How Does Inflation Affect the Exchange Rate

between Two Nations?

 
The rate of inflation in a country can have a major impact on the value of the
country's currency and the rates of foreign exchange it has with the currencies
of other nations. However, inflation is just one factor among many that
combine to influence a country's exchange rate.

Inflation is more likely to have a significant negative effect, rather than a

significant positive effect, on a currency's value and foreign exchange rate. A
very low rate of inflation does not guarantee a favorable exchange rate for a
country, but an extremely high inflation rate is very likely to impact the
country's exchange rates with other nations negatively.

Inflation and Interest Rates

Inflation is closely related to interest rates, which can influence exchange
rates. Countries attempt to balance interest rates and inflation, but the
interrelationship between the two is complex and often difficult to manage.
Low interest rates spur consumer spending and economic growth, and
generally positive influences on currency value. If consumer spending
increases to the point where demand exceeds supply, inflation may ensue,
which is not necessarily a bad outcome. But low interest rates do not
commonly attract foreign investment. Higher interest rates tend to
attract foreign investment, which is likely to increase the demand for a
country's currency. (See also, The Mundell-Fleming Trilemma.)

KEY TAKEAWAYS

 Inflation is closely related to interest rates, which can influence

exchange rates.
 Other factors, such as economic growth, balance of trade (which
reflects the level of demand for the country's goods and services),
interest rates, and the country's debt level all influence the value of a
given currency.
 The most powerful determiner of value and the exchange rate of a
nation's currency is the perceived desirability of that currency.
The ultimate determination of the value and exchange rate of a nation's
currency is the perceived desirability of holding that nation's currency. That
perception is influenced by a host of economic factors, such as the stability of
a nation's government and economy. Investors' first consideration in regard to
currency, before whatever profits they may realize, is the safety of holding
cash assets in the currency. If a country is perceived as politically or
economically unstable or if there is any significant possibility of a
sudden devaluation or other change in the value of the country's currency,
investors tend to shy away from the currency and are reluctant to hold it for
significant periods or in large amounts.

Other Factors Affecting Exchange Rate

Beyond the essential perceived safety of a nation's currency, numerous other
factors besides inflation can impact the exchange rate for the currency. Such
factors as a country's rate of economic growth, its balance of trade (which
reflects the level of demand for the country's goods and services), interest
rates and the country's debt level are all factors that influence the value of a
given currency. Investors monitor a country's leading economic indicators to
help determine exchange rates. Which one of many possible influences on
exchange rates predominates is variable and subject to change. At one point
in time, a country's interest rates may be the overriding factor in determining
the demand for a currency. At another point in time, inflation or economic
growth can be a primary factor.

Exchange rates are relative, especially in the modern world of fiat

currencies where virtually no currencies have any intrinsic value, say, as
defined in terms of gold, for which the currency could be exchanged. The only
value any country's currency has is its perceived value relative to the currency
of other countries or its domestic purchasing power. This situation can
influence the effect that an input such as inflation has on a country's exchange
rate. For example, a country may have an inflation rate that is generally
considered high by economists, but if it is still lower than that of another
country, the relative value of its currency can be higher than that of the other
country's currency.

Understanding the Effects of Fiscal Deficits

on an Economy
Fiscal deficits arise whenever a government spends more money than it
brings in during the fiscal year. This imbalance, sometimes called the current
accounts deficit or the budget deficit, is common among contemporary
governments all over the world. Since 1970, the U.S. government has had
higher expenditures than revenues for all but four years. The four largest
budget deficits in American history occurred between 2009 and 2012, each
year showing a deficit of more than $1 trillion.

Fiscal Deficit Impact on Economy

Economists and policy analysts disagree about the impact of fiscal deficits on
the economy. Some, such as Nobel laureate Paul Krugman, suggest that the
government does not spend enough money and that the sluggish recovery
from the Great Recession of 2007-09 was attributable to the reluctance of
Congress to run larger deficits to boost aggregate demand. Others argue that
budget deficits crowd out private borrowing, manipulate capital structures and
interest rates, decrease net exports, and lead to either higher taxes, higher
inflation or both.

Fiscal Deficit Impact on the Shorter-Term Economy

Even though the long-term macroeconomic impact of fiscal deficits is subject
to debate, there is far less debate about certain immediate, short-term
consequences. However, these consequences depend on the nature of the
deficit.

If the deficit arises because the government has engaged in extra spending

projects—for example, infrastructure spending or grants to businesses—then
those sectors chose to receive the money receive a short-term boost in
operations and profitability. If the deficit arises because receipts to the
government have fallen, either through tax cuts or a decline in business
activity, then no such stimulus takes place. Whether stimulus spending is
desirable is also a subject of debate, but there can be no doubt that certain
sectors benefit from it in the short run.

Financing a Deficit
All deficits need to be financed. This is initially done through the sale of
government securities, such as Treasury bonds (T-bonds). Individuals,
businesses, and other governments purchase Treasury bonds and lend
money to the government with the promise of future payment. The clear, initial
impact of government borrowing is that it reduces the pool of available funds
to be lent to or invested in other businesses. This is necessarily true: an
individual who lends $5,000 to the government cannot use that same $5,000
to purchase the stocks or bonds of a private company. Thus, all deficits have
the effect of reducing the potential capital stock in the economy. This would
differ if the Federal Reserve monetized the debt entirely; the danger would be
inflation rather than capital reduction.

Additionally, the sale of government securities used to finance the deficit has a
direct impact on interest rates. Government bonds are considered to be
extremely safe investments, so the interest rate paid on loans to the
government represent risk-free investments against which nearly all
other financial instruments must compete. If the government bonds are paying
2% interest, other types of financial assets must pay a high enough rate to
entice buyers away from government bonds. This function is used by the
Federal Reserve when it engages in open market operations to adjust interest
rates within the confines of monetary policy.

Economic effects of a budget deficit

 A budget deficit is the annual shortfall between government spending and tax
revenue. The deficit is the annual amount the government need to borrow. The
deficit is primarily funded by selling government bonds (gilts) to the private sector.

Summary of effects of a budget deficit

 Rise in national debt

 Higher debt interest payments
 Increase in Aggregate Demand (AD)
 Possible increase in public sector investment
 May cause crowding out and higher bond yields – if close to full capacity

UK national debt increased since high deficits of 1999

The government will have to borrow from the private sector. In the UK, the Debt
Management Office (DMO) sells bonds and gilts to the private sector. The public
sector debt is the total amount of debt owed by the government.

Higher debt interest payments

When the government borrows, it offers to pay an interest payment to those who buy
the bonds. The interest rate attracts investors to lend the government money.

In 2009/10, the cost of debt interest payments on UK government debt was £30bn.
By 2010/11 this interest cost had increased to £45bn.

Increased aggregate demand (AD)

A budget deficit implies lower taxes and increased Government spending (G), this
will increase AD and this may cause higher real GDP and inflation. For example, in
2009, the UK lowered VAT in an effort to boost consumer spending, hit by the great
recession.

Fund public sector investment

A government may run a budget deficit to finance infrastructure investment. This

could include building new roads, railways, more housing and improved
telecommunications. This public sector investment can help increase long-run
productive capacity and enable a higher rate of economic growth. If growth does
improve, then the borrowing can pay for itself. For example, many public sector
investment projects can have a rate of return higher than the cost of borrowing

Future – higher taxes and lower spending

In the future, the government may have to increase taxes or cut spending in order to
reduce the deficit. After 2010, the coalition government implemented a period of
austerity. This involved cutting public sector spending; in particular, areas such as
local government, public sector pay saw cuts in government spending – affecting
public services and public pay.
 Increased interest rates/bond yields

If the government borrows more, this can cause interest rates to increase. This is
because they will need to increase interest rates in order to attract investors to buy
the extra debt. In 2012, countries in the Eurozone saw a rise in bond yields because
there was a lack of confidence in Eurozone economies and the ability to finance the
deficit.

Crowding Out

Increased government borrowing may cause a decrease in the size of the private
sector. The government borrow by selling bonds to the private sector. Therefore, if
the private sector (banks/private individuals) buy government bonds, they have less
money to invest in private sector projects. If there is crowding out, government
borrowing will not cause higher aggregate demand.

Inflation

 In extreme circumstances, the government may increase the money supply to

pay the debt, and this will lead to inflation. This has occurred in countries such as
Germany (1920s) and Zimbabwe (2000s). However, inflation from a budget deficit is
rare in developed economies.
 If the government sells short-term gilts to the banking sector then there will be
an increase in the money supply, this is because banks see gilts as near money,
therefore, they can maintain there lending to customers.

Evaluation of the effects of a budget deficit

1. Depends on the situation of the economy

If the government increases borrowing in a recession, then there is unlikely to be

crowding out. In a recession, we get a fall in private sector spending and investment
– and a rise in private sector saving. In other words, in a recession, there is more
surplus saving and therefore higher demand for the ‘relatively safe’ government
bonds.

10-year bond yield in the UK

From 2009 to 2015, UK bond yields fell – despite high levels of borrowing. This was
because there was high demand for buying government bonds.

However, if the government increase borrowing during a period of rapid economic

growth – it is more likely to cause crowding out and rising bond yields.

2. Depends on why the government borrow

If the government borrow to finance infrastructure investment, it can help boost the
supply side of the economy and enable higher economic growth. If growth improves,
then there will be higher tax revenues to pay back the debt.

However, if the government is borrowing to pay pensions or welfare benefits, then

there is no supply-side improvement, and it will be harder to pay back the debt.
 3. Economic growth can influence future tax revenues

If the government borrow in a recession as part of expansionary fiscal policy then it

can help accelerate an economic recovery and reduce unemployment. This will lead
to improved public finances in the medium term and the budget deficit will prove
more temporary. However, if the government borrow during a period of high growth,
the crowding out will mean growth and cyclical tax revenues will be unchanged.

Risks of Rapid Rise in Debt

One feature of past few years is the rapid rise in government borrowing. – not just a
rise in real debt but a rise in debt to GDP. This means debt burdens are a bigger %
of National Output. It’s not the first time this has happened. A rise in debt to GDP
typically occurs during periods of war and recession. However, the rise in debt
seems to have affected countries in the Eurozone more than those outside.

A rise in government borrowing can create various problems.

 Rise in bond yields and general interest rates

 Potential for inflation, if governments fund deficits by printing money
 Likelyhood of higher taxes and spending cuts in future.
 See: Problems of government borrowing

Governments borrow by selling bonds on the bond market. Traditionally government

debt is seen as secure, because governments rarely default. Therefore,
governments can usually sell debt (government bonds) at a low interest rate. (For
example, 10 year bond yield on UK bonds is currently 3.5%)

However, suppose that debt in the UK rose so rapidly that the ratio of debt to
National output looked unmanageable. If markets felt the government were
borrowing beyond their capacity to repay their debt, it would look very unattractive to
hold UK bonds. At worst, the government may default and not pay you back. If
markets feared government debt was unmangeable, less people would hold bonds,
this would push up interest rates on debt, making it more expensive to borrow.

This market fear can spread contagiously. i.e. if some people start selling bonds, it
may spread as no one wants to hold onto bonds.

When Does Debt Become Unmanageable?

This is the key question. Japan has a huge national deficit (close to 200% of GDP)
and yet bond yields in Japan are barely above 1%. Yet, Spain with a national debt of
60% is causing markets to be worried. Over next few years, the US has a similar
borrowing requirement to Greece, and yet markets don’t seem worried about US
debt.

A key issue is forecasts for growth and inflation. If a country faces years of negative
growth and a period of deflation (falling prices). This means the debt to GDP ratio will
rise rapidly. If a country has growth forecast, this will help to maintain a reasonable
debt to GDP ratio.

A period of deflation increases the real value of debt making it more difficult to pay
back.

Problems of Government Borrowing

 Tejvan Pettinger April 15, 2017  economics
What are the problems of high government borrowing?

There are many potential problems with high levels of government borrowing. These
can include; higher debt interest payments, a need to raise taxes in the future,
crowding out of the private sector and could even cause inflationary pressures.

Potential problems of high government borrowing

Higher debt interest payments. As borrowing increases, the government have to

pay more interest rate payments on those who hold bonds.

Higher interest rates. In some circumstances, higher borrowing can push up

interest rates because markets are nervous about governments ability to repay and
they demand higher bond yields in return for perceived risk. This was particularly a
problem for countries in the Eurozone because in 2011/12 there was no real lender
of last resort. In periods of high inflation, investors will also demand higher bond
yields – e.g. in the 1970s, high government borrowing caused an increase in bond
yields.
 In 2010/11 – countries in the Eurozone with high deficits experienced rapidly rising
interest rates because of markets fears over their ability to repay. (see: bond yields
on EU debt)

Higher interest rates on government bonds tend to push up other interest rates in the
economy and reduce spending and investment. (This impact of higher interest rates
in reducing private sector spending is known as financial crowding out)

Crowding out. A classical monetarist argument is that high levels of government

borrowing cause ‘crowding out’. What they mean is that the government borrow from
the private sector by selling bonds. Therefore, because the private sector lends
money to the government, they have less money to spend and invest. Therefore
although government spending increases, private sector spending falls and there is
no overall boost to the economy. However, critics argue that government spending is
usually more inefficient than the private sector.

 However, crowding out is unlikely to apply in a recession because in a

recession private sector saving is rising and there are surplus savings. If the
government borrow, they are making use of surplus savings and so do not ‘crowd
out’ the private sector.The government are spending to offset the rise in private
sector saving.

Higher taxes in the future. If the debt to GDP rises rapidly, the government may
need to reduce debt levels in the future. It means future budgets will need to
increase taxes and/or limit spending. The danger is that if taxes are increased too
early too quickly, it could snuff out the recovery and cause a further downturn. But, if
they don’t raise taxes, markets may be alarmed at the size of borrowing. High
government borrowing can cause difficult choices for future chancellors; it is a
difficult situation to be in.

Vulnerable to capital flight. If a government finances its deficit by borrowing from

abroad, then there is potential for the economy to suffer from capital flight in the
future. For example, if investors feared a country like Greece would be forced out of
the Euro and devalue, investors would lose out from the devaluation. THerefore, this
would encourage foreign investors to sell – causing more pressure on the economy.

Inflationary pressures. It is rare for government borrowing to cause inflation. But,

some governments may be tempted to deal with high levels of debt by printing more
money. This increase in the money supply can cause inflationary pressures to
increase.

Suppose markets fail to buy enough gilts to finance the deficit, the deficit can always
be financed through ‘monetisation’. i.e. creating money. This creation of money
creates inflation, reduces the value of exchange rate and makes foreign investors
less willing to hold that countries debt.

However, in the period 2010-16 in the UK and US, quantitative easing did not cause
inflation because of the falling velocity of circulation (and depressed economy). But,
if the economy was close to full capacity, printing money to ‘monetize the debt’ would
lead to inflation. In the case of Zimbabwe, high government debt and printing money
led to a severe case of hyperinflation.

Evaluation of government borrowing

It depends on the state of the economy. In a recession, Keynes argued borrowing
can be beneficial in creating economic stimulus and shortening the recession. A
growing deficit when the economy is close to full capacity will be more damaging.
For example, see: irresponsible tax cuts

It depends on levels of domestic saving. In 2016, Japan has a national debt over
225% of GDP, but bond yields are low because there is strong domestic demand for
buying government borrowing.

It depends on levels of government debt. If bond yields are low and borrowing
relatively low, a government can finance debt by a relatively small share of tax
revenues. This debt is manageable. However, if debt increases beyond a certain
level and a growing share of GDP needs to go on debt repayments, debt can start to
take tax revenue that is needed for public sector investment. Many developing
countries suffered from a growing debt burden, which meant they struggled to meet
even the debt interest payments

What Is Budget Deficit?

A budget deficit occurs when expenses exceed revenue and indicate the
financial health of a country. The government generally uses the term budget
deficit when referring to spending rather than businesses or individuals.
Accrued deficits form national debt.

Volume 75%
 

1:41
How Budget Deficits Work
Budget Deficit Explained
In cases where a budget deficit is identified, current expenses exceed the
amount of income received through standard operations. A nation wishing to
correct its budget deficit may need to cut back on certain
expenditures, increase revenue-generating activities, or employ a combination
of the two.

KEY TAKEAWAYS

 A budget deficit happens when current expenses exceed the amount of

income received through standard operations.
 Certain unanticipated events and policies may cause budget deficits.
 Countries can counter budget deficits by raising taxes and cutting
spending.

Causes

Many situations can cause spending to exceed revenue. An involuntary job

loss can eliminate revenue. Sudden medical expenses can quickly send
spending skyward. Spending can easily outpace revenue if the consequences
of debt aren't too painful. That occurs in the early stages of credit card debt.
The debtor keeps charging, and only paying the minimum payment. It's only
when interest charges become excessive that overspending becomes too
painful.

Like families, governments also lose revenue during recessions. As workers

lose jobs, there aren't enough taxes coming in.

Unlike families, the federal government can keep adding each year's deficit to
the debt for a long time. As long as interest rates remain low, the interest on
the national debt is reasonable.

The federal budget deficit is not an accident. The president

and Congress intentionally create it in each fiscal year's budget. That's
because government spending drives economic growth. It's a result
of expansionary fiscal policy. Job creation gives more people money to spend,
which further boosts growth. Tax cuts also expand the economy.

For this reason, politicians get re-elected for running budget deficits if they are
creating jobs and growing the economy. They lose elections
when unemployment is high and when they raise taxes.
Effects

There are immediate penalties for most organizations that run persistent
deficits. If an individual or family does so, their creditors come calling. As the
bills go unpaid, their credit score plummets. That makes new credit more
expensive. Eventually, they may declare bankruptcy.

The same applies to companies who have ongoing budget deficits. Their bond
ratings fall. When that happens, they have to pay higher interest rates to get
any loans at all. These are called junk bonds.

Governments are different. They receive income from taxes. Their expenses
benefit the people who pay the taxes. Government leaders retain popular
support by providing services. If they want to continue being elected, they
will spend as much as possible. Most voters don't care about the impact of the
debt. As a result, deficit spending has increased the U.S. debt to
unsustainable levels. The World Bank says this tipping point is when a
country's debt to gross domestic product ratio is 77 percent or higher.

How to Reduce a Budget Deficit

There are only two ways to reduce a budget deficit. You must either increase
revenue or decrease spending. On a personal level, you can increase revenue
by getting a raise, finding a better job, or working two jobs. You can also start
a business on the side, draw down investment income, or rent out real estate.

Decreasing spending is easier in the short-term. Many experts recommend

cutting out non-essentials, like Starbucks coffees and cable subscriptions. It
also works for someone with a spending addiction, if they get help. But
increasing revenue is more sustainable in the long run. Constantly evaluate
and improve your skills to maximize your revenue from the job market.

Governments can only increase revenue by raising taxes or increasing

economic growth. Tax increases are tricky. If they are too excessive, they will
slow growth. Politically, they often end a politician's career. Increasing growth
can only be done moderately. If growth is faster than the ideal range of 2-3
percent, it will create a boom, which leads to a bust.

Cutting spending also has pitfalls. Government spending is a component of

GDP. If the government cuts spending too much, economic growth will slow.
That leads to lower revenues and potentially a larger deficit. The best solution
is to cut spending on areas that do not create many jobs.
Governments can finance their debt in two main ways

1. Selling bonds to the private sector - either domestic or foreign

2. The Central Bank can finance shortfall in revenue by increasing the money supply and buying
bonds.

Factors which influence how much a government can borrow

 Domestic savings. If consumers have a high savings ratio, there will be a greater ability for
the private sector to buy bonds. Japan has very high levels of public sector debt, but with
high domestic savings, there has been a willingness by the private sector to buy the
government debt. Similarly, during the Second World War, the government was able to tap
into the high levels of domestic savings to finance UK debt.

 Relative interest rates. If government bonds pay a relatively high interest rate compared to
other investments, then ceteris paribus, it should be easier for the government to borrow.
Sometimes, the government can borrow large amounts, even with low interest rates
because government bonds are seen as more attractive than other investments. (e.g. in a
recession government bonds are often preferred to buying shares (which are more
vulnerable in a recession). This is why US bond yields fell 2008-11, despite growth in US
government borrowing.

 Lender of last resort. If a country has a Central Bank willing to buy bonds in case of a
liquidity shortages, investors are less likely to fear a liquidity shortage. If there is no lender of
last resort (e.g. in the Euro) then markets have a greater fear of liquidity shortages and so
are more reluctant to buy bonds.

 Prospects for Economic Growth. If one country faces prospect of recession, then tax
revenues will fall, the debt to GDP ratio will rise. Markets will be much more reluctant to buy
bonds. If there is forecast for higher growth. This will make it much easier to reduce debt to
GDP ratios. The irony is that cutting government spending to reduce deficits, can lead to
lower economic growth and increase debt to GDP ratios.

 Confidence and Security. Usually, governments are seen as a safe investment. Many

governments have never defaulted on debt payments so people are willing to buy bonds
because at least they are safe. However, if investors feel a government is too stretched and
could default, then it will be more difficult to borrow. Therefore, some countries like
Argentina with bad credit histories would find it more difficult to borrow more. Political
uncertainty can make investors more concerned.

 Foreign Purchase. A country like the US attracts substantial foreign buyers for its debt
(Japan, China, UK). This foreign demand makes it easier for government to borrow.
However, if investors feared a country could experience inflation and a rapid devaluation,
foreigners would not want to hold securities in that country.

 Inflation. Financing the debt by increasing the money supply is risky because of the
inflationary effect. Inflation reduces the real value of the government debt, but, that means
 people will be less willing to hold government bonds. Inflation will require higher interest
rates to attract people to keep bonds. In theory, the government can print money to reduce
the real value of debt; but existing savers will lose out. If the government creates inflation, it
will be more difficult to attract savings in the future.

GDP growth, per capita income rise and how it affects us

February 6, 2012, 6:23 AM IST Deepa Venkatraghvan in Money Happy Returns | Economy | ET
This week, the Government released a slew of statistics. The government
expects GDP growth in 2012-13 to be higher than 7.2%, but not close to potential
8.6%.  Per capita income crosses Rs 50,000 for first time in 2010-11. As a layman,
what should you make of these numbers? 
Let’s start with the GDP
GDP or Gross Domestic Product is the value of economic output of a country. For
beginners, here’s a simple example. Take a family of 6 brothers, A, B, C, D, E and F.
Here’s what each of them does for a living:
A: Furniture maker. His full year sale is Rs 5 lakh
B: Makes and sells steel utensils. His full year sale is Rs 3 lakh
C: Operates a tiffin service. His full year sale is Rs 2 lakh
D: Manufactures steel sheets. His full year sale is Rs 1 lakh. Out of this Rs 1 lakh, he
has sold steel sheets for Rs 25000 to B.
E: Produces and sells rice. His full year sale is Rs 50,000. Out of this Rs 50.000 he
has sold rice for Rs 20000 to C. 
F: A teacher who earns Rs 1 lakh per year. 

(Sale value in all these cases includes cost of raw materials, labour plus owner’s
profits.)
Let’s calculate their total GDP. 
Step 1: Calculate total sales. This works out to Rs 12.5 lakh.
Step 2: Calculate overlapping sales, called intermediate consumption, that is, sale of
one person that becomes raw material for another person. This works out to Rs
45,000.
Step 3: Reduce the total sales by intermediate consumption to eliminate double
counting (for instance, the sale value of B includes the cost of steel sheets
purchased from D). This works out to Rs 12.05 lakh.

The GDP for this family of 6 brothers is Rs 12.05 lakh. Now instead of 6 brothers,
when this exercise is done for the entire country, we arrive at the GDP of a country. 

The rate of growth of GDP reflects the pace of the economy. For instance, a
slowdown in the US economy has led to the GDP of the US growing at a snail’s pace
of 1-2% in the last several years, sometimes slipping into the negative territory. By
contrast, India clocked a GDP growth of 7-8% in the past few years. And the Govt is
projecting it will clock 7.2% in 2012-13.

While 7.2% sounds great, especially in this weak global environment, especially
when compared to 1-2% growth rates elsewhere, it really does not translate into too
much for India’s standard of living. Not at least in the near future. And this is where
GDP per capita and Gross National Income (GNI) per capita comes into play.
GDP per capita and Income per capita

GDP per capita is nothing but GDP per person; the country’s GDP divided by the
total population. In our example, it would be Rs 12.05 lakh divided by the total
number of people including the workers who work at each of the 6 brothers’
factories. Because the GDP is divided by the total number of workers, the GDP per
capita very closely reflects the ‘average’ revenue per person in the economy. As
GDP grows it is assumed that everyone in the chain will benefit and the growth will
have a trickledown effect on the population, thus improving standard of living. If you
earn more, you are able to pay more for your domestic help, thus improving their
standard of living. Of course, the growth must be more than inflation. 

I must go over a few more explanations before I get to the key point. So do bear with
me. Gross National Income, GNI, is slightly different from the GDP. While the GDP
measures only the production and services within a country, GNI also includes net
income earned from other countries. Per capital GNI or per capita income is the GNI
divided by the population. 

Now, according to the Government, India’s per capita income has crossed Rs 50,000
for the first time in 2010-2011. It is at Rs 53,000 or around USD 1,000. This is at
current prices or market prices. The same works out to USD 790 at constant prices,
that is, after factoring inflation. 
Statistics mean nothing in absolute terms. So let’s get to some serious global
comparison. According to this HSBC report, in 2010, here is how these countries
ranked in terms of GDP:
#1 US
#3 China
#8 India
In the same year, this is how per per capita incomes looked:
US: $36,354
China: $2,396
India: $790
 Okay so that was when
India was rank 8. Let us look into the future. The report projects the top economies
by 2050.

Accordingly, in 2050, this is how the countries will rank:

#1 China: GDP at USD 24.6 trillion
#2 USA: GDP at USD 22.3 trillion
#3 India: GDP at USD 8.1 trillion
And here are the projections of per capita income in 2050:
China: USD 17,372
US: USD 55,134
India: USD 5,060

In terms of income per capita, among the countries that will be the top 30 biggest
economies in 2050, India ranked last in 2010 and will also rank last in 2050. China
ranked at 27 in 2010 but will jump to rank 20 by 2050. The report also projects that
India’s population will beat China’s by 2050. 
Making sense
So why is India’s per capita income so dismally low? 
– Because our GDP is just not big enough for the large population base
By the time the huge GDP trickles down, there is not much left. For almost the same
population, look at China’s GDP in 2050. The US has the highest GDP in absolute
terms but also has a lower population as compared to China and India. China is
ranked next to the US in terms of absolute GDP but the large population drags down
the GDP to much below the US. But because the GDP itself is large, per capita GDP
is better than India’s. 
– Because our GDP is not growing fast enough
HSBC in its report has projected India’s average growth rate for the next 4 decades
to be in the range of 5-6% (average growth between 2000 and 2009 was 5.5%). That
growth rate looks good when developed countries are growing at just 1-2%. But it is
obviously not enough for our population base. The country needs to be far more
aggressive for any kind of growth to even make a difference to average income
levels quickly. A 7-8% maybe alright for now but India has to maintain it and that too
consistently if it has to beat HSBC’s assumption of 5-6% average over the next 4
decades. Just because we are better off at 7% as compared to 3-4% in the past, it
does not make us good. We need to look at the future and not the past.
So what exactly should we expect from our Govt?
Well, we know the Govt needs to focus on health, education, infrastructure etc. But
apart from doing social good, these things are going to have a bearing on our
economics. Here’s how:
– For GDP and GNI to grow at ambitious multiples, it is not enough for the rich alone
to get richer. The entire population must see improved incomes. For that to happen,
health and education levels of the people has to be improved; the environment for
agriculture as well as business needs to be aggresively improved; India needs a big
thrust. The US got that thrust in the 1920s through rapid growth in industry and
infrastructure. The Government has to do a lot more than just harp on 7% growth
rates. It has to act, fast and in one direction.
– Inflation continues to remain high; over a period of time this will erode real incomes
even more. A lot of the recent inflation has been from food inflation. The Govt needs
to match demand and supply by increasing productivity in agriculture.
– And above all there is corruption and black money. How does black money impact
GDP? Well, the Government calculates GDP only on the basis of declared figures.
Undeclared revenues, black money, do not get counted in the GDP. Bringing all that
money into the system will increase GDP; make funds available for reinvestment; will
enable higher tax collection and give more money in the hands of the Govt for
developmental spending. Honest Govt spending.

Of course, a lot of the data from HSBC is based on several assumptions and
arithmetics. Nobody knows the future. India’s population may not rise at that pace.
Even if China grows aggressively, it might face a slow down because of the one-
child policy. There is also the problem of the other extreme that the US faces. While
the going was good the US created a great standard of living. Now when the
economy is moving slowly, people are finding it difficult to maintain the standard of
living but at the same time its tough to lower it. 

Top 6 Effects of Inflation |

Economy
The following points highlight the six major effects of inflation. The
effects are: 1. Effects on Distribution of Income and Wealth 2.
Effects on Production 3. Effects on Income and Employment 4.
Effects on Business and Trade 5. Effects on the Government
Finance 6. Effects on Growth.
1. Effects on Distribution of Income and Wealth:
The impact of inflation is felt unevenly by the different groups of
individuals within the national economy—some groups of people
gain by making big fortune and some others lose.

We may now explain in detail the effects of inflation on

different groups of people:
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(a) Creditors and debtors:

During inflation creditors lose because they receive in effect less in
goods and services than if they had received the repayments during
a period of low prices. Debtors, on other hand, as a group gain
during inflation, since they repay their debts in currency that has
lost its value (i.e., the same currency unit will now buy less goods
and services).

(b) Producers and workers:

Producers gain because they get higher prices and thus more profits
from the sale of their products. As the rise in prices is usually higher
than the increase in costs, producers can earn more during
inflation. But, workers lose as they find a fall in their real wages as
their money wages do not usually rise proportionately with the
increase in prices. They, as a class, however, gain because they get
more employment during inflation.

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(c) Fixed income-earners:

Fixed income-earners like the salaried people, rent-earners,
landlords, pensioners, etc., suffer greatly because inflation reduces
the value of their earnings.

(d) Investors:
The investors in equity shares gain as they get dividends at higher
rates because of larger corporate profits and as they find the value
of their shareholdings appreciated. But the bondholders lose as they
get a fixed interest the real value of which has already fallen.

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(e) Traders, speculators, businesspeople and black-
marketers:
They gain because they make more profits from the persistent rise
in prices.

(f) Farmers:
Farmers also gain because the rise in the prices of agricultural
products is usually higher than the increase in the prices of other
goods.

Thus, inflation brings a shift in the pattern of distribution of income

and wealth in the country, usually making the rich richer and the
poor poorer. Thus during inflation there is more and more
inequality in the distribution of income.

2. Effects on Production:
The rising prices stimulate the production of all goods—both of
consumption and of capital goods. As producers get more and more
profit, they try to produce more and more by utilising all the
available resources at their disposal.

But, after the stage of full employment the production cannot

increase as all the resources are fully employed. Moreover, the
producers and the farmers would increase their stock in the
expectation of a further rise in prices. As a result hoarding and
cornering of commodities will increase.

But such favourable effects of inflation upon production are not

always found. Sometimes, production may come to a standstill
position despite rising prices, as was found in recent years in
developing countries like India, Thailand and Bangladesh. This
situation is described as stagflation.

3. Effects on Income and Employment:

Inflation tends to increase the aggregate money income (i.e.,
national income) of the community as a whole on account of larger
spending and greater production. Similarly, the volume of
employment increases under the impact of increased production.
But the real income of the people fails to increase proportionately
due to a fall in the purchasing power of money.

4. Effects on Business and Trade:

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The aggregate volume of internal trade tends to increase during

inflation due to higher incomes, greater production and larger
spending. But the export trade is likely to suffer on account of a rise
in the prices of domestic goods. However, the business firms
expand their businesses to make larger profits.

During most inflation since costs do not rise as fast as prices profits
soar. But wages do not increase proportionate with prices, causing
hardships to workers and making more and more inequality. As the
old saying goes, during inflation prices move in escalator and wages
in stairs.

5. Effects on the Government Finance:

During inflation, the government revenue increases as it gets more
revenue from income tax, sales tax, excise duties, etc. Similarly,
public expenditure increases as the government is required to spend
more and more for administrative and other purposes. But the
rising prices reduce the real burden of public debt because a fix sum
has to be paid in instalment per period.

6. Effects on Growth:
A mild inflation promotes economic growth, but a runaway inflation
obstructs economic growth as it raises cost of development projects.
Although a mild dose of inflation is inevitable and desirable in a
developing economy, a high rate of inflation tends to lower the
growth rate by slowing down the rate of capital formation and
creating uncertainty.

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Conclusion:
But inflation, especially a runaway inflation, is an unstable
situation. It makes the business world uneasy and uncertain.
Society gets disturbed as there grows discontentment among the
salaried people and they demand an increase in their wages and
salaries.

The middle-class people suffer hard as the real value of their income
becomes very low. Inflation is also unjust as it makes one class of
people richer and the other poorer. But the most serious effect of
inflation from the standpoint of the economy is that it makes the
economic environment of business unstable.

Concept of National Income

National income means the value of goods and services produced by
a country during a financial year. Thus, it is the net result of all
economic activities of any country during a period of one year and is
valued in terms of money. National income is an uncertain term and
is often used interchangeably with the national dividend, national
output, and national expenditure. We can understand this concept by
understanding the national income definition.

Concept of National Income

The National Income is the total amount of income accruing to a
country from economic activities in a years time. It includes
payments made to all resources either in the form of wages, interest,
rent, and profits.

The progress of a country can be determined by the growth of the

national income of the country

National Income Definition

There are two National Income Definition

 Traditional Definition
 Modern Definition
 Source: freepik.com

Traditional Definition

According to Marshall: “The labor and capital of a country acting

on its natural resources produce annually a certain net aggregate of
commodities, material and immaterial including services of all kinds.
This is the true net annual income or revenue of the country or
national dividend.”

The definition as laid down by Marshall is being criticized on the

following grounds.

Due to the varied category of goods and services, a correct estimation

is very difficult.

There is a chance of double counting, hence National Income cannot

be estimated correctly.

For example, a product runs in the supply from the producer to

distributor to wholesaler to retailer and then to the ultimate
consumer. If on every movement commodity is taken into
consideration then the value of National Income increases.

Also, one other reason is that there are products which are produced
but not marketed.
For example, In an agriculture-oriented country like India, there are
commodities which though produced but are kept for self-
consumption or exchanged with other commodities. Thus there can
be an underestimation of National Income.

Read more about Income and Expenditure Method here in detail

Simon Kuznets defines national income as “the net output of

commodities and services flowing during the year from the country’s
productive system in the hands of the ultimate consumers.”

Following are the Modern National Income definition

 GDP
 GNP

Gross Domestic Product

The total value of goods produced and services rendered within a

country during a year is its Gross Domestic Product.

Further, GDP is calculated at market price and is defined as GDP at

market prices. Different constituents of GDP are:

1. Wages and salaries

2. Rent
3. Interest
4. Undistributed profits
5. Mixed-income
6. Direct taxes
7. Dividend
8. Depreciation

Gross National Product

For calculation of GNP, we need to collect and assess the data from

all productive activities, such as agricultural produce, wood,
minerals, commodities, the contributions to production by transport,
communications, insurance companies, professions such (as lawyers,
doctors, teachers, etc). at market prices.

It also includes net income arising in a country from abroad. Four

main constituents of GNP are:

1. Consumer goods and services

2. Gross private domestic income
3. Goods produced or services rendered
4. Income arising from abroad.

GDP and GNP on the basis of Market Price and Factor Cost

a) Market Price

The Actual transacted price including indirect taxes such as GST,

Customs duty etc. Such taxes tend to raise the prices of goods and
services in the economy.

b) Factor Cost

It Includes the cost of factors of production e.g. interest on capital,

wages to labor, rent for land profit to the stakeholders. Thus services
provided by service providers and goods sold by the producer is
equal to revenue price.

Alternatively,
Revenue Price (or Factor Cost) = Market Price (net of) Net Indirect
Taxes

Net Indirect Taxes = Indirect Taxes Net of Subsidies received

Hence,

Factor Cost  shall be equal to

(Market Price) LESS (Indirect Taxes ADD Subsidies)

Net Domestic Product

The net output of the country’s economy during a year is its NDP.
During the year a country’s capital assets are subject to wear and tear
due to its use or can become obsolete.

Hence, we deduct a percentage of such investment from the GDP to

arrive at NDP.

So NDP=GDP at factor cost LESS Depreciation.

The Accumulation of all factors of income earned by residents of a

country and includes income earned from the county as well as from
abroad.

Thus, National Income at Factor Cost  shall be equal to

NNP at Market Price LESS (Indirect Taxes ADD Subsidies)

Question on National Income

Q. Enumerate the various methods of measuring National
Income?
Ans. There are various methods for measuring National Income:

1. Gross Domestic Product (GDP)

2. Gross National Product (GNP)
3. Net National Product (NNP)
4. Net Domestic Product (NDP)
5. National Income at Factor Cost (NIFC)
6. Transfer Payments
7. Personal Income
8. Disposable Personal Income

Inflation and Interest Rate  – Are they

Related?
Interest rate affects inflation and both are closely related. They are generally

referred together in macroeconomics. In this article, we look at the

differences between Interest Rates and Inflation.

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What is Inflation?
Inflation is the rate at which the general level of prices for goods and

services rise. As for price increase, this leads to falling in purchasing power

of the currency. It is very much necessary to keep inflation rate within

permissible limits for the smooth functioning of an economy.

Let us understand inflation with example- Suppose in 1990 a man buys

petrol daily of INR 100 for his car and price of one liter was INR 40, in INR

100 he gets 2.5 Litres of petrol and now, if he buys petrol of INR 100

considering the current rate of petrol INR 90 per liter, he will get 1.1 L of

petrol. Although INR 100 remain the same but its purchasing power

decreased in 28 years earlier, he gets 2.5L petrol at the same price as

today’s 1.1L of petrol. This is called inflation.

 
What is Interest Rate?
The interest rate is the rate at which the lender is lending funds to the

borrower. The interest rate has a vital impact on the economy of the

country and has a major impact on stock and other investment.

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The interest rate is decided by considering two factors.

  Capital availability, if a rate of interest is high then capital is costly.

 If the rate of interest is low, bank customer will not get sufficient

return on their fund which will demotivate customer to keep the

amount in the bank as a result bank will not have funds.

If money is cheap, people will get the motivation to get money in the

market and as a result value of money will decrease. This will increase

inflation.

The rate of interest for loans and deposit are different. The rate of interest

for loans are high whereas for deposits comparatively less. The interest rate

is a price for holding or loaning money i.e. price for depositing or

borrowing of money.

 
Inflation vs Interest Rate Relationship
Infographics
Here we provide you with the top relationship between Inflation and

Interest Rate
To understand the relationship between inflation vs interest rate better it’s

important to know about the Quantity Theory of Money.

 
The relationship between Inflation and Interest
Rate
 Quantity Theory of Money determines that supply and demand for

money determine inflation. If the money supply increases, as a result,

inflation increase and if money supply decreases lead to a decrease in

inflation.

 This principle is applied to study the relationship between inflation vs

interest rate where when the interest rate is high, supply for money is
 less and hence inflation decrease which means supply is decreased

whereas when the interest rate is decreased or low, supply of money

will be more and as a result inflation increase that means that

demand is increased.

 In order to control high inflation, the central bank increases the

interest rate. When interest rate increases, the cost of borrowing rises.

This makes borrowing expensive. Hence, borrowing will decrease and

the money supply will fall. A fall in money supply in the market will

lead to a decrease in money with people to expense on goods and

services. With the supply constant and the demand for goods and

service will decrease which leads to falling of the price of goods and

services.

 In a low inflationary situation, the rate of interest reduces. A

decrease in the rate of interest will make borrowing cheaper. Hence,

borrowing will increase and the money supply will increase. With a

rise in the money supply, people will have more money to spend on

goods and services. So, demand for goods and services will increase

and with supply remaining constant this leads to a rise in the price

level and that is inflation.

 Hence,  they are inversely related to each other and have its own impact. As

describe above if an interest rate is high, then inflation and money

circulation in a market will be low and if an interest rate is less, then money

circulation will be high in a market and hence inflation will increase.

 
Interest vs Inflation – Inverse Relationship?
Let’s now look at the head to head difference relationship between Inflation

and Interest Rate

Basis for Relationship

between Interest Rate Interest Rate Inflation

vs Inflation

If interest rate increase, inflation decreases If inflation increase, interest rate decreases

Money Circulations in market decreases Money Circulations in market increases

Borrowing became expensive Borrowing became cheap

Effect of Increase 
Demand for goods & services decrease Demand for goods & services increase

Interest rate increase leads to falling of Inflation leads to a rise in the price of service

price of services and goods and goods

If interest rate decrease, inflation increases If  inflation decreases, interest rate increase
Effect of Decrease
Money Circulations in market increases Money Circulations in market decreases
 Borrowing became cheap Borrowing became expensive

Demand for goods & services increase Demand for goods & services decrease

Interest rate decrease leads to a rise in the Inflation decrease leads to falling of price of

price of services and goods services and goods

Above we can see the relationship between the inflation vs interest rate.

Through this, we can say that Inflation vs Interest rate is dependent on each

other and the relation between them is an inverse relationship where one

increase and other decrease and vice versa.

 
Final Thoughts
Inflation effect price of goods and services and these prices are very

important for the customer as well for the seller as they want secure

inflation where prices are stable or if in case it increases it should increase

gradually. The purchasing power of their currency should not effect. Price

stability is very much needed for a healthy economy. Considering this

interest rate is decided. As to control inflation interest rate needed to

change after a regular interval to maintain a healthy economy. Inflation vs

Interest rate has a vital role in a market it helps the investor to calculate

how much return his investment need to make maintain his standard of
living and investor invests in a product that gives return more than of

inflation.