By Dr.

Charu Banga

Information Economics

Information

Economics

Collection of data

A Study of how people choose to use resources

Information is made up of a collection of data and knowledge is made up of different strands of information. Information has gone from scarce to superabundant. That brings huge new benefits but also big headaches - Kenneth Cukier Data are becoming the new raw material of business: an economic input almost on a par with capital and labour. Knowledge is power & information is a valuable resource

Think..

Is Information an Asset???

Nowadays, information is being treated as a commodity that can be owned, controlled and traded in the market Today the availability of abundant data enables companies to cater to small niche markets anywhere in the world. Now statisticians mine the information output of the business for new ideas.

Information Economics is a branch of economic theory that studies how information affects an economy and economic decisions Information activity" is defined to include those specific industries and occupations whose primary function is to produce, process, or transmit economically valuable information Information Economics treats information explicitly as a resource

Value of information is not quantifiable, it depends on its use and context There is a great deal of difference between personal & group information or you may call it as organizational use of information. So, the division of information gathered may be the most fundamental form of division of labour.

The cost of producing information is independent of the scale on which it is used.

Learning takes time, so there is a limit to the rate at which decision makers can absorb information. There are usually significant information differentials in terms of possession of information, access to information & capacity to use information. The complexities of information activities makes information as a resource difficult to contain within the traditional production function mode of analysis. The greater part of cost of information is often the cost incurred by the recipient.

 Better workforce, better trained and more capable of dealing with problems. Better product planning and marketing, based on more knowledge about consumer needs. Better engineering, based on availability and use of scientific and technical information. Better economic data, leading to improved investment decisions and allocation of resources.

Better management from improved communication and decision-making.

Costs are incurred in acquiring information. It is likely that the return is over the long term, while the expenditure is made immediately. Except for the information industries information is not directly productive. themselves,

Rarely are results clearly attributable to the information on which they were based. Accounting practice treats, information as an overhead expense, subject to cost-cutting.

As far as importance of information to business is concerned, business plan should identify the role of information in support of the business objectives, so that any potential investor can assess the extent to which it has been recognized. Information is important for support of product research and development, for access to finance, for marketing, for knowledge of government regulations, for use of industry standards, for management of personnel. The returns to profitability from investment in information are real and large.

It is an economic policy of the government applied for regulating the volume of currency and credit in the economy. Its major tasks:
Exchange rate stability Control of inflation High employment High rate of capital formation Increase in savings Achievement of BOP Equilibrium

Open Market Operations Buying and selling of government bonds.

In inflation RBI sells government bonds, people withdraw money from banks, banks have less cash, thus banks give less loans/ credit creation falls, AD falls and prices falls. In deflation RBI buyback government bonds, people get their money that they deposit in banks, credit creation rises, AD rises and prices rise.

Bank Rate/Discount Rate Policy rate at which commercial banks borrow from central banks.
In inflation bank rate is increased, banks borrow less from RBI, credit creation falls, AD falls and prices falls. Also if banks borrow at higher rate from RBI, bank lending rates rises, people borrow less, credit creation falls, AD falls and thus, prices falls. In deflation - bank rate is reduced, banks borrow more from RBI, credit creation rises, AD rises and prices rise. Also if banks borrow at lower rate from RBI, bank lending rates falls, people borrow more, credit creation rises, AD rises and thus, prices rise.

Changes in CRR CRR is the percentage of total deposits of bank that must be kept with RBI as cash.
In inflation CRR is increased, less money with banks, credit creation falls, AD falls, prices fall. In deflation - CRR is reduced, more money with banks, credit creation rises, AD rises, prices rise.

Change in margin requirement it is that % of loan that a borrower has to give as security over & above the value of loan. E.g. if MR is 30% & loan requirement is Rs. 1 lac, borrower has to give security worth Rs. 1.3 lac or collateral money worth Rs. 30000.
In inflation MR rises, borrower has to pay more security, borrower takes less loans, credit creation falls, AD falls, prices falls. In deflation MR falls, borrower pays less security & borrows more, credit creation rises, AD rises and prices rise.

Current rates as on October 31, 2012:

Inflation 7.5% Bank rate 9% CRR 4.25% SLR 23% Repo rate 8% Reverse repo rate 7%

Exchange Rate is the relative price of one currency in terms of another. It is one of the important macroeconomic variable like interest rate & money supply. It influences trade & capital flows across national boundaries, relative profitability of various industries, real wages of workers and finally, allocation of resources within and across countries.

Fixed/Pegged Vs. Floating/Flexible Exchange Rate Spot Vs. Forward Exchange Rate Bilateral Vs. Effective Exchange Rate Real Effective Exchange Rate (REER) Vs. Nominal Effective Exchange Rate (NEER)

During the Bretton Woods era, Indian rupee was pegged to pound sterling. After the collapse of fixed rate system, there was a gap when it was pegged to US Dollar and then restored back to sterling in 1972 & maintained till September 1975. Then came the basket peg where the margins of +/- 2.25% to current rate & further, +/- 5% were introduced. Finally came the Liberalized Exchange Rate Management System (LERMS) in March 1992 and market-determined exchange rate system in February, 1993.

Exposure is a measure of sensitivity of the value of a financial item (asset or liability) to changes in the relevant risk factor. Risk is the measure of variability of the value of the item attributable to the risk factor. The magnitude of risk is determined by the magnitude of exposure and the degree of variability in the relevant risk factor.

Currency Exposure

Short-term

Long-term

Accounting/ Translation

Cash Flows

Operating

Strategic

Contractual

Anticipated

Interest is the price paid for borrowed funds that is the cost to the borrower & return to the lender. Interest rate volatility is the major source of uncertainty particularly for financial institutions.

Simple Vs. Compounded/Effective Fixed Vs. Floating

Nominal Vs. Real

Relationship between nominal interest rate, real interest rate and inflation rate (Fisher effect)

Fluctuations in interest rate affect a firms cash flows by affecting interest rate income on financial assets & interest expenses on liabilities.

Effective assessment & management of interest rate exposure requires a clear statement of firms risk objective. Interest rate exposure through Gap Analysis can be assessed

At the macro level, several developing countries have suffered from the increase in real interest rates as interest payments on their floating rate borrowings have eaten away a progressively increasing part of their real export earnings. For instance:
If the Co. has borrowed on the floating rate basis, at every reset date, the following period would be set in line with the market rate. The firms future interest payments are therefore uncertain. A rise in rates shall affect cash flows. Consider a firm that wants to undertake a fixed investment project. Suppose it requires foreign currency financing & is forced to borrow on floating rate basis. Since its cost of capital is uncertain, an additional element of risk is introduced in project appraisal.

 Consider a firm that has borrowed on a fixed rate basis to finance a fixed investment project. Subsequently, inflation rate in the economy slows down & market rate of interest declines. The cash flows of a project may decline as a result of fall in the rate of inflation but the firm is locked into a high cost borrowing. A fund manager is holding a portfolio of fixedincome securities such as government & corporate bonds. Fluctuations in interest rates causes 2 kinds of risk:
The market value of his portfolio varies inversely with interest rates (capital gain/loss risk) He receives periodic interest payments on his holdings that have to be reinvested. Returns on these reinvestments is uncertain.

Process through which changes in monetary policy instruments affects inflation, output & other economic variables is known economic mechanism. Monetary transmission channels are classified into two:
Price channels such as interest rate channel, exchange rate channel & other asset price rate channels, that affect aggregate demand by affecting price/cost of credit. Quantity channels/credit channels such as bank lending channel, that affects the aggregate demand by altering quantity or availability of credit.

With the reforms in place & changes in the structure of the Indian economy, the interest & exchange rates are emerging to be crucial monetary transmission channels.

It is the trend of a countrys trade balance following a devaluation or depreciation under a certain set of assumptions. A devalued currency means imports are more expensive, and on the assumption that the volume of imports and exports change little immediately, this causes a depreciation of the current account. After some time, though, the volume of exports may start to rise because of their lower more competitive prices to foreign buyers; and domestic consumers may buy fewer of the costlier imports. Eventually, if this happens, the trade balance may improve on what it was before the devaluation.

Moreover, in the short run, demand for the more expensive imports (and demand for exports, which are cheaper to foreign buyers using foreign currencies) remain price inelastic. This is due to time lags in the consumer's search for acceptable, cheaper alternatives (which might not exist).

Equally, many foreign consumers may switch to purchasing the products being exported into their country, which are now cheaper in the foreign currency, instead of their own domestically produced goods and services.

The

distinction between fixed and floating exchange rates. How the short-run effects of monetary and fiscal policy depend crucially upon the exchangerate regime. Whether exchange rates should be fixed or floating.

Assumption 1: The domestic interest rate is equal to the world interest rate (r = r*). Assumption 2: The price level is exogenously fixed since the model is used to analyze the short run (P). This implies that the nominal exchange rate is proportional to the real exchange rate. Assumption 3: The money supply is also set exogenously by the central bank (M). Assumption 4: Our LM* curve will be vertical because the exchange rate does not enter into our LM* equation.

Goods market equilibrium the IS* curve:

e

where e = nominal exchange rate = foreign currency per unit domestic currency

The IS* curve is drawn for a given value of r*. Intuition for the slope:

IS* Y

Money market equilibrium the LM* curve:

The LM* curve:

is drawn for a given value of r*. is vertical because: given r*, there is only one value of Y that equates money demand with supply, regardless of e.

LM*

Balance of payment (BOP) curve:

i i>i*

When there is perfect capital mobility, the BoP line is horizontal.

BoP
i<i*

above BoP line: capital inflow below BoP line: capital outflow

LM

BP IS Y

In a system of floating exchange rates, e is allowed to fluctuate in response to changing economic conditions. In contrast, under fixed exchange rates, the central bank trades domestic for foreign currency at a predetermined price. Next, policy analysis
first, in a floating exchange rate system then, in a fixed exchange rate system

Mundell-Fleming Model Flexible Exchange Rate

i LM BoP IS1 IS2

1 2

perfect capital mobility fiscal policy ineffective

G IS shifts right i>i* FA e NX IS shifts left

i LM1
1

perfect capital mobility monetary policy effective

LM2 BoP IS1

IS3
2

MS LM shifts right i<i* FA e NX IS shifts right

Mundell-Fleming Model Fixed Exchange Rate

i
perfect capital mobility fiscal policy effective

LM1

LM3 BoP

IS1
1

IS2

G IS shifts right i>i* FA e LM shifts right e

Mundell-Fleming Model Fixed Exchange Rate

i
LM1
2 1

LM2 BoP IS y

perfect capital mobility monetary policy ineffective

MS LM shifts right i<i* FA e LM shifts left e

If two countries trade a lot, one countrys policies can effect the other country. With secondary IS curve movements, there is an opposite effect on the other country. Monetary policy hurts the other country.
shift LM right causes a secondary effect of shift IS right: NX here NX abroad shift IS left abroad y abroad

Fiscal policy helps the other country.

shift IS right causes a secondary effect of shift IS back left: G here NX here NX abroad shift IS right abroad y abroad

This is why the government strongly encourages other countries to use a fiscal stimulus and strongly discourages other countries from using a monetary stimulus.

Krugman modified the Mundell-Fleming Model Impossible Trinity by arguing that we can attain any two of the three desirable attributes, but not all three:

As rises, the choice between monetary independence & exchange rate stability sharpens