Basic and Fundamental Concepts of Economics for Bankers

Introduction

Economics is a field of study that has become extremely important for all of us. As we are globally connected the importance of Economic awareness is increasing day by day. So we need to understand some of the basic and fundamental economic concepts.

Economy is about study of

  • Individual choices of using the resources in the country,
  • It is about production and consumption of goods & services,
  • It is also about trade and commerce,
  • Also about money, borrowing, taxes etc.

As an individual we all face, constrain of limited resource (natural resources are limited, our salary is limited and profit of business/ organization is limited). Therefore our choices of fulfilling our needs and wants are restricted based on the resource we have. As a result individual’s spending and savings are varies. Thus economy has become a part and parcel of one’s life.

Relation between Economics and Banking

Banks play a vital role in the financial system of a country. It acts as a bridge between savers and borrowers in the financial system. The financial services offered by the Banking system helps the economy to become efficient and productive.

Bank takes the risk on behalf of the savers and supports the potential borrowers. So that the borrowers invest those funds in a business. That business will offer job opportunities to some people and in turn they spend their salary in the shops.

 The shop owner will deposit the money in a bank and the cycle continues. This cycle is the economic function of the bank which provides economic growth and channelize our people to be productive.

Meaning and Definition of Economics

Throughout the history there were many definitions given by the economic experts. “The father of Modern Economics” Adam Smith defines Economics as a study of wealth i.e. how wealth is created and utilized.  This definition only bothers about wealth not about the people. So it is called wealth definition.

 According to Alfred Marshall an English economist (1842 to 1924) “Economics is a science of human welfare. He thought wealth means any commodity which gives satisfaction and provides welfare to the people. Hence his definition is called as welfare definition.

Lionel Robbins a British economist (1898 to 1984) defines “Economics is science of studying the human behaviour as a relationship between ends (meaning wants or needs) and scarce means (limited wealth) which have alternate uses”. This definition gives emphasis on scarcity of the resources or wealth and its alternate use. Thus this definition is known as scarcity definition.

Economics is also known as science of choice since the resources available in the country is limited and can also be used for different purposes. The available resources are scarce and so the people cannot fulfill all of their needs or wants. So they have to take decision based on the available resources with them. Therefore it is also referred as science of choice. 

From the above definitions we can have a layman understanding that Economics is choices of people for using the scarce resources of the country for their welfare or development. 

Different Branches of Economics

If we say choices of Peoples then choices of individual and choices of majority or overall will come into picture. Thus Economics has two branches namely

  1. Microeconomics and
  2. Macro Economics

Microeconomics: 

It studies the individuals and firms decision to allocate their available resources in the markets where good and services are bought. It analysis how household and firms reacts to the price change; Why different goods has different values? What is the reason for people’s demand for a particular goods or services?

Macroeconomics

It is a branch of economics that look the economy on the national or international level. It studies about the way a nation allocates its limited resources such as land, labour and capital. It also deals with international trade, country’s fiscal policy and monetary policy, level of inflation, national unemployment etc.

Difference between Economics and Economy

Now we know what economics is all about. Now we will look onto economy. We most often hear the word economy in news channels and read it in newspapers. Let us understand about the term economics.

Economics is a study of human behaviour in conjunction with the limited resources, while economy is the practical application of those economic theories and knowledge to design and structure a nation for its growth.

If Economics is a science then, Economy is a technology or engineering. So in simple terms Economy means application of economic studies in a country for its growth.

How economic activities are measured for a country or an economy?

For individuals, their economic activities are measured in the name of income. For business people and firm, it is measured in terms of production, sales and profit. So how about a country? How the country’s economic activities are measured?

There are three important measures used by economists to study about the growth of an economy.

  1. National Income
  2. Unemployment rate
  3. Inflation

National Income

The total value of goods and services created by the citizens of the nation over a particular period of time is called National Income. It is calculated in 4 different ways as follows.

  1. Gross Domestic Product (GDP)
  2. Net Domestic Product (NDP)
  3. Gross National Product (GNP)
  4. Net National Product (NNP)

Concept of Gross and Net value:

Before going further we first understand the concept of Gross and Net value in accounting. The concept of Gross and Net has baffled many bankers and accountants. 

We see Gross Profit and Net profit, Gross sales and Net sales, Gross and net revenue etc., while doing balance sheet analysis.

Even salaried individual’s salary slip has these term gross salary and net salary. So we have to understand the concept of Gross and Net.

Gross means total amount before anything is deducted (that is why we feel happy about our Gross salary!!! :))

Net means amount after adjustments made for any debts, deductions or expenses (ah!!! I hate those deductions in my gross salary).

So Net amount = Gross amount – Adjustments for loans, expenses or any other deductions. 

Gross Domestic Product (GDP)

The total value of Goods and Services at market price produced within the geographical boundaries (domestic) of a country by residents and foreigners residing in that country for a given period of time is called Gross Domestic Product (GDP). GDP is the main primary measuring tool used by the economists to analyse the growth of a country.

Here the place of earning is important so it includes both the income of residents and foreigners which are generated within India. Therefore if an income is generated by a resident outside the territory of India that income is not included in our GDP.

Let us take an example: The profit earned by State Bank of India branch in Saudi Arabia  will not be included in the Gross domestic Product of India as the income generated is not a part of territory of India.

Net Domestic Product. (NDP)

Every business and asset had been created by using capital. Some assets such as house property, vehicles, fittings & furniture, computers & electronic equipments will have depreciation (reduction) due to wear and tear. So the capital invested in those assets will be depreciating (reducing).

Recollect what we learnt about concept of net value. It means amount after adjustments made in the gross amount. Here the adjustment is depreciation.

Therefore the value of goods and services at market price after deducting the depreciation is called Net Domestic Product (NDP). So in simple,

NDP = GDP – Depreciation

Gross National Product:

The total value of Goods and Services at market price produced by the citizens of the country for a given period of time is called Gross National Product (GNP). Here citizenship is important so an NRI (Indian) earned income in Saudi or in USA is also considered in GNP. But the income of foreigner running business in India is not considered in calculation of GNP.

GNP = GDP + total capital gains from overseas investment – foregin national incomes earned in India

 Net National Product.

The value of goods and services at market price produced by the citizens of country for a given time after deducting the depreciation is called Net national Product (NDP). So in simple terms,

NNP = GNP – Depreciation

Factor costs vs. Market price:

The value of goods and services are calculated in two ways

  1. Value of goods or services calculated at input or production phase and
  2. Value of goods or services calculated at output or during consumer purchase.

Factor cost is nothing but factory cost; means cost incurred to produce goods and services after considering the cost of production. Here cost of production means amount spent to get the land, labour and capital. So this is the base value of the product as this is the amount that we need to produce a good or service.

Then after government may give subsidy to the manufacturers based on the type of goods & service. The purpose of this subsidy is to reduce the price of basic needs to boost the export, help the farmers, or may be political.

Market price means the price at which the consumer or final buyer purchased a product. So this price includes all the indirect taxes of the government, all the commissions of intermediates traders and profit of the manufacturer. But it does not include the value of subsidy as the subsidy amount is already paid to the manufacture to reduce the production cost.

So GDP at market price = GDP at factor cost + indirect taxes – Subsidies

GNP at market price = GNP at factor cost + indirect taxes – Subsidies.

Unemployment rate

Unemployment rate:

Another important measurement of any economy is measuring the presence of unemployed labour force in the country. It is a kind of lagging indicator means if economy is improving then unemployment rate will be lower and vice versa.

The unemployment rate is the ratio of number of unemployed persons to number of total labour force in the economy. The unemployment rate is always expressed in percentage.

Here work force means people who want to work or actively seeking job but does not include who are retired, disabled and able to work but not looking for job.

For example a person resigned his job but not actively looking for jobs because of any personal reasons like taking care of their ill parents or children. He is not included in the labour force while computing unemployment rate. Same way if a housewife is looking for job even though she doesn’t worked anywhere, she is included in the labour force.

Media gets lot of attention on unemployment rate but actually it has some disadvantages. Some economists consider the unemployment rate has flaws in it. The main disadvantage is it does not consider the quality of the jobs. Many people who can’t find jobs are taking low wages job due to family situations or we can say they are underemployment. The unemployment rate does not address this issue. 

Inflation

The general and sustained increase in the price of goods and services over a period of time in a country is called inflation. As inflation affects purchasing power of a currency it is also one of the important measuring tools of an economy.

Inflation does not talk about a single good or a service, it talks about movement of prices of selected baskets of goods and services over a period of time. It tells how purchasing power of a currency is reduced over a period of time by examining the rate of change of some group of important goods and services over a period of time.

Measures of Inflation rate:

Inflation rate is calculated as a percentage of increase on current price index from the base year. The formula is nothing but a simple percentage increase calculation i.e.

Inflation rate = [(Price index in Current year – Price Index of Base year) / Price index of Base year] * 100.

Inflation rate is purely depends upon the price index. In simple terms of understanding, price index means measure of average price of a particular class of good or service in particular region during the given period of time.

Let’s take an example food. In food category we have many types of commodities like fruits, vegetables , Cereals, pulses, beverages, live stock etc,. So we consider some fundamental food commodities such as wheat, rice, dhall, tomatoes, onions, milk, meat etc. Now if we take rice there are plenty of varieties of rice are available in the market based on different region e.g. Ponni, Seeraga Samba, Basmathi rice, etc, etc,.

Now consider the price of Basmati rice, the price will vary from state to state and district to district. Even if we take the price of Basmati in a particular district or a region the price will be changing twice or thrice in a month. I think now you would have realized the complication in evaluation of a price for a single food product.

After considering all these and other complications the price indexes are calculated.  To ease out the process the indexes take certain group of goods or series and call them as basket.

The following are the most important price indexes in India.

  1. Wholesale Price Index (WPI)
  2. Food Inflation index
  3. Consumer Price Index (CPI)
  4. GDP Deflator

Especially CPI is most important for our country (for bankers too as our D.A is depended on it 😛 :P).  In India inflation rate is measured using the change in Consumer price index over period of time. Consumer Price index means a comprehensive measure of basket of goods and services that are consumed by the households. It includes more than 80000 products in its basket.

Conclusion

I hope in this post I have given some insights on basics of Economics for your CAIIB ABM preparation. Remember, Banking and Finance are part of economics which in turn one of the backbones of a country’s economy.  So learning about fundamentals of economics and its relation to Banking sector is a must for all bankers. So that, we can understand how changing the monetary policy (SLR, CRR, and others) has effects on individual, firm, banking sector and our economy. 

 Please feel free to provide your valuable suggestions and feedbacks in the comment section.

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