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Tag: economic concepts

  • How does the Central bank control inflation?

    You may have heard in the news in the last year, that the Fed has been raising the interest rate. In this post, I will be explaining which is the “interest rate” and how the central bank of the U.S. (the Federal Reserve) does that to control inflation.

    After Jan 2022, there has been a steady rise in prices of many items, esp. fuel, housing rent, and food prices. If you want to understand what inflation is and how it is calculated, you can read my detailed article on inflation here.

    Inflation always happens when there is more demand than supply and when there is an expectation of inflation to continue. Producers raise the price of the goods and services in demand, to make more profit from them.

    The central bank of a country (the Federal Reserve in the US) intervenes when inflation is out of control or is significantly high compared to the target level. As this blog mostly focuses on the US Federal Reserve monetary tools, I use the terms the Fed and central bank interchangeably. However, central banks in other countries also use similar monetary tools.

    Is inflation always bad?

    In the US and many advanced countries, the target average rate of inflation is around 2% every year. This little bit of inflation rate is considered desirable, as it helps borrowers pay off their debt. When there is some inflation, borrowers will have to pay slightly less in purchasing power terms because their money is now worth less to the lenders, exactly by the rate of inflation.

    Additionally, it also motivates people to spend their money on goods and services instead of holding on to them, as their money will lose its value next year by the rate of inflation. So, we get our normal production and consumption, and the economy continues to run smoothly.

    What are the two goals of a central bank and how does it achieve it?

    The central bank uses monetary policy to keep inflation low and promote maximum employment. By maximum employment, we mean the highest level of employment that an economy can sustain while maintaining a stable inflation rate. In the US, these goals are referred to as the Fed’s dual mandate.

    You may ask how the Fed achieves its dual goals. Essentially, the Fed uses its monetary policy tools to start a chain reaction in the economy, each causing one another. In the US, the Fed’s chief body for monetary policymaking is called the Federal Open Market Commission (FOMC). FOMC meets eight times a year and looks at data on current economic conditions, like what is going up and what is going down and how the economy is likely to do in the future based on the data. Based on that information the FOMC makes monetary policy decisions.

    When inflation is high for a long period and unemployment is at a very low level, we call it an overheating economy. The central banks try to raise the interest rates to slow down the overheating economy. This is called contractionary or tight monetary policy.

    Tools of Monetary Policy

    Now, let’s look at the tools the Fed can use to bring inflation down to the stable 2% average rate. This is done in two steps:

    First, the Federal Open Market Committee (FOMC) will raise the target range for the Federal funds rate. This is the rate at which commercial banks borrow and lend their excess reserves to each other overnight. This rate is not set by the Fed, instead, it is determined by the market forces of demand and supply between commercial banks.

    On any given date, there are many different transactions in the federal funds market and they settle at slightly different rates, the effective federal funds rate measures the median rate of these transactions.

    FOMC sets a target range for the federal funds rate. In other words, the majority of the banks’ transactions should fall within the target range. Banks with deficits can borrow money from other commercial banks. The next day those banks return the money with a little bit of interest.

    Now, the main task for the Fed is to use its monetary tools so that this federal funds rate goes up because this is the driving force for all the other interest rates in an economy.

    Interest on reserve balance is the main tool

    So, to steer the federal funds rate in the target range set by FOMC, the Fed uses interest on reserve balance as its primary monetary policy tool. The interest on reserve balances rate is the interest received by commercial banks on deposits that banks hold in their reserve balance account at a regional Federal Reserve Bank. This interest rate is a risk-free investment option for commercial banks. This, the interest on reserve balances rate is set by the Fed and is, therefore, an “administered rate,”.

    Interest on reserve balance: Banks can deposit the excess reserve with the Fed risk-free overnight, and earn interest just like you can do with a savings account.

    When the Fed sees the economy is overheating with high inflation and a tight labor market, it tries to slow down the economy by raising the interest on the reserve balance. With that, the banks will be more willing to deposit their reserves with the Fed, rather than lending to other banks in the federal funds market.

    A key point to note here is that the interest on reserve balances rate serves as a reservation rate or the floor rate for banks. This is the minimum interest banks would be willing to accept in order to lend to each other, rather than keeping it with the Fed. If the Fed raises this interest on the reserve balance, commercial banks must raise the Federal funds rate in order to attract other banks to lend to them.

    Another key concept that ensures that the federal funds rate does not fall far below the interest on reserve balances rate is called arbitrage. Arbitrage means simultaneous purchase and sale of funds (or goods) in order to profit from a difference in price.

    So, for example, if we assume the federal funds rate is 1.75 percent and the interest on reserve balances rate is slightly higher at 2.25 percent, banks will see that they can borrow funds in the federal funds market at a lower rate and earn higher interest by depositing those funds at the Fed. They will keep doing that until with the forces of demand and supply, the increase in demand for funds in the federal funds market will cause the federal funds rate to rise. It will keep rising until it reaches the interest on reserve balances rate so that banks no longer see the opportunity to profit by borrowing in the federal funds market and depositing it with the Fed. 

    As the Fed sets the interest on reserve balances rate directly, the Fed can steer the federal funds rate up or down by raising or lowering the level of the interest on reserve balances rate. In fact, this phenomenon of arbitrage makes interest on reserve balances a very effective tool for steering the federal funds rate direction.

    There are two other tools that the Fed can use to guide the federal funds rate

    1. By setting a floor with an overnight reverse repurchase rate,

    2. and by setting the ceiling using a discount window

    Let’s understand both of them.

    The Fed has an overnight reverse repurchase facility that is open to a broader set of financial institutions, as interest on reserve balances is available only to banks and a few other institutions. This facility allows these financial institutions to deposit their funds at a Federal Reserve Bank and earn the overnight reverse repurchase agreement rate offered by the Fed.

    Thus, the overnight reverse repurchase agreement rate does the same thing as the interest on reserve balances rate does by acting as a reservation rate for these financial institutions. If this rate is higher than the federal funds rate, then by pressure of demand and supply, the Federal funds rate starts going up until there is no profit from arbitrage. The overnight reverse repurchase agreement facility is a supplementary tool because the rate the Fed sets for it helps set a floor for the federal funds rate.

    So when it raises the overnight reverse repurchase rate, the Federal funds rate tends to move up as well.

    The discount rate is the rate banks have to pay to the Fed for borrowing money from the Fed through the Fed’s discount window. Banks are more likely to borrow from each other (at the federal funds rate) only if it is lower or equal to the discount rate that they have to pay to borrow from the Fed. Thus, the discount rate acts as a ceiling for the federal funds rate. Also, it is set higher than the interest on reserve balances rate and the overnight reverse repurchase agreement rate.

    Lastly, there is another tool that used to be the Fed’s primary tool to control the money supply in the economy before the 2008 financial crisis. This is called open market operations where the Fed would buy or sell t-bonds. Now, with ample reserves in the banking system, the Fed only uses this as a supplemental tool to help maintain ample levels of reserves. The Fed can buy or sell government securities in the open market to increase or decrease these reserves in the banks account with the Fed.

    In a nutshell, when the Fed wants to control inflation, it would set a higher range for the Federal funds rate. To achieve this target, it would increase the interest on reserve balances rate as the main monetary policy tool. It can also use additional tools by raising overnight reverse repurchase agreement rate, and discount rate. All this will ensure the federal funds rate stays within the high target range set by the FOMC.

    Why does the Federal fund rate matter?

    Since the federal funds rate affects all the other interest rates in the economy, all the other interest rates go up as well. At high interest rates, households will borrow less money to buy big-ticket items they want. This will cause a reduction in spending by households. This will cause overall savings to increase because now they are getting higher interest rate to save money in a bank.

    Once household demand is reduced, firms will reduce their investments. They will also reduce their workforce and demand fewer workers. This will reduce employment levels also and cause the inflated prices to return to the target of 2%.

    The now-raised federal fund rate would cause other market interest rates like mortgage, auto, and other interest rates that banks charge from households and businesses to rise as well. The increased cost of borrowing will reduce spending across all sectors of the economy, lowering excess demand and bringing prices back to normal.

    The Fed will do the exact reverse of this process when the economy is in a recession when the inflation is below the 2% target rate and there is high unemployment. It will lower the Federal funds rate target range by lowering interest on the reserve balance. It can also use additional help from lowering interest on overnight reverse repurchase agreement rates, and discount rates to give a boost to the economy.

    How effective are these tools in reality?

    All these monetary policy tools only work when inflation is caused by demand-pull factors. However, if it is due to cost-push factors, this measure may cause more harm than good. Cost-push factors include supply shocks when the supply of the products is hampered. There could be many reasons for a reduction in supply such as increased cost of raw material and other inputs, and natural calamities. Trade restrictions such as sanctions imposed on a country can also cause supply disruptions.

    Also, there is a direct link between reducing inflation and reducing overall economic growth. Even though central banks aim for a soft landing when they raise interest rates to bring down inflation, sometimes it doesn’t go as planned.

    In economics, a soft landing means a moderate economic slowdown following a period of growth. In the past, the Fed in the US has had a mixed record in achieving a soft landing when it raised interest rates.

    In addition, inflation expectations continue to play a key role in how people react to the contractionary monetary policy. If people continue to believe the prices to go up, they will tend to make the purchases now, rather than in the future when the worth of their money can get further low.

    The board of governors at the Fed, as well as various economists that work there, take into consideration all these factors and keep a watch on the trend. They can alter the monetary policy according to the direction of its performance.

  • What are the Fed’s new monetary policy tools?

    Today we’re going to talk about a really important topic: what are the main tools that the Federal Reserve uses to influence the economy and how does it do it?

    We will also learn the tools that the Fed uses in its new monetary policy and how they are different from their old way. Don’t worry if you’re not familiar with economics, because I am going to break it down step by step.

    So, first things first, what is the Federal Reserve? Well, it’s the central bank of the United States and to put it simply, The Federal Reserve (the Fed) is like a bank for the U.S. government.


    If you look at the Federal Reserve website, it says “One of the most important functions of the Fed is to promote economic stability using monetary policy. The Fed’s goals for monetary policy, as defined by Congress, are to promote maximum employment and price stability.” This means the highest level of employment that the US economy can sustain while maintaining a stable inflation rate of around 2%.

    So how does the Fed control the economy?

    The Fed has some tools to control the economy, these are monetary policy tools. Imagine the economy is like a car. If it’s going too fast and might crash, then the Fed can step on the brakes. If it’s too slow, they can press the gas pedal.

    The FOMC is the money boss

    So let’s understand how the Fed works, The Federal Open Market Committee, or the FOMC is like the money boss of the Federal Reserve. They meet in Washington, D.C., eight times a year to talk about the economy. They look at economic data and statistics, talk to economists, and decide how much interest banks should charge each other.

    This interest is called the federal funds rate. Fed funds rate is the banks’ overnight lending and borrowing rate from each other. This rate matters because it affects how much regular people pay for things like houses and cars. If it’s high, things are a bit more expensive. If it’s low, things are more affordable.

    Let’s understand it step by step, Banks have a place where they put some of their money, called the Federal Reserve. They earn interest on it. Sometimes, one bank has extra money and another needs some to do their everyday stuff. So, the bank with extra money can lend it to the one that needs it. The important part is that the interest rate for this lending is not decided by the big boss or the Fed but by the banks themselves. They agree on a fair rate and it is thus market-determined.

    So how does the Fed steer this key interest rate in the target range set up by FOMC?

    The Fed uses its two administered rates – the first is the interest on reserve balance and the second is the rate on reverse purchase agreement. These are their main monetary tools to control the Federal funds rate in the current times.

    According to the Fed’s chair, Jeremy Powell, “The Federal Reserve sets two overnight interest rates: the interest rate paid on banks’ reserve balances and the rate on our reverse repurchase agreements. We use these two administered rates to keep a market-determined rate, the federal funds rate, within a target range set by the FOMC.”

    When the FOMC wants the fed funds rate to go up, the Fed moves the interest on the reserve balance up. This rate sets the lowest interest rate banks are willing to accept when lending out their money to anyone else. Since banks can also earn this interest by depositing their money at the Federal Reserve and keeping money with the Fed is a safe way to earn money, banks prefer to do this rather than lend it at a lower rate to another bank.

    This acts as a floor for the Federal funds rate, which means the banks will not accept any lower interest rate than this to lend money to one another for a short term.

    Another important concept to understand here is called “arbitrage,” which is like making a profit by buying low and selling high. So let’s say the federal funds rate is 5.5%, and the Fed pays 6% for deposits to be kept at Fed, banks can borrow at 5.5% from other banks and then deposit at 6% to make a profit.

    This pushes the federal funds rate up until it’s close to the interest on reserve balances rate (6%). Similar to the interest on reserve balance which is mainly for commercial banks, the Fed also has other tools, like the “Overnight Reverse Repurchase Agreement Facility,” which is the interest other broader financial institutions can earn by keeping money at the Fed. Thus, it serves the same purpose as the interest on reserve balance and sets a floor for the federal funds rate, which means the federal funds rate won’t go below this.

    The other tool the Fed uses is the Discount Window. Because banks will not likely borrow at a higher rate than they can borrow from the Fed, this acts as a ceiling. It is set higher than the interest on reserve balances rate and the overnight reverse repurchase agreement rate.

    So these are two tools that the Fed is now using in the ample reserves case.

    The Fed’s tools before the 2008 crisis

    The Fed used to use this tool called Open Market Operations as its primary tool, where it bought treasury securities to pump money into the economy. However, after the 2008 financial crisis, it has ample reserves that it only buys government securities to make sure the reserves remain ample in the banking system. So, it uses open market operations only as a supplement tool.

    So how does the FOMC decide on the target interest rate?

    Economic data on inflation and unemployment helps the FOMC decide its target interest rate. Over the years, FOMC has been changing this Federal funds rate target range up and down to help the economy. Think of it like a volume knob on your music player.

    When the economy was in trouble after the 2008 financial crisis, the Fed turned the volume to almost zero to help it get better in 2015.

    Then, when the COVID-19 pandemic happened, they quickly turned the volume back down to almost zero to help the economy during that tough time.

    Most recently, since last June 2022, the Fed has been raising the interest rate to control inflation. As of today, the target range for the Federal funds rate is between 5.25 to 5.50%.

    So, you can think of the Fed as a DJ for the economy, adjusting the volume to keep things running smoothly.

  • How government intervention is needed for social benefit?

    Today, we’re diving into the fascinating world of economics to discuss a crucial concept that often goes unnoticed but has a profound impact on our daily lives – externalities.

    What are externalities?

    Before we delve into examples, let’s define what externalities are. In economics, externalities refer to the unintended consequences of economic activities that affect individuals or entities not directly involved in the transaction. These external effects can be positive or negative, and they often lead to a divergence between private and social costs or benefits.

    Some Examples of Positive Externalities

    1. Education

    To better understand positive externalities, let’s take the example of education. When an individual pursues education, they gain knowledge and skills that benefit them personally. However, education also has positive externalities that extend beyond the individual. When educated people enter the workforce, they contribute to the economy’s productivity, innovation, and overall growth.

    2. Vaccination

    Another example is when the Government provides Vaccination. In the most recent case of the COVID-19 pandemic, people who got vaccines were less likely to get extremely sick or spread the virus to others.

    Similarly, any vaccination for other infectious illnesses provides health benefits not just to the person receiving the vaccine but also to the entire community of people he or she comes in contact with.

    Negative Externality

    Now, let’s shift our focus to negative externalities, using the example of pollution.

    When a factory produces goods, it incurs private costs like labor and raw materials. However, it may also release harmful pollutants into the air or water, causing damage to the environment and people nearby.

    Impact of Externalities

    Externalities can significantly impact market efficiency. When externalities are present, markets may fail to achieve an optimal allocation of resources, leading to overproduction or underproduction of goods and services.

    How can government intervention solve the problem?

    Governments can step in to correct the market failure caused by positive externalities. For example, they may provide subsidies to educational institutions or offer tax breaks to individuals pursuing education. This encourages more people to invest in education, leading to a better-educated workforce and more prosperous society.

    Similarly, to address negative externalities like pollution, governments may impose regulations, taxes, or fines on polluting industries. By internalizing the external costs into the production process, these measures encourage businesses to adopt cleaner and more environmentally friendly practices.

    Conclusion

    Externalities are all around us, influencing our decisions and shaping our economy in both positive and negative ways.

  • The economics behind overbooking done by the Airlines

    Picture this: you’ve arrived at the airport, excited about your upcoming trip, only to hear those dreaded words at the gate, “We regret to inform you that this flight has been overbooked.” Frustrating, isn’t it? But have you ever wondered why airlines resort to overbooking flights? Let’s find out.

    Today, we’re delving into a question that has puzzled many passengers: Why do airlines overbook flights?

    What is overbooking?

    But first things first, what exactly is overbooking? Put simply, it’s when an airline sells more tickets for a flight than the available seats on the aircraft. Seems counterintuitive, right? Well, airlines engage in this practice based on historical data and statistical analysis.

    Reason 1: No-show Passengers: Airlines overbook flights because they expect a certain number of passengers to not show up. This happens more often than you might think. Passengers may miss their flights due to various reasons, such as traffic delays, personal emergencies, or even connecting flight issues.

    So, why do airlines take the risk of overbooking flights?

    Overbooking allows airlines to maximize their revenue and efficiently utilize their available resources. It’s a balancing act, predicting the number of no-show passengers to ensure a full flight without causing excessive inconvenience to passengers.

    Overbooking helps airlines maintain high load factors, which means filling as many seats as possible on each flight. This leads to optimal fuel usage, better cost management, and a higher chance of profitability. Moreover, a full flight reduces the need for rescheduling or canceling flights, which can disrupt passengers’ travel plans.

    Reason 3: Compensation Options

    When an airline realizes that a flight is overbooked and there are not enough volunteers to give up their seats, they might have to involuntarily deny boarding to some passengers. In such cases, the passengers are entitled to compensation, which can vary depending on local regulations. This compensation usually includes options like rebooking on a later flight, accommodations, meal vouchers, and sometimes monetary compensation.

    Now It’s clear that airlines have their reasons for overbooking, but it’s important to address passengers’ concerns as well. Let’s talk about that.

    So how do airlines handle the frustration and inconvenience caused by overbooking?

    Airlines understand that overbooking can be frustrating for passengers, and they strive to minimize the impact. They typically use sophisticated algorithms and predictive models to estimate the number of no-shows accurately. If a flight is overbooked, airlines prioritize finding volunteers willing to give up their seats in exchange for compensation before resorting to involuntary denial of boarding.

    Conclusion

    Thus, airlines overbook flights to optimize their operations, maximize revenue, and account for the possibility of no-show passengers.

  • Understanding Credit Scores

    A credit score is a three-digit number that represents your creditworthiness, that is, how likely you are to repay a debt. Credit scores range from 300 to 850, with higher scores indicating better creditworthiness. A credit score is calculated based on various factors, such as your payment history, credit utilization, length of credit history, types of credit used, and new credit accounts.

    How are credit scores calculated?

    Let’s take a closer look at how credit scores are calculated. Payment history is the most important factor, accounting for 35% of your credit score. It refers to how you’ve paid your debts in the past and whether you’ve made payments on time. Late payments, defaults, or collections can significantly lower your credit score.

    The second factor is credit utilization, which makes up 30% of your credit score. It’s the amount of credit you’re using compared to your credit limit. Keeping your credit utilization below 30% is considered good, and exceeding it can negatively impact your credit score.

    The length of your credit history makes up 15% of your credit score. The longer your credit history, the better, as it indicates a more stable financial track record.

    The types of credit you use also matter, accounting for 10% of your credit score. Having a mix of different types of credit, such as credit cards, car loans, and mortgages, is considered good, as it shows you can handle different types of debt.

    Finally, the last factor is new credit accounts, which make up 10% of your credit score. Opening too many new credit accounts in a short period can negatively impact your credit score.

    Why are credit scores important?

    Now that we know how credit scores are calculated, why are they important? Your credit score can affect your ability to get approved for credit cards, loans, or mortgages. A higher credit score can lead to lower interest rates, saving you money in the long run. Additionally, employers and landlords may also check your credit score to evaluate your financial responsibility and trustworthiness.

    Now, let’s look at some examples of credit scores and how they’re typically categorized:

    • A credit score of 750 or above is generally considered very good or excellent. This indicates a strong credit history and may qualify you for the best interest rates and terms on loans and credit products.
    • A credit score between 700 and 749 is typically considered good. This shows that you have a solid credit history, but there may be some room for improvement in certain areas.
    • A credit score between 650 and 699 is generally considered fair or average. This means you may have some negative items on your credit report or a shorter credit history, but you may still be able to qualify for credit products.
    • A credit score between 600 and 649 is typically considered poor. This indicates a higher risk to lenders and may result in higher interest rates or less favorable terms on loans and credit products.
    • A credit score below 600 is generally considered very poor. This indicates a significant risk to lenders and may make it difficult to qualify for credit products or result in very high-interest rates.

    It’s important to keep in mind that credit score ranges and categories can vary depending on the scoring model used and the lender’s specific criteria. However, in general, a higher credit score is typically viewed more positively than a lower score.

    CONCLUSION

    In conclusion, understanding credit scores is crucial for your financial health. It’s a three-digit number that represents your creditworthiness, calculated based on various factors such as payment history, credit utilization, length of credit history, types of credit used, and new credit accounts. A higher credit score can lead to better financial opportunities, while a lower score can limit your options. So, be sure to monitor your credit score regularly, pay your debts on time, and keep your credit utilization in check.

  • The latest inflation report is out! What to expect next from the Fed?

    The bureau of labor statistics (BLS) just released the inflation number for January 2023 for the United States.

    There is a 0.5% increase from the December number, and inflation sits at still a whooping high of 6.4% over the last 12 months from January 2022.

    As you can see in the BLS chart above, the year-to-year inflation is 6.4% for all the items, 10.1% for food, 8.7% for energy, and 5.6% for all the things except food and energy. Also, in their press release, they mentioned the index for shelter was the largest contributor to the monthly inflation number.

    By shelter, they mean rents and owner equivalent rent cost of housing.

    If you look at this detailed table from them, it shows the breakdown in prices for all the individual items.

    Source: BLS


    Under the energy category, fuel oil is still up by 27.7% for the 12 months. Natural gas is also up by 26.7% in the 12 months.

    There is a 14% rise in Dairy and related products in the food category. 

    You can see that the highest inflation happened in cereal and bakery products. This was mainly because of the rise in egg prices because we felt that in the grocery stores.

    What caused egg prices to rise so much?

    Economists think the bird flu was the main reason behind increased egg prices because about 40 million egg-laying hens died in 2022 because of this disease.

     At the same time and the demand for eggs continues to rise because it provides a cheaper source of protein to many Americans. Thus both these supply and demand factors contributed to a significant rise in egg prices. 

    Was this inflation expected?

    This came as a little bit of a disappointment because people were expecting the overall inflation not to rise if not fall from the December level, even though fuel prices seem to be falling.


    Inflation is still high on many essential things, and it continues to be the biggest hit to poor Americans. It acts like an indirect tax on them.

     
    Unfortunately, most of this inflation we are experiencing is caused by supply-side factors, which are difficult to fix in the short run.

    Policy implication

    The government can only focus on controlling the demand aspect of inflation in the short run. As a result, the Fed will continue to tighten the monetary policy and raise interest rates until inflation reaches around 2%

    The federal reserve has been trying to control inflation using interest rate hikes to slow the demand in the economy.


    To learn more about inflation, how it is calculated, and the factors that cause it, please see my post here.

  • Does more money make people happier?

    The answer to this question is not very easy. I think it depends on a person’s income or wealth level and state of their mind.

    When someone is poor, any additional money they get will bring them a lot of happiness and satisfaction. The value of $100 is much more to a homeless person than to a millionaire.

    Happiness Economics

    A subfield of economics, known as happiness economics, studies various factors that affect the well-being of a person. In 1974, American economist Richard Easterlin came up with an interesting concept called Easterlin Paradox.

    His findings showed that happiness doesn’t increase with an increase in income or wealth after a certain point. This graph shows the Paradox of how the happiness curve rises with income in the initial stages but becomes flat when the income keeps rising.

    He based his findings on the belief that money has diminishing returns. What it means is that at a low level of income, you get more happiness and satisfaction with any additional money that you get. However, at higher levels of income, that additional benefit becomes less and less. In fact, after a point, it just does not bring any additional happiness.

    We value something when we have less of it, but when we have too much of it, we don’t value it as much.  It is as simple as this.

    If you study behavioral economics, you will know that the key assumption of conventional economics – human beings are rational, doesn’t always hold true. People do not always choose the option that maximizes their material well-being.

    Economics deals with humans and human minds are complex. Various factors, both at the macro and micro level play a role in determining what choices humans make.

    So what factors other than income affect your well-being?

    There are a lot of factors that affect a person’s happiness than just their income or overall wealth.

    The big, macro factors are the things we can’t directly control like:

    • good governance
    • good healthcare
    • clean air and water
    • right to good education
    • political stability in a country
    • availability of jobs for people in the labor market
    • good community and social support
    • good infrastructure
    • woman’s equality in that country
    • Corruption free society
    • and overall safety.

    Yes, I know many of these macro factors are more favorable in rich countries, as a lot of these cost money. Developed countries can provide good infrastructure, healthcare, public safety, and better jobs more easily.

    But there are factors beyond individual incomes and the economic development of a country, which affect the happiness of its people.

    World Happiness report findings

    The survey done by the World happiness report shows that the countries with the highest level of satisfaction in the world are not the ones with the highest GDP per capita.

    In 2021, Finland’s GDP per capita was $53,982, and the US GDP was $69,287 according to World Bank data. Even with a lower GDP compared to that of the US, Finland ranks first in the happiness index. The US, which has the 6th highest GDP per capita ranks lower in the happiness index, coming at number 16.

    Though the data shows a strong correlation between the countries with high GDP per capita and happiness, it is not perfect.

    According to the analysis done by World happiness report 2022, the six variables: GDP per capita, social support, healthy life expectancy, freedom to make life choices, generosity, and freedom from corruption are key in determining overall happiness.

    I got this table from their report and it shows their regression analysis. You may skip this section and scroll to the next if this seems very mathematical. But I want to explain their findings so you can understand.

    The weird part of economics is that it tries to explain the obvious through data and mathematics

    Regression analysis is an Econometrics tool to study how well different “independent factors or variables“ explain a phenomenon or the “dependent variable“.

    In their survey report, the six independent variables are the log of GDP per capita, social support, healthy life expectancy, freedom to make life choices, generosity, and perceptions of corruption.

    The dependent variable is the average happiness across countries. A total of 156 countries were surveyed using data from the years 2005 to 2021.

    In the table below, wherever you see three stars *** next to an independent variable value in paranthesis, it shows that the variable (of the six I mentioned) is statistically significant in explaining the average happiness (dependent variable).

    It means the majority of the people surveyed reported that factor to be an important determinant in explaining their happiness level.

    If you look at the statistics I circled above, called Adjusted R-squared, you will see a value of 0.753. This means together these six factors explained more than 75% of the variation in national annual average happiness scores.

    Thus, as you see real GDP per capita is only one of the indicators for measuring the prosperity of a country. Other variables that are part of the happiness index actually tell a better story of the well-being of a country’s population.

    Economist Simon Kuznets, who invented the concept of GDP, in his first report to the US Congress in 1934 said “the welfare of a nation can scarcely be inferred from a measure of national income.” So, we see that GDP per capita, has limitations and I will cover those in a separate post later.

    So are there other factors that the report missed?

    There could be some internal factors that the report hasn’t covered explicitly. These are the factors that we have more control over.

    When we see on social media people vacationing and throwing big parties, we instantly assume that they must be very happy. Because we think this happiness can only come from the extra money they have, to afford that extravagant lifestyle.

    People start comparing themselves to their peers and get depressed. They are not unhappy because they have less money, but because their friends or relatives have more. People immediately associate more money with happiness.

    But is it always the case?

    Increased urbanization has taken away the simplicity of life. The materialistic nature of western countries has engulfed every single country now.

    To earn higher incomes, many times people live away from their families and work in jobs that increase their stress levels.

    Long working hours are physically and mentally draining for most people

    Their progress at work comes at a cost of missing family time because they are overworked. If people don’t have time to focus on their health, then that additional income is not even worth it. There is this huge opportunity cost to having a higher income, which we mostly overlook.

    Conclusion

    I feel a person’s health and relationships also play a huge role in determining the level of their happiness.

    In a true sense, a person’s happiness depends on their state of mind. They should have enough money to lead a fulfilling and healthy life. But we need to be aware that there will be, always, many people above or below us in terms of wealth and income.

    People should be able to meet their needs and most of their wants, but not at the price of their health and relationships. Wants are never ending and are different for each income level.

    For most people, money, and happiness can go together if they spend their extra money the right way.

    If people can pursue a quality life, then they could be actually happy. Worthwhile acts like donating to charities, getting the time to pursue their interests, having a work-life balance, and the ability to spend leisure time with family and friends, all affect the quality of life. In the absence of these, wealth alone may not bring true happiness.

    Similarly, people with less means can also lead a happy life. In fact, I notice that many times, people with low levels of income are more satisfied with their life. This could be because they have lower expectations and get content easily compared to relatively wealthy individuals.

    On a personal level, it is the state of my mind that influences my ability to find happiness. It could come from small things and moments in my life, and from the big ones, where I worked hard. Having a clean home, good health and a supportive family and friends are the things that make me truly happy.

    My ability to follow my interest and passions, share my thoughts about things that matter to me, and do charity give me happiness. Wealth matters, but being content with what I have achieved so far without comparing it with others matters more to me.

    What do you people think? Do share your views in the comment section below. It will be nice to know!

  • Law of demand, price elasticity and its implications in our everyday lives

    What is a law of demand?

    When the price of something falls people usually demand more of it. This happens because you can now afford to buy more of it and also more people can afford it now. This is called the law of demand.

    This means the higher the price, the lower the demand is, and the lower the price, the higher the demand for any normal good or service. Undeniably, a change in people’s tastes, income, and preferences can affect the demand for something, but we will assume that these other factors don’t change, so we can only focus on the relationship between price and quantity demanded.

    The Law of demand is a key economic concept and has many uses and implications in our daily lives. The demand curve slopes downward when you plot the price on y-axis and the quantity demanded on the x-axis.

    But does it happen to every single item and is there a way to find out by how much?

    The answer to this is yes, and this brings us to another important topic, which is the price elasticity of demand.

    By how much does the demand change with a change in its price?

    The answer to this question depends on how responsive or sensitive the demand is to a change in price.

    Economists call it elasticity of demand. Similar to the concept of a stretch of an elastic, we can look at how much does the demand stretches (changes) in response to a change in the price.

    Many factors affect the elasticity of demand. Whether there are any substitutes for that good, if the good is a necessity or not, loyalty to a specific brand of good, time duration, and how much income you spend on that good all play a role in determining its elasticity.

    In economics, if the percent change in the quantity demanded is more than the percent change in the price, we call it elastic. Going with the same logic, if the percent change in the quantity demanded is less than the percent change in the price, we call it inelastic.

    Just if you are interested, here’s the formula to calculate elasticity.

    So if the value is greater than 1, it means the good is elastic and is sensitive to price change.

    So, those goods where a small change in price creates a big change in the quantity people demand, we call them having an elastic demand.

    Similarly, those goods and services, where a change in price do not cause a change in demand, have inelastic demand.

    Who uses this calculation anyway?

    Businesses and corporations use this calculation to see whether their total revenue will increase or decrease, due to a decrease or increase in price. This also helps them in deciding how much discount to give you during the holiday season.

    The government also uses price elasticity to select goods and services on which to impose excise duty for maximum revenue.

    If you are interested in knowing more uses, here is another article that lists some other ones.

    Let’s look at some real-life goods and services to understand this concept better.

    Inelastic goods

    A classic example of inelastic demand is gasoline in the short run. Anyone going to work every day needs gasoline to drive. Even if there is a rise in the price of gasoline, people will still need it. Some of us might find a carpool or use public transport, but for most of us, we will still need to fill up our gas tanks despite the high price.

    Addictive things like tobacco have inelastic demand as well. Smokers still use it even if there is rise in its price. Similarly, certain prescription drugs, like insulin, because of their limited substitute availability also have inelastic demand.

    Elastic goods

    Now, let’s look at some things which have elastic demand. If the price of Pepsi goes up, a lot of people can switch to a close substitute like Coke, unless they are die-hard Pepsi fans. So Pepsi has a very elastic demand. So any item that has a perfect substitute, will have an elastic demand.

    The duration of a price change and the category of the good or service also makes it more elastic. Too complicated! Let me example this with an example.

    In my example above, over the short run, people may not find alternatives to going to work if the gas price goes up, so the demand is inelastic in the short run. However, over the long run, people can find alternative options, like using electric cars or working from home. Thus, the demand for gas will be elastic in long run.

    A specific brand of milk can have elastic demand if people can substitute it with other brands, but milk in general will have more inelastic demand, as there are not many substitutes for dairy lovers. So here you saw the broad category of food has inelastic demand, meaning its demand won’t change if the price of milk goes up. However, a specific brand of milk can see a decrease in demand if its price increases.

    The first chart shows price elasticity > 1, the second shows price elasticity < 1, and the third shows price elasticity close to 1.

    Are there other types of elasticities as well?

    Yes, there are two other types – cross elasticity, which looks at the effect of a change in the price of a substitute or complementary good or service), and income elasticity (which looks at the effect of change in income on quantity demanded. These are important because changes in demand can also happen due to changes in income level and price of other supplements or complementary goods.

    But to not make the post overly long, I only focused on price elasticity in today’s post, as we wanted to see the effect of a change in price only.

    Hope you found this microeconomics post helpful, to see my other microeconomics posts, please click here. And, yes, if you can think of another elastic or inelastic good or service, please write in the comment below.

  • What factors influence the exchange rate?

    The exchange rate is the rate at which one country’s currency trades or exchanges against another country’s currency. Simply put, if there are two countries US and India, how many Indian Rupees equate to 1 USD? You can also write it as the ratio of one currency over another currency.

    Many factors influence how the exchange rates are set. In this post, you will learn about those, but first, let’s understand where the currency exchange takes place.

    Foreign Exchange Market is the biggest market in the world by volume and it determines the exchange rates of currencies against each other

    The currency exchange happens in the foreign exchange market, also called the forex market. It is the global marketplace that sets the exchange rate for currencies around the world. It is a decentralized or over-the-counter market for the trading of currencies at their current market price.

    Foreign exchange markets include large international banks, central banks, multinational companies, investment banks, forex dealers, hedge funds, etc. All of these buy, sell, exchange, and make guesses on the relative exchange rates of any two currency combinations.

    Why do we care about exchange rate fluctuations?

    For any international currency transaction, you need to know the exchange rate. So, if the current exchange rate is 1 USD=80 Indian Rupees, this means when you go to India, you would get approx. Rs 80 for 1 USD. Similarly, if an Indian comes to the US, they would have to pay approx. Rs 8000 to get $100. In real life, foreign exchange dealers make a small profit on any foreign exchange transaction.

    USD appreciated against major currencies of the World

    Recently, in the news, you must have heard that the US Dollar has appreciated against major currencies of the world. I found this chart from IMF’s Oct 4, 2022 blog post and it shows the US dollar vs major currencies. You can see how the USD appreciated against the British Pound sterling, Japanese Yen, Indian Rupee, Euro, and many others since the start of 2022.

    The IMF post stated that economic fundamentals are a major factor in the appreciation of the dollar. Rising US interest rates and its more favorable terms-of-trade compared to other countries in Eurozone, UK, Japan and China have caused the US dollar to emerge stronger.

    Don’t worry if this isn’t clear to you yet, I will explain this mechanism in just a bit.

    What factors influence a price of a currency against another currency?

    The answer to this question lies in the fundamental economic concept of excess demand. The price of a currency relative to another currency will go up if there is more demand for it.

    A country’s exchange rate can either Appreciate, which is an increase in the value of the currency, or the exchange rate

    Or

    Depreciate/devalue, which is a decrease in the value of a country’s currency or the exchange rate.

    Below I have a chart from google finance showing a continued appreciation of USD or the depreciation of Indian Rupees. Twenty years ago, the exchange rate for 1 USD was around 45 Rupees. Since then, the demand for USD has been rising and the price of USD relative to the Indian Rupee has been rising. As of Oct 15, 2022, it is 82 Rupees to 1 USD.

    In the graph below, you can see how the intersection of demand and supply determines the price or exchange rate. We will take call point A as the year 2014 when the exchange rate for 1 USD was 65 Indian Rupees, where demand and supply met.

    With a continued increase in demand for USD, the demand curve shifted up to the right. With the same supply, the new intersection happens at point B, at this point the price of 1 USD is 80 Rupees in Oct 2022. Thus, if the demand for a currency is high relative to another currency, its exchange rate will go up. The opposite will happen when the demand for a currency is low relative to another currency.

    What causes a change in the demand for a currency?

    Many factors can influence the currency’s demand and the exchange rate. Let’s understand the most important ones below. Since we are looking at the appreciation of the USD against major currencies, I will use USD as an example to explain it.

    • Relative Interest rates

    When interest rates are higher in a country there are more money inflows in the US. This happens because international investors would invest there to get better returns. As investment happens in the USD, there’s more demand for USD. This causes the USD value or the exchange rate to appreciate.

    • Relative inflation

    A low and stable inflation rate also plays a key role. Many developed countries such as the US, and the UK have had inflation of around 2% in the past. Although this has changed recently after the pandemic and Ukraine war, it is still lower than in many other countries.

    A lot of times more than one factor play a role in influencing the exchange rate

    A low Inflation rate in the U.S. relative to another country, such as India, can cause the US currency to appreciate. Let me explain why this happens. Low inflation in the US will mean US imports become cheaper to India and India will demand more US-made goods. I just want to point out that when India imports from the US, it pays for those in USD. So, increased demand for US imports will lead to increased demand for USD. This will cause its relative value or exchange rate to rise against the Indian rupee. For more than a year US economy has been witnessing high inflation. The reason USD is going strong is because other countries are dealing with even higher inflation.

    • Current account surplus

    A current account is the balance of trade between a country and other countries it does international trade with. It includes all the payments between countries for physical goods, services, interest, and dividends.  A deficit in the current account shows a country’s imports are more than its exports. To cover this deficit, that country will usually borrow capital from other foreign countries. This causes its currency to depreciate.

    • Relative Strength of the economy

    Also, the relative strength of the US in comparison to other developed countries plays a role too.  If the world is worried about other developed countries’ performances such as the UK, EU, and Russia, the U.S. dollar price will rise in the international market.

    • Speculation

    Also, expectation and speculation play a role in determining a currency exchange rate. If more people believe that the value of the U.S. dollar will rise relative to other currencies in the future, they will demand more of the US dollar to sell it later for a profit. This is going to further increase the demand for the U.S. dollar causing an increase in its value.

    • Relative Competitiveness

    If businesses in the US become more competitive relative to the UK, this will also cause an increase in demand for US-made goods causing an appreciation or increase in the value of the U.S. dollar compared to the pound sterling.

    Conclusion

    In the long run, how strong a country’s economy is and how competitive it is relative to its other countries will determine its exchange rate. A technological innovation that leads to higher productivity will strengthen that country in the international market and will lead to an appreciation in its value.

    What has caused exchange rate fluctuations can be hard to pinpoint, as most of the time several factors play the role.

    Clearly, an appreciation in the US dollar has made travel to the UK and other countries much more affordable for the US people. To see who all benefit from the appreciation or depreciation of a currency, stay tuned for my next post.

    Credit: Images from Freepik

  • How does people’s expectation about inflation affect the actual inflation?

    What people like you and me think about inflation directly impacts the actual inflation rate. So, if we think inflation will be high in the coming months, it will most likely be. In this post, I will explain how this phenomenon works.

    If we expect that overall prices are going to rise in the coming months, we may buy more things now, rather than in the future. If a lot of people do that, this increases the demand for goods and services.

    High inflation is directly linked to a higher demand that is not immediately matched by an increase in supply. As a result, firms increase the prices of goods and services when there is more demand. This enables them to make more profit. As a result, we see increased prices passed on to the consumers causing higher inflation.

    On the other hand, if people expect prices to fall in the future, they may delay spending now to get a better deal. This will result in a decrease in demand for goods and services and businesses will end up lowering prices to clear up their stock.

    So, now we understand how inflation expectations affect actual inflation. If you want to know more about inflation and how it is calculated, you can refer to my post here.

    What is the current inflation expectation in the U.S.?

    After suffering from really high inflation close to 8%-9% for over half a year, we foresee some good news. A survey conducted by the Fed reserve bank of New York shows a decrease in these expectations.

    People in the U.S. feel that one and three-year-ahead inflation are now going to be 5.7 % and 2.8 % respectively.

    These are clearly lower than 6.2 % and 3.2 % in June for one and three years ahead inflation rates respectively. In the figure from the Federal Reserve of New York website, you can see how there is a decline in the curve of the expected inflation rate towards the end. This is the survey done in the month of August 2022 about what people think inflation may look like for 1 year and 3 years.

    It shows that people’s expectations are consistent with what the Fed is trying to achieve. By raising interest rates, the Fed is trying to slow down the demand in the U.S. When borrowing becomes expensive, people generally tend to borrow less for things like cars, mortgages, etc.

    In their September 20 meeting, the Fed is most likely going to raise the key federal funds rate by another 75 basis points. The Fed has been raising interest rates to fight the high inflation in the U.S for the last 6 months. Central banks in a lot of other countries fighting inflation have been doing the same.

    To learn more about the role of the central bank, stay tuned for my next post.