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In our nation, while literacy – the ability to read and write – is a fundamental part of the socio educational structure, there is little emphasis on nancial literacy. Students complete their schooling without any formal nancial education, which results in not only poor personal nancial skills but also in non-structured understanding of nance as a subject. It is our endeavor to make young minds understand the art of managing and understanding money.

Congratulations for being a part of the nancial literacy brigade. And may you spread the wings of nancial literacy far and wide!

Leading a debt-free life is the biggest gift one can reward oneself with. The need to achieve complete nancial freedom acts as a pre-requisite to achieve any major goal in life. We all wish to remain nancially independent throughout our lives but often struggle to achieve that. If there is one lesson to be learnt from the most celebrated entrepreneurs such as Warren Buffett, Dhirubhai Ambani, Sir Richard Branson etc., it is to start early. This alone was their rst step on the road to a lifelong nancial supremacy and has been our inspiration to launch India’s rstever nancial literacy campaign.

International Finance Olympiad Association

PREFACE

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INDEX

GRAND NATIONS AND HISTORY OF FINANCE

CREDIT, INTEREST, LOANS, DESIRES & ROTTING FISHES- IT IS ALL IN HERE!

LESSONS FROM JACK & THE BEANSTALK & FROMTHE RICHTER SCALE

BIRTH OF FISCAL - WELFARE, WARFARE AND THEITALIAN JOB

CREATIVE DESTRUCTION, CORPORATE

Section B : Comprehensive Approach

FINANCIAL MARKETS

ECONOMY

INFLATION AND INFLATION CONTROL

Section A : Historical Approach

6

14

22

29

37

6.

7.

8.

1.

2.

3.

4.

5.

43

53

62

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SECTION AHistorical Approach

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LEARNING OBJECTIVES

• Conceptual Framework of History and Finance• Powerful Nations and Story of Finance• Spanish Case Study : Story of Ination and Hyperination

Chapter 1GRAND NATIONS ANDHISTORY OF FINANCE

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The difference between mere sustenance and prosperity will be knowledge of utilizing

money. Better savings, better investments, better budgeting will lead to nancial

welfare and creation of enterprises which are value based and will lead to a grander

India. Corruption has tarnished our country’s image.

With adequate nancial knowledge and planning, the Indian community would earn

passive income (through interest, dividends, rents etc.) and would be more ethical,

overall improving the economic image of our nation.

The Ascent of Man, a compelling work by Jacob Bronowski was rst televised on BBC in 1974. The Ascent of Man explores the evolution of man from proto-ape, alks of early human migration, provides a foundation for the development of tools, architecture, sculpture, re, metals and of course alchemy. It then moves on to the creation of mathematics, astronomy, industrial revolution and physics.

History taught us that great nations were built either through war (example Alexander’s Greece), through message of peace (example Ashoka’s India) or through nancial strength (example Croesus’ Lydia). Of the three, it was Croesus’ principle of utilising nancial strength to create formidable nation which requires greater discussion.

The Ascent of Man is arguably one of the nest works on history and provides a historical surmise of the importance of money for the development of all explorations. Infact, it would not be unfair to say that development of a money system preceded any form of medieval – modern exploration and the presence or absence of the same caused success or failure of any such explorative endeavor of humankind.

Trade had developed worldwide then and the coins printed at Lydia became a symbol of trust. Croesus’ rise was phenomenal. Today also Croesus’ name is synonymous with extreme wealth. Lydia, became one of the most wealthy and powerful nation until Cyrus defeated Croesus.

Croesus in 550 BC, created a system of separating gold from silver ore, which created trust on his kingdom’s gold coins and led the world to trade on his gold coins or his kingdom’s currency. Lydia (now represented as areas of East Turkey) was arguably the rst nation to have minted gold coins and silver coins.

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History taught us that great nations were built either through war (example Alexander’s Greece), through message of peace (example Ashoka’s India) or through nancial strength (example Croesus’ Lydia). Of the three, it was Croesus’ principle of utilising nancial strength to create formidable nation which requires greater iscussion..

You would later read about strong and robust monetary systems that through the history have created various powerful nations across the globe. In subsequent pages you would also see how a strong monetary system led to nations winning wars and how misuse of such systems created internal rife, economic anarchy and even revolutions.

Today the dollar of United States of America earns that respect as a currency. Gold, as you may now understand has always been considered as a trustworthy commodity for exchange and therefore is considered a safe investment.

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‘Mary had a little lamb’- Why is history so important?

those regions of South America. The Incas not only lost their complete independence but were also subjected and exploited to work in those mines.

There is a peculiarity about history. All developments in the world have been due to a necessity to improve upon existing orders. These developments in some cases created positive evolutionary impacts or in some cases created regressive impacts. To grasp any concept or development, if the need for which it was developed is known, the concept tends to get hammered in us. For example, if we understand the need for the development of a telegraph it would be easier for us to understand and appreciate its development and consequently its concept.

“Mary had a little lamb.”

Similarly, to understand ination, one can just look back at history and argue that one of the rst recorded inationary crises in the world may have been in Spain after its conquest of South America. Not only does this historical fact make for an exciting reading but also provides a base for understanding ination.

“Ination in its easiest form may be dened as too much money chasing too few a goods.”

It is said that the rst great invention developed by Edison in Menlo Park (Menlo Park is incidentally where Google was also born) was the tin foil phonograph. While working to improve the efciency of a telegraph transmitter, he noted that the tape of the machine gave off a noise resembling spoken words when played at a high speed. This caused him to wonder if he could record a telephone message. He began experimenting with the diaphragm of a telephone receiver by attaching a needle to it. He reasoned that the needle could prick paper tape to record a message. His experiments led him to try a stylus on a tinfoil cylinder, which, to his great surprise, played back the short message he recorded,

“Who could better explain the invention than the inventor himself ”

Like Lydia of 550 BC, Spain by 1550 AD was one of the most economically powerful

The Spanish conquest of South America led to the discovery of Peruvian mountains rich in Gold and Silver for the world. The natives Incas, who were socialist in nature, had developed a robust barter system and an advanced agricultural system. Although, the Inca’s were the real owners of those gold and silver mines but due to their economic structure they never realized the importance of gold and silver which the Spaniards were easily able to exploit. It was in 1545 that an American Indian named Diego Gualpa found the silver mountain of Potosi, now in Bolivia. This discovery led to the immediate mining rush amongst the Spaniards who were ruling

1http://inventors.about.com/library/inventors/bledison.htm, Mary Bellis

p102Europe and England in the Sixteenth Century, T. A. Morris, 1998, pg 121-122

Are you angry that the world is so unfair?

Infuriated by fat-cat capitalists and billion bonus bankers? Throughout the history of western civilization, there has been a recurrent hostility to nance and nanciers, rooted in the idea that those who make their living from lending money are somehow parasitical on the real economic activities of agriculture and manufacturing. This hostility has three causes. It is partly because debtors have tended to outnumber creditors and the former have seldom felt for the latter. It is also because nancial crises and scandals occur frequently enough to make nance appear to be a cause of poverty rather than prosperity, volatility rather than stability. And it is partly because, for centuries, nancial services in all countries all over the world were disproportionately provided by members of ethnic or religious minorities, who had been excluded from land ownership or public ofce but enjoyed success in nance because of their own tight knit networks of kinship and trust. -Adapted from ‘The Ascent of Money’ by Niall Ferguson (Penguin 2009)

In-fact in 1557, due to rising military costs and hyperination, Spain led for its rst Bankruptcy or Moratorium. Spain to meet its burgeoning government expenditures, started borrowing from neighboring European nations, started defaulting on its payment and consequently went bankrupt.

And what rises astronomically tends to fall. With such a huge reserve of silver and gold coins, the Spaniards were plush with funds. But there was a catch. Spaniards like other Europeans were warring for better part of the 16th century. There had been little emphasis on production and agriculture. Therefore the supply of goods and services was limited.

In Spain, its main cause was arguably the ood of bullion (precious metal coins) from the Americas, along with population growth, and government spending.

nations due to their exploitation of South American resources and the main ore was Silver found at Potosi.

Now with their new found wealth after the conquest of South America, Spaniards had enough gold and silver to purchase enough ‘need based’ and ‘luxury’ products and services for themselves. The catch unfortunately was limited supply of goods and services and the problem was magnied by further wars.

It is notably a classical case where too much money chased too few a products and services. The prices started escalating and Spain was engulfed with Ination and later on Hyper Ination. Ination throughout Europe in the sixteenth century was a broad and complex phenomenon.

By 1570, Spain resurfaced again on the back of Money and this time it was due to

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For Finance acionados, Potosi still remains proverbial

the creation of their currency coins called the Pieces of Eight. Pieces of Eight were also silver coins that were mined out from the large reserves of Potosi. Pieces of Eight became the trusted coin for trade and maintained its dominance well into the nineteenth century.

3un Potosi’ which means ‘worth a fortune .for its wealth. Spaniards today still say something is ‘vale

Discovery of the Gold rich Potosi Mountains, Bolivia, led to massive mining rush among the Spanish. With the accumulation of huge reserves of the most precious metal, provided the Spanish with uncontrolled wealth supply. Stormed by the rising military cost because of their ongoing wars, soon they became a victim of hyperination and began borrowing from other countries. Consistently defaulting on their debt repayment, In 1557, Spain went bankrupt!

3“A History of the world in 100 objects”,Neil MacGregor, 2010, pg 522

In Spain, its (ination’s) main cause was arguably the ood of bullion (precious metal coins) from the Americas, along with population growth, and government spending2.The Flood of Bullion, as you would now appreciate was due to the Spanish exploitation of South American resources. Population growth also adds to ination. The supply is limited and the demand keeps increasing. So does Government spending. Government expenditure tends to put more money in the economic system, thereby fuelling ination. Had the expenditure been for increase of supplyof products or services, it would have been a different case. But in our example, the Spanish Government spending was basically military expenditure, which created further inationary pressures. Such was the dominance of the Spanish Pieces of Eight that when the British authorities in Australia wanted to create a local currency, they converted these Pieces of Eight into ve shilling coins.

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GlossaryAlchemy:

Croesus:Croesus was the king of Lydia from 560 to 547 BC until his defeat by the Persian king Cyrus. Lydia (now eastern parts of Turkey) was arguably the richest nation during his reign.

Cyrus:Cyrus the Great (576 BC–530 BC) was the founder of Achaemenid Empire. He defeated Croesus and controlled his empire till 530(BC).

Alchemy is an inuential philosophical tradition whose early practitioners’ claim that profound powers were known to them, from antiquity. Practical applications of alchemy produced a wide range of contributions to medicine and the physical sciences.

Incas:The Inca Empire was the largest empire in pre-Columbian America. The Inca civilization arose from the highlands of Peru sometime in the early 13th century. The Inca Empire was the last sovereign political entity that emerged from the Andean civilizations before conquest by Spaniards.

Peru:

Luxury goods are products and services that are not considered essential.

Peru is a democratic republic divided into 25 regions in the continent of South America.

Need Base Products:

Luxury Products:

Ination is a general rise in prices of goods and services. Ination results in loss of value of money.

Ination:

Monetary System:A monetary system is a scheme developed by a government to facilitate exchange. It also provides a means to generate and measure wealth and debt.

Products that are essentially required.

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A person who is very knowledgeable and enthusiastic about an activity, subject, or pastime. A legal proceeding involving a person or business that is unable to repay outstanding debts.

Extremely rapid or out of control ination. Hyperination is a situation where the price increases are so out of control that the concept of ination is meaningless.

A legal proceeding involving a person or business that is unable to repay outstanding debts.

They are historical Spanish dollar Eight coins minted in the Americas from the late 15th century through the 19th century. Made of silver, they were in nearly worldwide circulation by the late 19th century and were legal currency in the United States until 1857.

Acionado:

Hyper Ination:

Moratorium:

Bankruptcy:

Pieces of Eight:

A period of time in which there is a suspension of a specic activity until future events warrant a removal of the suspension or issues regarding the activity have been resolved.

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LEARNING OBJECTIVES

• Conceptual understanding of “Barter System”• Evolution of Credit & Interest• Evolution of “Letter of Credit”• Conceptual understanding of “Loan for consumption” and “Loan for production”• Evolution of “Saving”

Chapter 2CREDIT, INTEREST, LOANS,DESIRES & ROTTING FISHES

- It is all in here!

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Credit facilities have been the backbone of any economic system. Assume a situation, when there was no money and we all lived our lives on barter. A situation where few individuals were involved in agricultural activities, few individuals were shing and few perhaps hunting. The hunters gave away their meat for sh from the shermen and the shermen gave away their shes for say barley. In simplest terms, this is what a barter system or an exchange system looked like.

From being barbaric to being civilized, humans have come a long way. Civilization in its simplest form ‘civility’ reects the ability of humans to co-exist in groups and develop economically, socially and culturally. One of the earliest known civilizations, the Mesopotamian Civilization, changed the way humans lived. It marked the beginning of social order and the beginning of a change from individual sustenance to community sustenance. The backbone of this community co-existence was the Barter system.

Excess has always created debacles. We saw in the previous chapter when Spain had excess of coins, it resulted in ination and an economic debacle. The French Revolution was also caused due to a currency and stock mismanagement leading to a nancial misfortune. Since 2008, we have witnessed a credit chaos, where expansion of baseless credit facilities almost created another Depression worldwide. Although, these discussions merit further explanation which we would undertake subsequently, we must study and understand the evolution and the concept of the word credit.

Barter system for its success had a unique requirement of a single authority in case of defaults on the barter. What if, our above mentioned farmers, required shes but had to wait for the harvesting of barley to initiate this required exchange? Also what if the farmer gave away the barley but sherman refused to provide the shes?

This meant that the authority or the then government was required not only for providing justice but also for providing solutions related to immediate consumption for a future promise of exchange. The solution lay in the development of credit and interest system.

Creditum, a Latin word for Credit reected the amount of money with which an individual or a group could be trusted. The concept was simple one could borrow today and repay later. This naturally would mean that the lender would be undergoing a certain amount of risk of losing the money. For this risk appetite, the lender should be rewarded in some manner. This reward came to be known as Interest.

Do You Know!! In India, we now have a creditworthiness check body called the CIBIL.

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Marc Von De Mieroop in the book ‘The origins of Value - The Financial Innovations that created Modern Capital Markets’ discusses the aspect of ‘Interest’ based on the materials from the period of 3200-1600 BC, as they were found in South Mesopotamia. Historians concur that ‘Credit’ and ‘Interest’ have therefore been pivotal for the development of civilizations.

From the same period, it becomes evident that any nancial obligation that needed to be fullled in the future was considered a loan. A promise to deliver wooden

4objects at a certain point in the future, for example was also phrased as Loan .

The image above shows a red clay with cuneiform inscription of around 1820 BC. The text records the loan of 9.33 grams of silver to Nabi-Ihshu from Sharmash. The tablet stipulates that the loan will be repaid with ‘Interest’

4The Origins of value: The Financial Innovation that Create ModernCapital Market.- William N Goetzman, K Geerth Rouwenhort Pg 17-25

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A loan for consumption is a contract under which the lender provides the borrower with consumable goods. And the borrower is obligated to return the goods with specied quantity & quality, within a given time period.

Whereas a production loan is a borrowing for purposes of generating returns on a commercial stage.

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The loan documents as shown in the adjacent image were generally red clay tablets with cuneiform inscriptions. Because of the nature of the loan contract as a document attesting that something was owed, it could be passed on from the original creditor to another person. This meant that the loan document could also act as a ‘Letter of Credit’5.

Over the past 3500 years, we have utilized the same concepts. And it is of no surprise as human necessities, although evolved, fundamentally remain the same. The farmers today also borrow from Micro credit agencies to sow seeds, the manufacturer borrows from banks to purchase raw material and we as consumers tend to borrow for fullling either our necessities such as homes or education or for fullling our wants and luxuries.

The interest paid on these loans are now market determined and regulated and as you can now appreciate are a reward that we pay to the nancial institutions for the risk that they undertake while providing for a loan against our creditworthiness.

The concept of Loan can broadly be divided as Loans for Consumption and Loans for Production.

Loans for production can be explained as borrowing for commercial purposes and are expected to generate returns in future. Logic and ethics call for a prudent behavior in dealing with such returns as the allocation of such returns should be rst towards the repayment of the borrowed loans.

Historically and even today, loans for consumption purposes are condemned as imprudent. Going by the same logic you may raise a moral question over the usage of personal credit cards.

to the present.

What Hammurabi wrote is still followed, almost 3000 years later!!

The Mesopotamian code of Hammurabi (1800 BC) made these rates legal maximums, establishing a tradition of interest rate regulations that has lasted

In the third millennium BC, Mesopotamians used both grains and ingots of silver as mediums of exchange. The customary interest rates were 33.33% per annum for loan of grains and 20% per annum for loan of silver.

- Homer, Sidney, Richar Sylla. A history of interest rates, 1996.

In the current context, the central bank manages these interest rates. In India, the role of Central Bank is played by the Reserve Bank of India.

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Credit, Borrowing, Loans and Interest form a backbone of our neo nancial systems but their roots are in history. Appreciating their necessity can further allow us to rationalize on these concepts and perhaps but somewhat difcult, allow us to rationalize our desires.

Because the desire to consume often does not match the timing of the receipts of income, individuals regularly engage in saving (consuming income from the past) and borrowing (consuming income from the future). And as mentioned above, saving is a more prudent form of meeting desire than borrowing for consumption.

It is indeed hard to imagine what the regular Mesopotamian (Sumerian) sherman who wanted barley must have done. The choice was either storing shes (letting them rot without the modern facilities) or borrow in lieu of a promise to supply shes at a later point of time!

Desire has no barter. As humans, we moved from the barter system to a more elaborate nancial system and so did our desires, which moved with the same pace and elaboration.

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Glossary

It is the risk of loss due to any change in the interest rates.

Richter Scale:

Pledge is a cash deposit or placing of owned property by a debtor (the pledger) to a creditor (the pledgee) as a security for a loan or obligation.

Default:

Richter scale is a Quantitative measure of earthquake-strength (magnitude) that indicates the seismic energy released by an earthquake at its epicenter (measured from a distance of 100 miles) on a 1 to 10 scale.

Sub-prime Crisis:Subprime mortgage crisis is a set of events and conditions that led to the late-2000s nancial crisis, characterized by a rise in subprime mortgage delinquencies and foreclosures, and the resulting decline of securities backed by said mortgages. It all

Pledge:

Probability:

Risk of Capital is the risk of loss of the amount invested, faced by company / individual.

Risk is the chance that an investment’s actual return will be different than expected. Risk includes the possibility of losing some or all of the original investment.

Risk of Interest:

Risk of time frame:

Probability is a measure of the expectation that an event will occur.

Risk of Capital:

Risk:

Risk of time frame is the risk that an investment’s value will change according to the different intervals of time.

Default is the inability to pay interest or principal when due. Default occurs when a debtor is unable to meet the legal obligation of debt repayment. Borrowers may default when they are unable to make the required payment or are unwilling to honor the debt within a specied time period.

started in 2006 with US Market tumbling down due to defaults by thesub-prime borrowers.

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A money changer is a person / institution which exchanges the currency of one country for that of another, at a xed or variable rate.

Money changers:

Medici Family: The Medici family was a political, banking family & later a royal house. The family originated in Mugello region and established the Medici bank in Florence, Italy. It was the largest and the most respected bank in Europe during the 15th century AD.

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LEARNING OBJECTIVES

• Understanding the Risk & Return Paradox• Conceptual understanding of Risk of Capital, Risk of Return, Risk of Time frame• Introduction of “Probability” to Risk & Return Paradox• Conceptual understanding of “Magnitude” in case of Risk of Capital• Evolution of Pledging, Mortgage Loans• Evolution of Trade & Banking

Chapter 3LESSONS FROM JACK & THE

BEANSTALK & FROMTHE RICHTER SCALE

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Jack was rewarded with a golden egg laying hen ONLY after he walked the chancy extra mile of climbing the beanstalk. Higher risk has higher the probability of high returns!

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Assuming you pay 1000 rupees to your friend, who promises to return 1100 in a year’s time, can you identify the principal, interest component and possible risks that you face?

What is of signicance is the identication of the risk. The rst and foremost risk is whether the capital will be returned, let alone the interest. The second risk is whether you would actually get the promised interest (or the reward that you get in return for taking this risk) and nally whether you would actually get your principal and interest within a year’s time.

To simplify, we may call them the Risk of Capital, Risk of Interest and Risk of Time frame.

Ideally, you would not lend at all if the probability of return is 0 but you may still take the risk of lending but at a higher interest. Similarly, you might not even charge interest or charge an exceptionally low interest, if you are certain that he will return the principal. Interest as we have discussed is the reward for taking that higher risk.

To begin with, the principal would be your 1000 rupees. The return or interest component is 100 rupees or in our case 10% over principal. This interest is what you are charging for the risk that you take in giving your friend the 1000 rupees.

This pure logic of understanding Risk and Return are actually taught to us in our pre-school days. Jack was indeed a brave boy, who took the grave risk of climbing a beanstalk and was rewarded with a golden egg laying hen! It would not be wrong to

What if, your friend is notorious for not returning or seldom returning the borrowed amounts? Assuming your friend pays back only 3 out of 10 times that he borrows what is the probability of his returning the money to you. In all simplicity, it is 0.3. What if he never pays back, the probability is 0 and what if he always pays back the probability is 1.

Seeds of Mortgage Crises!!

One of the great successes of the United States in this century has been the partnership forged by the national government and the private sector to steadily expand the dream of the homeownership to all Americans. Since 1993, nearly 2.8 million new househ olds have joined the ranks of America’s homeowners, nearly twice as in the previous 2 years. But we have to do a lot better. The goal of this strategy, to boost homeownership to 67.5 percent by the year 2000, would take it to an all time high, helping as many as 8 million American families across the threshold.-President Bill Clinton Remarks on the National Homeownership Strategy University of California- June 5 1995. (Adapted from The Rise & Fall of the US Mortgage & Credit Markets, James R Barth, Pg 30)

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In all truthfulness, Jack took a brave risk and probability supported him.

Till now, we have spoken of interest as a reward for taking a risk but what if, our magnitude of ‘risk of capital’ increases due to increase in loaned capital?

“Risk magnies with magnitude.”

Earthquake is most devastative when it is above 6.0 on the Richter scale. Similarly higher the capital loaned higher the devastation if there is a default on repayment. The same concept can easily be related to modern day borrowing of a consumer for home. Home loans are generally high capital loans and create serious risk of capital for the lender. In the case of a home loan, the house is pledged with the lender or in

simpler terms, the house would be owned by the lender in case the borrower defaults on repaying the loan. This measure safeguards the lender against possible default by the borrower and reduces the risk of capital.

Mortgage Loans today, generally, refer to Housing Loans across the world. In-fact, the US Sub Prime Crises was a direct effect of lending excessive loans to non credit worthy individuals or sub-prime individuals.

Returning to our favored example of your friend borrowing money from you, what if, your friend actually required a greater sum of money?

The concept of Risk of Capital is not new. Although lending by pledging a personal property was practiced in many ancient societies, the rst clear evidence of specialized safeguarded lending or pledged lending came in the fth century AD where Buddhist monasteries in China ran commercial operations of lending against pledged property. It is argued that India may have been the center of rst such commercial operations as Buddhism originated in India.6 Some temple run lending commercial units may have been done for charitable purposes but it is said that increasingly all such units started charging interest.

“Higher the Risk; Higher the Probability of high Returns”and

“Lower the Risk; Lower the Probability of low Returns”

6T. S Whelan, The Pawnshop in China, Ann Arbor, 1979.

As mentioned in the previous chapter, excess has always been detrimental for economies. In this case it was this excess of sub- prime lending that nally led to the full blown sub-prime crises.

money-lending.The development of entrepreneurship and international trade led to the prominence of

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By 1200’s, the government began to operate such operations and proceeds were used to fund military expenditures of China. In medieval Europe, money lending was mostly in the hands of the Jews and Italians.Why was the practice of money-lending gaining prominence? The answer lay in development of entrepreneurship and development of international trade. For international trade, capital was required for purchasing raw material from one country and then for managing the logistics of selling the raw material or semi nished product in another country.

International Trade created requirements not only of commercial lending shops but also for shops that were moneychangers. In Europe, Italians became pioneers in both money lending and money changing and the Medici Family of Florentine combined the two for creating the base for the Banking System.

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Glossary

It is the loan for Project / Business nancing and is linked to repayment through revenue generation.

Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets, over a period of time. It is most commonly the price paid for the use of borrowed money.

Letter of credit:

Loans for consumption is a contract express or implied under which a lender hands over certain consumable goods to a borrower and he is obligated to return the same or equivalent type of goods within a specied or reasonable time period.

Barter System:

Civilization is an advanced state of human society in which a high level of culture, science, industry and government has been developed.

Credit means to give or lend money

French Revolution:The French Revolution (1789–1799), was a period of radical social and political changes in France that had a major impact on the country and throughout the rest of Europe. The absolute monarchy that had ruled France for centuries collapsed in three years.

Depression:

Credit:

Depression is a severe and prolonged recession characterized by inefcient economic productivity, high unemployment and investments. There tends to be general economic pessimism.

Civilization:

Barter System is a trading system in which goods are exchanged for goods. In ancient times when money was not invented, trade as a whole was on barter system.

Interest:

A letter from a bank guaranteeing that a buyer’s payment to a seller will be received on time and for the correct amount.

Loans for consumption:

Loans for production:

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Saving is income not spent, or deferred consumption.

Credit Card:

Desire:

Saving:

Mesopotamia:

Any card that may be used repeatedly to borrow money or buy products and services on credit.

Desire is strong wants to which the person is dedicated. In economics, it is the difference between ‘need’ and ‘want’.

Mesopotamia (Modern day Iraq) encompassed the land between the Euphrates and Tigris rivers. The need for irrigation was the reason behind the evolution of Mesopo-tamian Civilization.

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LEARNING OBJECTIVES

• Conceptual understanding of government expenditure• Conceptual understanding of Fiscal Surplus/Decit• Dening Government Bonds• Relation between price of bond and interest rate

Chapter 4BIRTH OF FISCAL - WELFARE,

WARFARE AND THE ITALIAN JOB

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If successful, the wars of conquest more than paid for themselves as the victorious nations lled up their coffers from the defeated country’s looted resources.

Nearly, all wars are fought due to a nation’s internal economic conditions (for example scarcity of arable land), geographic greed (for example in search of more arable land) and to resist external threats. The patterns of victory and defeat in wars through the history have shaped the direction of the world economy and its

8institutions .

This cost, in simplest forms gave birth to Government Expenditure, an expenditure by the Government (governing body) for social welfare and in our case to meet the challenges of the Barter system.

It becomes evident that warehousing as a concept has been with us for more than 4500 years. It is logical to assume that the governing body to solve the problems of barter and to provide for rations engaged in warehousing and storage. The storage dilemma was solved but someone had to bear the cost for the storage.

In modern economic sense, all facilities including infrastructure investment and research facilities provided by the Government to facilitate economic development constitute government expenditure.

War and Finance

Barley as a key symbol in early Mesopotamia

8Joshua S Goldstein, The Oxfort Enclyopedia of World History, Volume 5, pg 216

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Whenever there is a time lag in receipt of income and immediate expenses, recall how savings or borrowings come to the rescue for an individual. In the same manner, the Government could also dig into its previous year’s surplus’ to meet current expenditure. If there were to be no previous year’s surplus, and the current revenues were not enough to meet the expenses then the government has no option but to borrow.

With the added dimension of warfare to welfare, we return to our unanswered question, “Who pays for this expenditure?”

Therefore printing currency could not have been the only solution. The Government had to earn revenue and that came through Taxes. The earliest taxes were paid in kind, since there was no money. Cattle, grain and wool were common in kind produce. In kind payments required record keeping and measurements and gave birth to the art of book keeping or modern day Accounting. Even with the invention of money, in

9kind payments continued to exist, especially in the agrarian societies.

Assume a situation of a country which has excessively high scal decit but intends to

The Government has the option of nancing this expenditure through generating revenues by levying taxes, by borrowing from the public or international community (raising debts) and by printing currency.

The creation of gold coinage by Lydia is perhaps the earliest known methods of nancing government expenditure. We have also read of how Spain’s issuance of ‘Pieces of Eight’ after its conquest of Potosi, dened Spanish economic success but also magnied the inationary spiral.

For the Government it becomes prudent to manage its decit as greater the scal decit, greater the chances of default by the government on its borrowings. Corollary, greater the scal decit of any government, lesser would be its creditworthiness in the eyes of potential lenders.

More elaborate study of the historic time frames reveals that warfare more than welfare, across these time frames constituted a larger percentage of the government expenditure. Wars created powerful nations and power created responsibility. Both welfare and warfare or social needs and security needs of the public added a dimension of responsibility for the government and consequently created a nancial burden of servicing them.

9David G Surdam, The Oxfort Enclyopedia of World History, Volume 5, pg 70-7210O’Sullivan, Arthur; Steven M. Sheffrin (2003). Economics: Principles in action.

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Recall the risk and return paradox and the answer is within your grasp.

War, declared the ancient Greek philosopher Heraclitus, is the father of all things. It was certainly the father of the bond market. The ability to nance war through a market for government debt was, like so much else in nancial history, an invention of

11the Italian Renaissance.

A crucial feature of the Florentine system was that such loans could be sold to other citizens if the investor needed ready money. In effect, then, Florence turned its citizens into its biggest investors. By the early fourteenth century, two thirds of the households had contributed in this way to nancing the public debt, though the bulk

12of subscriptions were accounted for by a few thousand wealthy individuals.

borrow for meeting its current expenditure. What kind of interest would such a country end up paying on its borrowings?

The issuance of a promissory note by the government to repay the loan with interest gave birth to one of the most important nancial instruments-Government Bonds. The need to borrow by the government was necessitated across the ages by innumerous wars and the burgeoning scal decits.

As we learnt in the previous chapter, the Medici family of Florence, (Italy) combined the art of lending and money changing and is credited with creation of the banking system.

Like most of the large companies of medieval and Renaissance Italy, the Medici not only housed an important banking but also brought and sold merchandise of all kinds. They were merchants who were into nancial businesses as well and funded their own expansion through the earnings of their enterprise.

The Italian Job

Italian states during the course of fourteenth and fteenth century were at war with each other. The states did not create their own armies but engaged independent military units for these incessant wars with other states. Florence not only due to the Medici’s but also due to ourishing trade was one of the richest states of Italy and undertook heavy expenses on account of war.

The heavy expenses of war created a government decit and the government of Florence engaged itself in raising loans from their own public.

In simplest form: Fiscal policy is the use of government revenue collection (taxation) 10and expenditure (spending) to inuence the economy.

11Niall Ferguson, The Ascent of Money-A nancial history of the world, pg 7012Niall Ferguson, The Ascent of Money-A nancial history of the world, pg 72-73

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The Italians to serve their warfare requirements developed one of the most powerful nancial tools, the Government bond, which not only nanced the debt but also became a trade-able instrument.

The Medici’s with a few other wealthy families also controlled most of the Florentine government and took deep care in making sure that interest was paid on the government borrowings against the issuance of the Bonds.

Now within the same month, the government realized that its scal requirements are not being met through the previous issue of bonds. Simply stated, the government was in need of more loans. Higher loan meant that the chances of default by the government went a notch higher and so did the risk of default for the public. Consequently, the public demanded more interest in lieu of the risk that they were taking. Let us assume that the interest rate was settled at 6%. This meant that the government could now borrow from the public at 6% interest and not at 5%. This also meant that the annual return on the bond for the public became 60 rupees from the previous 50 rupees. Let us call this bond, ‘Bond B’

What could be a way of removing this disparity between Bond A and Bond B?

In simplest terms, Rs 50 should ideally become 6% of the principal amount or mathematically

The government is the same and so are the risk for the public but the yields are different. One bond provides Rs 50 interest while the other provides Rs 60 interest to the public. Just in case someone wanted to sell Bond A in lieu of ready cash, nobody would buy it. The disparity had to be removed.

As mentioned above, such loans could be sold to other citizens if the investor needed ready money. How did Bonds become a trade-able instrument? And how were they traded?

Returning to our Risk and Return paradox, the Capital risk is Rs 1000, the interest rate risk is 5% and the time frame risk is 15 years.

Assume a situation where the government required a loan to fund its war decit and issued bonds of a particular currency. (Let us assume the currency as rupees.) So this particular government issued bonds of Rs. 1000 for 15 years and was willing to pay the investor say 5% on an annual basis. Corollary this meant that the public could provide the government a loan of Rs 1000 for 15 years and would generate 5% or 50 rupees return on an annual basis. Let us call this bond ‘Bond A’

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X= 50/6% or X=833.3

6% of X= 50

Notice how the price of the bond fell from Rs 1000 to Rs 833.3 as interest rate rose from 5% to 6%.

The whole nancial bond market is a little more complicated than the current example but the previous example should be enough to illustrate the reason for the inverse relationship between the interest rate and the price of the bond.

Debt in simplest terms would mean ‘Promise to Repay’. Unfortunately in our Italian war example, the heavy expense towards war nally led to a disastrous decit and the Italian government actually defaulted on the repayment of the Bonds.

The treasury bonds are also referred as Fixed Income Instruments or Debt Instruments.

In modern jargons, if the government defaults on repaying the loans borrowed through such bonds, the bonds are termed as ‘Junk Bonds’.

Let us just summarize what Debt really means.

Bond A:Price = Rs. 1,000Time =15 YearsInterest = 5% p.a.

Bond B:Price = Rs.1,000Time = 15 YearsInterest = 6% p.a.

The Treasury bonds as they are referred today are one of the most traded instruments in the world.

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Glossary

Fiscal Policy deals with tax rates and government expenditures in order to control macro economic factors like ination, unemployment, interest rates etc.

Surplus:

Government Expenditure:

Currency:

Fiscal Policy:

Fiscal Decit:

Surplus is the quantity left due to fullment of the requirements.

The expenditure made by the government on purchase of nal goods and services. It is used by the government to manage functions like Education, Banking, Defense, Railways etc.

Currency is something that is generally accepted and is used as a medium of exchange.

Debt:

Accounting:

Agrarian Society:

Debt is the money borrowed by an entity from another. These entities/parties could be government, companies, individuals etc. The debt incurred by a party on a condition to be paid back on a later date, usually, with interests.

The act of systematic recording, summarizing, analyzing and reporting of nancial transactions of a business is referred to as Accounting.

It is a society / Culture which relies heavily on agricultural activities as a means of their livelihood.

Fiscal Decit is the difference between government's expenditures and its revenue, which is excludes borrowing.

Promissory note: It is a written document between two parties, where one promises to pay a specied amount to another on a specied date.

Renaissance:Renaissance or rebirth, is a known revival of art, culture, literature, which began in Italy and spread through Europe in the 14th century AD.

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Bond:Bond is an instrument of indebtedness of the bond issuer to the holders.

Treasury Bonds:

Junk Bonds are corporate bonds with high yield and high-risk.

Treasury bond is a marketable, xed-interest U.S. Government Bond, which is also known as T – Bond. It has a maturity of more than 10 years.

Junk Bonds:

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LEARNING OBJECTIVES

• Conceptual understanding of raising capital for a company• Dening working capital• Introduction of rst-ever joint stock company• Conceptual understanding of Limited Liability

Chapter 5CREATIVE DESTRUCTION,

CORPORATE FINANCE ANDTHE LEGACY OF MUSCOVY

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The development of the nancial system owed its success to agents who were willing to innovate - the wild spirits (entrepreneurs) as coined by the Austrian-American Economist, Joseph Schumpeter.

The earlier innovations like the Bond market, (as previously learnt) had supported the government in meeting their expenditures but gradually the innovations in the nancial systems, gained momentum with the creative destruction brought about by the Entrepreneurs, who also gave birth to the capitalistic economic structures.

From a micro level standpoint, the need of capital was imminent. How could a rm raise money to establish itself and to nance growth?

Leaders of the corporations became important political leaders, as in the case of Medici family of Florence, formerly representatives of the corporations of bankers and traders. This in turn gave impetus to various entrepreneurs to corporatize, to get legal sanctions and to develop mechanisms to access capital.

The beginning of the twelfth century saw the feudalist system give way to the creation of the commune or the newer corporations in economic life. Corporations cropped out throughout Europe. Corporations for example in Italy came up in various forms like the Mercadantia-a corporation of merchants and Artes-a corporation of artisans.

Much of the theory on entrepreneurship is laid down by Joseph Schumpeter. His fundamental theories are often referred to as Mark I and Mark II. In the rst, Schumpeter argued that the innovation and technological change of a nation comes from the entrepreneurs, or wild spirits. He coined the word Unternehmergeist, German for entrepreneur-spirit. In Mark II, he asserted that the agents that drive innovation and the economy are large companies which have the resources and

13capital to invest in research and development.

Throughout history, most of the rms were largely nanced through the risk appetite of the rm’s owners and his or her friends, family and business acquaintances.

Working capital - the monies required to support the ongoing day to day activities of the rm and investment capital-those monies required to nance long-term

14 development tended to be personal in nature. Increasingly, the entrepreneurs found it difcult to grow with limited personal nance and started seeking working capital from the banks and long-term investments from the stock market. With industrialization, rms increasingly raised capital from the nancial markets through equity capital and through issuance of its own corporate bonds.

13Schumpeterian patterns of innovation Camb. J. Econ. (1995) 19 (1): 47-6514Sue Bowden, Corporate Governance in a Political Climate. Chapter 8, pg 175

The rst joint stock company was formed in 1553 called Muscovy.

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Muscovy with its concept of joint stock created a very powerful corporate nancing instrument-the equity.

Subscription to equity or stock meant that it was now possible for entrepreneurs to raise nance which was not supported by a promissory note. Equity and Stock in true sense meant ownership and the stock owners were owners of the corporation. The return on the investment was completely linked with the success of corporation. Stocks also provided an opportunity to the entrepreneurs to possibly take greater risks in hope for greater rewards. Muscovy for example was indeed a very risky venture and in the rst voyage lost all its crew members.

Muscovy never made it to China but on their third voyage they met with success in creating a mercantile relationship with Russia. Soon afterwards Levant and East India Company were formed with similar concept in England.

Bonds as learnt previously, are promissory notes and the corporations issued such notes to raise capital to meet their long-term growth requirements. The corporations promised xed interest rates to the loan providers. The concept is very similar to the modern day concept of Non Convertible Debentures (NCD’s)

Entrepreneurs are wild spirits and the rst known joint stock company Muscovy is a true testimony of the same. It was the year 1553 and England was in complete economic mess. Few spirited individuals came together to create a company Muscovy-’Mystery and Company of Merchant Adventurers for the Discovery of Regions, Dominions, Islands, and Places Unknown’ - whose purpose was to create mercantile relations with unknown geographical boundaries. The company’s grand idea was to create a trading link up with the then Cathay or China. The company was the joint enterprise of the crown (English Monarchy) and 200 inuential and wealthy individuals who subscribed pound 6000 for the project.

Non - convertible debentures are the debentures which can’t be converted into shares or equities.

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The joint stock company was further rened with the legal denition of limited liability, which restricts the liability of the members for the company’s debts

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Glossary

A joint stock company is a business entity which is owned by shareholders.

Non Convertible Debentures:

Feudalist System:

Non-Convertible debentures are the debentures which can’t be converted into shares or equities.

Entrepreneurs:

Limited liability is a type of liability in which the nancial liability of the person remains xed.

Limited Liability:

Joint Stock Company:

An entrepreneur is a person who organizes and operates business (es) and taking on nancial risk to do so.

A system of ownership usually associated with pre-colonial England, in which the king or other sovereign is the source of all rights.

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SECTION BComprehensive Approach

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LEARNING OBJECTIVES

• Introduction of Financial Markets• Introduction of Primary & Secondary Market• About IPO, Shares & Share Market• Introduction of Equity and Equity Market• Introduction of Derivates & Derivative Market

Chapter 6FINANCIAL MARKETS

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A market is dened as the sum total of all the buyers and sellers in the area or region under consideration. The area may be the earth, or countries, regions, states, or cities.

A nancial market may be a physical location or a virtual one over a network (for example, the Internet). Here, people who have a specic good or service they want to sell (the supply) interact with people who wish to buy it (the demand).Prices in a nancial market are determined by changes in supply and demand. If market demand is steady, an increase in market supply results in a decline in market prices and vice versa. If market supply is steady, a rise in demand results in a rise in market prices and vice versa.

Market

The value, cost and price of items traded are as per forces of supply and demand in a market. The market may be a physical entity, or may be virtual. It may be local or global, perfect and imperfect.

Financial MarketThe nancial market is a broad term describing any marketplace where trading of securities including equities, bonds, currencies and derivatives occurs. Although some nancial markets are very small with little activity, some nancial markets including the New York Stock Exchange (NYSE) and the forex markets trade trillions of dollars of securities daily.

Producers advertise goods and services to consumers in a nancial market in order to generate demand. Also, the term "market" is closely associated with nancial assets and securities prices.

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In case you have always dreamt of starting your own business. You love pizza, and you have done your homework to gure out how much it would cost to launch a new pizza business and how much money you could expect to earn each year in prot. For instance the hypothetical costs that you have identied are as follows:

• Annual expenses (ingredients, employee salaries,

In this case, if investors paid a total of $750,000 for shares in the pizza restaurant, they could expect to earn $75,000 annually - which means that they can expect a complete 10 % as return.

You could take a loan, but for that you need to pay interest & thereby increase your liability.

utilities) would cost an additional $250,000.

WHY SHARES?Let’s take an example to understand the concept:

• Building and Equipment would cost $500,000.

• With annual earnings of $325,000.• You expect to make a $75,000 prot each year.

The only problem is that you don't have $750,000 (building + equipment + expenses) in cash to cover all of those costs.

What about nding investors who would give you money in exchange for a share of the ownership of the restaurant?

This is the logic that companies use when they make the decision to issue stock to investors. They believe that the company will be protable enough that investors will see a good return.

As the owner of the pizza restaurant, you can set the initial price of the company, as well as the total number of shares of stock you want to sell. Each person who buys a share of stock essentially owns a piece of the company and has a say in how the

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A securities market is an exchange where sale and purchase transactions of securities are conducted on the basis of demand and supply. A well-functioning securities market should be able to provide timely and accurate information on the past transactions, liquidity, low transaction costs (internal efciency) and securities prices that rapidly adjusted to all available information

(external efciency).

There are two levels of securities markets: A Securities market is an exchange where sale and purchase transactions of securities are conducted on the base of demand and supply. A well-functioning securities market should be able to provide timely and accurate information on the past transactions, liquidity, low transaction costs (internal efciency) and securities prices that rapidly adjusted to all available information (external efciency).

company is run. That is why the understanding of nancial markets becomes essential.

Securities Market

There are two levels of securities markets:

The primary market refers to the market where securities are created, while the secondary market is one in which they are traded among investors. Knowing how the primary and secondary markets work is key to understanding how stocks trade.

The word "market" can have many different meanings, but it is used most often as a catch-all term to denote both the primary market and the secondary market. In fact, "primary market" and "secondary market" are both distinct terms.

Primary & Secondary Market

Capital Market Money Market

Financial Market Overview

Finance Market

Primary Market Secondary Market

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An IPO is also referred to as a public offering. When a company initiates the IPO process, a very specic set of events occurs. The chosen underwriters facilitate all of these steps.

An initial public offering (IPO) is the rst time that the stock of a private company is offered to the public. IPOs are often issued by smaller, younger companies seeking capital to expand, but they can also be done by large privately owned companies looking to become publicly traded. In an IPO, the issuer obtains the assistance of an underwriting rm, which helps determine what type of security to issue, the best offering price, the amount of shares to be issued and the time to bring it to market.

Without them, the stock market would be much harder to navigate and much less protable.

The secondary market commonly referred to as the "stock market." This includes the New York Stock Exchange (NYSE), Nasdaq and all major exchanges around the world. The dening characteristic of the secondary market is that investors trade among themselves. That is, in the secondary market, investors trade previously issued securities without the issuing companies' involvement. For example, if you go to buy Microsoft stock, you are dealing only with another investor who owns shares in Microsoft. Microsoft is not directly involved with the transaction.

Initial Public Offering

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The stock market is a nancial market that enables investors to buy and sell shares of publicly traded companies. The primary stock market is where new issues of stocks are rst offered. Any subsequent trading of stock securities occurs in the secondary market.

Equity and Equity Market

The value of a company, divided into many equal parts owned by the shareholders is referred to as equity.

Stocks are securities that are a claim on the earnings and assets of a corporation.

Shares and Share Market

An external IPO team is formed, consisting of an underwriter, lawyers, certied public accountants (CPAs) and Securities and Exchange Commission (SEC) experts.

The capital of a company is divided into shares. Each share forms a unit of ownership of a company and is offered for sale so as to raise capital for the company Shares can be broadly divided into two categories - equity and preference shares. Equity shares give their holders the power to share the earnings/prots in the company as well as a vote in the AGMs of the company. Such a shareholder has to share the prots and also bear the losses incurred by the company.

A stock market, equity market or share market is the aggregation of buyers and sellers of stocks (also called shares), which represent ownership claims on businesses; these may include securities listed on a public stock exchange as well as those only traded privately.

The Stock Market is a series of exchanges where successful corporations go to raise large amounts of cash to expand. Stocks are shares of ownership of a public corporation that are sold to investors through broker dealers.

The equity market (often referred to as the stock market) is the market for trading equity instruments.

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Derivatives are nancial contracts that derive their value from an underlying asset. These could be stocks, indices, commodities, currencies, exchange rates, or the rate of interest. These nancial instruments help you make prots by betting on the future value of the underlying asset. So, their value is derived from that of the underlying asset. This is why they are called 'Derivatives'.

A derivative is a security with a price that is dependent upon or derived from one or more underlying assets. The derivative itself is a contract between two or more parties based upon the asset or assets. Its value is determined by uctuations in the underlying asset.

An example of an equity instrument would be common stock shares, such as those traded on the New York Stock Exchange.

Derivates and Derivate Market

For example, a stock's value may rise or fall, the exchange rate of a pair of currencies may change, indices may uctuate, commodity prices may increase or decrease. These changes can help an investor make prots. They can also cause losses.

This is where derivatives come handy. It could help you make additional prots by correctly guessing the future price, or it could act as a safety net from losses in the spot market, where the underlying assets are traded.

The derivative market in India, like its counterparts abroad, is increasingly gaining signicance. Since the time derivatives were introduced in the year 2000, their popularity has grown manifold.

Let us take an example, a farmer fears that the price of Wheat (underlying), when his crop is ready for delivery will be lower than his cost of production due to the bumper crop that led to high supply.

Understanding Derivatives Through a Detailed Example

Let's say the cost of production is Rs.8,000 per ton. In order to overcome this uncertainty in the selling price of his crop, he enters into a contract (derivative) with a merchant, who agrees to buy the crop at a certain price (exercise price), when the crop is ready in three months time (expiry period).

EARN MONEYWITHOUTPHYSICAL

SETTLEMENT

HEDGINGAGAINST PRICEFLUCTUATIONS

ARBITRAGETRADING

TRANSFEROF RISK

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This is because the farmer can sell the Wheat he has produced at Rs.9000 per tonne even though the market price is much less. Thus, the value of the derivative is dependent on the value of the underlying.

If the selling price of Wheat goes down to Rs.7,000 per ton, the derivative contract will be more valuable for the farmer, and if the price of Wheat goes down to Rs 6,000, the contract becomes even more valuable.

In this case, say the merchant agrees to buy the crop at Rs.9,000 per ton. Now, the value of this derivative contract will increase as the price of Wheat decreases and vice-a-versa.

If the underlying is a nancial asset like debt instruments, currency, share price index, equity shares, etc, the derivative is known as a nancial derivative.

The contract also has a xed expiry period mostly in the range of 3 to 12 months from the date of commencement of the contract. The value of the contract depends on the expiry period and also on the price of the underlying asset.

Derivatives are specialised contracts which signify an agreement or an option to buy or sell the underlying asset of the derivate up to a certain time in the future at a prearranged price, the exercise price.

The word 'derivative' originates from mathematics and refers to a variable, which has been derived from another variable. Derivatives are so called because they have no value of their own. They derive their value from the value of some other asset, which is known as the underlying.

If the underlying asset of the derivative contract is coffee, wheat, pepper, cotton, gold, silver, precious stone or for that matter even weather, then the derivative is known as a commodity derivative.

More about DerivativesThe primary objectives of any investor are to maximise returns and minimise risks. Derivatives are contracts that originated from the need to minimise risk.

Derivative contracts can be standardized and traded on the stock exchange. Such

For example, a derivative of the shares of Infosys (underlying), will derive its value from the share price (value) of Infosys. Similarly, a derivative contract on Wheat depends on the price of Wheat.

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Such derivatives are called over-the-counter (OTC) derivatives. Continuing with the example of the farmer above, if he thinks that the total production from his land will be around 150 quintals, he can either go to a food merchant and enter into a derivatives contract to sell 150 quintals of Wheat in three months time at Rs 9,000 per ton. Or the farmer can go to a commodities exchange, like the National Commodity and Derivatives Exchange Limited, and buy a standard contract on Wheat.

The standard contract on Wheat has a size of 100 quintals. So the farmer will be left with 50 quintals of Wheat uncovered for price uctuations.

derivatives are called exchange-traded derivatives. Or they can be customised as per the needs of the user by negotiating with the other party involved.

However, exchange traded derivatives have some advantages like low transaction costs and no risk of default by the other party, which may exceed the cost associated with leaving a part of the production uncovered.

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LEARNING OBJECTIVES

• Understanding Economy• Understanding types of economy• About Trade Cycle• About Market Failure.

Chapter 7ECONOMY

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EconomyEconomy is the large set of inter-related production and consumption activities that aid in determining how scarce resources are allocated. This is also known as an economic system.

Economics is a social science concerned with the production, distribution and consumption of goods and services.

I t s t ud ie s how i nd i v idua l s , businesses, governments and

nations make choices on allocating resources to satisfy their wants and needs, and tries to determine how these groups should organize and coordinate efforts to achieve maximum output.

Economics can generally be broken down into macroeconomics, which concentrates on the behaviour of the aggregate economy, and microeconomics, which focuses on individual consumers.

Microeconomics

An entire network of producers, distributors and consumers of goods and services in a local, regional or national community constitutes the economy.

The word “Micro” has come from a Greek word “Mikros” which means millions of parts. Microeconomics discusses about individual parts of the whole economy. Microeconomics is also called price theory.

According to the economist Henderson —“Microeconomics is the study of the economic actions of individuals and well dened groups of individuals.”

Microeconomics is the study of decisions that people and businesses make regarding the allocation of resources and prices of goods and services. This means also taking into account taxes and regulations created by governments. Microeconomics focuses on supply and demand and other forces that determine the price levels seen in the economy. For example, microeconomics would look at how a specic company could maximize its production and capacity so it could lower prices and better compete in its industry.

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2. To provide tools for economic policies.

Example - Micro economics:

4. Efcient utilisation of resources.

6. Useful in decision making

The word “Macro” comes from a Greek word “Makros” which means large. Macroeconomics is concerned with aggregates and averages of the entire economy, such as national income, savings and investments, aggregate demand and supply etc.

Microeconomics gives its focus to individual sections of the economy, for example Raj is concerned about the changes in the price of petrol, which is different from macroeconomics at which Raj would serve his concern in the general increase in prices (ination).

Microeconomics occupies a vital place in economics and it has both theoretical and practical importance. It is highly helpful in the formulation of economic policies that will promote the welfare of the masses.

Importance of micro economics:

1. To understand the operation of an economy.

Macroeconomics:

Macroeconomics is the income theory that explains the level of total production and why the level rises and falls. Macroeconomics is the eld of economics that studies the behaviour of the economy as a whole and not just on specic companies, but entire industries and economies.

Macroeconomics deals not with individual quantities but with aggregates of these quantities, not with individual incomes but with national income, not with individual price but with price level, not with individual output but with national output.

Another example could be that Apple Inc is concerned on how many iPhone 6 should be exported to South Africa, as compared to American export of goods and services in South Africa.

3. To examine the condition of economic welfare

5. Useful in international trade.

7. Useful in optimal utilisation of resources and price determination.

This looks at economy-wide phenomena, such as Gross Domestic Product (GDP). It is the broadest quantitative measure of a nation's total economic activity. More specically, GDP represents the monetary value of all goods and services produced within a nation's geographic borders over a specied period of time and how it is affected by changes in unemployment, national income, rate of growth, and price levels.

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For example, macroeconomics would look at how an increase/decrease in net exports would affect a nation's capital account or how GDP would be affected by unemployment rate.

3. No science can study its entire eld without attempting some sort of aggregative approach.

THE TRADE CYCLE

2. The study of macroeconomics is indispensable for understanding the working of the economy of a country.

1. The study of macro economics becomes the basis of formulation and successful execution of government economic policies.

Importance of Macro Economics

The trade cycle refers to the ups and downs in the level of economic activity which extends over a period of several years. If we examine the past statistical record of the business conditions, we will nd that business has never run smoothly for ever. There are many uctuations in the period. Sometimes prosperity is followed by adversity. In Economics this tendency of the business activities, to uctuate from prosperity to adversity is called business cycle.

Transfers Taxes

Disposableincome Government

borrowing

Total Income= Total Production

GDP

Investment

ExportsImports

Rest ofthe world

Households

Government

FinancialInstitutions

Firms

Consumption Consumptionplus net exports

Recov

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Boom

Depression

Full

Employment

Numbers of Years

Level

of

Econom

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Rec

over

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Phases of the trade cycle:

1. Slump or Depression :-

2. Recovery :-This phase develops when the stock with the businessman is exhausted. Due to this cost begins to decline and the prices which are at its lowest level stop falling further. There is complete harmony between cost and price. Prot begins to re-appear in the business. The repairs and replacement of capital equipment starts. There is a gradual re-employment of labour. The money income increases the purchasing power. Government also starts some productive and non-productive projects. The commercial banks also expand the credit.

In the period of depression economic activities are low and there is a fall in the national income, employment and production. The costs are relatively higher than the prices. Prot falls and there is a reduction in the consumer and capital goods, producer suffers loss. Bank credit demand also falls. Effective demand and savings remains low.

In this phase economic activities increases production, prices, employment, wages, interest rate, prot volume of credit and investment also increases. New plants and factories are set up and old ones are fully utilized. Demand for labour increases and there is a rich prot.

In this phase the costs begin to increase more than the prices. Because the less efcient factors of production are employed at higher costs. The prot begins to disappear. There is a fall in the production, Investment and employment. Even the businessman closes the business.

The uncertainty created by a volatile business cycle tends to cause lower investment, and this can lead to lower long-term economic growth.

A volatile business cycle is considered bad for the economy. A period of economic boom (rapid growth in GDP) invariably leads to ination with various economic costs. This inationary growth tends to be unsustainable and leads to a bust (recession).

The biggest problem of the business cycle is that recession represents a large wastage of resources. A prolonged period of unemployment can also lead to a loss of labour productivity as workers get discouraged and leave the labour market.

4. Recession :-

Impact of business cycle on economy

3. Expansion Phase or Boom :-

The recession phase comes to an end and goes into depression. These four phases go on replacing each other.

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Trough

The expansion phase started in the third quarter of 2009 when GDP rose 1.3 percent. That was thanks to the stimulus spending from the American Recovery and Reinvestment Act. The unemployment rate continued to worsen, reaching 10.0 percent in October. Four years into the expansion phase, the unemployment rate was still above 7 percent.

Recession The 2008 recession was so nasty because the economy immediately contracted 2.7 percent in the rst quarter of 2008. When it rebounded 2 percent in the second quarter, everyone thought the downturn was over. But it contracted another 1.9 percent in the third quarter, before plummeting a whopping 8.2 percent in the fourth quarter.

That's because the contraction phase was so harsh.

The trough occurred in the second quarter of 2009, according to the NBER. GDP contracted 0.5 percent. Unemployment rose to 9.5 percent.

The economy received another wallop in the rst quarter of 2009 when it contracted a brutal 5.4 percent. The unemployment rate rose from 5.0 percent in January to 7.3 percent by December.

Expansion

How these phases of business cycle occur in an economy, let's take an example:

Some economists argue that the business cycle is an essential part of an economy. Even downturns have their role to play as it tends to 'shake-up' the economy and weed out 'inefcient' rms and creating greater incentives to cut costs and be efcient. However, this view is controversial, and other economists argue that in a recession, even 'good efcient' rms can go out of business leading to a permanent loss of productive capacity.

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1. Negative externalities (e.g. the effects of environmental pollution) causing the social cost of production to exceed the private cost

The peak that preceded the 2008 recessions occurred in the third quarter 2007. GDP growth was 2.7 percent. For other examples, see History of Recessions.

3. Imperfect information or information failure means that merit goods are under-produced while demerit goods are over-produced or over-consumed

7. Equity (fairness) issues Markets can generate an 'unacceptable' distribution of income and consequent social exclusion which the government may choose to change.

Market Failure is an economic term that encompasses a situation where, in any given market, the quantity of a product needed by consumers does not equate to the number supplied by producers. In economics, market failure is a situation that

4. The private sector in a free-markets cannot protably supply to consumers pure public goods and quasi-public goods that are needed to meet people's needs and wants

5. Market dominance by monopolies can lead to under-production and higher prices than would exist under conditions of competition, causing consumer welfare to be damaged

2. Positive externalities (e.g. the provision of education and health care) causing the social benet of consumption to exceed the private benet

Market failure happens when the price mechanism fails to allocate scarce resources efciently or when the operation of market forces lead to a net social welfare loss. Market failure exists when the competitive outcome of markets is not satisfactory from the point of view of society.

Markets can fail for lots of reasons:

Peak

6. Factor immobility causes unemployment and a loss of productive efciency

Market Failure

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allocation of products and services is not efcient. In simple terms market failure occurs when markets do not bring about economic efciency. There is a clear economic case for government intervention in markets where some form of market failure is taking place

Governments intervene in markets to address inefciency. In an optimally efcient market, resources are perfectly allocated to those that need them in the amounts they need. In inefcient markets that is not the case; some may have too much of a resource while others do not have enough. Inefciency can take many different forms. The government tries to combat these inequities through regulation, taxation, and subsidies.

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Glossary

Gross Domestic Product is one of the primary indicators which is used to know the growth and development of country’s economy.

Economic Growth is referred to an increase in aggregate productivity . There is an increase in the capacity of an economy to produce goods and service, which is compared from one period of time to another.

Negative Externalities refers to the cost suffered by a a thrid party due to production and consumption of good. The transaction can be monetary also.

Economic Growth -

Gross Domestic Product -

Negative Externalities -

Regulatory actions taken by a government in order to affect or interfere with decisions made by individuals, groups, or organizations regarding social and economic matters.

Recession -

Government Intervention-

A signicant decline in activity across the economy which may last longer than few months which has a visible impact on GDP, Income, Employment, Industrial Production and Retail Sales.

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LEARNING OBJECTIVES

• Understand the concept of Ination.• Classify the various types of Ination.• Analyse the various measures to Control Ination (Monetary and Fiscal Policies)

Chapter 8INFLATION AND

INFLATION CONTROL

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Glossary

It is a place where shares of pubic listed companies are traded.

Finance is a eld that deals with the study of investments.

is where companies oat shares to the general public in an initial public offering (IPO) to raise capital.

Finance -

Initial public offering or stock market launch is a type of public offering in which shares of a company usually are sold to institutional investors that in turn, sell to the general public, on a securities exchange, for the rst time.

Derivative -

Initial Public Offering (IPO) -

Stock Market -

The Primary Market -

Security and Exchange Board of India (SEBI) -The secondary market or the stock exchanges are regulated by the regulatory authority.

Derivative is a security with a price that is dependent upon or derived from one or more underlying assets.

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What is Ination?

Economists today tend to agree that the main cause of ination is 'too much money chasing too few goods’

Ination occurs when prices rise. Low ination is a very important aim for any country.

Ination is normally measured as a rate per year.

Amidst all the expensive things today, one thing is for sure: prices would denitely continue to rise. All because of one culprit, Ination.

Ever heard your grandparents recall how simple life was during their time? Back in the days, people could survive with basic necessities by bringing just Rs. 100 as their salary.

CONCEPT OF INFLATION

Did you know that when McDonalds launched the big Mac in 1967 its cost was only $ 0.45 and in the year 1995 it cost $2.45 where as in 2015 it cost $5.30 but today the same Big Mac costs $8.70!!!

"Ination is inevitable like death" is the saying of one of the economists.

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This means people are able to increase their spending on goods and services faster than producers can supply the goods and services they want to buy.

The rise in spending causes an excess of aggregate demand for goods and services and their prices are forced upwards.

Ination is the increase in the average pricelevel of goods and services over time.

When prices rise - Each unit of the currency buysfewer goods and services.

Therefore it reduces the purchasingpower of money.

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Consider the following scenario to understand the impact on a country when Ination continues to prevail for a long period of time.

Country X - Rapid InationWorkers wages will not buy as many goods as beforeWhich means that peoples real incomes will fallReal income is the value in terms of what can be bought of an income.If a worker receives 5% wage increase but prices rise by 10% then the workers real income has fallen by 50%. Workers may demand higher wages - so that their real income increases.Prices of the goods produced in Country X will be higher than those in other countries. People may buy foreign goods instead and hence jobs in Country X will be lost.Businesses will be unlikely to want to expand and create more jobs in the future. The living standards in Country X are likely to fall.

Causes of Ination:

There is no such cause that's universally agreed upon, but at least two theories are generally accepted while the debate still goes on:

1. A depreciation of the exchange rate increases the price of imports and reduces the foreign price of a country's exports. If consumers buy fewer imports, while exports grow, AD in will rise – and there may be a multiplier effect on the level of demand and output.

What are the main causes of Demand-Pull Ination?

1. Demand-Pull Ination – This theory can be summarized as “too much money chasing too few goods”. It is a mismatch between demand and supply if demand is growing faster than supply, prices will increase. This usually occurs in growing economies as more people gain purchasing power while the supply is not able to catch up to growing demand. When the government of a country print money in excess, prices increase to keep up with the increase in currency, leading to ination.

3. Monetary stimulus to the economy: A fall in interest rates may stimulate too

2. Higher demand from a scal stimulus e.g. lower direct or indirect taxes or higher government spending. If direct taxes are reduced, consumers have more disposable income causing demand to rise. Higher government spending and increased borrowing creates extra demand in the circular ow.

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4. Fast growth in other countries – providing a boost to UK exports overseas. Export sales provide an extra ow of income and spending into the UK circular ow – so what is happening to the economic cycles of other countries denitely affects the UK.

5. The rst country to hyperinate in the 21st century is Zimbabwe. In 2008, a loaf of bread cost 1.6 trillion Zimbabwe dollars. Ofcials in Zimbabwe blamed it on rising global food prices and international sanctions.

2. The post-WWII hyperination of Hungary holds the record for the most rapid monthly ination increase ever: 41,900,000,000,000,000% for July 1946, which means prices doubled every 13.5 hours.

Some interesting facts about Ination

much demand – for example in raising demand for loans or in leading to house price ination. Monetarist economists believe that ination is caused by “too much money chasing too few goods" and that governments can lose control of ination if they allow the nancial system to expand the money supply too quickly.

8. The high mortality rate during the Bubonic Plague in Europe increased the supply of available currency, which in turn created substantial ination until the mid 1370s. Higher ination decreased the purchasing power of wage laborers, so that even though they were paid more, their higher wages could not purchase more.

3. In 2008, the top three countries with the most ination were Zimbabwe (12,563.0%), Burma (35%), and Guinea (23.4%).

4. In 2008, the three countries with the lowest ination rates were Naru (-3.6%), San Marino (-1.5%), and Burkina Faso (-0.2%).

1. The Zimbabwean dollar bank note holds the record for the greatest number of zeros shown (100,000,000,000,000). Hungary holds the record for the largest banknote ever issued, but its bank note did not depict all the zeros—the amount was spelled out.

7. Imported gold and silver from the New World caused widespread ination in Europe between the 15th and 17th centuries.

9. The annual ination rate in the United States has uctuated greatly over its history, ranging from nearly zero ination to 23% ination. The federal government tries to keep ination around 2-3%.

6. Twenty-eight hyperinations occurred in the 20th century, with twenty happening after 1980.

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10.Hyperination occurred in Germany in 1920, leading to great social unrest. The purchasing power of money fell so low that the German currency, the Mark, became cheaper than rewood. Hitler blamed the Jews for spiraling ination,

awhich helped pave the way for the Holocaust.

1. Component costs: e.g. an increase in the prices of raw materials and other components. This might be because of a rise in commodity prices such as oil, copper and agricultural products used in food processing. A recent example has been a surge in the world price of wheat.

Cost-push ination occurs when rms respond to rising costs by increasing prices in order to protect their prot margins.

There are many reasons why costs might rise:

3. Expectations of ination are important in shaping what actually happens to ination. When people see prices are rising for everyday items they get concerned about the effects of ination on their real standard of living. One of the dangers of a pick-up in ination is what the Bank of England calls “second-round effects" i.e. an initial rise in prices triggers a burst of higher pay claims as workers look to protect their way of life. This is also known as a “wage-price effect”.

2. Cost-Push Ination – When production costs go up, there is an increase in prices to maintain prot margins. Increased costs can include things such as wages, taxes, or increased costs of imports.

2. Rising labour costs - caused by wage increases, which are greater than improvements in productivity. Wage costs often rise when unemployment is low because skilled workers become scarce and this can drive pay levels higher. Wages might increase when people expect higher ination so they ask for more pay in order to protect their real incomes. Trade unions may use their bargaining power to bid for and achieve increasing wages, this could be a cause of cost-push ination.

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5. A fall in the exchange rate – this can cause cost push ination because it leads to an increase in the prices of imported products such as essential raw materials, components and nished products.

4. Higher indirect taxes – for example a rise in the duty on alcohol, fuels and cigarettes, or a rise in Value Added Tax. Depending on the price elasticity of demand and supply for their products, suppliers may choose to pass on the burden of the tax onto consumers.

6. Monopoly employers/prot-push ination – where dominants rms in a market use their market power (at whatever level of demand) to increase prices well above costs.

Cost-push ination happens on the supply side. Sellers raise their pricing in order to cover their increased production costs such as labour and components of the items they produce.

To summarise - Causes of Ination:

In the demand-pull scenario, consumer demand for goods and services is greater than the available supply. Thus, the pricing of those items is raised to prevent inventories from being depleted.

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This type of strong ination is when prices rise between 3-10% a year. It is harmful to the economy because it heats up economic growth too fast. People start to buy more than they need, just to avoid tomorrow's much higher prices. This drives demand even further, so that suppliers can't keep up. More important, neither can wages. As a result, common goods and services are priced out of the reach of most people.

II. TYPES OF INFLATION -

4. Hyper Ination

Let's see this phenomenon from Indian Economy perspective

Hyperination is when the prices skyrocket more than 50% a month. It is fortunately very rare. In fact, most examples of hyperination have occurred when the government printed money recklessly to pay for war. Examples of hyperination include Germany in the 1920s, Zimbabwe in the 2000s, and during the American Civil War.

5. Stagation:

2. Walking Ination

As the nature of ination is not uniform in an economy for all the time, it is wise to distinguish between different types of ination. Ination may be caused by a variety of factors. Its intensity or pace may be different at different times. It may also be classied in accordance with the reactions of the government toward ination.

1. Creeping InationCreeping or mild ination is when prices rise 3% a year or less. According to the Central Bank when prices rise 2% or less, it's actually benecial to economic growth. That's because this mild ination sets expectations that prices will continue to rise. As a result, it sparks increased demand as consumers decide to buy now before prices rise in the future. By increasing demand, mild ination drives economic expansion.

3. Galloping InationWhen ination rises to ten percent or greater, it wreaks absolute havoc on the economy. Money loses value so fast that business and employee income can't keep up with costs and prices. Foreign investors avoid the country, depriving it of needed capital. The economy becomes unstable, and government leaders lose credibility. Galloping ination must be prevented.

Stagation is just like its name says: when economic growth is stagnant, but there still is price ination. This seems contradictory, if not impossible. Why would prices go up when there isn't enough demand to stoke economic growth? It happened in the 1970s when the U.S. went off the gold standard. Once the dollar's value was no longer tied

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There are three broad ways in which governments try to control ination.

to gold, the number of dollars in circulation skyrocketed. This increase in the money supply was one of the causes of ination. Stagation didn't end until then-Federal Reserve Chairman Paul Volcker raised the Fed funds rate to the double-digits -- and kept it there long enough to dispel expectations of further ination. Because it was such an unusual situation, it probably won't happen again.

III. MEASURES TO CONTROL INFLATION

Effective policies to control ination need to focus on the underlying causes of ination in the economy.

2.Monetary measures

These are-

3.Other measures

1. Fiscal measures.

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Ination can, therefore, be controlled by increasing the supplies of goods and services and reducing money incomes in order to control aggregate demand.

Monetary measures aim at reducing money incomes.

(b) Demonetisation of Currency:

(a) Credit Control:One of the important monetary measures is monetary policy. The central bank of the country adopts a number of methods to control the quantity and quality of credit. For this purpose, it raises the bank rates, sells securities in the open market, raises the reserve ratio, and adopts a number of selective credit control measures, such as raising margin requirements and regulating consumer credit. Monetary policy may not be effective in controlling ination, if ination is due to cost-push factors. Monetary policy can only be helpful in controlling ination due to demand-pull factors.

1. Monetary Measures:

(c) Issue of New Currency:

However, one of the monetary measures is to demonetise currency of higher denominations. Such a measure is usually adopted when there is abundance of black money in the country.

The most extreme monetary measure is the issue of new currency in place of the old currency. Under this system, one new note is exchanged for a number of notes of the old currency. The value of bank deposits is also xed accordingly. Such a measure is adopted when there is an excessive issue of notes and there is hyperination in the

Measures to Control Ination

MonetaryMeasures

FiscalMeasures

OtherMeasures

• Credit Control• De-Monetization of Currency• Issue of New Currency

• Cut in Expenditure• Increase in taxes• Increase in Saving• Surplus Budget• Public Debt

• Raise Production• Rational Wage Policy• Price Control• Rationing

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(e) Public Debt:At the same time, it should stop repayment of public debt and postpone it to some future date till inationary pressures are controlled within the economy. Instead, the government should borrow more to reduce money supply with the public.

Another measure is to increase savings on the part of the people. This will tend to reduce disposable income with the people, and hence personal consumption expenditure. But due to the rising cost of living, people are not in a position to save much voluntarily.

(d) Surplus Budgets:An important measure is to adopt anti-inationary budgetary policy. For this purpose, the government should give up decit nancing and instead have surplus budgets. It means collecting more in revenues and spending less.

To cut personal consumption expenditure, the rates of personal, corporate and commodity taxes should be raised and even new taxes should be levied, but the rates of taxes should not be so high as to discourage saving, investment and production. Rather, the tax system should provide larger incentives to those who save, invest and produce more.

(b) Increase in Taxes:

The government should reduce unnecessary expenditure on non-development activities in order to curb ination. This will also put a check on private expenditure which is dependent upon government demand for goods and services. But it is not easy to cut government expenditure. Though this measure is always welcome but it becomes difcult to distinguish between essential and non-essential expenditure. Therefore, this measure should be supplemented by taxation.

2. Fiscal Measures:

(a) Reduction in Unnecessary Expenditure:

Monetary policy alone is incapable of controlling ination. It should, therefore, be supplemented by scal measures. Fiscal measures are highly effective for controlling government expenditure, personal consumption expenditure, and private and public investment.

country. It is a very effective measure but is inequitable as it hurts the small depositors the most.

Further, to bring more revenue into the tax-net, the government should penalise the tax evaders by imposing heavy nes. Such measures are bound to be effective in controlling ination. To increase the supply of goods within the country, the government should reduce import duties and increase export duties.

(c) Increase in Savings:

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Rationing aims at distributing consumption of scarce goods so as to make them available to a large number of consumers. It is applied to essential consumer goods

(a) To Increase Production:

Like monetary measures, scal measures alone cannot help in controlling ination. They should be supplemented by monetary, non-monetary and non-scal measures.

(iii) Efforts should also be made to increase productivity. For this purpose, industrial peace should be maintained through agreements with trade unions, binding them not to resort to strikes for some time.

(d) Rationing:

The other types of measures are those which aim at increasing aggregate supply and reducing aggregate demand directly.

(c) Price Control:

(i) One of the foremost measures to control ination is to increase the production of essential consumer goods like food, clothing, kerosene oil, sugar, vegetable oils etc.

(v) All possible help in the form of latest technology, raw materials, nancial help, subsidies, etc. should be provided to different consumer goods sectors to increase production.

Another important measure is to adopt a rational wage and income policy. Under hyperination, there is a wage-price spiral. To control this, the government should freeze wages, incomes, prots, dividends, bonus, etc.But such a drastic measure can only be adopted for a short period as it is likely to antagonise both workers and industrialists. Therefore, the best course is to link increase in wages to increase in productivity. This will have a dual effect. It will control wages and at the same time increase productivity, and hence raise production of goods in the economy.

Price control and rationing is another measure of direct control to check ination. Price control means xing an upper limit for the prices of essential consumer goods. They are the maximum prices xed by law and anybody charging more than these prices is punished by law. But it is difcult to administer price control.

The following measures should be adopted to increase production:

(b) Rational Wage Policy:

(ii) If there is need, raw materials for such products may be imported on preferential basis to increase the production of essential commodities.

3. Other Measures:

(iv) The policy of rationalisation of industries should be adopted as a long-term measure. Rationalisation increases productivity and production of industries through the use of brain, brawn and bullion.

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such as wheat, rice, sugar, kerosene oil, etc. It is meant to stabilise the prices of necessaries and assure distributive justice. But it is very inconvenient for consumers because it leads to queues, articial shortages, corruption and black marketing.

Conclusion:Ination or price rise has been a major concern of policymakers for a long long time. Common man also lists price rise among his top most concerns. Responsibility of controlling price rise lies with government and RBI.

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Glossary

Illegal free market which ourishes in economies where consumer goods are scarce or are heavily taxed.

Credit -

Taxes -

Black Marketing-

Demonetisation -

It is a contractual agreement in which a borrower receives something of value now and agrees to repay the lender at some date in the future.

A fee charged levied by a government on a product, income, or activity. If tax is levied directly on personal or corporate income.

The monetary value of an asset decreases over time due to use, wear and tear or obsolescence.

Depreciation-

Demonetization is the act of stripping a currency unit of its status as a legal tender.