing, deck installations, siding, and general home maintenance. They
employ three full-time workers, who typically work forty hours per week for an
average of twelve dollars per hour. The company has been in business in the same
town for than twenty years and has a solid reputation for quality work and reliability.

Expansion

Normal Maintenance is busy and has recently had to turn down jobs because it lacks
the capacity to do all the work offered. Homeowners now want to make home repairs
and improvements which they had had to put off during the sour economy. With the
economy improving, others are fixing up their homes to sell. Faced with so much
demand, the owner of Normal Maintenance must decide whether to pay his existing
workers overtime (which will increase the costs for each job and reduce profits) or
hire additional workers. The competition for qualified construction labor is steep, and
he is concerned that he will have to pay more than his usual rate of twelve
dollars per hour or possibly get workers who are not as qualified as his current crew.
He is, however, able to charge higher prices for his work because homeowners are
experiencing long waits and delays getting bids and jobs completed.  The owner
purchases a new truck and invests in additional tools in order to keep up with the
demand for services. Customers are willing to pay more than usual so they can get
the work done. Business is expanding to such an extent that Normal Maintenance
and its suppliers are starting to have trouble obtaining materials such as shingles
and siding because the manufacturers have not kept pace with the economic
expansion. In general, business is great for Normal Maintenance, but the expansion
brings challenges.

Peak  

At the peak of the business cycle, the economy can be said to be “overheated.”
Despite hiring additional workers, the owner and crews of Normal Maintenance are
working seven days a week and are still unable to keep up with demand. They can’t
work any harder or faster. As a result, the crews are exhausted and the quality of
their work is beginning to decline. Customers leave messages requesting work and
services, but the owner is so busy he doesn’t return phone calls. Jobs are getting
started and completed late as the crews struggle to cover multiple job sites. As a
result, customer complaints are on the rise, and the owner is worried about the long-
term reputation of the business. Neither the business nor the economy can sustain
this level of activity, and despite the fact that Normal Maintenance is making great
money, everyone is ready for things to let up a little.

Contraction

As the economy begins to contract, business begins to slow down for Normal
Maintenance. They find that they are caught up on work and they aren’t getting so
many phone calls. The owner is able to reduce his labor costs by cutting back on
overtime and eliminate working on the weekends. When the phone does ring,
homeowners are asking for bids on work—not just placing work orders. Normal
Maintenance loses out on several jobs because their bids are too high. The company
begins to look for new suppliers who can provide them with materials at a cheaper
price so they can be more competitive. The building material companies start
offering “deals” and specials to contractors in order to generate sales. In general,
competition for work has increased and some of the businesses that popped up
during the expansion are no longer in the market. In the short term the owner is
confident that he has enough work to keep his crew busy, but he’s concerned that if
things don’t pick up, he might have to lay off some of the less experienced workers.

Trough

On Monday morning, the crew of Normal Maintenance show up to work and the
owner has to send them home: there’s no work for them. During the week before,
they worked only three days, and the owner is down to his original crew of three
employees. Several months ago he laid off the workers hired during the expansion.
Although that was a difficult decision, the owner knows from hard experience
that sometimes businesses fail not because their owners make bad decisions, but
because they run out of money during recessions when there isn’t enough customer
demand to sustain them. Without enough working capital to keep the doors open,
some are forced to close down.

Representatives from supply companies are stopping by the office hoping to get an
order for even the smallest quantity of materials. The new truck and tools that the
owner purchased during the boom now sit idle and represent additional debt and
costs. The company’s remaining work comes from people who have decided to fix
up their existing homes because the economy isn’t good enough for them to buy new
ones. The owner increases his advertising budget, hoping to capture any business
that might be had. He is optimistic that Normal Maintenance will weather this
economic storm—they’ve done it before—but he’s worried about his employees
paying their bills over the winter.

The owner of Normal Maintenance has been in business for a long time, so he’s had
some experience with the economic cycle. Though each stage has its stressors, he
has learned to plan for them. One thing he knows is that the economy will
eventually begin to expand again and run through the cycle all over again.

KEY TAKEAWAYS
  Business cycles are identified as having four distinct phases: peak,
trough, contraction, and expansion.
 Business cycle fluctuations occur around a long-term growth trend and
are usually measured by considering the growth rate of real gross
domestic product.
 In the United States, it is generally accepted that the National Bureau of
Economic Research (NBER) is the final arbiter of the dates of the peaks
and troughs of the business cycle.

Demand-Pull Inflation

What Is Demand-Pull Inflation?

Demand-pull inflation is the upward pressure on prices that follows a shortage
in supply. Economists describe it as "too many dollars chasing too few goods."

Demand-pull inflation is a tenet of Keynesian economics that describes the

effects of an imbalance in aggregate supply and demand. When the
aggregate demand in an economy strongly outweighs the aggregate supply,
prices go up.

This is the most common cause of inflation.

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Demand-Pull Inflation
Understanding Demand-Pull Inflation
The term demand-pull inflation usually describes a widespread phenomenon.
That is, when consumer demand outpaces the available supply of many types
of consumer goods, demand-pull inflation sets in, forcing an overall increase
in the cost of living.

KEY TAKEAWAYS

 When demand surpasses supply, higher prices are the result. This is
demand-pull inflation.
 A low unemployment rate is unquestionably good in general, but it can
cause inflation because more people have more disposable income.
 Increased government spending is good for the economy, too, but it can
lead to scarcity in some goods and inflation will follow.
In Keynesian economic theory, an increase in employment leads to an
increase in aggregate demand for consumer goods. In response to the
demand, companies hire more people so that they can increase their output.
The more people firms hire, the more employment increases. Eventually, the
demand for consumer goods outpaces the ability of manufacturers to supply
them.

Causes of Demand-Pull Inflation

There are five causes for demand-pull inflation:

 A growing economy. When consumers feel confident, they spend more

and take on more debt. This leads to a steady increase in demand,
which means higher prices.  
 Asset inflation. A sudden rise in exports forces an undervaluation of the
currencies involved.
 Government spending. When the government spends more freely,
prices go up.
 Inflation expectations. Companies may increase their prices in
expectation of inflation in the near future.
 More money in the system. An expansion of the money supply with too
few goods to buy makes prices increase.

Demand-Pull Inflation Vs. Cost-Push Inflation

Cost-push inflation occurs when money is transferred from one economic
sector to another. Specifically, an increase in production costs such as raw
materials and wages inevitably is passed on to consumers in the form of
higher prices for finished goods.

 
In good times, companies hire more. But, eventually, higher consumer
demand may outpace production capacity, causing inflation.

Demand-pull and cost-push move in practically the same way but they work
on a different aspect of the system. Demand-pull inflation demonstrates the
causes of price increases. Cost-push inflation shows how inflation, once it
begins, is difficult to stop.

Example of Demand-Pull Inflation

Say the economy is in a boom period, and the unemployment rate falls to a
new low. Interest rates are at a low point, too. The federal government,
seeking to get more gas-guzzling cars off the road, initiates a special tax credit
for buyers of fuel-efficient cars. The big auto companies are thrilled, although
they didn't anticipate such a confluence of upbeat factors all at once.

Demand for many models of cars goes through the roof, but the
manufacturers literally can't make them fast enough. The prices of the most
popular models rise, and bargains are rare. The result is an increase in the
average price of a new car.
It's not just cars that are affected, though. With almost everyone gainfully
employed and borrowing rates at a low, consumer spending on many goods
increases beyond the available supply.

That's demand-pull inflation in action.

Cost-Push Inflation

What Is Cost-Push Inflation?

Cost-push inflation occurs when overall prices increase (inflation) due to
increases in the cost of wages and raw materials. Higher costs of production
can decrease the aggregate supply (the amount of total production) in the
economy. Since the demand for goods hasn't changed, the price increases
from production are passed onto consumers creating cost-push inflation.

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Cost-Push Inflation
Understanding Cost-Push Inflation
The most common cause of cost-push inflation starts with an increase in
the cost of production, which may be expected or unexpected. For example,
the cost of raw materials or inventory used in production might increase,
leading to higher costs.

Inflation is a measure of the rate of price increases in an economy for a basket

of selected goods and services. Inflation can erode a consumer's purchasing
power if wages haven't increased enough or kept up with rising prices. If a
company's production costs rise, the company's executive management might
try to pass the additional costs onto consumers by raising the prices for their
products. If the company doesn't raise prices, while production costs increase,
the company's profits will decrease.

For cost-push inflation to take place, demand for the affected product must
remain constant during the time the production cost changes are occurring. To
compensate for the increased cost of production, producers raise the price to
the consumer to maintain profit levels while keeping pace with expected
demand.

KEY TAKEAWAYS

 Cost-push inflation occurs when overall prices increase (inflation) due to

increases in the cost of wages and raw materials.
  Cost-push inflation can occur when higher costs of production decrease
the aggregate supply (the amount of total production) in the economy.
 Since the demand for goods hasn't changed, the price increases from
production are passed onto consumers creating cost-push inflation.
Causes of Cost-Push Inflation
As stated earlier, an increase in the cost of input goods used in
manufacturing, such as raw materials. For example, if companies use copper
in the manufacturing process and the price of the metal suddenly rises,
companies might pass those increase on to their customers.

Increased labor costs can create cost-push inflation such as when mandatory
wage increases for production employees due to an increase in minimum the
wage per worker. A worker strike due to stalled to contract negotiations might
lead to a decline in production and as a result, higher prices ensue for the
scare product.

Unexpected causes of cost-push inflation are often natural disasters, which

can include floods, earthquakes, fires, or tornadoes. If a large disaster causes
unexpected damage to a production facility and results in a shutdown or
partial disruption of the production chain, higher production costs are likely to
follow. A company might have no choice but to increase prices to help recoup
some of the losses from a disaster. Although not all natural disasters result in
higher production costs and therefore, wouldn't lead to cost-push inflation.

Other events might qualify if they lead to higher production costs, such as a
sudden change in government that affects the country’s ability to maintain its
previous output. However, government-induced increases in production costs
are more often seen in developing nations.

Government regulations and changes in current laws, although usually

anticipated, may cause costs to rise for businesses because they have no way
to compensate for the increased costs associated with them. For example, the
government might mandate that healthcare be provided, driving up the cost of
employees or labor.

Cost-Push vs. Demand-Pull

Rising prices caused by consumers is called demand-pull inflation. Demand-
pull inflation includes times when an increase in demand is so great that
production can't keep up, which typically results in higher prices. In short, cost-
push inflation is driven by supply costs while demand-pull inflation is driven by
consumer demand—while both lead to higher prices passed onto consumers.

Example of Cost-Push Inflation

The Organization of the Petroleum Exporting Countries (OPEC) is a cartel that
consists of 13 member countries that both produce and export oil. In the early
1970s, due to geopolitical events, OPEC imposed an oil embargo on the
United States and other countries. OPEC banned oil exports to targeted
countries and also imposed oil production cuts.1

What followed was a supply shock and a quadrupling of the price of oil from
approximately $3 to $12 per barrel.2 Cost-push inflation ensued since there
was no increase in demand for the commodity. The impact of the supply cut
led to a surge in gas prices as well as higher production costs for companies
that used petroleum products. 

How Inflation and Unemployment Are Related

The relationship between inflation and unemployment has traditionally been

an inverse correlation. However, this relationship is more complicated than it
appears at first glance and has broken down on a number of occasions over
the past 45 years.1 Since inflation and (un)employment are two of the most
closely monitored economic indicators, we'll delve into their relationship and
how they affect the economy.

Labor Supply and Demand

If we use wage inflation, or the rate of change in wages, as a proxy for
inflation in the economy, when unemployment is high, the number of people
looking for work significantly exceeds the number of jobs available. In other
words, the supply of labor is greater than the demand for it.

With so many workers available, there's little need for employers to "bid" for
the services of employees by paying them higher wages. In times of high
unemployment, wages typically remain stagnant, and wage inflation (or rising
wages) is non-existent.2

In times of low unemployment, the demand for labor (by employers) exceeds

the supply. In such a tight labor market, employers typically need to pay
higher wages to attract employees, ultimately leading to rising wage inflation.3

Over the years, economists have studied the relationship between

unemployment and wage inflation as well as the overall inflation rate.

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Does Raising The Minimum Wage Increase Inflation?
The Phillips Curve
A.W. Phillips was one of the first economists to present compelling evidence
of the inverse relationship between unemployment and wage inflation. Phillips
studied the relationship between unemployment and the rate of change of
wages in the United Kingdom over a period of almost a full century (1861-
1957), and he discovered that the latter could be explained by (a) the level of
unemployment and (b) the rate of change of unemployment.4  5

Phillips hypothesized that when demand for labor is high and there are few
unemployed workers, employers can be expected to bid wages up quite
rapidly. However, when demand for labor is low, and unemployment is high,
workers are reluctant to accept lower wages than the prevailing rate, and as a
result, wage rates fall very slowly.6

A second factor that affects wage rate changes is the rate of change in
unemployment. If business is booming, employers will bid more vigorously for
workers, which means that demand for labor is increasing at a fast pace (i.e.,
percentage unemployment is decreasing rapidly), than they would if the
demand for labor were either not increasing (e.g., percentage unemployment
is unchanging) or only increasing at a slow pace.6

Since wages and salaries are a major input cost for companies, rising wages
should lead to higher prices for products and services in an economy,
ultimately pushing the overall inflation rate higher. As a result, Phillips graphed
the relationship between general price inflation and unemployment, rather
than wage inflation.6 The graph is known today as the Phillips Curve.

Inflation - Policies to Control Inflation

Inflation can be reduced by policies that slow down the growth of AD and/or boost the rate of
growth of aggregate supply (AS)

Fiscal policy:

1. Controlling aggregate demand is important if inflation is to be controlled. If the government

believes that AD is too high, it may choose to ‘tighten fiscal policy’ by reducing its own
spending on public and merit goods or welfare payments
2. It can choose to raise direct taxes, leading to a reduction in real disposable income
3. The consequence may be that demand and output are lower which has a negative effect on
jobs and real economic growth in the short-term

Monetary policy:
 1. A ‘tightening of monetary policy’ involves the central bank introducing a period of higher
interest rates to reduce consumer and investment spending
2. Higher interest rates may cause the exchange rate to appreciate in value bringing about a
fall in the cost of imported goods and services and also a fall in demand for exports (X)

Supply side economic policies:

1. Supply side policies seek to increase productivity, competition and innovation – all of

which can maintain lower prices. These are ways of controlling inflation in the medium term

i.A reduction in company taxes to encourage greater investment

ii.A reduction in taxes which increases risk-taking and incentives to work – a cut in income
taxes can be considered both a fiscal and a supply-side policy

iii.Policies to open a market to more competition to increase supply and lower prices

Rising productivity will cause an outward shift of aggregate supply

Direct controls - a government might choose to introduce direct controls on some prices and
wages

1.
a. Public sector pay awards – the annual increase in government sector pay might be
tightly controlled or even froze (this means a real wage decrease).
b. The prices of some utilities such as water bills are subject to regulatory control – if
the price capping regime changes, this can have a short-term effect on the rate of
inflation

Evaluation points – how best can inflation be controlled?

 The most appropriate way to control inflation in the short term is for the government and
the central bank to keep control of aggregate demand to a level consistent with our
productive capacity
 AD is probably better controlled through the use of monetary policy rather than an over-
reliance on using fiscal policy as an instrument of demand-management
 Controlling demand to limit inflation is likely to be ineffective in the short run if the main
causes are due to external shocks such as high world food and energy prices
 The UK is an open economy in which inflation is strongly affected by events in the rest of the
world
 In the long run, it is the growth of a country’s supply-side productive potential that gives an
economy the flexibility to grow without suffering from acceleration in cost and price
inflation.
Print page

What Is Deflation?
Deflation is a general decline in prices for goods and services, typically
associated with a contraction in the supply of money and credit in the
economy. During deflation, the purchasing power of currency rises over time.

KEY TAKEAWAYS

 Deflation is the general decline of the price level of goods and services.
 Deflation is usually associated with a contraction in the supply of money
and credit, but prices can also fall due to increased productivity and
technological improvements.
 Whether the economy, price level, and money supply are deflating or
inflating changes the appeal of different investment options.
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Deflation
Understanding Deflation
Deflation causes the nominal costs of capital, labor, goods, and services to
fall, though their relative prices may be unchanged. Deflation has been a
popular concern among economists for decades. On its face, deflation
benefits consumers because they can purchase more goods and services with
the same nominal income over time.

However, not everyone wins from lower prices and economists are often
concerned about the consequences of falling prices on various sectors of the
economy, especially in financial matters. In particular, deflation can harm
borrowers, who can be bound to pay their debts in money that is worth more
than the money they borrowed, as well as any financial market participants
who invest or speculate on the prospect of rising prices.

Causes of Deflation
By definition, monetary deflation can only be caused by a decrease in the
supply of money or financial instruments redeemable in money. In modern
times, the money supply is most influenced by central banks, such as the
Federal Reserve. When the supply of money and credit falls, without a
corresponding decrease in economic output, then the prices of all goods tend
to fall. Periods of deflation most commonly occur after long periods of artificial
monetary expansion. The early 1930s was the last time significant deflation
was experienced in the United States. The major contributor to this
deflationary period was the fall in the money supply following catastrophic
bank failures. Other nations, such as Japan in the 1990s, have experienced
deflation in modern times.
World-renowned economist Milton Friedman argued that under optimal policy,
in which the central bank seeks a rate of deflation equal to the real interest
rate on government bonds, the nominal rate should be zero, and the price
level should fall steadily at the real rate of interest. His theory birthed the
Friedman rule, a monetary policy rule.

However, declining prices can be caused by a number of other factors: a

decline in aggregate demand (a decrease in the total demand for goods and
services) and increased productivity. A decline in aggregate demand typically
results in subsequent lower prices. Causes of this shift include reduced
government spending, stock market failure, consumer desire to increase
savings, and tightening monetary policies (higher interest rates). 

Falling prices can also happen naturally when the output of the economy
grows faster than the supply of circulating money and credit. This occurs
especially when technology advances the productivity of an economy, and is
often concentrated in goods and industries which benefit from technological
improvements. Companies operate more efficiently as technology advances.
These operational improvements lead to lower production costs and cost
savings transferred to consumers in the form of lower prices. This is distinct
from but similar to general price deflation, which is a general decrease in the
price level and increase in the purchasing power of money. 

Price deflation through increased productivity is different in specific industries.

For example, consider how increased productivity affects the technology
sector. In the last few decades, improvements in technology have resulted in
significant reductions in the average cost per gigabyte of data. In 1980, the
average cost of one gigabyte of data was $437,500; by 2010, the average
cost was three cents. This reduction caused the prices of manufactured
products that use this technology to also fall significantly.

Changing Views on Deflation’s Impact

Following the Great Depression, when monetary deflation coincided with high
unemployment and rising defaults, most economists believed deflation was an
adverse phenomenon. Thereafter, most central banks adjusted monetary
policy to promote consistent increases in the money supply, even if it
promoted chronic price inflation and encouraged debtors to borrow too much.

British economist John Maynard Keynes cautioned against deflation as he

believed it contributed to the downward cycle of economic pessimism during
recessions when owners of assets saw their asset prices fall, and so cut back
on their willingness to invest. Economist Irving Fisher developed an entire
theory for economic depressions based on debt deflation. Fisher argued that
the liquidation of debts after a negative economic shock can induce a larger
reduction in the supply of credit in the economy, which can lead to deflation
which in turn puts even more pressure on debtors, leading to even more
liquidations and spiraling into a depression.

In recent times, economists have increasingly challenged the old

interpretations about deflation, especially after the 2004 study by economists
Andrew Atkeson and Patrick Kehoe. After reviewing 17 countries across a
180-year time span, Atkeson and Kehoe found 65 out of 73 deflation episodes
with no economic downturn, while 21 out of 29 depressions had no deflation.
Now, a wide range of opinions exist on the usefulness of deflation and price
deflation.

Deflation Changes Debt and Equity Financing

Deflation makes it less economical for governments, businesses, and
consumers to use debt financing. However, deflation increases the economic
power of savings-based equity financing.

From an investor's point of view, companies that accumulate large cash

reserves or that have relatively little debt are more attractive under deflation.
The opposite is true of highly indebted businesses with little cash holdings.
Deflation also encourages rising yields and increases the necessary risk
premium on securities.

Monetary Policy Explained Including Its

Objectives,Types, and Tools

Monetary policy is an economic policy that manages the size and growth
rate of the money supply in an economy. It is a powerful tool to regulate
macroeconomic variables such as inflation and unemployment.

These policies are implemented through different tools, including the

adjustment of the interest rates, purchase or sale of government securities,
and changing the amount of cash circulating in the economy. The central
bank or a similar regulatory organization is responsible for formulating
these policies.

Objectives of Monetary Policy

The primary objectives of monetary policies are the management of

inflation or unemployment, and maintenance of currency exchange rates.
 

Inflation

Monetary policies can target inflation levels. A low level of inflation is

considered to be healthy for the economy. If inflation is high, a
contractionary policy can address this issue.

Unemployment

Monetary policies can influence the level of unemployment in the economy.

For example, an expansionary monetary policy generally decreases
unemployment because the higher money supply stimulates business
activities that lead to the expansion of the job market.

Currency exchange rates

Using its fiscal authority, a central bank can regulate the exchange rates
between domestic and foreign currencies. For example, the central bank
may increase the money supply by issuing more currency. In such a case,
the domestic currency becomes cheaper relative to its foreign counterparts.

Tools of Monetary Policy

Central banks use various tools to implement monetary policies. The widely
utilized policy tools include:

Interest rate adjustment

A central bank can influence interest rates by changing the discount rate.
The discount rate (base rate) is an interest rate charged by a central bank to
banks for short-term loans. For example, if a central bank increases the
discount rate, the cost of borrowing for the banks increases. Subsequently,
the banks will increase the interest rate they charge their customers. Thus,
the cost of borrowing in the economy will increase, and the money supply
will decrease.

Change reserve requirements

Central banks usually set up the minimum amount of reserves that must be
held by a commercial bank. By changing the required amount, the central
bank can influence the money supply in the economy. If monetary
authorities increase the required reserve amount, commercial banks find
less money available to lend to their clients and thus, money supply
decreases.

Commercial banks can’t use the reserves to make loans or fund investments
into new businesses. Since it constitutes a lost opportunity for the
commercial banks, central banks pay them interest on the reserves. The
interest is known as IOR or IORR (interest on reserves or interest on
required reserves).

Open market operations

The central bank can either purchase or sell securities issued by the
government to affect the money supply. For example, central banks can
purchase government bonds. As a result, banks will obtain more money to
increase the lending and money supply in the economy.

Expansionary vs. Contractionary Monetary Policy

Depending on its objectives, monetary policies can be expansionary or

contractionary.

Expansionary Monetary Policy

This is a monetary policy that aims to increase the money supply in the
economy by decreasing interest rates, purchasing government securities by
central banks, and lowering the reserve requirements for banks. An
expansionary policy lowers unemployment and stimulates business
activities and consumer spending. The overall goal of the expansionary
monetary policy is to fuel economic growth. However, it can also possibly
lead to higher inflation.

Contractionary  Monetary Policy

The goal of a contractionary monetary policy is to decrease the money

supply in the economy. It can be achieved by raising interest rates, selling
government bonds, and increasing the reserve requirements for banks. The
contractionary policy is utilized when the government wants to control
inflation levels.

What Is a Central Bank?

The central bank has been described as the "lender of last resort," which
means it is responsible for providing its nation's economy with funds
when commercial banks cannot cover a supply shortage. In other words, the
central bank prevents the country's banking system from failing.

However, the primary goal of central banks is to provide their countries'

currencies with price stability by controlling inflation. A central bank also acts
as the regulatory authority of a country's monetary policy and is the sole
provider and printer of notes and coins in circulation. Time has proved that the
central bank can best function in these capacities by remaining independent
from government fiscal policy and therefore uninfluenced by the political
concerns of any regime. A central bank should also be completely divested of
any commercial banking interests.

KEY TAKEAWAYS

 Central banks carry out a nation's monetary policy and control its money
supply, often mandated with maintaining low inflation and steady GDP
growth.
 On a macro basis, central banks influence interest rates and participate
in open market operations to control the cost of borrowing and lending
throughout an economy.
  Central banks also operate on a micro scale, setting commercial banks'
reserve ratio and acting as lender of last resort when necessary.
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Central Bank
The Rise of the Central Bank
Historically, the role of the central bank has been growing, some may argue,
since the establishment of the Bank of England in 1694. It is, however,
generally agreed upon that the concept of the modern central bank did not
appear until the 20th century, in response to problems in commercial banking
systems.

Between 1870 and 1914, when world currencies were pegged to the gold

standard (GS), maintaining price stability was a lot easier because the amount
of gold available was limited. Consequently, monetary expansion could not
occur simply from a political decision to print more money, so inflation was
easier to control. The central bank at that time was primarily responsible for
maintaining the convertibility of gold into currency; it issued notes based on a
country's reserves of gold.

At the outbreak of World War I, the GS was abandoned, and it became

apparent that, in times of crisis, governments facing budget deficits (because
it costs money to wage war) and needing greater resources would order the
printing of more money. As governments did so, they encountered inflation.
After the war, many governments opted to go back to the GS to try to stabilize
their economies. With this rose the awareness of the importance of the central
bank's independence from any political party or administration.

During the unsettling times of the Great Depression and the aftermath of

World War II, world governments predominantly favored a return to a central
bank dependent on the political decision-making process. This view emerged
mostly from the need to establish control over war-shattered economies;
furthermore, newly independent nations opted to keep control over all aspects
of their countries – a backlash against colonialism. The rise of managed
economies in the Eastern Bloc was also responsible for increased government
interference in the macro-economy. Eventually, however, the independence of
the central bank from the government came back into fashion in Western
economies and has prevailed as the optimal way to achieve a liberal and
stable economic regime.

How the Central Bank Influences an Economy

A central bank can be said to have two main kinds of functions:
(1) macroeconomic when regulating inflation and price stability and
(2) microeconomic when functioning as a lender of last resort.

Macroeconomic Influences
As it is responsible for price stability, the central bank must regulate the level
of inflation by controlling money supplies by means of monetary policy. The
central bank performs open market transactions (OMO) that either inject the
market with liquidity or absorb extra funds, directly affecting the level of
inflation. To increase the amount of money in circulation and decrease the
interest rate (cost) for borrowing, the central bank can buy government bonds,
bills, or other government-issued notes. This buying can, however, also lead
to higher inflation. When it needs to absorb money to reduce inflation, the
central bank will sell government bonds on the open market, which increases
the interest rate and discourages borrowing. Open market operations are the
key means by which a central bank controls inflation, money supply, and
prices.

Microeconomic Influences
The establishment of central banks as lenders of last resort has pushed the
need for their freedom from commercial banking. A commercial bank offers
funds to clients on a first-come, first-serve basis. If the commercial bank does
not have enough liquidity to meet its clients' demands (commercial banks
typically do not hold reserves equal to the needs of the entire market), the
commercial bank can turn to the central bank to borrow additional funds. This
provides the system with stability in an objective way; central banks cannot
favor any particular commercial bank. As such, many central banks will hold
commercial-bank reserves that are based on a ratio of each commercial
bank's deposits.

Thus, a central bank may require all commercial banks to keep, for example, a
1:10 reserve/deposit ratio. Enforcing a policy of commercial bank reserves
functions as another means to control the money supply in the market. Not all
central banks, however, require commercial banks to deposit reserves. The
United Kingdom, for example, does not, while the United States does.

The rate at which commercial banks and other lending facilities can borrow

short-term funds from the central bank is called the discount rate (which is set
by the central bank and provides a base for interest rates). It has been argued
that, for open market transactions to become more efficient, the discount rate
should keep the banks from perpetual borrowing, which would disrupt the
market's money supply and the central bank's monetary policy. By borrowing
too much, the commercial bank will be circulating more money in the system.
The use of the discount rate can be restricted by making it unattractive when
used repeatedly.
Transitional Economies
Today developing economies are faced with issues such as the transition from
managed to free market economies. The main concern is often controlling
inflation. This can lead to the creation of an independent central bank but can
take some time, given that many developing nations want to maintain control
over their economies. But government intervention, whether direct or indirect
through fiscal policy, can stunt central bank development.

Unfortunately, many developing nations are faced with civil disorder or war,
which can force a government to divert funds away from the development of
the economy as a whole. Nonetheless, one factor that seems to be confirmed
is that, for a market economy to develop, a stable currency (whether achieved
through a fixed or floating exchange rate) is needed. However, the central
banks in both industrial and emerging economies are dynamic because there
is no guaranteed way to run an economy, regardless of its stage of
development.

The Bottom Line

Central banks are responsible for overseeing the monetary system for a
nation (or group of nations), along with a wide range of other responsibilities,
from overseeing monetary policy to implementing specific goals such as
currency stability, low inflation, and full employment. The role of the central
bank has grown in importance in the last century. To ensure the stability of a
country's currency, the central bank should be the regulator and authority in
the banking and monetary systems.

Contemporary central banks are government-owned, but separate from their

country's ministry or department of finance. Although the central bank is
frequently termed the "government's bank" because it handles the buying and
selling of government bonds and other instruments, political decisions should
not influence central bank operations. Of course, the nature of the relationship
between the central bank and the ruling regime varies from country to country
and continues to evolve with time.

Fiscal Policy of India: Meaning,

Objectives and Impacts on the Economy
Fiscal policy deals with the taxation and expenditure decisions of the
government. Some of the major instruments of fiscal policy are as follows:
Budget, Taxation, Public Expenditure, public revenue, Public Debt, and
Fiscal Deficit in the economy.
Fiscal policy means the use of taxation and public expenditure by
the government for stabilization or growth of the
economy. According to Culbarston, “By fiscal policy we refer to
government actions affecting its receipts and expenditures which
ordinarily as measured by the government’s receipts, its surplus or
deficit.” The government may change undesirable variations in private
consumption and investment by compensatory variations of public
expenditures and taxes.
Fiscal policy also feeds into economic trends and influences monetary
policy. When the government receives more than it spends, it has a
surplus. If the government spends more than it receives it runs a deficit.
To meet the additional expenditures, it needs to borrow from domestic or
foreign sources, draw upon its foreign exchange reserves or print an
equivalent amount of money. This tends to influence other economic
variables.
On a broad generalization, excessive printing of money leads to
inflation. If the government borrows too much from abroad it leads to a
debt crisis. Excessive domestic borrowing by the government may lead to
higher real interest rates and the domestic private sector being unable to
access funds resulting in the “crowding out” of private investment. So it
can be said that the fiscal deficit can be like a double edge sword, which
need to be tackled very carefully.
Main Objectives of Fiscal Policy in India
Before moving on the discussion on objectives of India’s Fiscal Policies,
firstly know that the general objective of Fiscal Policy.

General objectives of Fiscal Policy are given below:

1. To maintain and achieve full employment.
2. To stabilize the price level.
3. To stabilize the growth rate of the economy.
4. To maintain equilibrium in the Balance of Payments.
5. To promote the economic development of underdeveloped countries.

Fiscal policy of India always has two objectives, namely improving the
growth performance of the economy and ensuring social justice to the
people.
The fiscal policy is designed to achieve certain objectives as
follows:-
1. Development by effective Mobilisation of Resources: The
principal objective of fiscal policy is to ensure rapid economic growth and
development. This objective of economic growth and development can be
achieved by Mobilisation of Financial Resources. The central and state
governments in India have used fiscal policy to mobilise resources.
The financial resources can be mobilised by:-
a. Taxation: Through effective fiscal policies, the government aims to
mobilise resources by way of direct taxes as well as indirect taxes
because most important source of resource mobilisation in India is
taxation.
b. Public Savings: The resources can be mobilised through public
savings by reducing government expenditure and increasing surpluses of
public sector enterprises.
c. Private Savings: Through effective fiscal measures such as tax
benefits, the government can raise resources from private sector and
households. Resources can be mobilised through government borrowings
by ways of treasury bills, issuance of government bonds, etc., loans from
domestic and foreign parties and by deficit financing.
2. Reduction in inequalities of Income and Wealth: Fiscal policy aims
at achieving equity or social justice by reducing income inequalities
among different sections of the society. The direct taxes such as income
tax are charged more on the rich people as compared to lower income
groups. Indirect taxes are also more in the case of semi-luxury and luxury
items which are mostly consumed by the upper middle class and the
upper class. The government invests a significant proportion of its tax
revenue in the implementation of Poverty Alleviation Programmes to
improve the conditions of poor people in society.
3. Price Stability and Control of Inflation: One of the main objectives
of fiscal policy is to control inflation and stabilize price. Therefore, the
government always aims to control the inflation by reducing fiscal deficits,
introducing tax savings schemes, productive use of financial resources,
etc.
4. Employment Generation: The government is making every possible
effort to increase employment in the country through effective fiscal
measures. Investment in infrastructure has resulted in direct and indirect
employment. Lower taxes and duties on small-scale industrial
(SSI) units encourage more investment and consequently generate more
employment. Various rural employment programmes have been
undertaken by the Government of India to solve problems in rural areas.
Similarly, self employment scheme is taken to provide employment to
technically qualified persons in the urban areas.
5. Balanced Regional Development: there are various projects like
building up dams on rivers, electricity, schools, roads, industrial projects
etc run by the government to mitigate the regional imbalances in the
country. This is done with the help of public expenditure.
6. Reducing the Deficit in the Balance of Payment: some time
government gives export incentives to the exporters to boost up the
export from the country. In the same way import curbing measures are
also adopted to check import. Hence the combine impact of these
measures is improvement in the balance of payment of the country.

7. Increases National Income: it’s the strength of the fiscal policy that

is brings out the desired results in the economy. When the government
want to increase the income of the country then it increases the direct
and indirect taxes rates in the country. There are some other measures
like: reduction in tax rate so that more peoples get motivated to deposit
actual tax.

8. Development of Infrastructure: when the government of the

concerned country spends money on the projects  like railways, schools,
dams, electricity, roads etc to increase the welfare of the citizens, it
improves the infrastructure of the country. A improved infrastructure is
the key to further speed up the economic growth of the country.
 
9. Foreign Exchange Earnings: when the central government of the
country gives incentives like, exemption in custom duty, concession in
excise duty while producing things in the domestic markets, it motivates
the foreign investors to increase the investment in the domestic country.

What Is the Money Market?

The money market refers to trading in very short-term debt investments. At the
wholesale level, it involves large-volume trades between institutions and
traders. At the retail level, it includes money market mutual funds bought by
individual investors and money market accounts opened by bank customers.

In all of these cases, the money market is characterized by a high degree of

safety and relatively low rates of return.

KEY TAKEAWAYS

 The money market involves the purchase and sale of large volumes of
very short-term debt products, such as overnight reserves or
commercial paper.
 An individual may invest in the money market by purchasing a money
market mutual fund, buying a Treasury bill, or opening a money market
account at a bank.
 Money market investments are characterized by safety and liquidity,
with money market fund shares targeted to $1.
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Money Market
Understanding the Money Market
The money market is one of the pillars of the global financial system. It
involves overnight swaps of vast amounts of money between banks and the
U.S. government. The majority of money market transactions are wholesale
transactions that take place between financial institutions and companies.

Institutions that participate in the money market include banks that lend to one
another and to large companies in the eurocurrency and time deposit markets;
companies that raise money by selling commercial paper into the market,
which can be bought by other companies or funds; and investors who
purchase bank CDs as a safe place to park money in the short term. Some of
those wholesale transactions eventually make their way into the hands of
consumers as components of money market mutual funds and other
investments.

In the wholesale market, commercial paper is a popular borrowing mechanism

because the interest rates are higher than for bank time deposits or Treasury
bills, and a greater range of maturities is available, from overnight to 270
days.1 However, the risk of default is significantly higher for commercial paper
than for bank or government instruments.

Individuals can invest in the money market by buying money market funds,
short-term certificates of deposit (CDs), municipal notes, or U.S. Treasury
bills. For individual investors, the money market has retail locations, including
local banks and the U.S. government's TreasuryDirect website. Brokers are
another avenue for investing in the money market.

The U.S. government issues Treasury bills in the money market, with

maturities ranging from a few days to one year.2 Primary dealers buy them in
large amounts directly from the government to trade between themselves or to
sell to individual investors. Individual investors can buy them directly from the
government through its TreasuryDirect website or through a bank or a broker.
State, county, and municipal governments also issue short-term notes.

Money market funds seek stability and security with the goal of never losing
money and keeping net asset value (NAV) at $1. This one-buck NAV baseline
gives rise to the phrase "break the buck," meaning that if the value falls below
the $1 NAV level, some of the original investment is gone and investors will
lose money. However, this scenario only happens very rarely, but because
many money market funds are not FDIC-insured, meaning that money market
funds can nevertheless lose money.

Types of Money Market Instruments

Money Market Funds
The wholesale money market is limited to companies and financial institutions
that lend and borrow in amounts ranging from $5 million to well over $1 billion
per transaction. Mutual funds offer baskets of these products to individual
investors. The net asset value (NAV) of such funds is intended to stay at $1.
During the 2008 financial crisis, one fund fell below that level.3 That triggered
market panic and a mass exodus from the funds, which ultimately led to
additional restrictions on their access to riskier investments.

Money Market Accounts 

Money market accounts are a type of savings account. They pay interest, but
some issuers offer account holders limited rights to occasionally withdraw
money or write checks against the account. (Withdrawals are limited by
federal regulations. If they are exceeded, the bank promptly converts it to a
checking account.) Banks typically calculate interest on a money market
account on a daily basis and make a monthly credit to the account.

In general, money market accounts offer slightly higher interest rates than
standard savings accounts. But the difference in rates between savings and
money market accounts has narrowed considerably since the 2008 financial
crisis. Average interest rates for money market accounts vary based on the
amount deposited. As of August 2020, the best-paying money market account
with no minimum deposit offered 0.99% annualized interest. 4

 
Funds in money market accounts are insured by the Federal Deposit
Insurance Corporation (FDIC) at banks and the National Credit Union
Administration (NCUA) in credit unions. 

Certificates of Deposit (CDs)

Most certificates of deposit (CDs) are not strictly money market funds because
they are sold with terms of up to 10 years. However, CDs with terms as short
as three months to six months are available.

As with money market accounts, bigger deposits and longer terms yield better
interest rates. Rates in August 2020 for twelve-month CDs ranged from about
0.5% to 1.5% depending on the size of the deposit.5 Unlike a money market
account, the rates offered with a CD remain constant for the deposit period.
There is a penalty associated with any early withdrawal of funds deposited in
a CD.

Commercial Paper
The commercial paper market is for buying and selling unsecured loans for
corporations in need of a short-term cash infusion. Only highly creditworthy
companies participate, so the risks are low.

Banker's Acceptances
The banker's acceptance is a short-term loan that is guaranteed by a bank.
Used extensively in foreign trade, a banker's acceptance is like a post-dated
check and serves as a guarantee that an importer can pay for the goods.
There is a secondary market for buying and selling banker's acceptances at a
discount.
Eurodollars
Eurodollars are dollar-denominated deposits held in foreign banks, and are
thus, not subject to Federal Reserve regulations. Very large deposits of
eurodollars are held in banks in the Cayman Islands and the Bahamas. Money
market funds, foreign banks, and large corporations invest in them because
they pay a slightly higher interest rate than U.S. government debt.

Repos
The repo, or repurchase agreement, is part of the overnight lending money
market. Treasury bills or other government securities are sold to another party
with an agreement to repurchase them at a set price on a set date.

What Are Capital Markets?

Capital markets are venues where savings and investments are channeled

between the suppliers who have capital and those who are in need of capital.
The entities that have capital include retail and institutional investors while
those who seek capital are businesses, governments, and people.

Capital markets are composed of primary and secondary markets. The most
common capital markets are the stock market and the bond market.

Capital markets seek to improve transactional efficiencies. These markets

bring those who hold capital and those seeking capital together and provide a
place where entities can exchange securities.

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Capital Markets
KEY TAKEAWAYS

 Capital markets refer to the places where savings and investments are
moved between suppliers of capital and those who are in need of
capital.
 Capital markets consist of the primary market, where new securities are
issued and sold, and the secondary market, where already-issued
securities are traded between investors.
 The most common capital markets are the stock market and the bond
market.
Understanding Capital Markets
The term capital market broadly defines the place where various entities trade
different financial instruments. These venues may include the stock market,
the bond market, and the currency and foreign exchange markets. Most
markets are concentrated in major financial centers including New York,
London, Singapore, and Hong Kong.

Capital markets are composed of the suppliers and users of funds. Suppliers
include households and the institutions serving them—pension funds, life
insurance companies, charitable foundations, and non-financial companies—
that generate cash beyond their needs for investment. Users of funds include
home and motor vehicle purchasers, non-financial companies, and
governments financing infrastructure investment and operating expenses. 

Capital markets are used to sell financial products such as equities and debt
securities. Equities are stocks, which are ownership shares in a company.
Debt securities, such as bonds, are interest-bearing IOUs.

These markets are divided into two different categories: primary markets—
where new equity stock and bond issues are sold to investors—
and secondary markets, which trade existing securities. Capital markets are a
crucial part of a functioning modern economy because they move money from
the people who have it to those who need it for productive use.

Primary Versus Secondary Capital Markets

Capital markets are composed of primary and secondary markets. The
majority of modern primary and secondary markets are computer-based
electronic platforms.

Primary markets are open to specific investors who buy securities directly
from the issuing company. These securities are considered primary offerings
or initial public offerings (IPOs). When a company goes public, it sells its
stocks and bonds to large-scale and institutional investors such as hedge
funds and mutual funds.

The secondary market, on the other hand, includes venues overseen by a

regulatory body like the Securities and Exchange Commission (SEC) where
existing or already-issued securities are traded between investors. Issuing
companies do not have a part in the secondary market. The New York Stock
Exchange (NYSE) and Nasdaq are examples of the secondary market.

 
The secondary market serves an important purpose in capital markets
because it creates liquidity, giving investors the confidence to purchase
securities.

Capital Markets Expanded

Capital markets can refer to markets in a broad sense for any financial asset.
Corporate Finance
In this realm, the capital market is where investable capital for non-financial
companies is available. Investable capital includes the external funds included
in a weighted average cost of capital calculation—common and preferred
equity, public bonds, and private debt—that are also used in a return on
invested capital calculation. Capital markets in corporate finance may also
refer to equity funding, excluding debt.

Financial Services
Financial companies involved in private rather than public markets are part of
the capital market. They include investment banks, private equity, and venture
capital firms in contrast to broker-dealers and public exchanges.

Public Markets
Operated by a regulated exchange, capital markets can refer to equity
markets in contrast to debt, bond, fixed income, money, derivatives, and
commodities markets. Mirroring the corporate finance context, capital
markets can also mean equity as well as debt, bond, or fixed income markets.

Capital markets may also refer to investments that receive capital gains

tax treatment. While short-term gains—assets held under a year—are taxed
as income according to a tax bracket, there are different rates for long-term
gains.1 These rates are often related to transactions arranged privately
through investment banks or private funds such as private equity or venture
capital.

What Is the Foreign Exchange Market?

The foreign exchange market (also known as forex, FX, or the currency
market) is an over-the-counter (OTC) global marketplace that determines the
exchange rate for currencies around the world. Participants are able to buy,
sell, exchange, and speculate on currencies.

Foreign exchange markets are made up of banks, forex dealers, commercial

companies, central banks, investment management firms, hedge funds, retail
forex dealers, and investors.

KEY TAKEAWAYS

 The foreign exchange market is an over-the-counter (OTC) marketplace

that determines the exchange rate for global currencies.
 It is, by far, the largest financial market in the world and is comprised of
a global network of financial centers that transact 24 hours a day,
closing only on the weekends.
  Currencies are always traded in pairs, so the "value" of one of the
currencies in that pair is relative to the value of the other.
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Forex Market Basics
Understanding the Foreign Exchange Market
The foreign exchange market—also called forex, FX, or currency market—
was one of the original financial markets formed to bring structure to the
burgeoning global economy. In terms of trading volume, it is, by far, the
largest financial market in the world. Aside from providing a venue for the
buying, selling, exchanging, and speculation of currencies, the forex market
also enables currency conversion for international trade settlements and
investments.

According to the Bank for International Settlements (BIS), which is owned

by central banks, trading in foreign exchange markets averaged $6.6 trillion
per day in April 2019.1

Currencies are always traded in pairs, so the "value" of one of the currencies
in that pair is relative to the value of the other. This determines how much of
country A's currency country B can buy, and vice versa. Establishing this
relationship (price) for the global markets is the main function of the foreign
exchange market. This also greatly enhances liquidity in all other financial
markets, which is key to overall stability.

The value of a country's currency depends on whether it is a "free float" or

"fixed float". Free-floating currencies are those whose relative value is
determined by free market forces, such as supply-demand relationships. A
fixed float is where a country's governing body sets its currency's relative
value to other currencies, often by pegging it to some standard. Free-floating
currencies include the U.S. dollar, Japanese yen, and British pound, while
examples of fixed floating currencies include the Chinese Yuan and the Indian
Rupee.

One of the most unique features of the forex market is that it is comprised of a
global network of financial centers that transact 24 hours a day, closing only
on the weekends. As one major forex hub closes, another hub in a
different part of the world remains open for business. This increases the
liquidity available in currency markets, which adds to its appeal as the
largest asset class available to investors.

The most liquid trading pairs are, in descending order of liquidity:1

1. EUR/USD
 2. USD/JPY
3. GBP/USD

Forex Leverage
The leverage available in FX markets is one of the highest that traders and
investors can find anywhere. Leverage is a loan given to an investor by their
broker. With this loan, investors are able to increase their trade size, which
could translate to greater profitability. A word of caution, though: losses are
also amplified.

For example, investors who have a $1,000 forex market account can trade
$100,000 worth of currency with a margin of 1%. This is referred to as having
a 100:1 leverage. Their profit or loss will be based on the
$100,000 notional amount.

Benefits of Using the Forex Market

There are some key factors that differentiate the forex market from others, like
the stock market.

 There are fewer rules, which means investors aren't held to the strict
standards or regulations found in other markets.
 There are no clearing houses and no central bodies that oversee the
forex market.
 Most investors won't have to pay the traditional
fees or commissions that you would on another market.
 Because the market is open 24 hours a day, you can trade at any time
of day, which means there's no cut-off time to be able to participate in
the market.
 Finally, if you're worried about risk and reward, you can get in and out
whenever you want, and you can buy as much currency as you can
afford based on your account balance and your broker's rules for
leverage.