Purchasing Power Parity

We have on varied and multiple occasions breathed long and vocal sighs when we hear the large dollar/pound/euro salaries and benefits that our very close and dear friends earn when they work in developed countries like USA, UK, Netherlands, Australia, etc (at least I do this purposefully on every occassion :)) What we tend to dismiss with the wave of our hand or the flick of our finger is their living expenses based on a certain minimum lifestyle in such countries. Obviously this applies to people who have stayed back for some duration like for say 4-5 years and not the other set of friends who were there on a short stay (how they behave is beyond of the scope of discussion in a blog post!) And this is where we should think of Purchasing Power Parity or more commonly known as PPP.

PPP: In simple terms it is difference in cost of a Big Mac at McDonalds in your native country vs. in the foreign country you are comparing to. Or you could say it is the cost of a meal/ movie/ party/ car/ house/ etc. in the countries you are putting in the comparison bucket. Again always look at averages across items, and across geographical regions within each country. So the coffee your NRI friend buys for $4 you can very well buy for ₹25 here - its like saying that the value of $4 is the same as the value of ₹25.

Are there any standard measures: Not really. Over the years various economists and organizations have tried to do something in this direction without much success or recognition. Although the Big Mac Index has some popularity in this matter - it was first popularized by The Economist. It essentially tracks the price of a Big Mac produced and sold across 120 countries that have a McDonald's outlet. Since this burger is a standardized product it is very loosely indicative of PPP or currency under/over valuation. Again, it is not a serious economic indicator, as in no country would probably base its economic policy on this. But it comes in handy when you want to write a post like this !

Why should I be bothered: Well, we probably wouldn't even use it in our day-to-day life unless you are economic policy advisor to the Government of India. But it helps to look at things in perspective, and realize errors in leading media articles like this on TOI today. I usually am wary of our media - half the time their content and the journalistic quality is such crap such that I cringe to pick up the morning newspaper. Some have gone so bad that their editorials come out as incoherent jingoistic babble in favor of the babus and netas. But this particular piece takes the cake pretty near the bottom. Aren't newspapers supposed to raise awareness about issues that people are concerned with ?? And not mislead the junta ??

Oh, by the way, my favorite newspaper is "Bangalore Mirror" - flawless and entertaining in their coverage of storm drains, petty theft, celebrity sightings, and your sex problems! What more can you ask for ??

Why Socialism fails !

An economics professor at a local college made a statement that he had never failed a single student before, but had once failed an entire class.


That class had insisted that Obama's socialism worked and that no one would be poor and no one would be rich, a great equalizer.

The professor then said, "OK, we will have an experiment in this class on Obama's plan".

All grades would be averaged and everyone would receive the same grade so no one would fail and no one would receive an A.

After the first test, the grades were averaged and everyone got a B.

The students who studied hard were upset and the students who studied little were happy.

As the second test rolled around, the students who studied little had studied even less and the ones who studied hard decided they wanted a free ride too so they studied little.

The second test average was a D! No one was happy.

When the 3rd test rolled around, the average was an F.

The scores never increased as bickering, blame and name-calling all resulted in hard feelings and no one would study for the benefit of anyone else.

All failed, to their great surprise, and the professor told them that socialism would also ultimately fail because when the reward is great, the effort to succeed is great but when government takes all the reward away, no one will try or want to succeed.



Couldn't be any simpler than that!

General Welfare

They are full of pride and high expectations. An appointment with the minister! Finally they are admitted, and finally they have the opportunity to make their cause heard. The petition is submitted to the minister. Great injustice and unbearable sufferings have befallen them, they add. The unfair competition of the sun was a burden not only to them, but to the whole people. If government could only decide to compel all citizens to darken their rooms with thick curtains during daytime, the candle-makers would be fine. And not only they! Also the butcher would have to slaughter more animals to produce tallow for candles. This would improve nutrition for everyone. And the producers of beeswax... and, and, and...

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Even the meanest selfish interest will be concealed as a contribution to the “general welfare” in the political debate – even if it causes more damage than benefit. Extracted from The Essential Frederic Bastiat

From Dr. Gavin Kennedy's post

Dr. Gavin Kennedy asks if his blog readers can spot the errors in this post. Since I do not feel qualified to put a direct comment on that blog, here I am recording my response.

The first error is in David Ross' assumption that Adam Smith was an economist. That is wrong. Adam Smith was a moral philosopher first and then an economist if at that, evidence in the fact that his "Theory of Moral Sentiments" was published to his "The Wealth of Nations".

The other mistake I am still searching for. Anybody help ??

For people who are not yet aware, Dr. Gavin Kennedy writes on his blog Adam Smith's Lost Legacy about the obvious topic - Adam Smith and his works. I have that blog listed on my side bar. This blog forms part of my daily read and keeps my intellectual synapses functional, keeping the student in me alive.

CRR and Inflation

For the uninitiated, CRR is Cash Reserve Ratio, the amount of money that a bank must maintain as deposit with the central bank of the country (which is Reserve Bank of India in the case of India), before it can lend out any to individuals or corporations or any other customer.

The observation
Each time the central bank raises the CRR, inflation seemingly goes down.

How much money can banks lend??
Suppose you were to deposit Rs. 100 in the bank tomorrow. And the CRR is 6%. The bank where you deposited your money will keep aside Rs. 6 for the central bank. So it can lend out the remaining Rs. 94. But that's not the end. The banks are further allowed to reason this way: If the borrower of Rs. 94 decides to give out the money to somebody, that somebody may deposit the amount with the bank. So the bank can lend out an extra Rs. 88.36 (Rs. 94 - 6% of Rs. 94). And if the second borrower gives it to another person who brings it back, the banks will obviously have more to lend.

Following the calculation, it can be seen that the amount of money that the bank will be able to lend out is the sum of a geometric progression whose ratio is 0.94 (when the CRR is 6%), and the starting amount is Rs. 100
Rs. 100 + Rs. 94 + Rs. 88.36 + ... = Rs. 100 / (1 - 0.94) = Rs. 1666.67

Or put more plainly, the bank can lend 16.67 times the money you deposit into the bank. And they are legally allowed to think like that. All this time I kept wondering why banks keep getting rich! Also, the point to note that at each amount in the above sum, the bank has a debtor who carries the cost of borrowing and thereby the banks are safe (unless the people start to default on their loans).

Effect of change in CRR to the money supply situation
From above, we can deduce that if the CRR is decreased to say 5% the amount of money that the banks can lend is increased to 20 times. While if the CRR is increased to say 10% the amount of money that the banks can lend is decreased to 10. Thus when the central bank feels that the banks will not be able to handle the credit scenario, that is there is too much money in the system, it will increase the CRR and vice-a-versa. Although the central bank does not do this always. Sometimes it tries to use money market instruments such as treasury bills, bonds, repo rates and reverse repo rates, etc.

Effect of change in CRR on the credit situation (where the inflation part fits in)
Due to this increase in CRR, the ability of banks to lend money goes down. Now banks are also companies and they need to show profit for their business. So keep their profit up, they increase the lending rate which essentially decreases the availability of cheap loans. As the cost of loans go up, you and I tend to spend less on frivolous purchases or at the least try to keep them at the minimum. Thus demand of goods goes down in general. And as you know, the price of a good is driven by demand in a free market economy without price controls. So the prices go down. Consequently inflation goes down.

Effect on Stock Markets

• If there is an increase in CRR, there are chances that the profitability of banks go down. Thus sensing this loss banking stocks may take a hit.
• Parallel to this, the cost of loans that a company may have borrowed would go up. The higher the loan amount, the greater the hit on the bottom line growth of the company. With lesser anticipated profits, people may tend to sell of the stocks of the company with higher debt. This is one reason why corporations tend to prefer equity instead of debt.

Conclusion
The central bank cannot hope to increase the CRR infinitely because with that the consequent demand goes down, which in turn drive the prices into a downward spiral. This obviously leads to lesser profit and eventual losses for companies. To contain this, companies may reduce production, others may go out of business. Only the cash rich companies can afford to sit it out, or invest in newer technologies for more efficient production. In the extreme case, the market would become monopolistic. And you know who loses out in the long run. Keeping all of these factors and effects in the calculation, the central bank needs to decide its policy. No wonder, I don't envy the job of the RBI governor.

You might also want to read these articles from wikipedia:
Fractional Reserve Banking
Quantity Theory of Money
Reserve Requirements