Economic Insights

Question 0

Price adjusting vending machines?

Answer 0

Price Adjusting Vending Machines:

1. The Coca-Cola Company tested a vending machine that can automatically raise prices for its drinks during hot weather. A temperature sensor and a computer chip altered the required change you needed to insert into the machine to get your can of Coke.
2. The idea is based on price elasticity. If you want a Coke when it is hot outside, you will pay more than if you purchase it when it is cool. The reason is that consumers are less sensitive to a price increase when it is hot—they are thirstier. In cool weather, they aren’t as thirsty and figure they can wait to get a soda.
3. Coca-Cola also considered adjusting prices based on the demand at a specific machine. Prices could be discounted at a vending machine in a building during the evening or when there is less traffic. Reactions to the heat-sensitive Coke machine were not enthusiastic in the United States, but such machines are in operation in Japan.

Question 1

“Free Air” discuss the economic rationale of the dichotomy

Answer 1

“Free” Air?
- Although air might be what we describe as a free good, quality, breathable air is not free in many places in the world. In fact, breathable air is becoming a luxury in many places.

• Consider the Opus Hotel in Vancouver, British Columbia. It is the first North American hotel to offer hand-held oxygen dispensers in every room. These oxygen canisters are small enough to fit into a purse or briefcase and hold enough air for 12 minutes of breathing time.
• Breathing oxygen is said to increase energy, improve cognitive performance, and reduce the effects of hangovers.
• An oxygen bar where you can inhale 95 percent pure O2 is the latest craze to hit Dublin, Ireland, and other large cities around the world.
• Sniffing concentrated, flavored oxygen is a big hit in the United States.

Although these “luxury” purchases of oxygen are increasing, less-developed countries find their sales of oxygen to be more a matter of necessity.

• In Mexico City, clean, breathable air is hard to find. In this city of 20 million people and more than 3 million cars, dust, lead, and chemicals make the air unsafe to breathe more than 300 days a year. Beijing is no different.

Question 2

eBay and Online Markets

Answer 2

1. Internet auctions are attracting increasing numbers of buyers and sellers. The most well-known company in this online market arena is eBay, founded in 1995. On any given day, there are millions of items listed across thousands of categories. Sellers list an item for a small fee, and buyers bid for that item. The auctions typically last three or four days, and at the end of the auction time, the high bidder receives the item.
2. eBay is far from the only company offering online auctions. The biggest growth area for online auctions is that between businesses. Auto companies purchase supplies through online auctions; John Deere and other manufacturers purchase supplies through online auctions.
3. New business-to-business auctions are being created every day. The online auctions focus most attention on price; customers view or read about the product and the product’s features and then offer a price. The result is that prices are driven to their lowest possible level— much like the model of perfect competition.
4. What does the online auction mean for businesses wedded to buildings and face-to-face contact with customers?

When Walmart located in a small town, the local businesses were hard-pressed to compete with it. They could not offer the variety or the low prices that Walmart offered. In town after town, local businesses attempted to keep Walmart from entering. Think about what an online auction could do.

eBay is a rival to virtually every store in your city or neighborhood, and there is no way to keep eBay from entering.

Question 3

Dumping

Answer 3

Dumping:
1. Dumping means that a firm sells its products for less than its cost of production or, in other words, sells at a loss.

2. Why would a firm sell at a loss? One reason could be that a firm would sell in one market at a loss so that it could run other firms out of that market and then control the market.

Of course, this strategy would be a success only if the firm could keep others from entering that market after it takes control. Thus, dumping is a difficult thing to carry out.

3. What appears to be dumping can often merely be price discrimination.

A firm charges a lower price in another country than it does for the same product in its home country.

This would be a perfectly logical strategy if the consumers in the home country have a lower price elasticity of demand than consumers in the foreign country. In this case, the firm would increase revenue by setting a higher price in the home country and a lower one in the foreign country.

This pricing strategy would be no different than charging senior citizens lower prices for movie tickets than the general population is charged.

4. This is not to say that there are no legitimate cases of dumping, but many cases involve government subsidies and taxes rather than competition among firms.
5. One case of dumping occurred with sugar produced in the European Union (EU) and sold in China. The EU provides subsidies and protection to sugar producers, who then can sell their sugar at prices that are below production costs.

China pointed out that the average production cost of sugar in Guangxi is 2,230 yuan per ton, as compared to 5,623 yuan per ton in the EU.

But when the EU provides a subsidy of 4,127 per ton, the EU sugar exporters can sell for as low as 1,429 yuan and as high as 2,230 yuan and drive Chinese sugar producers out of the market.

The result of the dumping is that sugar prices in China have dropped by 35 percent, and the amount of sugar produced in China has declined significantly.

Question 4

Green tax or Ecotax

Answer 4

1. Ecotax (short for Ecological taxation) refers to taxes intended to promote environmentally friendly activities via economic incentives.
2. Such a policy can complement or avert the need for regulatory (command and control) approaches.
3. Often, an ecotax policy proposal may attempt to maintain overall tax revenue by proportionately reducing other taxes (e.g. taxes on human labor and renewable resources); such proposals are known as a green tax shift towards ecological taxation.
4. Ecotaxes are examples of Pigouvian taxes, which are taxes that attempt to make the private parties involved feel the social burden of their actions. An example might be philosopher Thomas Pogge proposed Global Resources Dividend.

Question 5

What is a Pigovian tax (also spelled, Pigouvian tax)

Answer 5

• is a tax applied to a market activity that is generating negative externalities (costs for somebody else). The tax is intended to correct an inefficient market outcome, and does so by being set equal to the negative externalities.
  1. In the presence of negative externalities:

the social cost of a market activity is not covered by the private cost of the activity. In such a case, the market outcome is not efficient and may lead to over-consumption of the product. An often-cited example of such an externality is environmental pollution.

2. In the presence of positive externalities:
   i. e., public benefits from a market activity, those who receive the benefit do not pay for it and the market may under-supply the product. Similar logic suggests the creation of a Pigovian subsidy to make the users pay for the extra benefit and spur more production.An example sometimes cited is a subsidy for provision of flu vaccine.
3. Pigovian taxes are named after economist Arthur Pigou who also developed the concept of economic externalities. William Baumol was instrumental in framing Pigou’s work in modern economics.

Question 6

Sin tax or sumptuary tax

Answer 6

A sin tax is a kind of sumptuary tax: a tax specifically levied on certain generally socially proscribed goods and services, for example alcohol and tobacco, candies, soft drinks, fast foods, coffee, and gambling.

Question 7

Explain “The Laffer Curve”.

Answer 7

It states that if the marginal tax rate is high, a reduction in the tax rate would actually increase tax revenue.

[Imagine a inverted-U shaped curve with tax revenue on x-axis and tax rate on y-axis]

If govt does not levy tax, that is, the tax rate is zero, there will be no tax revenue. As the tax rate increases, so will the tax revenue UNTILL THE TAX RATE REACHES AN OPTIMAL LEVEL ‘T’ (top of the inverted-U shaped curve). IF THE TAX RATE RISES ABOVE ‘T’, THE TAX REVENUE WILL BEGIN TO FALL.

After the optimal level ‘T’, any increase in the tax rate would lead to a substantive disincentive to work, and the resultant fall in GDP would lower the tax revenue. High tax rates may also lead to tax evasion which is illegal.

Thus, weather or not tax revenue will increase or decrease when tax rate is changed depends upon which side of the hump the original tax rate is.

After Prof Arthur Laffer convinced Ronald Reagan and Margaret Thatcher to reduce the tax rates, Rajiv Gandhi also reduced taxes in India (1974-75). In fact, with a 97.75% marginal income tax rate in India then, it was quite clear as to which side of the hump India was.

Question 8

Value of homemaker services

Answer 8

1. One way GDP underestimates the total value of a nation’s output is by failing to record nonmarket production. A prime example is the work homemakers do. Of course, people are not paid for their work around the house, so it is difficult to measure the value of their output. But notice that we say difficult, not impossible.
2. Assign value to homemaker services:
   - Economists can use several methods to assign value to homemaker services. One is an OPPORTUNITY COST APPROACH. This approach measures the value of a homemaker’s services by the forgone market salary the homemaker could have earned if he or she worked full-time outside the home.
   - The rationale is that society loses the output the homemaker would have produced in the market job in order to gain the output the homemaker produces in the home.
   - Another alternative is to estimate what it would COST TO HIRE WORKERS to produce the goods and services that the homemaker produces. For example, what would it cost to hire someone to prepare meals, iron, clean, and take care of the household?
   - It has been estimated that the average homemaker spends almost 8 hours a day, 7 days a week, on household work. This amounts to over 50 hours a week. At a rate of $20 an hour, the value of the homemaker’s services is over $1,000 a week.
   - Whichever method we use, two things are clear. The value of homemaker services to the household and the economy is substantial. And by failing to account for those services, the GDP substantially underestimates the value of the nation’s output.

Question 9

Underground Economy

Answer 9

The Underground Economy:

What is Underground Economy:

1. Official unemployment data, like national income data, do not include activity in the underground economy. Obviously, drug dealers and prostitutes do not report their earnings. Nor do many of the people who supplement their unemployment benefits with part-time jobs. In addition, people such as the waiter who reports a small fraction of his actual tips and the housecleaning person who requests payment in cash in order to avoid reporting taxable income are also part of the underground economy.

Why it is a problem?

2. Because activity in the underground economy goes unreported, there is no exact way to determine its size. Estimates range from 5 to 33 percent of the gross domestic product. With the GDP at $14.5 trillion, this places the value of underground activity between $73 billion and $4.7 trillion.

How to deal with it:

3. We will never know the true size of the underground economy, but evidence suggests that it is growing. That evidence has to do with cash. The vast majority of people working in the underground economy are PAID IN CASH.
4. One indicator of the growth of that economy, then, is the rise in currency over time relative to checking accounts. Also, per capita holdings of $100 bills have increased substantially. Certainly, much of the demand for $100 bills is a product of inflation (as the prices of goods and services go up, it is easier to pay for them in larger-denomination bills). But there is also a substantial rise in real holdings of $100 bills as well.

Implications:

5. The underground economy forces us to interpret government statistics carefully. We must remember the following:

● OFFICIAL INCOME STATISTIC UNDERSTATE THE TRUE NATIONAL INCOME.

● Official unemployment data OVERESTIMATE TRUE UNEMPLOYMENT.

● WHEN UNDERGROUND ECONOMY GROWS MORE RAPIDLY THE TRUE RATE OF GROWTH OF ECONOMY IS MORE THAN OFFICIAL FIGURES.

Question 10

Explain reasons of higher rate of unemployment with European context.

Answer 10

This is not true of all European countries, but it is certainly true for the biggest: France, Germany, Italy, and Spain.

1. One factor that contributes to the higher unemployment rates in these countries is GOVERNMENT POLICY WITH REGARD TO THE LABOUR MARKET.
   - It has been observed in a recent study that, Countries that have policies that encourage unemployment should be expected to have more unemployed workers.
   - Government policy aimed at protecting citizens against unemployment can create the very unemployment that is the cause for concern.
   - In ITALY, laws require parents to support their adult children who do not work, even if the children are entirely capable of working. The government requirement that parents support unemployed adult children encourages the children to remain unemployed.
   - Among men of prime working age (age 25–54), there are more who are inactive and not participating in the labor force than there are unemployed. The majority of these men are receiving benefits from the government, claiming disability or illness.
   - The unfortunate truth of human nature is that as you provide better support for those who truly need help, there will be more and more who do not truly need it yet will claim a need.
   - DENMARK has generous unemployment benefits. But in the 1990s, Danish eligibility requirements were tightened, creating greater incentives for the unemployed to look for work. Danish unemployment rates fell dramatically as a result.
   - Another effect of government policy is related to a person’s LOSS OF JOB SKILLS WHILE UNEMPLOYED.
   - Unemployment benefits in EUROPE are relatively high and can last a long time. Unemployment benefits in the United States are relatively low and have a shorter duration. Given just these facts, one would expect more European unemployment since the unemployed would be out of work for a longer time in Europe than in the United States.
   - Other factors contributing to higher unemployment rates in some countries are the RESTRICTION ON FIRMS ABILITY TO TERMINATE WORKERS and the requirement that firms pay HIGH SEPARATION COSTS to workers who are fired.

The more difficult it is for firms to adjust their labor force in the face of economic fluctuations, the less likely firms are to hire new workers.

• Such labor market rigidities, aimed at protecting workers from losing jobs, create incentives against hiring so that those who would like to work cannot get hired.

2. The lesson learned from large European countries is that GOVERNMENT POLICY MADE TO SAFEGUARD THE LABOURS CAN ACTUALLY CONTRIBUTE MORE IN THE INCREASING RATE OF UNEMPLOYMENT.

Then the COST IMPOSED ON THE ECONOMY IN TERMS OF TAXES and REDUCED LABOUR MARKET FLEXIBILITY may exceed the benefits to those who keep their jobs or receive unemployment com- pensation because of the programs.

Question 11

VAT [Value Added Tax]

Answer 11

Value-Added Tax:

• A value-added tax (VAT) is a tax levied on all sales of goods and services at each stage of production. As implied by the name, the tax applies ONLY TO VALUE ADDED AT EACH STAGE, and so a firm that pays VATs will pay tax only on the value that it added to the good or service that it sells.
• If a firm sells melons at a fruit stand, the VAT it pays is based on the difference between the cost the firm paid for the melons and the sales price it charges to its customers who buy the fruit. Of course, the customers bear the cost of the VAT, as it is built into the price they must pay.
• VATs are very popular around the world. Many countries adopted VATs in the 1990s. It is clear that there are more countries that use VATs than do not.
• Such a tax has its advantages. One important consideration is that a VAT IS A TAX ON CONSUMPTION. Anyone who buys goods and services will contribute to the government’s VAT revenue.
• Thus, VATs are very powerful revenue generators. Those individuals who evade income taxes and pay less than their legal obligation will not escape the VAT.
• For instance, a criminal who earns income illegally and pays no tax on that income will be taxed on all legal goods and services that he or she purchases.
• In this sense, there is a certain attractiveness to taxing consumption rather than income.
• But a VAT ALSO ACTS AS A REGRESSIVE TAX in that a poor person would tend to pay a higher fraction of income as VAT than a rich person.
• It is important to realize that no country relies strictly on a VAT for government revenue. VATs are part of an overall government tax policy that attempts to incorpo- rate fairness along with a need to raise sufficient revenue to finance public expenditures.

Question 12

Islamic Banking

Answer 12

Islamic Banking:

1. According to the Muslim holy book, the Koran, ISLAMIC LAW PROHIBITS THE INTEREST CHARGES ON LOANS .
2. Banks that operate under Islamic law still act as INTERMEDIARIES . However, THEY DO NOT CHARGE INTEREST ON LOANS OR PAY INTEREST ON DEPOSITS.
3. Instead, THEY TAKE PREDETERMINED PERCENTAGE OF BORROWING FIRMS PROFITS, UNTILL THE LOAN IS REPAID, THEN DISTRIBUTE IT AMONG THE DEPOSITORS.
4. Since the mid-1970s, more than a hundred Islamic banks have opened, most in Arab nations. Deposits in these banks have grown rapidly. In fact, in some banks deposits have grown faster than good loan opportunities, forcing the banks to refuse new deposits until their loan portfolio could grow to match available deposits.
5. One bank in Bahrain claimed that more than 60 percent of deposits during its first two years in operation were made by people who had never made a bank deposit before.
6. In addition to profit-sharing deposits, Islamic banks typically offer checking accounts, travelers’ checks, and trade-related services on a fee basis.
7. Because the growth of deposits has usually exceeded the growth of local investment opportunities, Islamic banks have been lending money to traditional banks to fund investments that satisfy the moral and commercial needs of both, such as lending to private firms. These funds cannot be used to invest in interest-bearing securities or in firms that deal in alcohol, pork, gambling, or arms.
8. The growth of mutually profitable investment opportunities suggests that Islamic banks are meeting both the dictates of Muslim depositors and the profitability requirements of modern banking.
9. The potential for expansion and profitability of Islamic financial services has led major banks to create units dedicated to providing Islamic banking services. In addition, there are stock mutual funds that screen firms for compliance with Islamic law before buying their stock. For instance, since most financial institutions earn and pay large amounts of interest, such firms would tend to be excluded from an Islamic mutual fund.

The most popular instrument for financing Islamic investments is “MURABAHA.” This is essentially COST+FINANCING in which the financial institution purchases goods or services for a client and then is repaid over time an amount that equals the original cost plus an additional amount of profit.

Such an arrangement is even used for financing mortgages on property in the United States. A financial institution will buy a property and then charge a client rent until the rent payments equal the purchase price plus some profit. After the full payment is received, the title to the property is passed to the client.*

Question 13

Why wages don’t fall during recession?

Answer 13

Why Wages Don’t Fall in Recessions:

1. A look at macroeconomic data across countries reveals that when economies experience recessions, unemployment rates rise, but wages fall very little, if at all.
2. If we think of a supply and demand diagram for labor, we would think that as demand for labor falls in a recession, the equilibrium quantity of labor would fall as well as the equilibrium price, the wage rate. We do see the quantity effect as workers lose their jobs and the unemployment rate rises. Why don’t we see wages also falling?
3. The text discusses LONGTERM WAGE CONTRACTS as one reason that wages may be relatively inflexible over time.
4. Beyond the presence of contracts, recent research points to HUMAN BEHAVIOUR as a contributing factor.* Surveys of firms and workers indicate that WORKERS MORALE IS A MAJOR REASON that wages are not reduced during recessions.
   - Workers would view a wage cut as an indication that the firm does not value their work as much, and they may, as a result, suffer lower morale and expend less effort.
   - When some workers are laid off, these workers suffer from the job loss, but they are no longer at the firm and cannot harm others’ morale and work effort.
5. Only in the case in which the VERY SURVIVAL OF THE FIRM IS AT STAKE WAGE-CUT APPEARS TO BE JUSTIFIED TO THE WORKERS
   Thus, wages are “sticky downwards” because this strategy promotes good worker effort and ensures that workers and firms share the same goals of efficient production and profit maximization.
   - Rather than keeping all workers when demand falls by paying lower wages to all, it may be better for the firm to lay off some workers and keep paying the remaining employees the same wage as before.

Question 14

Smoot-Hawley Tariff and The Great Depression of 1930s

Answer 14

Smoot-Hawley Tariff:

Many economists believe that the Great Depression of the 1930s was at least partly due to the Smoot-Hawley Tariff Act, signed into law by President Herbert Hoover in 1930.

1. Smoot-Hawley Tariff Act, 1930.

• Hoover had promised that, if elected, he would raise tariffs on agri- cultural products to raise U.S. farm income. The resulting bill increased tariffs on over 12,000 products. Tariffs reached their highest levels ever, about 60 percent of average import values.
• Before President Hoover signed the bill, 38 foreign governments made formal protests, warning that they would retaliate with high tariffs on U.S. products.
• World trade collapsed as other countries raised their tariffs in response.
• Between 1930 and 1931, U.S. imports fell 29 percent, but U.S. exports fell 33 percent. By 1933, world trade was about one-third of the 1929 level. As the level of trade fell, so did income and prices.
  2. Reciprocal Trade Agreements Act,1934:
• In 1934, in an effort to correct the mistakes of Smoot-Hawley, Congress passed the Reciprocal Trade Agreements Act, which allowed the president to lower U.S. tariffs in return for reductions in foreign tariffs on U.S. goods.
• This act ushered in the modern era of relatively low tariffs. In the United States today, tariffs are about 5 percent of the average value of imports.

3. Many economists believe the collapse of world trade and the Depression to be linked by a decrease in real income caused by abandoning production based on comparative advantage.
4. Few economists argue that the Great Depression was caused primarily by the Smoot-Hawley tariff, but the experience serves as a lesson to those who support higher tariffs to protect domestic producers.

Question 15

IMF and WB

Answer 15

The IMF and the World Bank:

History:

• The International Monetary Fund (IMF) and the World Bank were both created at the Bretton Woods conference in 1944.

Function:

IMF:

The IMF oversees,

1. The international monetary system,
2. Promoting stable exchange rates and macroeconomic policies.
3. The IMF provides loans to nations having trouble repaying their foreign debts.

WB:

The World Bank promotes the economic development of the poor nations.

• Before the IMF lends any money, however, the borrower must agree to certain conditions.
• The IMF conditionality usually requires that the country meet targets for key macroeconomic variables such as money supply growth, inflation, tax collections, and subsidies.
• The conditions attached to IMF loans are aimed at promoting stable economic growth.
• The IMF primarily employs economists to carry out its mission.
• The World Bank assists developing countries by providing longterm financing for development projects and programs.
• The bank also provides expertise in many areas in which poor nations lack expert knowledge: agriculture, medicine, construction, and education, as well as economics.
• The diversity of World Bank activities results in the employment of about 10,000 people. The IMF has a staff of approximately 2,400. Both organizations post employees around the world, but most work at the headquarters in Washington, DC.
• World Bank funds are largely acquired by borrowing on the international bond market.
• The IMF receives its funding from member country subscription fees, called quotas.
• A member’s quota determines its voting power in setting IMF policies. The United States, whose quota accounts for the largest fraction of the total, has the most votes.

Question 16

WTO

Answer 16

The World Trade Organization:

History:

• The World Trade Organization (WTO) is an international organization with 153 member countries, established in 1995 and headquartered in Geneva, Switzerland.
• The job of the WTO is to provide a venue for negotiating international trade agreements and then to enforce these global rules of international trade.
• The WTO trade agreements are negotiated and signed by a large majority of the world’s nations. These agreements are contracts for the proper conduct of international trade.
• An important role of the WTO is the settlement of trade disputes between countries. An example of such a dispute involved bananas and the European Union (EU). The EU restricted banana imports so that only a few countries—countries that were former European colonies—could ship bananas to the EU. As a result, the price paid for bananas in European markets was about twice the price of bananas in the United States. The world’s largest banana companies— Dole, Chiquita, and Del Monte, headquartered in the United States—complained that they were being harmed because their bananas, which came from other countries of Central and South America, were excluded from the EU system, which favored a few former colonies. The WTO ruled that the EU restrictions on banana imports were harmful and against the rules of trade to which all nations had agreed. This is but one example of the role of the WTO in promoting fair and free international trade.

Question 17

Explain, The Great Depression, 1930

Answer 17

“The Great Depression”?

• In 1930s, the world economy in general and the US economy in particular faced one of the worst economic crisis, commonly known as the Great Depression.
• A ‘Great Depression is the description of a phenomenon where GDP, employment, and prices in the economy fall quite drastically and remain at that level for a number of years. It started in 1929 and, within a few years, production and employment fell by about 25%.

Reasons:

1. OVER-INVESTMENT IN THE HOUSING INDUSTRY:
   which was financed mainly by banks. ( Immigration to the US too slowed down considerably after the First World War causing the FALL IN DEMAND FOR HOUSING )
2. HUGE DEFAULTS ON HOUSING LOANS:
   Slack in the demand for housing, REALTY PRICES STARTED GOING DOWN and both realtors and customers could not pay the bank loans. LOAN DEFAULTS BECOMING COMMON.
3. RUN ON THE BANKS:
   Bank were reluctant to give loans, customers too felt their money was not safe in the banks. CUSTOMERS STARTED WITHDRAWING THEIR CASH BUT BANKS WERE UNABLE TO HONOUR CASH WITHDRAWAL REQUESTS.resulting in RUN ON THE BANKS.
4. DRASTIC FALL IN MONEY SUPPLY:
   Banks started holding large stocks of cash, which resulted in lowering of loans and chequable deposits causing the money supply to fall.
5. BOND MARKET CRASH:
   As supply fell relative to demand of money, people started selling bonds. Rapid sell of bonds resulted in sharp drop in bond prices.
6. INTEREST RATE OVERSHOOT:
   As bond prices fell, interest rate started going up, which further reduced private investment, employment and output, FUELING THE ECONOMIC DEPRESSION.

Question 18

fluctuations of output and inflation in industrial countries had come down steadily since the mid-1980s.

Answer 18

1. World economy experiencing fewer accidents such as war and oil-price increases over this period.
2. Economies had changed, for example as corporations developed systems to acquire sales information more quickly and to translate it more continuously into production and inventory decisions. Such improvements could explain how economies had been able to avoid the more dramatic inventory buildups and production cutbacks that had characterised previous recessions.
3. as a result of advances in our economic understanding, central bankers, many of them former academic economists, understood better how monetary policy affected economic output.

Question 18

Explain, The Financial Crisis of 2007-08/ Great Recession and its repercussions on India.

Answer 18

1. THE ORIGINS:

• LOW INTEREST RATE:
  in US to stimulate the economy after recession of 2000-01(response to Dot-Com burst).
• INCREASE IN HOUSING DEMAND:
  House purchases picked up as more people found they could afford the lower mortgage payments. Increased housing demand encouraged more home construction already buoyant due to sustained low interest rates.
• SUBPRIME LOANS:
  eagerness to sale homes and to offer credit, loans were granted to many SUBPRIME US BORROWERS.
• PRECARIOUS COLLATERAL:
  Since real estate prices were high, banks and customers used the very homes they were buying as a collateral against the loans.
• GOVERNMENT SPONSORED ENTERPRISES (GSE):
  These subprime loan assets were sold by banks to Government-Sponsored Enterprises (GSE) such as Fannie Mae and Freddie Mac.
• MORTGAGE BACKED SECURITIES (MBS):
  GSEs in turn repackaged these loans as Mortgage Backed Securities (MGS) with much higher credit rating.
• HIGH SAVINGS IN DEVELOPING COUNTRIES:
  Eager for high-yield investments, foreign investors readily bought these MBS

2. THE GLITCH IN THE NARRATIVE:

• STIMULATED ECONOMY BUT NO REAL GROWTH IN JOBS:
  New jobs in construction did not offset job losses elsewhere.
• SUBPRIME/NINJA/LIAR LOANS:
  Loans to unworthy borrowers.
• ADJUSTABLE RATE MORTGAGES:
  Initially low rate of interest which rose afterwards
• DELINQUENT REGULATORS AND SUPERVISORS:
  High credit rating to precarious MBS, overlooked the NINJA loans.
• SHADOW BANKING:
  3. THE INEVITABLE:
• As interest rate rose borrowers defaulted en messe.
• Real estate prices started going down as housing demand sunk and short term interest rates went up.
• As home prices went down the loans could not be recovered through foreclosures.
• The ultimate MBS buyers got wind of it and started selling MBS in US stock market. Panic gripped the market and stock prices plunged.
  Lehman Brothers the leading financial firm in US went bankrupt in 2008.
• As the proverbial ‘animal spirits’ dimmed, many existing projects were wound up and prospective ones shelved which resulted in a recession in the US.
  4. REPERCUSSIONS:
• To recover the financial losses in the US, investors started liquidating their portfolios investment overseas including those in India. As a result stock prices plummeted in India as well.
• As investors took the funds out of India, increased demand for US dollar resulted in depreciation of rupee making imports difficult. On the other hand India’s exports dwindled due to recession in US and Europe.
• Thus falling exports and falling stock prices dimmed the business confidence in India, and production and investment fell. The recession has been passed on to India. The result– the GDP growth dropped to 4.93% in 2008-09.
• To counter this, the Indian government adopted an expansionary fiscal policy by cutting excise duty to 8% and service tax to 10%.
  RBI too followed expansionary monetary policy by lowering the repo rate significantly to give boost to domestic investment projects. As a result the average GDP growth rate of India bounced backed to 9% in 2009-10 and 2010-11.

Question 19

What is ‘Shadow Banking’?

Answer 19

> The shadow banking system is a term for the collection of non-bank financial intermediaries/companies (i.e. one that does not hold a banking license) that provide services similar to traditional commercial banks.

> Former (US) Federal Reserve Chair Ben Bernanke provided a definition in April 2012: “Shadow banking, as usually defined, comprises a diverse set of institutions and markets that, collectively, carry out traditional banking functions–but do so outside, or in ways only loosely linked to, the traditional system of regulated depository institutions.

> Examples of important components of the shadow banking system
include,
- securitization vehicles,
- asset-backed commercial paper (ABCP) conduits,
- money market mutual funds,
- markets for repurchase agreements (repos),
- investment banks, and
- mortgage companies.

• Shadow banking has grown in importance to rival traditional depository banking and was a primary factor in the subprime mortgage crisis of 2007-2008 and global recession that followed.

Question 20

Explain, Non-Banking Financial Companies (NBFCs)

Answer 20

> Non-bank financial companies (NBFCs) are financial institutions that provide banking services without meeting the legal definition of a bank, i.e. one that does not hold a banking license.

> These institutions typically are restricted from taking deposits from the public depending on the jurisdiction. Nonetheless, operations of these institutions are often still covered under a countries banking regulations.

> The specific banking products that can be offered by NBFCs depends on the jurisdiction, and may include services such as loans and credit facilities, savings products, investments and money transfer services.

> In some jurisdictions, such as New Zealand, any company can engage in banking business, except they are not allowed to use the word bank in their name. A company can only call itself a bank if is a registered as such with the nation’s central bank.

Question 21

Human Development Index (HDI)

Answer 21

> The Human Development Index (HDI) is a composite statistic of life expectancy, education, and income indices used to rank countries into four tiers of human development.

> It was created by the Pakistani economist Mahbub ul Haq and the Indian economist Amartya Sen in 1990 and was published by the United Nations Development Programme.

> In the 2010 Human Development Report a further Inequality-adjusted Human Development Index (IHDI) was introduced. While the simple HDI remains useful, it stated that “the IHDI is the actual level of human development (accounting for inequality)” and “the HDI can be viewed as an index of “potential” human development (or the maximum IHDI that could be achieved if there were no inequality)”.

> Published on 4 November 2010 (and updated on 10 June 2011), starting with the 2010 Human Development Report the HDI combines three dimensions:

• A long and healthy life: Life expectancy at birth
• Education index: Mean years of schooling and Expected years of schooling
• A decent standard of living: GNI per capita (PPP US$)

Question 22

Purchasing Power Parity (PPP)

Answer 22

> Purchasing power parity (PPP) is a component of some economic theories and is a technique used to determine the relative value of different currencies.

• It is a concept which assumes that if a common goods basket is priced differently in relation to the exchange rate of the relative currencies of the two countries, then, in a country with relatively lower price the demand would rise>exports will increase>currency will appreciate, while, on the other hand country with relatively higher prices, demand will fall>imports will increase>currency will depreciate – until in the long run an equilibrium/parity in the relative value of the currency is reached.

> Theories that invoke purchasing power parity assume that in some circumstances (for example, as a long-run tendency) it would cost exactly the same number of, say, US dollars to buy euros and then to use the proceeds to buy a market basket of goods as it would cost to use those dollars directly in purchasing the same market basket of goods.

> The concept has two major issues when applied in practice:

1. It is difficult to find the common goods basket as no two countries follow exactly similar consumption behaviour. Except, e.g. products offered by food chains like Big Mac, Subway etc
2. It assumes a perfectly open-competitive market without tariff, quota and like restrictive practices.

Question 23

GINI Coefficient

Answer 23

> The Gini coefficient (also known as the Gini index or Gini ratio)
is a measure of statistical dispersion intended to represent the income distribution of a nation’s residents.

> It was developed by the Italian statistician and sociologist Corrado Gini and published in his 1912 paper “Variability and Mutability”

> The Gini coefficient measures the inequality among values of a frequency distribution (for example levels of income).

> A Gini coefficient of zero expresses perfect equality, where all values are the same (for example, where everyone has the same income).

> A Gini coefficient of one (or 100%) expresses maximal inequality among values (for example where only one person has all the income).

• However, a value greater than one may occur if some persons represent negative contribution to the total (e.g., have negative income or wealth). For larger groups, values close to or above 1 are very unlikely in practice.

Question 24

Explain Transfer Pricing transactions and why it’s critical for governments corporate revenue (e.g. Corporate tax avoidance)

Answer 24

Transfer pricing:
is a profit allocation method used to attribute a multinational corporation’s net profit (or loss) before tax to countries where it does business.

Transfer pricing results in the setting of prices among divisions within an enterprise. Transfer prices are charges for goods and services between controlled (or related) legal entities within an enterprise.

Legal entities considered under the control of a single corporation include branches and companies that are wholly or majority owned ultimately by the parent corporation.

Certain jurisdictions consider entities to be under common control if they share family members on their boards of directors.

In principle a transfer price should match either what the seller would charge an independent, arm’s length customer, or what the buyer would pay an independent, arm’s length supplier.

While unrealistic transfer prices do not affect the overall enterprise directly, THEY BECOME A CONCERN WHEN THEY ARE MISUSED TO LOWER PROFITS IN A DIVISION OF AN ENTERPRISE THAT IS LOCATED IN A COUNTRY THAT LEVIES HIGH TAXES AND RAISE PROFITS IN A COUNTRY THAT IS TAX HEAVEN (that levies NO or LOW taxes).

TRANSFER PRICING IS A MAJOR TOOL FOR CORPORATE TAX AVOIDANCE.

Question 25

Explain: Non-compete clause or Covenant Not to Compete

Answer 25

1. A non-compete clause (often NCC), or covenant not to compete (CNC), is a term used in contract law under which one party (usually an employee) agrees not to enter into or start a similar profession or trade in competition against another party (usually the employer).
2. As a contract provision, a CNC is bound by traditional contract requirements including the consideration doctrine. The use of such clauses is premised on the possibility that upon their termination or resignation, an employee might begin working for a competitor or starting a business, and gain competitive advantage by exploiting confidential information about their former employer’s operations or trade secrets, or sensitive information such as customer/client lists, business practices, upcoming products, and marketing plans.
3. However, an over-broad CNC may prevent an employee from working elsewhere at all. English common law originally held any such constraint to be unenforceable as a matter of public policy. Contemporary case law permits exceptions, but generally will only enforce CNCs to the extent necessary to protect the employer.
4. Most jurisdictions in which such contracts have been examined by the courts have deemed CNCs to be legally binding so long as the clause contains reasonable limitations as to the geographical area and time period in which an employee of a company may not compete.

Question 26

What are “Tax Heavens”?

Answer 26

Tax havens are countries which have low tax regimes which provide individuals and business opportunities of tax avoidance or tax evasion.

There are roughly 45 tax havens in the world today. In Indian context, Mauritius is considered to be the most significant tax havens or tax evading route.

In more precise words the Mauritius route can be described as a channel used by individuals and Multi National Companies to evade paying taxes in India.

The tax evasion in India through this route is estimated to be in tune with 55 billion dollar, mostly attributed to the loopholes in a bilateral agreement on double taxation.

Question 27

Explain SPV/ SPE (Special Purpose Vehicle/Entity)

Answer 27

1. Also referred to as a “bankruptcy-remote entity” whose operations are limited to the acquisition and financing of specific assets. The SPV is usually a subsidiary company with an asset/liability structure and legal status that makes its obligations secure even if the parent company goes bankrupt.
2. A subsidiary corporation designed to serve as a counterparty for swaps and other credit sensitive derivative instruments. Also called a “derivatives product company.”

Investopedia explains ‘Special Purpose Vehicle/Entity - SPV/SPE’

Thanks to Enron, SPVs/SPEs are household words. These entities aren’t all bad though. They were originally (and still are) used to isolate financial risk.

A corporation can use such a vehicle to finance a large project without putting the entire firm at risk.

Problem is, due to accounting loopholes, these vehicles became a way for CFOs to hide debt.

Essentially, it looks like the company doesn’t have a liability when they really do. As we saw with the Enron bankruptcy, if things go wrong, the results can be devastating.

Question 28

What is “race to bottom”?

Answer 28

Race to the bottom > is a SOCIO-ECONOMIC PHENOMENON in which governments DEREGULATE the BUSINESS environment or TAXES in order TO ATTRACT or RETAIN ECONOMIC ACTIVITY in their jurisdictions > RESULTING in LOWER WAGES, WORSE WORKING CONDITIONS and FEWER ENVIRONMENTAL PROTECTIONS.

An OUTCOME of GLOBALISATION and FREE TRADE, the phenomenon may occur when competition increases between geographic areas over a particular sector of trade and production.

Question 29

Explain Hybrid Annuity Model floated by Govt to tackle the issues in roadways/infra construction financing.

Answer 29

HYBRID ANNUITY MODEL (HAM) in Highway Projects:

> DE-RISK PRIVATE CAPITAL in highway projects.

Builds on Build Operate-Transfer (BOT) model :

1. Government bears the commercial risk of toll collection
2. Pays the private operator the project cost+interest in the form of a half- yearly annuity.

I.e. RISKS OF FINANCING, OPERATING & MANAGEMENT, & REVENUE IS ON PRIVATE PARTY (Contractor)
Hybrid Annuity Model (HAM) :

1. Govt Pays a part of the capital cost @ commencement of the construction work (I.e. revenue stream to contractor even before the actual commercial operations begin),
2. Up to 10 % of the project cost will be paid by the NHAI, as a mobilisation advance.
3. Will have a REFERENCE INDEX with 70% weightage accorded to the WPI & 30% to the weekly CPI. (I.e. cost would be eligible for revision based on changes in the price index)
4. 60 % of the completion cost would be payable during the operation and maintenance period, and the reducing balance mode would be employed to pay interest at the rate of 2% + prevailing bank rate.

I.e. RISK OF : FINANCING THE PROJECT IS SHARED; O & M IS ON PRIVATE FIRM & REVENUE IS ON GOVT
WHY THE NEED?

1. OVER-LEVERAGED BALANCE SHEETS & OVER EXPOSURE TO HIGHWAY/INFRA PROJECTS = PRIVATE DEVELOPERS CAPACITY CONSTRAINTS
2. LACK OF AVAILABILITY OF DEBT PRODUCTS, Even banks have reached sectoral exposure limits, making it difficult for them to finance highway projects.
3. PROJECT EXECUTION ISSUES due delays in various clearances, holidays, labour, general elections

GOVT INITIATIVES to fast track :

1. DELEGATING THE POWERS TO GRANT FOREST CLEARANCES TO THE REGIONAL OFFICES to save 8-9 months otherwise required for such clearances
2. ONLINE FILING OF CLEARANCES to construct rail over bridges and under bridges-both were earlier major bottlenecks
3. INCREASING LIMITS ON SAND MINING etc

OTHER ISSUES :

> The concern of debt-laden corporate balance sheets would, however, continue to persist.

> ICRA’s analysis of 113 BOT road projects, covering almost half of such projects awarded in the country, points to a steady deviation from the earlier debt/equity (D/E) norm of 70:30, with around 37 per cent of the projects having a higher debt component. Around 10 per cent of the projects, mostly annuity based, have contracted debt to the extent of 90 per cent of the initial project cost.

> LENDERS @ HIGH RISK DUE TO GOVT-PRIVATE FIRM PROJECT COST MISMATCH :

The study shows that for around 40 per cent of the total projects, the DEBT SANCTIONED IS HIGHER THAN THE TOTAL PROJECT COST ESTIMATED BY NHAI, presumably because the project debt is based on the developer’s cost estimates that is, on average, higher by 35 per cent than the NHAI project cost > In such cases, the LENDERS ARE EXPOSED TO HIGHER RISK PARTICULARLY IN AN EVENT OF TERMINATION OF CONCESSION AGREEMENT wherein NHAI guarantees compensation based on its own appraised project cost and not the developer’s estimate.

> NO AMOUNT OF INNOVATIVE BIDDING WILL HELP RECKLESS BIDDERS Part of the trouble stems from the fact that companies have stretched themselves to bag these projects.

> IT IS MORE OF A INTER-INSTITUTIONAL DISCIPLINE ISSUE THAT THAN LIMITATIONS OF FUNDING MODELS. Banks and companies need to introspect.

IMMEDIATE (HAM) IMPLEMENTATION ISSUES :

1. Not ready for use : FURTHER FINE-TUNING is required before adopting;

Govt should start with three or four projects first to test the model and then improve and refine it.There could be distortions, so it is better to phase the projects over a period of time to get a better response.”

Question 30

What is “bright line” rule or test?

Answer 30

A bright-line rule (or bright-line test) is a CLEARLY DEFINED RULE OR STANDARD, generally used in law, COMPOSED OF UNAMBIGUOUS OBJECTIVE FACTORS

The purpose of a bright-line rule is TO PRODUCE CONSISTENT & PREDICTABLE RESULTS IN ITS APPLICATION.

Bright-line rules are usually standards established by courts in legal precedent or by legislatures in statutory provisions.

Bright-line rules are often CONTRASTED WITH ITS OPPOSITE BALANCING TEST (or “FINE LINE TESTING”), where a result is dependent on weighing several factors, which could lead to inconsistent application of law or reduced objectivity.