RISK MANAGEMENT CAIIB EBOOK

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As of today we have 78,, eBooks for you to download for free. CAIIB MADE SIMPLE ADVANCED BANK MANAGEMENT (CAIIB PAPER -1) Version MATERIALS / CAIIB DISCUSSION The downloader and seller share the risk of default. Risk Management Caiib Ebook Free Download. Please approve this email to receive our weekly eBook updateGift-wrap availableThank you for your. Risk management has assumed paramount importance amongst banks in order to protect them against the adverse effects of uncertainty caused by fluctuations.


Risk Management Caiib Ebook

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For instance, when the price of a particular good rises, I will substitute other similar goods for it as the price of mutton rises, I eat more chicken. Second is the income effect.

This comes into play when a higher price reduces quantity demanded. Because when price goes up, I find myself somewhat poorer than I was before. If petrol prices double, I have in effect less real income, so I will naturally curb my consumption of petrol and other goods.

Market Demand Our discussion of demand has so far referred to 'the' demand curve. But whose demand is it? The fundamental building block for demand is individual preferences. However, in this chapter we will focus on the market demand, which represents the sum total of all individual demands.

The market demand is what is observable in the real world. The market demand curve is found by adding together the quantities demanded by all individuals at each price. Does the market demand curve obey the law of downward - sloping demand?

It certainly does. If prices drop, for example, the lower prices attract new customers through the substitution effect. In addition, a price reduction will induce extra downloads of goods by existing consumers through both the income and the substitution effects. Conversely, a rise in the price of a good will cause some of us to download less. A whole array of factors influences how much will be demanded at a given price: The average income of consumers is a key determinant of demand.

As people's income rises, individuals tend to download more of almost everything, even if prices do not change. Automobile downloads tend to rise sharply with higher levels of income. The size, of the market - measured, say, by the population - clearly affects the market demand curve. Mumbai's 21 million people tend to download 1. The prices and availability of related goods influence the demand for a commodity. A particularly important connection exists among substitute goods - ones that tend to perform the same function, such as apples and oatmeal, pens and pencils, small cars and large cars, or oil and natural gas.

Demand for good A tends to be low if the price of substitute product B is low. In addition to these objective elements, there is a set of subjective elements called tastes or preferences.

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Tastes represent a variety of cultural and historical influences. They may reflect genuine psychological or physiological needs for liquids, love, or excitement.

And they may include artificially contrived cravings for cigarettes,. They may also contain a large element of tradition or religion eating beef is popular in America but taboo in India, while curried jellyfish is a delicacy in Japan but would make many Americans gag. Finally, special influences will affect the demand for particular goods. The demand for umbrellas is high in rainy Mumbai but low in sunny Delhi; the demand for air conditioners will rise in hot weather.

In addition, expectations about future economic conditions, particularly prices, may have an important impact on demand. Demand curves sit still only in textbooks. Why does the demand curve shift?

Because influences other than the good's price change. Let us work through an example of how a change in a non-price variable shifts the demand curve. We know that the average income of Indians rose sharply during the economic boom of Because there is a powerful income effect on the demand for automobiles, this means that the quantity of automobiles demanded at each price will rise. For example, if average incomes rose by 10 per cent, the quantity demanded of a car at a price of Rs.

This would be a shift in the demand curve because the increase in quantity demanded reflects factors other than the good's own price. The net effect of the changes in underlying influences is what we call an increase in demand.

An increase in the demand for automobiles is illustrated in Fig. Note that the shift means that more cars will be bought at every price. The supply side of a market typically involves the terms on which businesses produce and sell their products. The supply of tomatoes tells us the quantity of tomatoes that will be sold at each tomato price. More precisely, the supply schedule relates the quantity supplied of a good to its market price, other things being constant.

In considering supply, the other things that are held constant include input prices, prices of related goods and government policies. The supply schedule or supply curve for a commodity shows the relationship between its market price and the amount of that commodity that producers are willing to produce and sell, other things being constant.

The Supply Curve Table 2. These data show that at an apples' price of Rupees per box, no apples will be produced at all. At such a low price, apple cultivators might want to devote their resources to producing other types of products like cereals and pulses that earn them more profit than apples. As the price of apples increases, ever more apples will be produced. At ever-higher apples prices, cereal makers will find it profitable to add more workers and to download more automated apples-stuffing machines and even more apples factories.

All these will increase the output of apples at the higher market prices. Figure 2. One important reason for the upward slope is 'the law of diminishing returns'. Edible oil will illustrate this important law. If society wants more edible oil, then additional labour will have to be added to the limited farm suitable for producing edible oil crops.

Each new worker will be adding less and of less extra product. The price needed to coax out additional edible oil output is therefore higher. By raising the price of edible oil, society can persuade edible oil producers to produce and sell more edible oil; the supply curve for edible oil therefore is upward-sloping.

Similar reasoning applies to other goods as well. One major element underlying the supply curve is the cost of production. When production costs for a good are low relative to the market price, it is profitable for producers to supply a great deal. When production costs are high relative to price, firms produce little, switch over the production of other products, or may simply go out of business.

Production costs are primarily determined by the prices of inputs and. The prices of inputs such as labour, energy or machinery obviously have a very important influence on the cost of producing a given level of output.

For example, when petrol prices rose sharply in the s, the increase raised the price of energy for manufacturers, increased their production costs and lowered their supply. By contrast, as computer prices fell over the last three decades, businesses increasingly substituted computerized processes for other inputs, for example, in payroll or accounting operations, this increased supply.

An equally important determinant of production costs is technological advances, which consist of changes that lower the quantity of inputs needed to produce the same quantity of output. Such technological advances include everything from scientific breakthroughs to better application of existing technology or simply reorganization of the flow of work.

For example, manufacturers have become much more efficient over the last decade or so. It takes far fewer hours of labour to produce an automobile today than what it did just 10 years ago. This advance enables car-makers to produce more automobiles at the same cost. But production costs are not the only ingredient that goes into the supply curve.

Supply is also influenced by the prices of related goods, particularly goods that are alternative outputs of the production process.

If the price of one production substitute rises, the supply of another substitute will decrease. For example, auto companies typically make several different car models in the same factory. If there is more demand for one model, and its price rises, they will switch over more of their assembly lines to making that model, and the supply of the other models will fall.

Or if the demand and price for trucks rise, the entire factory can be converted to making trucks and the supply of cars will fall. Government policy also has an important influence on the supply curve. Environmental and health considerations determine what technologies can be used, while taxes and minimum-wage laws can significantly raise input prices. In the local electricity market, government regulations influence both the number of firms that can compete and the prices they charge.

Government trade policies have a major impact upon supply aspects. Finally, special factors affect the supply curve. The weather exerts an important influence on farming and on the agro- industry. The computer industry has been marked by a keen spirit of innovation, which has led to a continuous flow of newer products. Market structure will affect supply, and expectations about future prices often have an important impact upon supply decisions.

What lies behind these changes in supply behaviour? When changes in factors other than a good's own price affect the quantity supplied, we call these changes as shifts in supply.

Supply increases or decreases when the amount supplied increases or decreases at each market price. When automobile prices change, producers change their production and quantity supplied; however, the supply and the supply curve do not shift. By contrast, when other influences affecting supply change, supply changes and the supply curve shifts. We can illustrate a shift in supply for the automobile market. Supply would increase if the introduction of cost-saving computerized design and manufacturing reduced the labour required to produce cars, if autoworkers took a pay cut, if there were lower production costs in Japan, or if the government repealed environmental regulations on the industry.

Any of these elements would increase the supply of automobiles in the country at each price. We know the amounts that are willingly bought and sold at each price. We have seen that consumers demand different amounts of apples, cars and computers as a function of these goods' prices. Similarly, producers willingly supply different amounts of these and other goods depending on their prices.

But how can we put both sides of the market together? The answer is that supply and demand interacts to produce equilibrium price and quantity or market equilibrium. The market equilibrium comes at that price and quantity where the forces of supply and demand are in balance.

At the equilibrium price, the amount that downloaders want to download is just equal to the amount that sellers want to sell. The reason we call this equilibrium is that, when the forces of supply and demand are in balance, there is no reason for price to rise or fall, as long as other things remain unchanged. Let us work through the example of apples as given in Table 2.

To find the market price and quantity, we find a price at which the amounts desired to be bought and sold just match. If we try a price of Rs. Clearly not. As row A in Table 2. The amount supplied at Rs. Because too few consumers are chasing too many apples, the price of apples will tend to fall, as shown in column 5 of Table 2. Let us try at Rs.

Does that price clear the market? A quick look at row D shows that at Rs. Apples begin to disappear from the stores at that price. As people scramble around to find their desired apples, they will tend to bid up the price of apples, as shown in column 5 of Table 2. We could try other prices, but we can easily see that the equilibrium price is Rs. At Rs. Only at Rs. Market equilibrium comes at the price at which quantity demanded equals quantity supplied.

At that equilibrium, there is no tendency for the price to rise or fall.

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The equilibrium price is also called the market-clearing price. This denotes that all supply and demand orders are filled, the books are 'cleared' of orders and demanders and suppliers are satisfied. Equilibrium with Supply and Demand Curves We often show the market equilibrium through a supply-and-demand diagram like the one in Fig. This figure combines the supply curve from Fig. Combining the two graphs is possible because they are drawn with exactly the same units on each axis.

We find the market equilibrium by looking for the price at which quantity demanded equals quantity supplied. The equilibrium price comes at the intersection of the supply and demand curves, at point C. How do we know that the intersection of the supply and demand curves is the market equilibrium?

Let us repeat our earlier experiment. Start with the initial high price of Rs.

At that price, suppliers want to sell more than demanders want to download. The result is a surplus or excess of quantity supplied over quantity demanded, shown in the figure by the black line labeled 'Surplus. At a low price of Rs. We now see that the balance or equilibrium of supply and demand comes at point C, where the supply and demand curves intersect.

At point C, where the price is Rs. At point C, and only at point C, the forces of supply and demand are in balance and the price has settled at a sustainable level. The equilibrium price and quantity come where the amount willingly supplied equals the amount willingly demanded. In a competitive market, this equilibrium is found at the intersection of the supply and demand curves.

There are no shortages or surpluses at the equilibrium price. It can also be used to predict the impact of changes in economic conditions on prices and quantities. Let us change our example to the bread. Suppose that a spell of bad weather raises the price of wheat, a key ingredient of bread. That shifts the supply curve for bread to the left. This is illustrated in Fig. In contrast, the demand curve has not shifted because people's sandwich demand is largely unaffected by farming weather. What happens in the bread market?

The harvest causes bakers to produce less bread at the old price, so quantity demanded exceeds quantity supplied. The price of bread therefore rises, encouraging production and thereby raising quantity supplied, while simultaneously discouraging consumption and lowering quantity demanded. The price continues to rise until, at the new equilibrium price, the amounts demanded and supplied are once again equal. As Fig. Thus a bad harvest or any leftward. We can also use our supply-and-demand apparatus to examine how changes in demand affect the market equilibrium.

Suppose that there is a sharp increase in family incomes, so everyone wants to eat more bread. This is represented in Fig. The demand curve thus shifts rightward from DD to D'D'. The demand shift produces a shortage of bread at the old price. A scramble for bread ensues, with long lines in the bakeries. Prices are bid upward until supply and demand come back into balance at a higher price. Graphically, the increase in demand has changed the market equilibrium from E to E' in Fig.

For both examples of shifts a shift in supply and a shift in demand a variable underlying the demand or supply curve has changed. In the case of supply, there might have been a change in technology or input prices. For the demand shift, one of the influences affecting consumer demand incomes, population, and the prices of related goods or tastes changed and thereby shifted the demand schedule.

Suppose that you go to the store and see that the price of bread has doubled. Does the increase in price mean that the demand for bread has risen or does it mean that bread has become more expensive to produce? The correct answer is that without more information, you do not know it could be either one, or even both. Let us look at another example. If fewer airline tickets are sold, is the cause that airline fares have gone up or that demand for air travel has gone down?

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Economists deal with these sorts of questions all the time: When prices or quantities change in a market, does the situation reflect a change on the supply side or the demand side? Sometimes, in simple situations, looking at price and quantity. For example, a rise in the price of bread accompanied by a decrease in quantity suggests that the supply curve has shifted to the left a decrease in supply. A rise in price accompanied by an increase in quantity indicates that the demand curve for bread has probably shifted to the right an increase in demand.

This point is illustrated in Fig. In both panel a and panel b , the quantity goes up. But in a the price rises and in b the price falls. Figure 8 a shows the case of an increase in demand or a shift in the demand curve. As a result of the shift, the equilibrium quantity demanded increases from 10 to 15 units. The case of a movement along the demand curve is shown in Fig. In this case, a supply shift changes the market equilibrium from point E to point E'. As a result, the quantity demanded changes from 10 to 15 units.

But demand does not change in this case; rather, quantity demanded increases as consumers move along their demand curve from E to E' in response to a price change. Demand Schedule is the The choices are: Market Demand Curve obeys the The choices are: Forces behind the demand curve The choices are: A down ward Sloping Demand Curve relates quantity demanded to The choices are: Shifts in Supply means The choices are: Question 6.

The Equilibrium Price is also know as The choices are:. Forces behind the Supply Curve The choices are: Supply curve relates quantity supplied to The Choices are: Market equilibrium comes at the price at which quantity demanded equals to quantity The choices are: Let Us Sum Up www.

There exists a definite relationship between the market price of a good and the demanded quantity of that good, other things being constant. This relationship between price and quantity bought is called the demand schedule, or the demand curve. When the price of a commodity is raised and other things are held constant downloaders tend to download less of the commodity.

When there are changes in factors other than a good's own price which affect the quantity downloadd, we call these changes shifts in demand.

Demand increases or decreases when the quantity demanded at each price increase or decrease. The supply schedule or supply curve for a commodity shows the relationship between its market, price and the amount of that commodity that producers are willing to produce and sell, other things held constant. When the elements underlying demand or supply change, this leads to shifts in demand or supply and to changes in the market equilibrium of price and quantity.

Definition and measures of money concept 2. Causes and measures of inflation. Medium of Exchange;. A measure of value; 3. A store of value over time,; 4. Standard for deferred payments; Let us understand each of the above functions. Medium of Exchange: Individual goods and services, and other physical assets, are 'priced' in terms of money and are exchanged using money.

A Measure of Value: Money is used to measure and record the value of goods or services. A store of value over time: Money can be held over a period of time and used to finance future payments.

Standard for Deferred Payments: Money is used as an agreed measure of future receipts and payments in contracts. This is partly exogenous decided by the government and the central bank and partly endogenous..

Measures of Money Supply The four most common measures of money supply, which are used in India, are as follows: Inflation leads to fall in downloading power.

When the price level rises, each unit of currency downloads fewer goods and services; consequently, inflation is also erosion in the downloading power of money a loss of real value in the internal medium of exchange and unit of account in the economy. A chief measure of price inflation is the inflation rate, i. Inflation has both positive and negative effects on an economy. Negative effects of inflation include loss in stability in the real value of money and other monetary items over time, uncertainty about future inflation may discourage investment and saving, and high inflation may lead to shortages of goods if consumers begin hoarding out of concern that prices will increase further in the future.

Positive effects include a mitigation of economic recessions and debt relief by reducing the real level of debt. There are many factors that can trigger inflationary pressure in an economy.

The most important of these are: Demand-Pull Inflation 1. It is a rise in general prices caused by increasing aggregate demand for goods and services. Increasing quantity of money in the hands of the people increases the aggregate demand for goods and services, and if aggregate supply does not follow the suit, prices rise. Demand exceeding supply leads to shortage and hence, an increase in price Cost-Push Inflation 1.

It is a type of inflation caused by substantial increases in the cost of production of important goods or services where no suitable alternative is available. For example, if prices of some key inputs like oil rise, producers will have to either adjust output supply or translate the higher costs into higher output prices.

When output declines because of cost pressure on producers, there will be a shortage in output markets and as a result prices will rise.

The general price level is measured by a price index. When newspapers tell us 'Inflation is rising,' they are in fact reporting the movement of a price index. A price index is a weighted average of the prices of a selected basket of goods and services relative to their prices in some designated base-year. Calculating Inflation with Price Indexes Inflation is calculated by taking the price index from the year of interest and subtracting the base year from it, then dividing by the base year.

Food Inflation Index 3. WPI focuses on the price of goods traded between corporations at the wholesale stage, rather than goods bought by consumers. WPI helps to monitor price movements that reflect supply and demand in industry, manufacturing and construction sectors.

However the indices for the food group and fuel group will be announced weekly. It measures the prices at the retail level. This is the measure of inflation more relevant for the consumers. It is the cost of living index popularly known as Core Inflation. We have four different index numbers of consumer prices.

These are: GDP Deflator GDP deflator is a measure of the level of prices of all new, domestically produced, final goods and services in an economy. The GDP deflator is not based on a fixed basket of goods and services. The basket is allowed to change with people's consumption and investment patterns.

Specifically, for GDP, the 'basket' in each year is the set of all goods that were produced domestically, weighted by the market value of the total consumption of each good. Therefore, new expenditure patterns are allowed to show up in the deflator as people respond to changing prices. Money Supply refers to The choices are: Right Answer: Narrow Money consists of The choices are:.

Time Deposits are The choices are: Demand Deposits are The choices are: Which of the following statements is true about Inflation? Price Index used in India to calculate inflation for policy formulation is The choices are: Consumer price index measures prices at The choices are: Let Us Sum Up I.

Money performs four functions Medium of exchange, a measure of value, a store of value over time, Standard for deferred payments. Sources of Money supply analyzed by the RBI, consist of the following: Net bank credit to the government, Bank credit to the commercial sector, Net foreign exchange assets of the banking sector, Government's Currency Liabilities to the Public, Net nonmonetary liabilities of the RBI and the other banks.

The most common measures of money supply used in India are: Inflation is a sustained rise in the general level of prices of goods and services in an economy over a period of time.

A chief measure of price inflation is the inflation rate, the annualized percentage change in a general price index over time. The most important causes of inflation are: Demand-Pull Inflation is a rise in general prices caused by increasing aggregate demand for goods and services. Cost-Push Inflation is a type of inflation caused by substantial increases in the cost of important goods or services where no suitable alternative is available.

Inflation denotes a rise in the general level of prices. The most important price indexes are: Wholesale price index, Consumer price index and GDP deflator. The WPI reflects the change in the level of prices of a basket of goods at the wholesale level. GDP deflator is a measure of the level of prices of all new, domestically produced, final goods and services in an economy.

Consumer price index; GDP deflator. Equilibrium in the Money Market 4. Simultaneous Determination of Interest Rate and Income. Concept of Interest 2. Hicks-Hansen Synthesis: LM Curve Model 4. Determination of Interest Rate and Income. Three elements can be distinguished in interest: At any particular time there is a prevailing rate of interest, which many regard as a price determined like other prices in markets, by the demand to borrow in relation to the supply of loanable funds. This is pure interest.

Differences in the rate of interest on different loans made during the same period of time must, therefore, be due to differences in the risk or trouble involved. Thus, the rate of interest charged by a moneylender on an unsecured loan will be higher than the rate charged by a bank to one of its customers who can offer satisfactory collateral security. Similarly, the government has generally to offer a higher rate of interest on a long-term than on a short-term loan.

Keynes gave a new view of interest. According to him, the rate of interest is a purely monetary phenomenon and is determined by demand for money and supply of money. The theory is known as Liquidity Preference Theory. In order to explain the demand for money and interest-rate determination, Keynes assumed a simplified economy where there are two assets which people can keep in their portfolio balance. These two assets are: It is important to note that rate of interest and bond prices are inversely related.

When bond prices go up, rate of interest rises and vice versa. The demand for money by the people depends upon how they decide to balance their portfolios between money and bonds.

This decision about the portfolio balance can be influenced by two factors. First, the higher the level of nominal income in a two-asset economy, more the money people would want to hold in their portfolio balance. This is because of transactions motive according to which at the higher level of nominal income, the downloads by the people of goods and services in their daily life will be relatively larger, which require more money to be kept for transactions purposes.

Second, the higher the nominal rate of interest, the lower the demand for money for speculative motive. This is firstly because a higher nominal rate of interest implies a higher opportunity cost for holding money. At higher rate of interest, holders of money can earn more incomes by holding bonds instead of money.

Secondly, if the current rate of interest is higher than what is expected in the future, the people would like to hold more bonds and less money in their portfolio. On the other hand, if the current rate of interest is low in other words, if the bond prices are currently high , the people will be reluctant to hold larger quantity of bonds and instead they could hold more money in their portfolio because of the inherent fear that bond prices would fall in the future causing capital losses to them.

At a given level of nominal income, we can draw a money demand curve showing the quantity of money demanded at various rates of interest.

As demand for money is inversely related to the rate of interest, the money demand curve at a given level of income, say will be downwardsloping, as is shown by the curve LP, in Fig. When the level of money income increases, suppose from Yand Y the curve of demand for money shifts upward to the new position LP. Keynes, is determined by demand for money Liquidity Preference and supply of money.

The factors which determine demand for money has been explained above. The supply of money, at a given time, is fixed by the monetary authority of the country. In Fig. MS is the money supply curve which is a vertical straight line showing that Rs. It will be seen that quantity of money demanded equals the given money supply at 10 per cent rate of interest. So the money market is in equilibrium at 10 per cent rate of interest. There will be disequilibrium if rate of interest is either higher or lower than 10 per cent.

Suppose the rate of interest is 12 per cent. Supply of money exceeds the demand for money. The excess supply of money reflects the fact that people do not want to hold as much money in their portfolio as the monetary authority has made it available to them.

The people holding assets in the present two-asset economy would react to this excess money supply with them by. Since the total money supply at a given moment remains fixed, it cannot be reduced by downloading bonds by individuals. Such bonds-downloading spree would lead to the rise in prices of bonds.

The rise in bond prices mean the fall in the rate of interest. As will be seen from the Figure with the fall in the interest rate from 12 per cent to 10 per cent, quantity demand of money has increased to become once again equal to the given supply of money, and the excess supply of money is entirely eliminated and money market is in equilibrium.

On the other hand, if the rate of interest is lower than the equilibrium rate of 10 per cent, say it is 8 per cent, and then as will be seen from Fig. As a reaction to this excess demand for money, people would like to sell bonds in order to obtain a greater quantity of money for holding at lower rate of interest. The stock of money remaining fixed, the attempt by the people to hold more money balances at a rate of interest lower than the equilibrium level through sale of bonds will only cause the bond prices to fall.

The fall in bond prices implies the rise in the rate of interest. Thus, the process that started as a reaction to the excess demand for money at an interest rate below the equilibrium will end up with the rise in the interest rate of the equilibrium level. To begin with, ON is the quantity of money available.

Rate of interest will be determined where the demand for money is in balance or equal to the fixed supply of money ON. It is clear from the figure that demand for money is equal to ON quantity of money at Or rate of interest. Hence, Or is the equilibrium rate of interest. Assuming no change in expectations and nominal income, an increase in the quantity of money through downloading securities by the central bank of the country from the open market , will lower the rate of interest. In this case, we move down on the curve.

Thus, given the money demand curve or curve of liquidity preference, an increase in the quantity of money brings down the rate of interest. Let us see how increase in money supply leads to the fall in the rate of interest. With initial equilibrium at Or, when the money supply is expanded from ON to ON', there emerges excess supply of money at the initial Or rate of interest.

The people would react to this excess quantity of money supplied by downloading bonds. As a result, the bond prices will go up which implies that the rate of interest decline. This is how the increase in money supply leads to the fall in rate of interest. As has been explained above, a money demand curve is drawn by assuming a certain level of nominal income.

With the increase in nominal income, money demand for transactions and precautionary motives increase causing an upward shift in the money demand curve. Shifts in money curve demand curve or what Keynes called liquidity preference curve can also be caused by changes in the expectations of the people regarding changes in bond prices or movements in the rate of interest in future.

If some changes in events lead the people on balance to expect a higher rate of interest in the future than they had previously supposed, the money demand or liquidity preference for speculative motive will increase which will bring about an upward shift in the money demand curve or liquidity preference curve and this will raise the rate of interest.

It is worth noting that when the liquidity preference curve rises from LP to LP, the amount of money held does not increase; it remains ON as before. Only the rate of interest rises from Or to Oh to equilibrate the new liquidity preference or money demand with the available quantity of money ON.

They are of the opinion that the classical and loanable funds theories amount to the same thing. According to them, the difference between these two theories, i. Through derivation, the IS curve from the classical theory and LM curve from Keynes' liquidity preference theory, they have brought about a synthesis between the classical and Keynes' theories of interest to provide an adequate and determinate theory of the rate of interest.

From the classical theory they get a family of saving curves at various income levels. From these various saving curves at various income levels together with the given investment demand curve, the IS curve is derived.

This IS curve tells us what will be the various rates of interest at different levels of income, given the investment demand curve and a family of saving curves at different levels of income. On the other hand, from Keynes' formulation, the LM curve is obtained from a family of liquidity preference curves corresponding to various income levels together with the given stock of money supply.

This is because as the level of income increases, people would like to hold more money under the transactions motive. That is, the higher the level of income, the higher would be the liquidity preference curve.

With the given supply of money, the different levels of liquidity preference curves corresponding to various levels of income would determine different rates of interest. This yields LM curve, which depicts the various combinations of interest and income level, at which money market is in equilibrium. Now, Hicks and Hansen show that with the intersection of I S and LM curves, both the interest and income are simultaneously determined.

Thus the classical and Keynes' theories taken together help us in obtaining an adequate and determinate theory of interest. In what follows we explain how the IS curve is derived from the classical. Further, we will explain what factors determine the shape and the levels of IS and LM curves.

Thus, when income is Y the relevant savings curve is SY and the corresponding rate of that equalizes equalizing savings and investment is r. Similarly, for other levels of income rates of interest that equalize savings and investment can be obtained and plotted.

Since, as income increases, rate of interest falls, the IS curve slopes downward.

Thus, I S curve relates the rates of interest with the levels of income at which intended savings and investment are equal. In other words, the IS curve depicts the various combinations of levels of interest and income at which, intended savings equal investment; goods-market is in equilibrium. Since with the increase in income the savings curve shifts to the right, its intersection with the investment demand curve will lower the rate of interest, the level of income and rate of interest are inversely related.

That is, the IS curve slopes downward, as shown in Fig. Further, the steepness of the IS curve depends upon the elasticity or sensitiveness of investment demand to the changes in rate of interest. If the investment demand is highly elastic, that is, very sensitive to the changes in the rate of interest, a given change in interest will produce a large change in investment and thereby cause a large change in the level of income.

Thus when investment demand is greatly elastic or highly sensitive to the rate of interest, the IS curve will be flat i. On the other hand, when investment demand is not very sensitive to the changes in rate of interest, the IS curve will be relatively steep.

Now, what determines the position of IS curve and what would cause changes in its level. It is the level of autonomous expenditure such as government expenditure,. If the government expenditure or any other type of autonomous expenditure increases, it will increase the equilibrium level of income at the given rate of interest.

This will cause the IS curve to shift to the right. How much does the IS curve shift following an increase in expenditure depends on the size of multiplier. A reduction in government expenditure or transfer payments will shift the IS curve to the left. Liquidity preference or demand for money to hold depends upon transaction motive and speculative motive. It is the money held for transactions motive which is a function of income. The greater the level of income, the greater the amount of money held for transactions motive and, therefore, the higher the level of liquidity preference curve.

Thus, we can draw a family of liquidity preference curves at various levels of income. Now, the intersection of these various liquidity preference curves, corresponding to different income levels with the supply curve of money fixed by the monetary authority, would give us the LM curve that relates the rate of interest with the level of income as determined by money-market equilibrium corresponding to different levels of liquidity preference curve.

The LM curve tells us what the various rates of interest will be given the quantity of money and the family of liquidity preference curves at different levels of income.

But the liquidity preference curves alone cannot tell us what exactly the rate of interest will be. As income increases, liquidity preference curve shifts outward and therefore the rate of interest, which equates supply of money with demand for money, rises. This is because with higher levels of income, demand for money that is, the liquidity preference curve is higher and consequently the money market equilibrium, that is, the equality of the given money supply with liquidity preference curve occurs at a higher rate of interest.

This implies that rate of interest varies directly with income. It is important to know which factors determine the slope of the LM curve.

There are two factors on which the slope of the LM curve depends. First, the responsiveness of demand for money i. As the income increases, say from Y to Y, the liquidity preference curve shifts from LP to LP, that is, with an increase in income, demand for money would increase for being held for transactions motive, L is equal to f multiplied by Y. This extra demand for money would disturb the money-market equilibrium, and in order to restore the equilibrium the rate of interest will rise to the level where the given money supply curve intersects the new liquidity preference curve corresponding to the higher income level.

It is worth noting that in the new equilibrium position, with the given stock of money supply, money held under the transactions motive will increase whereas the money held for speculative motive will decline. The greater the extent to which demand for money for transactions motive increases with the increase in income, the greater the decline in the supply of money available for speculative motive.

Given the liquidity preference schedule for speculative motive, the higher the rise in the rate of interest the steeper the LM curve consequently. According to Keynes' liquidity preference theory, r is equal to f M, L where M 'S the stock of money available for speculative motive and L is the money demand or liquidity preference function for speculative motive. The second factor which determines the slope of the LM curve is the elasticity or responsiveness of demand for money i.

The lower the elasticity of liquidity preference with respect to the changes in interest rate, the steeper will be the LM curve. On the other hand, if the elasticity of liquidity preference money-demand function to the changes in the rate of interest is high, the LM curve will be relatively flat or less steep.

As seen above, an LM curve is drawn with a given stock of money supply. Therefore, when the money supply increases, given the liquidity preference function, it will lower the rate of interest at the given level of income.

This will cause the LM curve to shift down and to the right. On the other hand, if money supply is reduced, given the liquidity preference money; demand function, it will raise the rate of interest at the given level of income and therefore cause the LM curve to shift above and to the left.

The other factor that causes a shift in the LM curve is the change in liquidity preference money demand function for a given level of income. If the liquidity preference function for a given level of income shifts upward, this, given the stock of money, will lead to the rise in the rate of interest. This will bring about a shift in the LM curve above and to the left. On the contrary, if the liquidity preference function for a given level of income declines, it will lower the rate of interest and will shift the LM curve down and to the right.

Income and the rate of interest determined together at the equilibrium rate of. E in Fig. The equilibrium rate of interest thus determined is Or and the level of income determined is OY. At this point, income and the rate interest stand in relation to each other such that 1 investment and saving are in equilibrium, and 2 the demand for money is in equilibrium with the supply of money i. It should be noted that LM curve has been drawn by taking the supply of money as fixed.

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Thus, a determinate theory of interest is based on: We see, therefore, that according to Hicks and Hansen, both monetary and real factors, namely, productivity, thrift, and the monetary factors, that is, the demand for money liquidity preference and supply of money play a part in determining of the rate of interest. Any change in these factors will cause shift in I S or LM curve and will therefore change the equilibrium level of the rate of interest and income.

Pick odd man out: Question 2. According to J. Keynes rate of interest and bond prices are related The Choices are: Keynes explained interest in terms of The choices are: The initials LM stand for The choices are: I S curve is derived from The choices are:. LM curve is derived from The choices are: Let Us Sum Up 1. Interest is one of the four types of income, the others being rent, wages, and profit. Supply-and-demand analysis explains the rate of interest as a price determined by the demand for money and the supply of loans.

According to Keynes, rate of interest is determined by liquidity preference or demand for money to hold and the supply of money.

Interest is a reward for parting with liquidity for a specified period. In two-asset economy the demand for money by the people depends upon how they decide to balance their portfolios between money and bonds.

The position of money demand curve depends upon two factors: Keynes asserted that it is not the rate of interest which equalizes saving and investment. But this equality is brought about through changes in the level of income. Hicks and Hansen have brought about a synthesis between the Classical and Keynes' theories of interest and have thereby succeeded in propounding an adequate and determinate theory of interest through the intersection of what are called IS and LM curves.

I S curve tells us what will be the various rates of interest at different levels of income, given the investment demand curve and a family of saving curves at different levels of income. The IS curve and the LM curve relate the two variables: Intersection point of these two curves is the equilibrium rate of interest. Let Us Sum Up 5. Concept and characteristics of business cycle 2. Phases of a business cycle. These fluctuations occur around a long-term growth trend, and typically involve shifts over time between periods of relatively rapid economic growth expansion or boom , and periods of relative stagnation or decline contraction or recession.

Business cycle simply means the whole course of business activity which passes through the phases of prosperity and depression. A business cycle is not a regular,. Its timing is random and, to a large degree, unpredictable. The business cycles influence business decisions. The cycles affect not only the economy in general, but each individual business firm.

A business cycle is synchronic. The upward and downward movements tend to occur at almost the same period in all industries. The wave of prosperity or depression in one industry will soon generate a wave in other industries. A business cycle shows a wave-like movement.

The period of prosperity and depression can be alternatively seen in a cycle. Cyclical fluctuations are recurring in nature. The various phases are repeated. A boom is followed by depression and the depression again is followed by boom.

There can be no indefinite depression or eternal boom period. Business cycles are pervasive in their effects. The up and down movements are not symmetrical. The downward movement is more sudden and violent than the upward movement. Boom During the boom phase production capacity is fully utilized and also products fetch an above-normal price which gives higher profit.

This attracts more and more investors. To manufacture more number of products entrepreneur downloads new machines and also employees work at higher wage rate. The increasing cost tendency of the factors of production leads to a continuous increase in product cost. The fixed income group or.

As their income does not increase accordingly, they are now compelled to reduce their consumption. The demand is now more or less stagnant or it even decreases. Thus the boom or prosperity reaches its peak.

Recession Once economy reaches the peak the course changes. A downward tendency in demand is observed. But the producers who are not aware of this trend go on producing. The supply now exceeds demand. Now the producers come to notice that their stocks are piling up. They are compelled to give up future investment plans. The order for new equipments and raw materials are cancelled. A businessman even cuts down his existing business.

Workers are retrenched. Bankers insist on repayment, stocks accumulate, business failure increases, investment ceases and unemployment expands. Unemployment leads to fall in income, expenditure, prices, profits and industrial and trade activities. Desire for liquidity increases all around. At a low price of Rs. At point C, where the price is Rs.

At point C, and only at point C, the forces of supply and demand are in balance and the price has settled at a sustainable level. The equilibrium price and quantity come where the amount willingly supplied equals the amount willingly demanded.

In a competitive market, this equilibrium is found at the intersection of the supply and demand curves. There are no shortages or surpluses at the equilibrium price. It can also be used to predict the impact of changes in economic conditions on prices and quantities. Let us change our example to the bread. Suppose that a spell of bad weather raises the price of wheat, a key ingredient of bread.

That shifts the supply curve for bread to the left. This is illustrated in Fig. In contrast, the demand curve has not shifted because people's sandwich demand is largely unaffected by farming weather. What happens in the bread market? The harvest causes bakers to produce less bread at the old price, so quantity demanded exceeds quantity supplied. The price of bread therefore rises, encouraging production and thereby raising quantity supplied, while simultaneously discouraging consumption and lowering quantity demanded.

The price continues to rise until, at the new equilibrium price, the amounts demanded and supplied are once again equal.

As Fig. Thus a bad harvest or any leftward www. We can also use our supply-and-demand apparatus to examine how changes in demand affect the market equilibrium. Suppose that there is a sharp increase in family incomes, so everyone wants to eat more bread.

This is represented in Fig. The demand curve thus shifts rightward from DD to D'D'. The demand shift produces a shortage of bread at the old price. A scramble for bread ensues, with long lines in the bakeries. Prices are bid upward until supply and demand come back into balance at a higher price. Graphically, the increase in demand has changed the market equilibrium from E to E' in Fig. For both examples of shifts — a shift in supply and a shift in demand — a variable underlying the demand or supply curve has changed.

In the case of supply, there might have been a change in technology or input prices. For the demand shift, one of the influences affecting consumer demand —incomes, population, and the prices of related goods or tastes — changed and thereby shifted the demand schedule. Suppose that you go to the store and see that the price of bread has doubled. Does the increase in price mean that the demand for bread has risen or does it mean that bread has become more expensive to produce? The correct answer is that without more information, you do not know — it could be either one, or even both.

Let us look at another example. If fewer airline tickets are sold, is the cause that airline fares have gone up or that demand for air travel has gone down? Economists deal with these sorts of questions all the time: When prices or quantities change in a market, does the situation reflect a change on the supply side or the demand side?

Sometimes, in simple situations, looking at price and quantity www.

For example, a rise in the price of bread accompanied by a decrease in quantity suggests that the supply curve has shifted to the left a decrease in supply. A rise in price accompanied by an increase in quantity indicates that the demand curve for bread has probably shifted to the right an increase in demand.

This point is illustrated in Fig. In both panel a and panel b , the quantity goes up. But in a the price rises and in b the price falls. Figure 8 a shows the case of an increase in demand or a shift in the demand curve.

As a result of the shift, the equilibrium quantity demanded increases from 10 to 15 units. The case of a movement along the demand curve is shown in Fig. In this case, a supply shift changes the market equilibrium from point E to point E'. As a result, the quantity demanded changes from 10 to 15 units. But demand does not change in this case; rather, quantity demanded increases as consumers move along their demand curve from E to E' in response to a price change.

Demand Schedule is the The choices are: 1 Relationship between demand and quantity bought 2 Relationship between price and quantity bought 3 Relationship between price and demand 4 None of these Right Answer: 2 Relationship between price and quantity bought Question 2. Market Demand Curve obeys the The choices are: 1 Law of downward-sloping demand 2 Law of upward-sloping demand www. Forces behind the demand curve The choices are: 1 Expectation about future economic conditions 2 Average Income 3 Cost of production 4 Both 1 and 2 Right Answer: 4 Both 1 and 2 Question 4.

Shifts in Supply means The choices are: 1 When changes in factors other than goods own price affect the quantity supplied.

Question 6. The Equilibrium Price is also know as The choices are: www. There exists a definite relationship between the market price of a good and the demanded quantity of that good, other things being constant.

This relationship between price and quantity bought is called the demand schedule, or the demand curve. Law of downward-sloping demand: When the price of a commodity is raised and other things are held constant downloaders tend to download less of the commodity.

Similarly, when the price is lowered, other things being constant, quantity demanded increases. The market demand curve is found by adding together the quantities demanded by all individuals at each price. When there are changes in factors other than a good's own price which affect the quantity downloadd, we call these changes shifts in demand.

Demand increases or decreases when the quantity demanded at each price increase or decrease. The supply schedule or supply curve for a commodity shows the relationship between its market, price and the amount of that commodity that producers are willing to produce and sell, other things held constant. When changes in factors other than a good's own price affect the quantity supplied, we call these changes as shifts in supply. When the elements underlying demand or supply change, this leads to shifts in demand or supply and to changes in the market equilibrium of price and quantity.

Definition and measures of money concept 2. Causes and measures of inflation 3. Medium of Exchange; www. A measure of value; 3. A store of value over time,; 4. Standard for deferred payments; Let us understand each of the above functions. Medium of Exchange: Individual goods and services, and other physical assets, are 'priced' in terms of money and are exchanged using money.A chief measure of price inflation is the inflation rate, the annualized percentage change in a general price index over time.

Let us look at a simple example. Does the increase in price mean that the demand for bread has risen or does it mean that bread has become more expensive to produce? As per one estimate made in , overall teacher absenteeism has been at 25 per cent in India, compared with 16 per cent in Bangladesh and 29 per cent in Uganda.

Synergies provided by the manufacturing sector, liberalization of financial sector with entry of private sector in areas hitherto restricted to public sector and policy initiatives with regard to information technology led to surge in growth of services sector.

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