Financial Concepts for Loans and Real Estates

Now, Insurance Regulatory and Development Authority plans to review a rule that mandates insurers to offer guaranteed maturity benefits on unit-linked pension plans to boost sales of these products.

An online news portal about business and economy – economictimes.indiatimes.com, quotes a statement of a senior IRDA official, “The regulator will unveil new guidelines on pension products offered by insurers in a fortnight and they will come into force from April 1 this year.”

Further it quotes a statement of IRDA member-actuary R Kannan, “The 4.5% guaranteed return attached to the pension plan is something that deters insurers from launching pension products. Very few companies have launched pension products after the new norms came into force last year. We therefore plan to frame guidelines for pension products, keeping in view the differences in risk appetite for investors.”

In an analysis the news portal writes, “Today, insurers are mandated to offer a 4.5% guaranteed return on pension products offered under the unit-linked platform. The regulator had reckoned that a guaranteed return would protect policyholders even when markets crash. The idea was to encourage long-term savings and help policyholders build a nest egg to cater to their needs as they grow old.

However, a review has been warranted after a spate of complaints from insurers saying they are not in a position to guarantee returns on unit-linked pension plans as it would hurt their profitability. In fact, the insurance regulator had earlier hinted that a 4.5% return was not sacrosanct and could come up for review, depending on the economic environment.”

In a comparison, the news portal made a clear line, “The regulator is likely to ask life insurance companies to follow all the Sebi disclosure norms for a share offer, along with some additional norms that are being finalized by it on profitability. The idea is to help investors take informed decisions.

Sebi had cleared the life insurance IPO guidelines in October last year. All life insurance companies that have completed 10 years of operations will be allowed to list on bourses. HDFC Life, ICICI Prudential & SBI Life are companies that can raise equity from the markets.” You should know about Indirect Tax or Consumption Tax also from Managerial Economics.

Fiscal and Monetary policies are ‘indirect’ or ‘general controls.’ They affect the overall aggregate demand of the economy. They affect particular choice of consumer and producers. Such controls are in the form of licensing, price control, rationing, import duties, quotas etc. They are executed and designed to overcome specific shortage and surplus in the economy. A physical policy is to ensure proper allocation of scare resources like food, raw material, consumer goods and capital equipments etc.

Instruments of Physical Policy:

The instruments of Physical Policy are

Control over consumption and distribution

Control over investment and production foreign trade controls

Control over consumption and distribution: Consumption can be controlled and regulated in two ways.

a) By regulating the production of consumer goods directly, through a control over allocation of raw material and by fixing quotas.
b) By controlling the physical demand for goods, through price control and rationing.

Price control is less drastic and more comprehensive than rationing and therefore more useful. The prices of essential goods are fixed at a low level. At the level of such controlled prices, there always exists excess demand and therefore unless there is rationing, price controls may lead to queues, black marketing, hoarding, etc. Thus, unless there is an efficient network of public distribution, the purpose of price control may get defeated.

Price control may be administrated for not only goods in the commodity market, but also services in the factor market. Profit control, interest control, rent control and wage control are all examples of factor price control. Commodity and factor price are inter related.

Control over investment and production – From the stand point of allocation and utilization of scarce resources, such control are very essential. The usual methods of control in this context are fixation of import of certain essential raw materials and goods. Import controls are executed through a system of quotas and licenses.

Export controls – Export controls of quotas, issue of licenses, strict demarcation of the areas of small scale, foreign investment etc. In fact, production, distribution and consumption should be controlled simultaneously. Control over investment must be combined with price control and regulation of monopolies and restrictive trade practices.

Indirect tax differs from direct tax. Tax which is imposed on every unit of product is known as lump sum tax. E.g. excise tax and sales tax. Taxes depending on the value of particular product are called ‘ad valorem tax’ e.g. tax on airline tickets.

Value Added Tax (VAT) was originally introduced by West European countries. But it was introduced in India with few modifications to suit Indian economic system and called MODVAT. VAT is the tax on value added at each stage of production.

A good tax structure has to control and bring stability in economic system. There re few requirement of a good tax structure. They are –

The revenue earned though tax structure should be adequate.

The distribution of tax burden should be equal.

The excess burden or Dead Weight Loss should not exceed the amount of revenue earned.

It should help in stabilization and economic growth.

Administration cost should not be more than revenue earned.

Tax burden should be borne by the person who is taxed.

Lion share of government expenditure should come from tax.

Public expenditure – The unemployment condition after 1930’s Great Depression saw the need of government to create employment by various public work programmes that gained importance. Private sector is not always willing to use its resources in works like railway track, construction of dams, roads etc.

Project which need heavy investment and returns are low with a long gestation period. The responsibility of building up such infrastructure for economy and large capital goods industries has to be taken. Government has many more expenditure such as free health services, education, monetary assistance for unemployed youths, pension for senior citizens etc. Lots of expenditures on the defence activity, which is the most important for the security of a nation and subsidies on the essential commodities, cannot be ignored.

The chapter also has been taken from Managerial Economics book of SMU MBA in the continuation of Instruments of Fiscal Policy.

Some Important Instruments of Fiscal Policy:

Taxation: Taxation is always a very important source of revenue for both developed and developing countries. Tax comes under tow heading – Tax on individual (direct tax) and tax on commodity (indirect tax or commodity tax). Direct tax includes income tax, corporate tax, taxes on property and wealth. Indirect tax is tax on the consumptions. It includes sales tax, excise duty and custom duties.

Direct tax structure can be divided into three bases –

Progressive tax

Regressive tax

Proportional tax

Progressive tax: Progressive tax says that their level of income, greater the volume of tax burden you have to bear. This means as income increases, the tax contribution should also increase. Low income group people pay low tax, whereas the high income group people pay higher tax.

Regressive tax: It is theoretically possible, though no government implements such tax structure, because that leads to unequal distribution of income. As your income increases the contribution through tax decreases. Low income people will pay more and high income people will pay less.

Proportional tax: When the tax imposed is irrespective of the income you earn, every income group, high or low pay the same amount of tax.

The instruments of Fiscal Policy are Automatic Stabilizer and Discretionary Fiscal Policy.

Automatic Stabilizer: The tax structure and expenditure are programmed in such a way that there is increase in expenditure and decrease in tax in recession and decrease in expenditure and increase in tax revenue in the period of inflation. It refers to built-in response to the economic condition without any deliberate action on the part of government. It is called built-in-stabilizer to correct and thus restore economic stability.

Discretionary Fiscal Policy: Under this, to stabilize the economy, deliberate attempts are made by the government in taxation and expenditure. It entails definite and conscious actions.

Fiscal policy is a policy, which affects aggregate output, employment, saving, investment etc. A responsible government would contain its expenditure within its revenue and thus making the budget balanced.

The importance of fiscal policy as an economic tool was realized only after Great Depression in 1930s. During 1930, the private sector was not able to start recovery because the incentive to invest was not enough and that is when the government interference established. It is believed that fiscal policy is an effective method to alter aggregate demand and give way to economic stabilization.

Objectives of Fiscal Policy:

The objective of fiscal policy is to increase the rate of investment, reduce unemployment and control inflationary pressure. Some of the objectives are:

1. Full employment – The importance of fiscal policy as a economic tool was understood only after the great depression in 1930s, when there was chronic unemployment situation and their was need to stimulate employment. Increase in government expenditure will push the aggregate demand through multiplier effect. This increases the income and employment.

2. Economic stability – Economic stability is required for a steady growth in national income, employment and investment. If there is a condition of depression, then the fiscal policy should be designed in such a way that the government expenditure will be increased and the taxes will be reduced to increase the aggregate demand, employment and investment. If the economy is faced by inflation, the fiscal policy will help to bring stability in the economy.

Fiscal policy is one of the aspects of monetary policy. However, we already have discussed about quantitative instrument of monetary policy and qualitative instrument of monetary policy. Now, in this chapter we have discussed about fiscal policy and objectives of fiscal policy in details.

Fiscal policy and objective of fiscal policy chapter has been taken from Managerial Economics book of SMU MBA.

They are also known as selective instrument of credit control. They are called qualitative tools, as they influence the type and composition of credit. These instruments are very popular in developing countries like India. Some important selective credit control measures are:

1) Credit Rationing: Under this, certain conditions are laid by the Central Bank to see proper regulation of consumer credit. This is to prevent excess expansion of credit.

2) Direct Action: This includes charging penalty interest rates, qualitative credit ceiling etc. on Commercial Bank. It has its direction and restrictive measures, which all the concern banks should follow regarding the lending and investment.

3) Margin Requirement: Here, margin refers to difference between market value and amount borrowed against the securities. Bank, while advancing loan against security, do not lend the full amount, but less. This is done keeping in view the difference between the value of security and the amount of advance to cover any loss.

4) Moral Persuasion: This is used by many countries. It has a great influence over the loan policy of banks. There is a co-operation between them. Under this, the Central Bank makes an informal request to Commercial Bank to contract loans in the time of inflation and expand loans in depression. It helps the Central Bank to secure the willingness and co-operation, but then that depends on the amount of respect and authority the Central Bank enjoys among the member banks.

A Contractionary Monetary Policy in nature will shift the demand downwards, as it leads to decrease in consumption and investment. This will lead to decrease in aggregate demand.

These are the qualitative tools of monetary policy which is being described in details in this chapter. However, we already have discussed about quantitative tools of monetary policy in our previous post in this blog.

Quantitative Instruments:

It is called quantitative, as they regulate the total quantity of money. In this category, the tools are –

Bank Rate or Discount Rate

Open Market Operation

Minimum Reserve Requirements

Bank Rate or Discount Rate:

It is the oldest method of credit control. It was used by the Bank of England in 1839. Bank rate refers to the rate of interest at which the Central Bank rediscounts approved bills of exchange. I used as instrument with the assumption that market rate of interest respond to the change in bank rate. When bank rate is raised, this is called a dear money policy, where as when bank rate is reduced this is called as cheap money policy. When bank rate is raised the market rate of interest will increase and vice versa.

Let us understand this in detail. Money held by commercial bank is called reserve. If these reserves are kept idle, then the returns are nil. Commercial bank tries to keep their reserve as low as possible. In doing so, they run the risk of running below the Reserve requirement level. In such cases, they sell the securities in their possessions and deposit the proceeding at Central Bank or directly sell it to central bank. So, whenever commercial banks are in need the central bank lends reserves directly to the banks for a charge known as bank rte or discount rate.

Open Market Operation:

It refers to purchase or sale by Central Bank of any securities, to regulate the credit creating capacity of Commercial Bank. Whenever the Central Bank purchases the securities, it does payment by cheque to sellers. The seller with deposit it with the Commercial Bank and the bank reserve increases. This is done when the central bank wants to increase the money supply in the economy. When the reserves with the Commercial Bank increases, the loan giving capacity of commercial Bank increases. On the other hand, Central Bank will sell the securities and accept cheque payments by the people who will be depositing the cheques in Commercial Bank. This leads to decrease in the reserve with commercial bank; as a result the loan giving capacity will decrease.

Minimum Reserve Requirement:

Every Commercial Bank has to maintain certain amount of reserve with Central Bank. Central bank has the power to set the reserve requirement to control the lending capacity of Commercial Banks. By changing the reserve requirement, it can control the money supply. Reserve maintained by commercial bank is called Statutory Reserve and the reserve over and above the Statutory Reserve is called ‘Excess Reserve’.

Excess reserve = total reserve – statutory reserve

Statutory Liquidity Requirement (SLR) is the minimum amount of liquid assets maintained by the banks, which is equal to or not less than a specific percentage of outstanding deposit liabilities.

Cash Reserve Ratio (CRR):

Commercial Bank has to keep a deposit with the Central Bank. This amount of funds is equal to specific percentage of its own deposit liabilities. This is Cash Reserve Ratio. These reserve requirements of central bank work as a very strong weapon and cause sharp change in lending capacity of commercial bank.

Overall, the chapter has been dealt in the continuation of Monetary Policy.

Monetary Policy of any country refers to the regulatory policy in which the Central Bank maintains its control over the supply of money to achieve some goods like stability of employment and price, balanced economic growth and economic development. In other words, monetary policy is employing the central bank’s control of supply of money to achieve general economic stability. In a developing country like India, monetary policy has a wider role to play and they are designed to meet certain requirements. There are some measures of monetary policy like interest rates, Cash Reserve Ratio, selling and buying of bonds etc.

Many a times, there is a confusion regarding monetary policy and credit policy, but they differ from each other.

Monetary Policy is restricted to regulation of cost and availability of credit.

Credit Policy is of a greater significance, since it can affect allocation of bank credit according to the objective of monetary policy.

Monetary policy controls total volume of money in maintaining stability in purchasing power of money.

Credit Policy is the integral part of Monetary Policy.

Objective of Monetary Policy:

The objectives of Monetary Policy should match with that of the economic policy. Monetary Policy should have all the objectives necessary for the development of economy. An economy will grow only if there is growth with stability. We will discuss some objectives of Monetary Policy –

Price Stability – Price stability does not mean complete rigidity of price. It means constant price, over a period of time. A mild does of inflation or a mild increase in price will always work as an incentive for economic growth. Economic growth has no meaning if it is not reaching the common man.

Full Employment – Employment is necessary to bring people above poverty level; it improves the standard of living. Here employment means that ‘employment’ should be available to all those who are willing to work. After the great depression, this objective has gained a very important place in the monetary policy.

Economic Growth – Economic growth is the increase in production of goods and services, increase in GNP, increase in per capita income etc. To promote economic growth there is a need to increase the investment levels. Central Bank, by regulating its credit policy, can control the credit as per the requirement of the economy, Inflation should be controlled and the deflation should be prevented.

The theory has been taken from managerial economics. This is an introduction about understanding of monetary policy.

Consumer’s Price Index (CPI):

We compare over a period of time, the money outlays to purchase a basket of consumption of goods and services. This basket compromises pattern of a typical family from specific group. Taste varies across families even geographically. Therefore, CPI is constructed for different population group. Most of the CPI uses the uses the Laspeyre’s formula. The prices are retail prices actually paid by consumer.

CPI = cost of purchasing the base year basket in current/cost of purchasing the base year basket in base year x 100

CPI – consumer price index:

The consumption basket date comes from family budget survey, which carried from time to time, price data are taken from retail outlets. The base year is changed every few years, to take changes in taste appearance of few items. Such updating is required so that the usefulness is not lost.

Wholesale Price Index (WPI):

The items included in WPI are different from those included in CPI. They are fertilizers, minerals, industrial raw materials and semi-finished goods, machinery even light and power group. It is an index of prices paid by producers for their inputs. WPI is published monthly by the offices of economy adviser to Government of India.

National Income Deflators:

It is a price index, which covers all final goods and services. It is the ratio of current price GDP (Gross Domestic Product) to constant price GDP. The goods basket entering the calculation of GDP deflator is the basket produced in the current year. Deflator can also be calculated for NDP (National Domestic Product), GNP (Gross National Product), GDP etc.

Conclusion:

For inflation statistics, government refers to WPI, for cost of living adjustments in allowance, wage bargaining etc. It is the CPI that is relevant.

Use of Index Numbers:

Index number is used for many purposes and has economic significance.

Measuring the change in value of money:

Stable price is essential for a stable economy. Many policies are framed for price stability in economy. But, before framing such policies there is a need o measure the change in value of Money. This can be done with the help of index number.

Change in wages:

Changes in living of the people are known CPL – reflects the change in money outlay required to maintain a given standard of living.

Useful of planner:

There are different types of index numbers that the planning authorities can get the information from various sectors and get important data about economic changes.

Overall we learn about macro economics and the management decision making. There are some basic macro economics concepts also which has been dealt in another chapter. This subject is fully dedicated to national income and use of index number.