What is Economics? Fundamental Concepts Micro Economics
Macro Economics International Economics Economic Institutions

What is Economics?
Economics is the social science that studies the behavior of individuals, households, and organizations in managing or using scarce resources (which have alternative uses) to satisfy their unlimited wants. It is the basically a study of the use of limited resources to produce and distribute goods and services.

Economics focuses on the behavior and interactions of the many economic agents and how economies work and their relationships. Economics can generally be broken down into: macroeconomics, which concentrates on the behavior of the aggregate economy; and microeconomics, which focuses on individual consumers.

Fundamental Concepts
Fundamental economic concepts listed below are the principles that are at the heart of economics. A clear understanding of these concepts, is essential if one wishes to engage in any economic reading or discussion.

Cost-benefit Analysis
Cost-benefit analysis (CBA), sometimes called benefit–cost analysis (BCA), is a systematic approach to estimating the strengths and weaknesses of alternatives that satisfy requirements for any decision. It is a technique that is used to determine options that provide the best approach for the adoption and practice in terms of benefits in labour, time and cost savings etc. The CBA is also defined as a systematic process for calculating and comparing benefits and costs of a project, decision or government policy.

Broadly, CBA has two purposes:

  • To determine if it is a sound investment/decision (justification/feasibility),
  • To provide a basis for comparing projects. It involves comparing the total expected cost of each option against the total expected benefits, to see whether the benefits outweigh the costs, and by how much.

Supply & Demand
In microeconomics, supply and demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers (at current price) will equal the quantity supplied by producers (at current price), resulting in an economic equilibrium for price and quantity.

The basic law of supply and demand state that if supply remains unchanged, as demand increases, a shortage occurs & equilibrium prices will be higher and if demand decreases, a surplus occurs, leading to a lower equilibrium price. Similarly, if demand remains unchanged, and supply increases, there will be fall in prices and if supply decreases there will be rise in prices.

Economic & Market Equilibrium
Economic equilibrium is a state where economic forces such as supply and demand are balanced and in the absence of external influences the (equilibrium) values of economic variables will not change.

Market equilibrium refers to a condition where a market price is established through competition such that the amount of goods or services sought by buyers is equal to the amount of goods or services produced by sellers. This price is often called the competitive price or market clearing price and will tend not to change unless demand or supply changes and the quantity is called "competitive quantity" or market clearing quantity.

Division of Labor
The division of labour is the specialization of cooperating individuals who perform specific tasks and roles. . It is most often applied to systems of mass production and is one of the basic organizing principles of the assembly line.

Because of the large amount of labour saved by giving workers specialized tasks in industrial assembly lines, classical economists such as Adam Smith and engineers were proponents of division of labour.

Opportunity Costs
The opportunity cost of a choice is the value of the best alternative forgone /rejected, in a situation in which a choice needs to be made between several mutually exclusive (independent) alternatives given limited resources. Assuming the best choice is made, it is the "cost" incurred by not enjoying the benefit that would be had by taking the second best choice available.

The Oxford Dictionary defines it as "the loss of potential gain from other alternatives when one alternative is chosen". The notion of opportunity cost plays a crucial part in decision making and are not restricted to monetary or financial costs: the real cost of output forgone, lost time, pleasure or any other benefit that provides utility should also be considered opportunity costs.

Factors of Production
Factors of production are the inputs to the production process where finished goods are the output. The goods can be commodities or services.

There are four basic factors of production: (i) land (ii) labour (iii) capital and (iv) entrepreneurship. The production output depends upon inputs ie. any combination of the factors of production. Input is the starting point and output is the end point of production process and such input-output relationship is called a production function.

Market Economy vs. Planned Economy

  • Market Economy: is an economy in which decisions regarding investment, production and distribution are based on supply and demand, and prices of goods and services are determined in a free price system. The major defining characteristic of a market economy is that decisions on investment and the allocation of producer goods are mainly made through markets. This is contrasted with a planned economy, where investment and production decisions are embodied in a plan of production.
  • Planned Economy: is the economic system in which decisions regarding production and investment are embodied in a plan formulated by a central authority, usually by a public body such as a government agency. The planning aims to improve productivity and coordination by enabling planners to take advantage of better information achieved through the consolidation of economic resources when making decisions regarding investment and the allocation of economic inputs.

Scarcity is the fundamental economic problem of having seemingly unlimited human wants in a world of limited resources. Because of scarcity, various economic decisions must be made to allocate resources efficiently. These resources refer to the factors of production, namely land, labour and capital.

It states that society has insufficient productive resources to fulfill all human wants and needs. The production cost of something also determines if it is scarce or not. Additionally, scarcity implies that not all of goals/wants can be pursued at the same time; trade-offs are made of one good against others.

Micro Economics
Microeconomics is the study of how markets work; it examines factors that influence, and result from, the inner workings of economies. Specifically, it looks at how businesses in the market economy go about using limited resources to produce and distribute goods and services. It examines the behavior of basic elements in the economy, including individual agents and markets, their interactions, and the outcomes of interactions. Individual agents may include, for example, households, firms, buyers, and sellers.

Competition and Market Structures
In economics, market structure is the number of firms producing identical products which are homogeneous. The elements of Market Structure include the number and size distribution of firms, entry conditions, and the extent of differentiation.

The imperfectly competitive structure is quite identical to the realistic market conditions where some monopolistic competitors, monopolists, oligopolists, exist and dominate the market conditions. In economics, the following are the major types of market structures identified:

  • Monopoly: is a extreme market structure in which there is only one producer/seller for a product. In other words, the single business is the industry and there are no substitutes. Entry into such a market is restricted for economic, social or political reasons.
  • Monopolistic competition: is a type of imperfect competition such that many producers sell products that are differentiated from one another (e.g. by branding or quality) and hence are not perfect substitutes. In monopolistic competition, a firm takes the prices charged by its rivals as given and ignores the impact of its own prices on the prices of other firms
  • Oligopoly: is where there are only a few firms that make up an industry and they have control over the price. Like a monopoly, an oligopoly has high barriers to entry and there are no or very few/costly substitutes for the product.
  • Perfect competition: is a extreme theoretical market structure characterized by many buyers and sellers, many products that are similar in nature and, as a result, many substitutes. It means no or very small barriers to entry and prices are determined by supply and demand. The prices are determined by the market and producers do not have any leverage.

A consumer is a person or group of people, such as a household, who are the final users of products or services. The consumer's use is final in the sense that the product is usually not improved by the use.

Consumption is what consumers do. Within an economy, this can be broken down into (i) Private and (ii) Public consumption. The more resources an individual or society consumes, the less it has to save or invest. Economists suggest that at certain stages of life individuals are more likely to be saving than consuming, and at other stages they are more likely to be heavy consumers.

Demand along with is Supply are the twin driving forces of the market economy. Demand is not just about measuring what people want; for economists, it refers to the amount of a good or service that people are both willing and able to buy.

The Demand Curve measures the relationship between the price of a good and the amount of it demanded. Usually, as the price rises, fewer people are willing and able to buy it; in other words, demand falls.

Elasticity of Demand
Demand elasticity refers to how sensitive the demand for a good is to changes in other economic variables. Demand elasticity is a measure of how much the quantity demanded will change if another factor changes.

Demand elasticity is important because it helps firms model the potential change in demand due to changes in price of the good, the effect of changes in prices of other goods and many other important market factors. Elasticities greater than one are called "elastic," elasticities less than one are "inelastic," and elasticities equal to one are "unit elastic."

Income Distribution
In economics, income distribution is how a nation's total GDP is distributed amongst its population. Income and distribution has always been a central concern of economic theory and economic policy.

Market Prices
The current price at which an asset or service can be bought or sold. Economic theory contends that the market price converges at a point where the forces of supply and demand meet. Shocks to either the supply side and/or demand side can cause the market price for a good or service to be re-evaluated.

Price Mechanism
Price mechanism refers to the system where the forces of demand and supply determine the prices of commodities and the changes therein. It is the buyers and sellers who actually determine the price of a commodity. Price mechanism is the outcome of the free play of market forces of demand and supply. However, sometimes the government controls the price mechanism to make commodities affordable for the poor people too.

Production Production is a process of combining various material inputs and immaterial inputs (plans, know-how) in order to make something for consumption (the output). It is the act of creating output, a good or service which has value and contributes to the utility of individuals.

The most important forms of production are: (a) market (b) government & (c) household production.

There are different interpretations Profit. As financial /accounting term, it is residual of revenue minus the expenses or explicit costs. In Classical economics, profit is the return to an owner of resources from any production effort, or a return on bonds and money invested in capital markets.

In Neo-Classical economics, Economic profit is similar to accounting profit but smaller because it also considers the total opportunity costs (both explicit and implicit) of a venture. A Normal profit would then refer to a situation in which the 'economic profit' is zero.

Rational Behaviour
This is a part of decision making practice wherein an individual/company exercises sensible choice making, which provides him with the optimum amount of benefit. Rational behaviour facilitates decision making that may not always give the best possible returns materially. It strives to achieve benefits that are most optimal in nature to the decision maker, be it monetary or non-monetary.

Roles of Government

Law of supply states that other factors remaining constant, price and quantity supplied of a good are directly related to each other. In other words, when the price paid by buyers for a good rises, then suppliers increase the supply of that good in the market.

Law of supply depicts the producer behavior at the time of changes in the prices of goods and services. When the price of a good rises, the supplier increases the supply in order to earn a profit because of higher prices.

Macro Economics
Macroeconomics is the study of the factors that influence, and result from, the large scale functions of economies. It is the way economists measure the behavior and functioning of economies. It analyzes the entire economy (meaning aggregated production, consumption, savings, and investment) and issues affecting it, including unemployment of resources (labor, capital, and land), inflation, economic growth, and the public policies that address these issues (monetary, fiscal, and other policies).

Aggregate Demand
It is the total demand for final goods and services in the economy at a given time and price level. It specifies the amounts of goods and services that will be purchased at all possible price levels. This is the demand for the GDP of a country. The aggregate demand curve illustrates the relationship between two factors - the quantity of output that is demanded and the aggregated price level.

Aggregate Supply It is the total supply of goods and services that firms in a national economy plan on selling during a specific time period. It is the total amount of goods and services that firms are willing to sell at a given price level in an economy.

Bank Rate
RBI lends (against approved securities) to the commercial banks through its discount window to help the banks meet depositor's demands and reserve requirements for long term. The Interest rate the RBI charges the banks for this purpose is called bank rate.

If the RBI wants to increase the liquidity and money supply in the market, it will decrease the bank rate and if RBI wants to reduce the liquidity and money supply in the system, it will increase the bank rate.

An annual procedure to decide how much public spending there should be in the year ahead and what mix of taxation, charging for services and borrowing should finance it. In India, Union Budget keeps the account of the government's finances for the fiscal year that runs for the fiscal year from 1st April to 31st March.

According to Article 112 of the Indian Constitution, the Union Budget of a year, also referred to as the Annual Financial Statement, is a statement of the estimated Receipts and Expenditure of the government for that particular year. Union Budget is classified into Revenue Budget and Capital Budget.

Revenue budget: includes the government's Revenue Receipts and Expenditure. There are two kinds of Revenue Receipts - (i) Tax and (ii) Non-Tax revenue. Revenue expenditure is the expenditure incurred on day to day functioning of the government and on various services offered to citizens. If revenue expenditure exceeds revenue receipts, the government incurs a revenue deficit.

Capital Budget: includes capital receipts and payments of the government. Loans from public, foreign governments and RBI form a major part of the government's capital receipts. Capital expenditure is the expenditure on development of machinery, equipment, building, health facilities, education etc. Fiscal deficit is incurred when the government's total expenditure exceeds its total revenue.

Budget Deficits
There are three types of deficit in the budget

  1. Revenue deficit:- which is the excess of revenue expenditure over revenue receipts. It implies that resources have to be borrowed from other sectors of economy to cover this deficit. It may lead either to borrowing or sale of government asset thus high revenue deficit give a warning signal to the government either to curtail its expenditure or increase its revenue.
  2. Fiscal deficit:- is the excess of total expenditure over revenue receipts (revenue and capital receipts) excluding borrowing. Fiscal deficit = Total expenditure –Revenue receipt –Capital receipts (excluding borrowing). Fiscal deficit therefore is a compressive measure of the implications for in economy. It has serious implication for economy. The govt. has to borrow to meet this deficit a major part of fiscal deficit is financed by the deficit financing(printing extra currency notes). It leads to rise in the prices.
  3. Primary deficit: - The excess of fiscal deficit over payments of interest is called primary deficit. Thus, Primary deficit = Revenue deficit – Interest payments. Primary deficit shows how much of the govt. borrowing is going to meet expenses other than interest payment. A lower primary deficit indicates that the interest payment has forced the govt. to borrow. Thus it indicates the real position of govt.

Black Economy
A black market or underground economy is the market in which goods or services are traded illegally. The key distinction of a black market trade is that the transaction itself is illegal. The goods or services may or may not themselves be illegal to own, or to trade through other, legal channels. Because the transactions are illegal, the market itself is forced to operate outside the formal economy. Common motives for operating in black markets are to trade contraband, avoid taxes, or skirt price controls.

Such transactions do not normally show up in the figures for GDP, so the black economy may mean that a country is richer than the official data suggest.

Business Cycles
An economy witnesses a number of business cycles in its life. These business cycles involve phases of high or even low level of economic activities. A business cycle involves periods of economic (i) expansion, (ii) recession, (iii) trough and (iv) recovery. The duration of such stages may vary from case to case.

The real business cycle theory makes the fundamental assumption that an economy witnesses all these phases of business cycle due to technology shocks. Technological shocks include innovations, bad weather, stricter safety regulations, etc.

Capital Markets
Capital market is a market where buyers and sellers engage in trade of financial securities like bonds, stocks, etc. The buying/selling is undertaken by participants such as individuals and institutions. Capital markets help channelise surplus funds from savers to institutions which then invest them into productive use. Generally, this market trades mostly in long-term securities.

Capital market consists of primary markets and secondary markets. Primary markets deal with trade of new issues of stocks and other securities, whereas secondary market deals with the exchange of existing or previously-issued securities. Another important division in the capital market is made on the basis of the nature of security traded, i.e. stock market and bond market.

Cash Reserve Ratio (CRR)
Cash Reserve Ratio (CRR) is a specified minimum fraction of the total deposits of customers, which commercial banks have to hold as reserves either in cash or as deposits with the central bank. CRR is set according to the guidelines of the central bank of a country.

The amount specified as the CRR is held in cash and cash equivalents, is stored in bank vaults or parked with the Reserve Bank of India. The aim here is to ensure that banks do not run out of cash to meet the payment demands of their depositors.

CRR is a crucial monetary policy tool and is used for controlling money supply in an economy.CRR specifications give greater control to the central bank over money supply. Commercial banks have to hold only some specified part of the total deposits as reserves. This is called fractional reserve banking.

A comprehensive measure used for estimation of price changes in a basket of goods and services representative of consumption expenditure in an economy is called consumer price index.

Estimation of CPI is quite rigorous calculation exercise. Various categories and sub-categories have been made for classifying consumption items and on the basis of consumer categories like urban or rural. Based on these indices and sub indices obtained, the final overall index of price is calculated mostly by national statistical agencies. It is one of the most important statistics for an economy and is generally based on the weighted average of the prices of commodities.

Inflation is measured using CPI and it gives an idea of the cost of living

When the overall price level decreases so that inflation rate becomes negative, it is called deflation. It is the opposite of the often-encountered inflation. A reduction in money supply or credit availability is the reason for deflation in most cases. Reduced investment spending by government or individuals may also lead to this situation. Deflation leads to a problem of increased unemployment due to slack in demand.

Central banks aim to keep the overall price level stable by avoiding situations of severe deflation/inflation. They may infuse a higher money supply into the economy to counterbalance the deflationary impact. In most cases, a depression occurs when the supply of goods is more than that of money.

Deflation is different from disinflation as the latter implies decrease in the level of inflation whereas on the other hand deflation implies negative inflation.

Depression is defined as a severe and prolonged recession. A recession is a situation of declining economic activity. Declining economic activity is characterized by falling output and employment levels.

Generally, when an economy continues to suffer recession for two or more quarters, it is called depression. The level of productivity in an economy falls significantly during a depression. Both the GDP and GNP show a negative growth along with greater business failures and unemployment.

Economic Growth
Economic growth is the increase in the market value of the goods and services produced by an economy over time. It is conventionally measured as the percent rate of increase in real GDP.

Growth is usually calculated in real terms - i.e., inflation-adjusted terms - to eliminate the distorting effect of inflation on the price of goods produced. Further, of more importance is the growth of the ratio of GDP to population (GDP per capita), which is also called per capita income. An increase in same is referred to as intensive growth. GDP growth caused only by increases in population or territory is called extensive growth.

Fiscal Policy
Fiscal Policy refers to the policy of the government under which the instruments of taxation, public expenditure, public borrowing are used to achieve various objectives of the economic policy.

The government plays a balancing act with the different instruments of fiscal policy namely (1) Public Revenue (Taxation) (2) Public Expenditure & (3) Public borrowing.

National Income Aggregates
There are no of aggregates related to NI. To understand these aggregates its important to know the following relations -

  1. Domestic product & National product : DP is defined as the value of all final gods & services produced within the domestic territory of the country. National Product refers to the amount of final goods & services produced by the normal residents of the country whether operating within the domestic territory or outside. The difference between two is known as Net Factor Income from Abroad (NFIA).
  2. Gross & Net domestic product. GDP is the market value of all officially recognized final goods and services produced within a country in a year, or over a given period of time. The difference between GDP & NDP is depreciation of fixed capital where GDP includes the same and NDP excludes it.

The diff between GDP mp & GNP mp is NFIA.

Human Development Index (HDI)
The HDI is a statistical tool used to measure a country's overall achievement in its social and economic dimensions. HDI is a statistical tool used to measure a country's overall achievement in its social and economic dimensions. The social and economic dimensions of a country are based on the health of people, their level of education attainment and their standard of living.

Pakistani economist Mahbub ul Haq created HDI in 1990 which was further used to measure the country's development by the United Nations Development Program (UNDP). Calculation of the index combines four major indicators: life expectancy for health, expected years of schooling, mean of years of schooling for education and Gross National Income per capita for standard of living. Every year UNDP ranks countries based on the HDI report released in their annual report. HDI is one of the best tools to keep track of the level of development of a country, as it combines all major social and economic indicators that are responsible for economic development.

Inflation Inflation is the percentage change in the value of the money on a year-on-year basis. It effectively measures the change in the prices of a basket of goods and services in a year. In India, inflation is calculated by taking the WPI as base.

Formula = (WPI in month of current year-WPI in same month of previous year)*100 / WPI in same month of previous year

Inflation occurs due to an imbalance between demand and supply of money, changes in production and distribution cost or increase in taxes on products. When economy experiences inflation, i.e. when the price level of goods and services rises, the value of currency reduces. This means now each unit of currency buys fewer goods and services. Contrary to its negative effects, a moderate level of inflation characterizes a good economy.

Liquidity Trap
Liquidity trap is a situation when expansionary monetary policy (increase in money supply) does not increase the interest rate, income and hence does not stimulate economic growth.

Liquidity trap is the extreme effect of monetary policy in which the general public is prepared to hold on to whatever amount of money is supplied, at a given rate of interest. They do so because of the fear of adverse events like deflation, war. In a liquidity trap, the monetary policy is powerless to affect the interest rate.

Monetary Policy
The set of government rules and regulations to control or stimulate the aggregate indicators of an economy frames the macroeconomic policy. Aggregate indicators involve national income, money supply, inflation, unemployment rate, growth rate, interest rate and many more. In short, policies framed to meet the macro goals.

Two main regulatory macroeconomic policies are Fiscal policy and Monetary policy. Fiscal policy is the macroeconomic policy where the government makes changes in government spending or tax to stimulate growth. Monetary policy deals with changes in money supply or changes with the parameters that affects the supply of money in the economy. Contract laws, debt management policy, income policy are some of the other macroeconomic policies designed to modify macroeconomic indicators of the economy.

Money Supply
The total stock of money circulating in an economy is the money supply. The circulating money involves the currency, printed notes, money in the deposit accounts and in the form of other liquid assets.

Valuation and analysis of the money supply help the economist and policy makers to frame the policy or to alter the existing policy of increasing or reducing the supply of money. The valuation is important as it ultimately affects the business cycle and thereby affects the economy. Periodically, every country's central bank publishes the money supply data based on the monetary aggregates set by them. In India, the Reserve Bank of India follows M0, M1, M2, M3 and M4 monetary aggregates.

Poverty Trap
Poverty trap is a spiraling mechanism which forces people to remain poor. It is so binding in itself that it doesn't allow the poor people to escape it. Poverty trap generally happens in developing and under-developing countries, and is caused by a lack of capital and credit to people.

Poverty trap can be broken by planned investments in the economy and providing people the means to earn and be employed. A series of poverty alleviation programs can be enforced to raise individuals out of poverty by providing monetary aid for a period of time.

The transfer of ownership, property or business from the government to the private sector is termed privatization. The government ceases to be the owner of the entity or business. Privatization is considered to bring more efficiency and objectivity to the company, something that a government company is not concerned about. India went for privatization in the historic reforms budget of 1991, also known as 'New Economic Policy'.

Progressive Tax
Progressive tax is the taxing mechanism in which the taxing authority charges more taxes as the income of the taxpayer increases. A higher tax is collected from the taxpayers who earn more and lower taxes from taxpayers earning less. The government uses a progressive tax mechanism.

Under progressive taxes, it is believed that people who earn more should pay more. The income tax is divided into slabs. As the income of the tax payer crosses a benchmark income, a new rate of tax (higher than before) is charged to him.

Proportional Tax
Proportional tax is the taxing mechanism in which the taxing authority charges the same rate of tax from each taxpayer, irrespective of income. Since the tax is charged at a flat rate for everyone, whether earning higher income or lower income, it is also called flat tax. It is based on the theory that since everybody is equal, taxes should also be charged the same way.

Public Debt
Public debt refers to government debt. It refers to Government borrowings from individuals, financial institutions, organisations and foreign countries. If revenue collected through taxes and other sources is not adequate to cover expenditure, the government may resort to borrowings. Thus public debt is one of the instruments to cover deficits in budget.

Government borrowings within the country are known as internal debt. Borrowings by the government from abroad is known as external debt.

Public Distribution System (PDS)
Public distribution system is a government-sponsored chain of shops entrusted with the work of distributing basic food and non-food commodities to the needy sections of the society at very cheap prices. Wheat, rice, kerosene, sugar, etc. are a few major commodities distributed by the public distribution system. Food Corporation of India, a government entity, manages the public distribution system. The system is often blamed for its inefficiency and rural-urban bias.

Rationing refers to an artificial control on the distribution of scarce resources, food items, industrial production, etc. Rationing is done to ensure the proper distribution of resources without any unwanted waste. Banks use credit rationing to control lending beyond the monetary base of the bank. Controlling the prices and demand and supply leads to availability of goods and services for every section of the society.

Real vs. Nominal
In economics a nominal value is an economic value expressed in monetary terms (that is, in units of a currency). By contrast, a real value is a value that has been adjusted from a nominal value to remove the effects of general price level changes over time. Real values are a measure of purchasing power net of any price changes over time.

To use this understanding, if inflation is positive, which it generally is, then the real interest rate is lower than the nominal interest rate. If we have deflation and the inflation rate is negative, then the real interest rate will be larger.

Real Interest Rate = Nominal Interest Rate - Inflation

International Economics

Balance of Trade
The commercial balance or net exports, is the difference between the monetary value of exports and imports of output in an economy over a certain period, measured in the currency of that economy. It is the relationship between a nation's imports and exports. A positive balance is known as a trade surplus; a negative balance is referred to as a trade deficit or, informally, a trade gap. The balance of trade is sometimes divided into a goods and a services balance.

Balance of Payments
A statement that summarizes an economy’s transactions with the rest of the world for a specified time period. The BOP encompasses all transactions between a country’s residents and its nonresidents involving goods, services and income; financial claims on and liabilities to the rest of the world; and transfers such as gifts.

Barriers to Trade
They are government-induced restrictions on international trade. They are basically two types of barriers – Trariff & Non-tariff. Tariff barriers includes – taxes, custom duties, etc. The Non-tariff are form of restrictive trade where like quotas, levies, embargoes, sanctions and other restrictions, and are frequently used by large and developed economies.

Big Mac Index
The Big Mac index was devised by Pam Woodall of The Economist in 1986, as a light hearted guide to whether currencies are at their "correct" level. It is based on purchasing power parity (PPP) concept. In this case, the basket is a McDonalds' Big Mac, which is produced in more than 100 countries. The Big Mac PPP is the exchange rate that would leave hamburgers costing the same in the United States as elsewhere. Comparing actual exchange rates with PPP signals whether a currency is undervalued or overvalued. Some studies have found that the Big Mac index is often a better predictor of currency movements than more theoretically rigorous models.

Comparative Advantage
The benefit or advantage of an economy to be able to produce a commodity at a lesser opportunity cost than other entities is referred to as comparative advantage in international trade theory.

The principle of comparative advantage is fundamental to determination of the pattern of trade among nations. A nation will focus on producing that product where it has a comparative advantage over other nations.

Current Account
Current account is one of the two component accounts of the Balance of Payments of a nation. It records the trade of goods and services of an economy with other countries of the world.

Current account includes three components – (a) Net exchange i.e. exports minus imports of goods, (b) Net exchange of services and (c) Net transfers to and from the country. The current account figure reveals the pattern of foreign trade. If the balance of trade is negative, then the country is importing more goods and services than its exports of these. The other component of the BOP is the capital account.

The balance in this account before accounting for the transfer component is generally referred to as the balance of trade. In India, current account is reported by the Reserve Bank of India.

Exchange Rates
Also known as a foreign-exchange rate, forex rate, FX rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency. For example, an interbank exchange rate of 59 Indian Rupees (INR) to the United States dollar (US$) means that Rs.59 will be exchanged for each US$1.

Exchange rates can be floating or fixed. While floating exchange rates - in which currency rates are determined by market force – are the norm for most major nations, some nations prefer to fix or peg their domestic currencies to a widely accepted currency like the US dollar.

Purchasing Power Parity (PPP)
The theory aims to determine the adjustments needed to be made in the exchange rates of two currencies to make them at par with the purchasing power of each other. In other words, the expenditure on a similar commodity must be same in both currencies when accounted for exchange rate. The purchasing power of each currency is determined in the process.

PPP is used worldwide to compare the income levels in different countries. PPP thus makes it easy to understand and interpret the data of each country. Eg.: a pair of shoes costs Rs 2,500 in India then it should cost $50 in US when the exchange rate is 50 between the dollar and the rupee.

Economic Institutions

The International Monetary Fund (IMF) is an international organization that was initiated in 1944 at the Bretton Woods Conference and formally created in 1945 by 29 member countries.

Today, IMF is a self-described "organization of 188 countries, working to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty around the world."

Countries contribute funds to a pool through a quota system from which countries with payment imbalances temporarily can borrow money and other resources. Through this fund, and other activities such as surveillance of its members' economies and the demand for self-correcting policies, the IMF works to improve the economies of its member countries.

The Reserve Bank of India (RBI) is India's central banking institution, which controls the monetary policy of the Indian rupee. It was established on 1 April 1935 in accordance with the provisions of the RBI Act, 1934. Following India's independence in 1947, the RBI was nationalised in the year 1949.

The RBI plays an important part in the development strategy of the Government of India. The general superintendence and direction of the RBI is entrusted with the 21-member Central Board of Directors. It is headed by the Governor (currently Dr. Raghuram Rajan). Its Main functions are:

  1. Bank of Issue of currencies
  2. Monetary authority and the bank of the government (central & state)
  3. Regulator and supervisor of the financial system
  4. Managerial of foreign exchange control
  5. Banker of Banks

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