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SYBCom : Semester III

Ranga Sai
Vaze College,
Mumbai

June 2013

Business Economics
Paper II, Semester III
[III Edition 2013]

Ranga Sai

SYBCom Semester III


University of Mumbai
Business Economics Paper II (Macroeconomics: Theory and Policy)

With effect from June 2013

Objectives
This course is designed to present an overview of
macroeconomic issues and introduces preliminary model
for the determination of output, employment, interest rates,
and inflation. Monetary and fiscal policies are discussed to
illustrate policy application of macroeconomic theory.

1. Macroeconomics: Theory of Income and employment


Circular flow of incomes : closed ( two and three sector models) and open
economy models Trade cycles : Features and phases Concept of Aggregate
Demand Keynes Theory of Income distribution Theory of Multiplier
Acceleration Principle Super multiplier.
2. Monetary Economics
Concept of Supply of Money Constituents and determinants of Money supply
velocity of circulation of money : Meaning and factors determining demand
for money : Keynes Theory of demand for money Keynes theory of interest,
rate of interest Inflation : concept and rate of inflation demand pull and cost
push inflation Philips curve causes, effects and measures to control inflation.

3. Banking and integration of product and money market equilibrium


Commercial banking: assets and liabilities of commercial bank tradeoff
between Liquidity and profitability _ Money multiplier Monetary policy:
objectives and instruments Fiscal Policy: Objectives and instruments IS-LM
Model: framework, impact of fiscal and monetary policy changes.

SYBCom Business Economics Semester III

Ranga Sai

CONTENTS

1. Macroeconomics: Theory of Income and employment


Circular flow of incomes
Trade cycles
Keynes Theory of Effective demand
Theory of Multiplier
Acceleration Principle
Super multiplier
2. Monetary Economics
Concept of Supply of Money
Constituents and determinants of Money supply
Velocity of circulation of money
Factors determining demand for money
Liquidity preference theory
Inflation: inflationary gap
Rate of inflation
Demand pull and cost push inflation
Philips curve
Inflation: Causes, effects and measures

3. Banking and integration of product and money market equilibrium


Assets and liabilities of commercial bank
Tradeoff between Liquidity and profitability
Money multiplier
Monetary policy: objectives and instruments
Fiscal Policy: Objectives and instruments
IS-LM Model: Derivation
IS-LM Model: impact of fiscal and monetary policy changes.
`

SYBCom Business Economics Semester III

Ranga Sai

Dear Student friends


Thanks for granting 3000 hits per month.
We gratefully acknowledge your response to earlier editions and offer the
revised III Edition of SYBCom Paper II Semester III.
During these days of commercialization it becomes very difficult to find
information on web which is relevant, authentic as well as free.
We believe that knowledge should be free and accessible to all those who need.
With this intention the notes, which are originally intended for the students of
Vaze College, Mumbai, are made available to all, without any restrictions.
These notes will be useful to all the S.Y.B.Com students of University of
Mumbai, who will be writing their Business Economics Paper II examinations
after June 2013.
This is neither a text book nor an original work of research. It is simple reading
material, complied to help the students readily understand the subject and write
the examinations. We no way intend to replace text books or any reference
material.
This is purely for academic purposes and do not have any commercial value.
Feel free to use and share.
We solicit your opinions and suggestions on this endeavor.
Dr. Prof. Ranga Sai
rangasai@rangasai.com
June 2013

SYBCom Business Economics Semester III

Ranga Sai

1. Macroeconomics: Theory of Income and employment


Circular flow of incomes : closed ( two and three sector models) and
open economy models Trade cycles : Features and phases
Concept of Aggregate Demand Keynes Theory of Income
distribution Theory of Multiplier Acceleration Principle Super
multiplier.

Circular flow of Incomes


Circular flow of incomes is a static macroeconomic model providing
relationships between various macroeconomic variables. This is a classical
model of macroeconomics.
Circular flow of incomes was first developed by the Quesney a French
Physiocrat in the 17th century. Later it was developed as a macroeconomic
model of equilibrium.
The model can be developed into a dynamic model by providing input output
relationships. Such models help the economy in planning and regulation.
The two sector model includes household and firms. It is equilibrium between
consumption and expenditure. The industry provides the output for the
households to consume and also provides incomes. The household sector spends
the money at the markets to give back incomes to the firms. This is the circular
flow of incomes between households and firms.
The three sector model includes the banking sector, where the equilibrium
includes
Y=C+S
The households save the income that is not spent. Further the savings become
investment through the banking sector. Thus
Y=C+I, where S=I

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Government sector will include tax and expenditure made on both the sectors.
Y=C+I+G
It is closed economy. By including the external sector, it becomes an
equilibrium with open economy.
Y=C+I+G+(X-M)

This is a macroeconomic model with five sectors: household, firms, banking,


Government and the external sectors.
The circular flow of incomes is an important model or estimating national
income. It is useful in studying the interdependence between various sectors.

Trade Cycles
Periodic changes in the level of economic acclivities in the long run are
commonly termed as trade cycles. The level of economic activity periodically,
increases and reaches a peak, shows a change in trend, decreases and bottoms
out and finally, changes trend towards increase. Such cyclical changes in the
level of economic activities constitute the trade cycle.
Trade cycle is a neoclassical concept of macro economics which tries to explain
the changes in the economic activities with respect to time. The concept of
trade cycle was initially developed by Joseph Schumpeter. The different phases
in the trade cycle are named in relation to the full employment level.
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Accordingly, there are six phases of trade cycle:


1. Inflation
2. Boom
3. Deflation
4. Recession
5. Depression, and
6. Recovery

1. Inflation: When the economic activity increases after full employment


level, it is called inflation. During inflation, the demand pressures will be
high. Increasing demand leads to increasing product prices, increasing
demand for factors, higher wages and then increasing demand again.
2. Boom: Boom refers to the peak in the level of economic activity after full
employment. The demand pressures will be at the peak. The price level
will be very high.
3. Deflation: It is the downward trend in the economic activities after
boom. At boom level the Government will take corrective measures due
to which the economic activity will show a change in trend.
4. Recession: When the economic activity reduces below full employment It
is called recession. The level employment will decreases, the prices will
decrease and the economic activity shrinks.
5. Depression: This is the lowest level of economic activity. The markets
collapse. Large scale unemployment will lead to poverty and suffering.
The world experienced Great depression during 1929 and 1933.
6. Recovery: From the lowest levels of economic activity the markets
recover due to positive Government policy. The economic activity will
increase towards full employment. Three will be increase in the level of
employment, incomes, investment and demand.
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The reasons for the occurrence for the trade cycle has been not yet explained
satisfactorily. The Sun spot theory relates the level of economic activity with the
number of sun spots. In absence of any other theory, the Sun Spot theory still
holds valid.

Theory of Effective Demand


The classical economists failed to provide policy solutions to economic
problems. The classical theory believed in long run and full employment
equilibrium.
Criticisms of classical theories
1. Classical theories are long run theories: - According to Keynes
theory should aim at short run problems and policies. Long run
is imaginary.
2. Classical economists believed that economies could have
equilibrium only with employment. But countries have
equilibrium even with unemployment.
3. Increasing the level of employment is not possible by laissez
faire policy. Full employment is not automatically
4. Savings do constitute leakage in classical system .It reduces
demand.
5. Unemployment can not be solved by a wage-cut policy. Strong
trade union movement will resist any decrease in wages.
Keynesian economics is short run economics. According to the theory
equilibrium is possible even with unemployment. There is no automatic system
in long run, which will grant full employment.
According to Keynes employment theory, it should provide short run solutions
He assigns an active role to the Govt. This is a deviation from traditional laissez
faire system.
Keynesian theory is called the general theory of employment The private
investment can create employment to a certain level. Therefore the govt.
investment can help in increasing the level of employment.

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Factors Determining Effective Demand:There are two important factors determining effective demand.
1. Aggregate demand function and
2. Aggregate supply function
Aggregate Demand function deals with the various amount of money the
producers expect from the sale of output at different levels of
employment. These are the receipts the producers expect.
ADF is short run factor. So Keynes considers it for study in detail. The
Effective demand is determined by ADF in the short run. ADF inturn is
determined by Consumption, Investment and, Government investment or
expenditure.
Aggregate Supply function deals with the various amount of money the
producers must receive from the sale of output at different levels of
employment. These are costs the producers must receive.
ASF on the other hand is a long run factor. Keynesian economics is short
run economics, so it is kept as constant in the short run. ASF is
determined by long run factors like Population, natural resources, cost
structure, technology etc.
Level of
Employment (000)
100
200
300
400
500

Aggregate Demand
(000)
1000
1500
3500
6000
4000

Aggregate Supply
(000)
800
1400
3500
6200
4500

Relationship
ADF>ASF
ADF>ASF
ADF=ASF
ADF<ASF
ADF<ASF

Aggregate demand function represents receipt and Aggregate Supply Function


the costs.

At a point where ADF = ASF the effective demand is determined. In turn the
level of employment is found at
The level of employment can't increase above because ADF < ASF and
receipt < cost. If private investments cannot increase the level of employment
then, the govt. investment can increase. This is the prescription for increasing
the level of employment.
The economy may have equilibrium even with unemployment.
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Aggregate supply function as a long run factor is represented as a 45-degree line


cut at full employment. The proportionate increases do not affect the short run
factors.
ADF can be studied in terms of its components.
C - Consumption expenditure,
I - Investment expenditure and
G - Government expenditure.
National Income Y= C+I+G

C + I constitute ADF determining the equilibrium at . The level of


employment can be increased to the government expenditure. The increase in
employment and income can be seen on X-axis.

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The Keynesian perception of government investment helped in generating


employment during great depression (1929-33). It was adopted by the U.S.
under New deal policy. The government invested in irrigation projects.
Pump priming finances the activity of public expenditure. The money in
circulation is increased the government investment generates employment
increases incomes, demand and prices. Thereafter the private investments will
take over.
The fall out of Keynesian government investment is inflation. In the process of
generating resources for employment; the government increases the money in
circulation. This is also called as deficit financing. Deficit financing is highly
inflationary.
Hence inflation is purely post Keynesian occurrence. However government
investment is found highly suitable for financing development employment and
growth.

Investment Multiplier
Investment Multiplier tells us about the changes in income for changes in the
investment. The concept o Multiplier was developed by Kahn.
With change in the investment here will be a change in the income, because the
investment expenditure turns into income. There after the income induce the
consumption to increase depending on the level of marginal propensity of
consumption.

This way an increase in the consumption expenditure creates incomes in the


second round. The induced income again increases the consumption. This cycle
repeats and an increase in the investment generates income several times more.
This is called as the multiplier effect.

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Multiplier Effect

The multiplier has a time lag. The multiplier works into the long run. Each year
some income is added and consumption is generated. This may taper with time
but it shall continue for ever, theoretically. This is called multiplier effect
Propensity of Consumption
The intensity of consumption whether aggregate or additional is called
propensity of consumption. Propensity of consumption can be measured in two
ways.
Average propensity of consumption: APC is the ratio of consumption to
Income.
APC = C/Y.
Marginal propensity of consumption: The MPC measures changes in
consumption for changes in income. It is the measures of propensity of consume
for an increment in income.
MPC = C / P

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Derivation of Multiplier

Illustration
For a given change in the Investment of Rs. 10,000 cr and a MPC of 0.5:
Multiplier is the inverse of Marginal Propensity of Consumption.
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Then the multiplier value shall be 2. For the given illustration the Y will
increase to Rs, 20,000 cr
Working of Multiplier

Assumptions or Limitations or leakages in Multiplier


1. Multiplier effect lasts over a larger time period. There is time lag
in the realization of multiplier effect. So in the short run only a
part of the multiplier effect can be got. The remaining is
considered as a leakage in the multiplier.
2. If the increased incomes are used in the repayment of old debts,
the multiplier effect stops.
3. The increased incomes shall be spent on domestic consumption
only. Money pent on imports will shift the multiplier effect
outside the country.
4. With increased incomes the Government increases tax, the
multiplier effect reduces. This is because the disposable income
decreases each time.
5. There shall not be liquidity preference. If people hold cash
balances with out spending the multiplier effect stops.
6. Investment in second hand securities and gold reduces multiplier
effect.
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7. There should be excess capacity in the industry to produce goods


with increasing demand for consumer goods.

Acceleration Principle
The accelerator deals with changes in the investment for changes in the
consumption. It is the continuation of multiplier effect. The multiplier indicated
changes in Income for changes in the investment. With changes in the
consumption, changes in the investment are given by acceleration principle.

Normally, assets last over a fixed life period. This is useful for the calculation of
depreciation and capital consumption. At aggregate level, depreciation is treated
as replace investment. Depending on the rate of depreciation, annually, certain
investment is needed. This is called replacement investment.
The capital output ratio tells us about the demand for investment for a certain
output.
For an increase in the consumption there will be certain need for investment. In
addition there will be replacement investment. Together the total investment for
the economy is computed.
Assumptions of Acceleration Principle
1.

There is no excess capacity in the consumer goods industry


2. There is excess capacity at the capital goods industry
3. Increase in demand for consumer goods is permanent
4. Complementary resources are available
5. It is a case of less than full employment level
6. Capital output ratio remains constant

Super Multiplier
Investment Multiplier tells us about the changes in income for changes in the
investment. With change in the investment here will be a change in the income,
because the investment expenditure turns into income.
The simple multiplier means that investment determines output. The super
multiplier combines the multiplier with the accelerator that is consumption
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demand inducing further investment. The multiplier effect now becomes a


continuous process alternating with acceleration principle.
The simple investment multiplier was given by Keynes considering only one
time autonomous investment. The super multiplier effect is given by Hicks
which includes the induced investment to trigger off super multiplier effect.
Changes in investment will again trigger off the multiplier effect. In
continuation, multiplier and acceleration effect repeat. This is called the super
multiplier effect.

When the multiplier and the accelerator work in continuation it is called the
super multiplier effect. The multiplier will initially create demand for
consumption. The consumption will induce investment and the cycle repeats.
Assumptions
a.
b.
c.
d.
e.

Investment is induced due to increase in consumer demand


There is no excess capacity in industry
The marginal propensity of consumption remains same
The tax structure is same so that the disposable income remains same.
Consumption demand and demand for capital goods is fulfilled by
domestic economy.
f. The increase in the demand is permanent.
g. The complementary resources for production are available
h. The supply of capital goods is elastic.

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2. Monetary Economics

Concept of Supply of Money Constituents and determinants of Money


supply velocity of circulation of money : Meaning and factors
determining demand for money : Keynes Theory of demand for money
Keynes theory of interest, rate of interest Inflation : concept and rate
of inflation demand pull and cost push inflation Philips curve causes,
effects and measures to control inflation.

Supply of Money
Constituents of Money supply
The supply of money is the State function. The Central bank possesses the
monopoly of issue of currency. Traditionally the supply of constitutes coins and
currency. There are several approaches to the constituents of money supply.
1. With ever expanding properties and functions of money the constituents of
money has been rapidly changing. Since David Hume, the
composition of money started including coins and currency together
with demand deposits. The deposits which are chequable are as liquid
as cash. So primarily, money supply should be made up of:
Coins and currency + Demand deposits
2. Milton Friedman described money with wider coverage and functions.
According to him money supply should comprise coins and currency,
demand deposits and also time deposits. Time deposits are those
which have a time obligation between the bank and the depositors.
They are liquid but with a time prescription.
Coins and currency + Demand deposits + Time deposits

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The spending of the house hold is influenced by the cash held by


them. But the time deposits also enhance the spending decisions. Time
deposits can function as liquidity preference thus allowing households
exercise greater spending.
Milton Friedmans approach is accepted and followed all over the
world as the standard of measuring money supply. This is similar to
the measure M3 followed by Reserve Bank of India.
3. Gurley and Shaw offer the widest definition of money supply. According to
them, money supply shall include all that can be converted into cash,
depending on convertibility of asset.
However, the assets shall be included in money supply based on their
liquidity. E.g. Cash is cent percent liquid, where as time deposit has
lesser liquidity, loans, securities, gold all have liquidity which
gradually declines. These assets shall be included as per the
weightages assigned to their liquidity.
4. Bank of England follows the method suggested by Radcliffe Committee.
The method has wider coverage; it includes assets depending on
liquidity and convertibility. Reserve Bank of India followed method
similar to this upto 1977, when the II Working Group suggested an
alternative and indigenous method of measuring money supply.
5. Reserve bank of India
RBIs Third Working Group 1998
The Third working group in 1998 recommended compilation of monetary
aggregates which is simple, uncomplicated, comprehensive, and operationally
feasible in terms of frequency of availability of information.
Accordingly the group proposed compilation of following four measures of
monetary aggregates:
M0

= currency in circulation + bankers deposits with RBI + other


deposits with RBI.

Narrow money: Narrow money deals with transactions demand for money. The
constituents of narrow money are limited to the central bank and the central
government and commercial and co-operative banks.
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M0 is essentially the monetary base, i.e. reserve money. It is compiled weekly.


This measure denotes effects on the consumer price index.
M1

= currency with public + demand deposits with the banking system +


other deposits with RBI

M1 reflects the banking sectors non-interest bearing monetary liabilities. It is


compiled fortnightly.
M2

= M1 + time liability of savings deposits with the banking system +


certificates of deposit issued by banks + term deposits
= currency with public + current deposits with the banking system +
saving deposit with the banking system + certificates of deposit
issued by banks + term deposits the banking system + other deposit
with RBI

M3

= M2 + term deposits banking system + call borrowings from Non


banking financial corporations.

M3 is the international standard of money supply. IMF, World Bank and WTO
use this measure, uniformly, for comparing different economies of the world.
M3 is similar to Milton Friedmans measure of money supply. M3 is the measure
of aggregate liquidity in the economy. This is an important measure for
monetary targeting by RBI.
Liquidity measures for Broad money
In addition, the Third Working Group proposed two liquidity measures for
broad money for measuring overall economic activities (monthly and quarterly
compilation). This measure brings out the importance of Non depository
corporations (Non banking financial corporations).

L1
L2

L3

= M3 + all deposits with post office savings bank except NSC


= L1 + term deposits with Term Lending Institutions and
Refinancing Institutions (FIs) + term borrowing by FIs and
Certificates of Deposits issued by FIs
= L2 + public deposits of non banking financial companies

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Velocity of money
Velocity of money is defined simply as the rate at which money changes hands.
Velocity refers to how many times a given quantity of money is spent during the
period under consideration, usually one year.
If velocity is high, money is changing hands quickly, and a relatively small
money supply can fund a relatively large amount of purchases.
If velocity is low, then money is changing hands slowly, and it takes a much
larger money supply to fund the same number of purchases.
It is known that GDP = M x V; that is, GDP equals the quantity of money times
its velocity.
By dividing the Gross Domestic Product (GDP) by the Money Supply (M1)
Velocity of Money can be derived.

Factors determining velocity of money


1. Money Supply: Velocity of money depends upon the supply of money.
If the supply of money is less the velocity of money will
increase and if the money supply is less, the velocity of
money will fall.
2. Value of Money: The velocity of money is high during inflation and the
velocity of money is low during deflation.
3. Credit Facilities: With larger credit facilities the velocity of money
increases.
4. Volume of Trade: As the volume of trade increases the number of
transactions and the velocity of money increases and as the
volume of trade decreases, the velocity of money decreases.
5. Frequency of Transactions: With the increase in the frequency of
transactions, the velocity of money increases. Similarly, with
the decrease in the frequency of transactions, the velocity of
money decreases.
6. Business Conditions: The velocity of money increases during the
period of boom period and decreases during slump
conditions.
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7. Payment System: The velocity of money is also determined by the


frequency of wage payments. Velocity will increase with
increasing frequency of payments.
9. Propensity to Consume: Larger the propensity of consumption higher
will be the velocity of money. Lower the propensity to
consume, lesser will be the velocity of money.

Demand for money


Factors determining demand for money
Traditionally, the demand for money is expected to be a function of value of
money. There is a negative relationship between value of money and the
demand for money.
On the other hand value of money is a nominal concept. The value of money is
measured as the inverse of price level.
The demand for money is determined by several other factors.
Following are the various factors determining demand:
a. Interest rate: Interest rate is the price of holding money. It is the income
foregone by holding cash. There is a negative relationship between
rate of interest and demand for money.
b. Aggregate income: Larger the level of income larger will be the
demand for money. Larger income and output will need higher
liquidity for mobility in the process of payments.
c. Price level: Prices and the demand for money are inversely related.
With prices rise, the demand for money will be higher. With
decrease in prices the transaction demand for money falls.
d. Transaction demand: This is the demand for transactions as defined by
Keynes. Transaction demand depends on the level of income.
d. Velocity of money: Velocity of money is the rate at which money
performs transactions. Velocity of money is different for different
monetary systems; banking, cash transactions etc.
e. Hoardings: Demand for liquid cash for hoarding determines the
demand for money. The demand for such cash balance depends on
the rate of interest.

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f. Financial markets: Growth of financial markets and financial


instruments provide incentives for dishoarding cash balances.
Highly developed financial system will reduce demand for physical
money.
g. Buying pattern: Frequency of buying and buying pattern determine the
demand for money. Increased frequency of buying increases
demand for money.
h. Banking system and innovations in mode of payment : Healthy
banking system and innovations in the mode of financial payments
and transactions will affect demand for money. Physical cash will
be less in demand in those economies where banking system and
habits have highly developed.

Demand for Money - Liquidity preference theory Keynes


There are three chief motives for which money is demanded. These are
transactions, precaution and speculation. The first two motives are classical the
third motive of speculation is introduced by Keynes.
1. Transactions Motive:
Money is demanded for regular economic transactions. Both
households and firms have to carry out a variety of transactions for
which they need money.
It is related to the size of the income and type of activities
performed by individuals, households and firms. Demand for
money to satisfy transactions motive is about 50 percent of the size
of an individual or household income.
2. Precautionary motive:
Money demanded to satisfy the precautionary motive is for meant
for unforeseen circumstances. This amount of money kept aside
can be used during times of uncertainty or emergency. It depends
mainly on the size and responsibilities of the family and size of the

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income. In the short run these factors remain constant and hence
demand for money also remains nearly constant.
3. Speculative motive:
Keynes was the first to identify the role of speculative activities.
Such demand is made to invest in capital market for buying shares,
bonds, securities etc. when their prices are low.
Keeping money in this idle form is known as hoarding of money.
It all depends upon fluctuating prices and market conditions for
securities.
The total demand for money or liquidity can be classified into two parts:

Total demand for money = L = L1 + L2


L1 is that part of money or liquidity demanded to satisfy transactions and
precautionary motives. Keynes calls this the demand for Active Cash balances
or money. Active cash balances depend on the income of the households. The
second part L2 is money demanded made to satisfy the speculative motive.
Keynes has called this as demand for Passive Cash balances or money.
Speculative demand depends upon the prices of securities.

The negative relationship between rate of interest and liquidity preference is


found only up to a minimum interest rate. There after, the demand for money
becomes infinity. The zone where the demand for money is infinity is called as
the liquidity trap. Any increase in money supply at this level will not have any
effect on the liquidity preference. At liquidity trap the demand for money tends
to be infinity.
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The Relationship between Interest and Inflation


Inflation is caused by money supply in an economy. The Government uses
interest rate to control money supply and, consequently, the inflation rate. When
interest rates are high, it becomes more expensive to borrow money and savings
become attractive. When interest rates are low, banks are able to lend more,
resulting in an increased supply of money. As interest rates drop, consumer
spending increases and this in turn encourages economic growth.
Change in interest rate can be used to control inflation by controlling the supply
of money in the following ways:
1. A high interest rate affects consumption expenditure by shifting
consumers from borrowing to saving. This in turn effects the
money supply.
2. An increase in interest rate encourages savings. Low interest rates
encourage investments in shares. The consumption demand gets
affected.
3. A rise in the interest rate induces foreign investment. Foreign
investors will find profitable to divert investment to countries with
higher interest rates.
Nominal and real interest rates
Nominal interest is the rate of interest before adjustment for inflation. Real
interest is the rate of interest an investor expects to receive after allowing for
inflation.
The nominal interest rate is the interest rate at bank. The nominal interest rate
indicates the rate at which the saving is growing. The real interest rate corrects
the nominal rate for the effect of inflation. This is the net growth of savings
after considering inflation rate.
Irving Fisher states that the real interest rate is independent of monetary
measures, especially the nominal interest rate. The Fisher Effect is shown as:
Rr = Rn .

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This means, the real interest rate (Rr) equals the nominal interest rate (Rn)
minus rate of inflation (). Or nominal interest rate = real interest rate +
inflation rate.
The Fisher Effect shows how the nominal interest rate moves according to
inflation rate in the long run

Economics of Inflation
According to neoclassical economics inflation refers to increase in the level of
economic activity after full employment.
Presently, inflation is found even with unemployment. This is called stagflation.
Inflation
Inflation is post Keynesian concept. Primarily inflation is
caused by indiscriminate expansion of money supply.
Inflation means too much money chasing too few goods.
Increase in monetary resources against stagnant real output
leads to inflation.
Inflation is a monetary phenomenon.
Inflation is caused by excess demand pressures on the goods
and factors of production due to increase in monetary resources.
Inflationary Gap
Inflationary gap arise when there is an increase in incomes and the pout put
remaining same. The additional income is absorbed by the same out put, thus
causing the prices to increase.

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In the diagram, with an increase in the income the consumption function will
shift up wards. The equilibrium should move from E1 to E2. But E1 is a full
employment situation; the equilibrium can not shift to E2 (to the right of ASF)
but moves to E3. The additional income and expenditure is consumed by the
same real output. E1to E3 is the inflationary gap.
Classification inflation (Rates of Inflation)

Inflation can be classified in terms of rate of change. Inflation is classified in


terms of years taken for the prices to double. There are four types of Inflation:
1. Hyper inflation
2. Running Inflation
3. Walking inflation, and
4. Creeping inflation
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Hyper inflation: It is said to be hyper inflation when the prices double within
three years. The rate of inflation is more than 30 percent. This is
also called galloping inflation.
Running Inflation: If the prices double in eight to ten years it is called running
inflation. The rate of inflation is between 10 to 15 percent.
Walking inflation: If it takes fifteen years forth prices to double, it is called
walking inflation. It is moderate inflation suitable or a rapidly
growing economy.
Creeping inflation: If it takes 20 years to double the prices, it is called creeping
inflation. Such inflation may not promote high growth rates. The
industry will show a growth rate of 4 percent and agriculture will e
stagnant.
Types of Inflation
Inflation can be classified based on major causes. Accordingly, there can be
four types of inflation
Budgetary inflation:
This is the inflation caused by expansion of money supply resulting out of
Governments budgetary activities. The Government may increase money
circulation to meet the deficits in the budget for financing any
contingency.
If Government expands money for non productive purposes it leads to
inflation. During Post Keynesian period, this has been a major cause for
rapid increase in inflation all over the world.
Wartime inflation:
During the emergencies of war, the Government generates resources by
currency expansion. In addition, the prices may incase due to scarcity
followed by hoarding and black marketing.
Such inflation is generally controlled after war. War time inflation is a
common occurrence these days.
Demand Pull Inflation
Demand pull inflation is caused by increasing demand arising out of
excess money supply and increase in demand for factors by the industry.
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Demand pull factors


1. Increase in money supply due to budgetary activity
2. Increase in demand for goods
3. Increase in demand for factors by the industry

According to Keynes, after full employment E if the aggregate demand


increases to D1, D2, and D3, the real output can not increase and the equilibrium
will be shifting only on the ASF to E1, E2, and E3. As a result the prices will
increase to P1, P2, and P3. This is the inflation driven by demand pull factors
Demand-pull factors in India
a. The parallel economy creates demand pressures from unexpected
sectors of the economy.
b. The unorganized money markets pump in those additional resources
which cause inflation.
c. Increasing public expenditure creates large amount of incomes.
Public expenditure, which constitutes 43 percent of GNP is a
major source of income.
d. Rapid monetary expansion leads to excess inflationary pressures. A
monetary base of Rs. 2, 65,000 crore generates a large income
and the following demand.

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e. Deficit financing create those resources which create inflation. The


deficits create additional resources of around Rs.10,000 crores
annually.
f. Due to in appropriate taxation large disposable income is left
causing high rates of inflation.
Cost Push Inflation
Cost push factors
1. Increasing prices
2. Decrease in the real income (purchasing power)
3. Decreasing in the standard of living.
4. Increase in demand for factors
5. Increase in demand for more wages
6. Wages increase due to strong trade union
7. Increase in the cost of production
8. The prices increase.

Under cost push inflation even with increasing demand the supply can not shift.
Against an inelastic supply curve an increase in demand D1, D2, and D3 will
shift the supply curve. The cost structure undergoes a change and the
equilibrium will be found on the same inelastic supply curve. The real out put
remains same and the value of out put increases to P1, P2, and P3. Hence the
prices will increase. This is cost push inflation.

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Cost-push factors in India:


a. Administered prices tend to be inflationary. The prices of coal
and fertilizers affect agricultural prices and prices of power.
b. The prices determined by the Bureau of Industrial costs also tend
to be inflationary for inputs. With the cascading effect, the
prices spiral upwards.
c. The strong trade union movement always bargains higher wages.
The politicized trade unions command larger bargaining power.
d. Industrial strikes, lockouts lead to wastage of resources.
e. The labor legislation always provides higher wage than
productivity.

Effects of Inflation
Inflation affects all sectors and al sections of the economy. These effects of
inflation can be classified into four groups
1. Effects of inflation on Production
Inflation effects production by bringing in changes in investment, output, factor
markets, and financial markets
a) Output: The output will remain stagnant or show a marginal rise.
The value of output may increase but the real output will remain
constant.
b) Cost of production: The cost of production will increase due to
increase in the factor costs lead by increase in demand. With
increase in demand for inputs the quantity will remaining same. So
the factor cost increase.
c) Investment: The value of investment will increase but the real
investment will remain same.
d) Prices: The price level will increase. With increase in prices the
standard of living will decrease.
e) Business environment: There will be business optimism due to
increasing prices

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2. Effects of inflation on Consumption


a) Middle class: The fixed income groups will suffer a loss of
standard of living. The salary incomes will not increase as fast as
the business incomes.
b) Trade unions: The trade unions will become stronger to fight for
the workers welfare
c) Wages: The trade unions will demand higher wage. The wages will
increase due to strong trade unions
d) Consumption expenditure: The value of consumption will increase.
The consumption expenditure will increase where as the real
consumption will remain same.
3. Effects of inflation on Monetary sector
a) Surplus budget: The Government will adopt a surplus budget to
reduce money supply
b) Credit policy: The tight money policy will lead to a credit squeeze.
c) Money markets: There will be boom in financial markets. There
will be bullish trend leading to increase in share prices.
d) Interests: Excess money supply will lower the interests in the
money markets

Measure to control inflation


Inflation can be caused by a variety of factors; accordingly there are several
techniques to control inflation, each suitable to influence the kind of factors
causing it.
Following are the major methods of controlling inflation
1. Monetary measures
2. Fiscal measures
3. Real sector measures
1. Monetary measures
There are several monetary measures employed in controlling the supply of
money and credit. These are the basic components of monetary policy.
a. Bank rate : Bank rate is the rate at which he central bank rediscount
the bills presented b commercial banks. Bank rate helps in reducing
supply and demand for credit. An increase in bank rate helps in
making credit costly, thus reducing the demand for credit.
Accordingly, increase in the interest rate will reduce the demand for
credit.
b. Statutory liquidity ratio: indicates the minimum percentage of deposits
that the bank has to maintain. This rate is prescribed by the Central
bank. By increasing the reserve requirement, the credit creation can be
controlled. This method regulates the supply of credit.
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c. Open market operation: It refers to the purchase and sale by the


Central Bank of a variety of assets, such as foreign exchange, gold,
Government securities and company shares. In India, however it refers
to the purchase and sale of Government securities.
By way of open market operations, the central bank either increases or
decreases the money supply in the country. To increase the money
supply, the Central bank buys securities from commercial banks and
public and vice versa. Open market operations are used to provide
seasonal finance to banks.
d. Repo and Reverse REPO: Repo and Reverse Repo are tools available
in the hands of RBI to manage the liquidity in the system. It either
injects liquidity into the market if the conditions are tight or sucks out
liquidity if the liquidity is excess in the system through the Repo and
Reverse Repo mechanism, besides a host of other measures.
e. Interest rate mechanism: Certain central banks stipulate interest rates
for certain markets and portfolio. This is a positive measure in
controlling money supply.
f. Monetary targeting: Central banks adopt monetary targeting for
restricting the supply of money. Each year the central bank lays down
target for monetary expansion. It enables the government to assess the
level of monetary inflation.

2. Fiscal measures:
a. Taxation: Progressive taxation is used for reducing disposable
income. Progressive taxation helps in reducing demand by
reducing disposable income of higher income groups.
b. Public expenditure: Productive expenditure on developing
infrastructure helps in increasing productivity and production.
Third is regarding supply management.
c. Debt management: Disposable income of the higher income
groups can be reduced by soliciting debt. The government can
issue such instruments which will be a part of portfolio for the rich
an also reduce disposable income.
d. Budgetary management: The government adopts surplus budget to
withdraw monetary resources from the economy. Surplus budget
has larger tax revenue than public expenditure.

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3. Real sector measures


a. Import of capital goods: Import of capital goods will help in
increasing the production capacity of consumer goods. This is supply
side management.
b. Better infrastructure:
Development of infrastructure helps in
increasing productivity and production.
c. Technology up gradation: Larger expenditure outlays on research and
development will help in increasing productivity.
d. Public distribution system: Efficient public distribution system will
help the poorer classes in maintaining their standard of living. PDS
can deal with more and more consumer goods to counter act primary
inflation.
e. Price legislation: The Government can enact consumer legislation and
price control act to peg prices of essential goods.
f. Consumer movement: Effective consumer movement will counter act
any act of price exploitation by the industry.

Module 3
Banking and integration of product and money market
equilibrium

Commercial banking: assets and liabilities of commercial bank tradeoff


between Liquidity and profitability _ Money multiplier Monetary policy:
objectives and instruments Fiscal Policy: Objectives and instruments ISLM Model: framework, impact of fiscal and monetary policy changes.

Assets and liabilities of a commercial bank


Following are the various items appearing on the liabilities side of a balance
sheet.
1. Checkable Deposits - (10%)
a. Demand deposits (non-interest-bearing checking)
b. NOW accounts - interest-bearing checking
c. Money market deposit accounts (MMDAs) - money market mutual
funds.

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Checkable deposits are payable on demand, you can write a check for any
amount, including your entire balance. Checkable deposits are lowest cost
source of funds for a bank, sometimes 0 (demand deposits), because people like
the liquidity of checking accounts and will forego interest for convenience of
checks.

2. Non-transaction Deposits are the Primary source of bank funds


a. Savings accounts (passbook savings)
b. Small-denomination Time Deposits (CDs, certificate of deposits),
fixed maturity from several months to 10 years. Higher interest rates
than passbook savings, penalties for early withdrawal, less liquid, are
more costly for the bank.
c. Large-denomination Time Deposits, bought by corporations,
money market funds and other banks. Liquid, negotiable, marketable,
can be resold in secondary market before they mature, like a corporate
bond or T-bond. Alternative to commercial paper and T-bills.
3. Borrowings of bank funds:
a. from other banks - Fed Funds Market - to meet reserve requirements
b. from RBI- discount rate - to meet reserve requirements
c. from parent companies - bank holding companies
d. from corporations and from foreign banks - negotiable CDs and
Eurodollar deposits
4. Bank capital, equity from issuing new stock or capital from retained
earnings. Bank capital is also a cushion against a drop in the value of its assets,
to protect against insolvency, bankruptcy.
Banks are usually highly leveraged, very thinly capitalized.
Asset side of a balance sheet:
If liabilities indicate as to the source of funds, the liabilities indicate where the
funds have gone. This is about deployment of resources
A bank uses its deposits to acquire income-earning assets, to make profits, by
earning more interest on assets than they pay out on liabilities.
1. Reserves : Deposits kept on account at the Fed (all banks have an account at
the RBI) + Vault cash on hand at bank, stored in the vault overnight.

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2. Securities: Banks also hold securities like T-bills and mini bonds and
government debt instruments.
3. Loans: Most bank profits come from Loans. Loans make a large part of
bank assets:
a. Commercial loans to businesses
b. real estate loans (mortgages, home improvement loans, etc.)
c. consumer loans (credit card, automobiles)
d. interbank loans, Federal Funds market
e. other loans
Loans are less liquid than other assets (e.g. securities, T-Bills, etc.) because
the assets tied up for the length of the loan, 30 years in the case of a typical
mortgage. Loans are also more risky, higher default risk than securities.
Because loans are more risky and less liquid, they earn more interest for
banks.
4. Other Assets : Property, plant and equipment : Buildings, office equipment,
computer systems, etc.

Conflicting Objectives of Liquidity and Profitability


Banks are limited companies whose main aim is to create profit to its
shareholders. Most of the profit comes out of lending the money, which is
received from depositors, out to the customers.
So the more the depositors, bank has the more it can lend out, thus it can make
more profit and pay higher dividends to its shareholders. It follows that the
banks try to be as attractive to potential savers as possible. They can offer two
things: a high interest rate and a high liquidity. Both are very important, because
depositors want to be able to draw their money out any time they want and have
profit by receiving interest.
A bank has to maintain liquidity as well as profitability. Liquidity is meant for
maintaining the statutory responsibility to the depositors and profitability for its
survival.
So, a bank needs to maintain its portfolio in such a manner that it is able to
honor the demands of the depositors as well as earn profits out of its deposits
and other investments.

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In its operations, a commercial bank has to draw a balance between liquidity


and profitability.
The portfolio management of a commercial bank can be studied from the
arrangement of assets in the balance sheet.

A bank arranges its assets in such a manner that the liquidity decreases down q
wards in the asset side of the balance sheet. Liquidity is available at different
levels without fore going the profitability.
Now there is a clash for the bank between these two objectives. If they would
want to maximize the liquidity they would keep their assets in cash, which is the
most liquid form of assets, but the bank cannot earn any interest on that, so it
cannot give any interest to its depositors.
In portfolio management, a bank resolves the conflict of liquidity and
profitability

Due to security reasons of security and liquidity the banks to


have some portion of their assets in cash. This money earns
no interest.
The liquidity loss of keeping less cash is compensated by the
interest bearing loans at call or short notice (the money can
be received back immediately or after a week notice).

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Discount houses deals with bills and so can provide the


money immediately by selling some of them.
Treasury Bills which government issues every month for the
period of 91 days and which are very secure and bills issued
by other businesses.
Liquid assets form 9-12 percent of all the assets. They are
unprofitable compared to the other type of assets that are less
liquid: medium-term loans, investments and advances.
The main part of banks' assets is advances to its customers.
They form more than 50 percent of total assets and are
formed from overdrafts and loans of various types.
Government stocks are another very common type of
profitable assets. They are loans to government, who issues
interest-bearing bonds (e.g. Exchequer stock, Treasury
stock), which banks can then buy.
Banks have to make decisions which proportion of these assets described above
to choose to make profits and maintain liquidity. They do not have choice,
because great part of their liabilities is controlled by the Reserve Bank of India
(eligible liabilities).

Credit creation by commercial banks


The Commercial Banks crate credit out of their cash deposits. The banking
system can create credit several times more than the amount of cash deposits
received by them. This is called multiple credit creation or deposit
multiplication.

The initial cash deposit made is called as rte primary deposit. The commercial
bank will keep a part of the deposit for honoring the demands of the depositor
and the balance is extended as credit.
The advances are always made in cheque. So the borrower has to deposit the
loan in a different bank. This way a loan creates a deposit. The second bank will
again retain a part for honoring the demands of the depositors and the balance
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will be given as advance. This way, every deposit creates a loan and every loan
creates a deposit.
It can be seen that in this process a deposit creates loans several times more.
This is called multiple credit creation. A single bank can not create credit it
takes all the commercial banks to create credit.
However, in the process if there are more cash withdrawals the credit creation
stops. Money entering the banking system generates credit and cash
withdrawals reduce credit.
Though the credit is always extended as cheque cash deposits are essential.
Banks cannot create credit out of thin air, cash deposits are needed for
honoring the demands of the depositors.

Working of credit creation by commercial banks


Illustration:

Initial primary deposit of Rs. 10,000, and a reserve ratio of 10 percent


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Credit creation by banks


Banks.

Deposits

Reserves

Advances

10,000

1000

9,000

9,000

900

8,100

8,100

810

7,290

7,290

729

6,561

The deposit multiplier is computed as


Dm = 1

Where, is the reserve ratio.


Limitations of credit creation:
For several reasons the deposits may not expand as [per the deposit multiplier.
This is due to certain leakages and limitations of multiple credit creation.
Following are the limitations of credit creation by commercial banks
1. Cash with drawls: Money entering the banking system creates
credit and cash with drawls stop credit.
2. Liquidity reserve: Higher the liquidity reserve lower will be the
credit created. The liquidity reserve is prescribed by the Central
bank of a country.
3. Interest rate: Higher rates of interest reduce the demand for
credit.
4. Liquidity preference of households: If households prefer larger
liquidity, the cash deposits will decrease.
5. Banking habits: Healthy banking habits increase dependence on
banks and lager credit can be created.
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6. Banking system: A strong banking system and network will


encourage the usage of banking assets and products.
7. Collateral securities: If banks insist for larger collateral securities
the demand for credit will decrease.
8. Loan appraisal procedures: If the loan appraisal takes longer
duration, the dependence on institutional credit will decrease.
9. Credit control by Central bank: Finally, the Central bank of the
country will determine the extent of credit to be created by the
commercial banks. This is a part of the credit policy.

Monetary Policy
Monetary Policy deals with changing money supply and rate of interest for the
purpose of stabilizing the economy at full employment or potential output level
by influencing aggregate demand
The RBI makes use of instruments to regulate money supply and bank credit so
as to influence the level of aggregate demand for goods and services.
The monetary policy has to balance the objectives of economic growth and
price stability.
Economic growth requires expansion in the supply of money so that no
legitimate productive activity suffers due to finance shortage. Price stability
requires control the expansion of credit so that money supply does not cause
inflation.
Changes in the monetary policy can be made anytime during the year. The
Central Bank may adopt an expansionary or contractionary policy depending
on the general economic policy of the Government and conditions in the
economy.
Monetary policy may also be used to influence the exchange rate of the
countrys currency.
Objectives of monetary policy
Control of Inflation:
 In a developing country like India, increase in investment
activity puts a pressure on prices. A high degree of
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inflation has adverse effects on the economy. It raises the


cost of living, makes exports costlier, reduces the incentive
to save and encourages nonproductive investment.
 RBI increases the SLR which reduces availability of
loanable funds with commercial banks.
 By increasing bank rate, the cost of bank loan is increased
which in turn reduces money supply and credit which tend
to reduce price rise. Price stability means a reasonable rate
of inflation.
Economic Growth:
 Accelerating economic growth so as to raise national
income is another objective of the monetary policy. To
promote economic growth availability of bank credit is
increased and the cost of credit is reduced. Promotion of
economic growth needs a liberal monetary policy.
Exchange Rate stability:
 Until 1991 India followed fixed exchange rate system. The
policy of floating exchange rate and globalization of the
Indian economy have made the exchange rate volatile. The
RBI attempts to ensure exchange rate stability. A tight
policy will prevent fall in the value of rupee. Alternatively
to prevent depreciation of rupee, the Reserve Bank releases
more dollars from its foreign exchange reserves.
 A floating exchange rate or a flexible exchange rate is a
type of exchange rate regime wherein a currency's value is
allowed to fluctuate according to the foreign exchange
market. A currency that uses a floating exchange rate is
known as a floating currency Many economists think that,
in most circumstances, floating exchange rates are
preferable to fixed exchange rates. They reduce the shocks
and foreign business cycles.

Instruments of monetary Policy


1.
2.
3.
4.

Bank rate
Statutory liquidity ratio
Cash reserve ratio
Open Market Operations

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5. REPO and Reverse REPO


6. Marginal Standing Facility
7. Market stabilization scheme
1. Bank rate
Bank Rate is the rate at which central bank of the country (in India it is
RBI) allows finance to commercial banks. Bank Rate is a tool, which
central bank uses for short-term purposes. Any upward revision in Bank
Rate by central bank is an indication that banks should also increase
deposit rates as well as Base Rate / Benchmark Prime Lending Rate.
This is the rate at which central bank (RBI) lends money to other banks or
financial institutions. If the bank rate goes up, long-term interest rates also
tend to move up, and vice-versa. Thus, it can said that in case bank rate is
hiked, in all likelihood banks will hikes their own lending rates to ensure
that they continue to make profit.
2. Statutory Liquidity Ratio
SLR stands for Statutory Liquidity Ratio. This term is used by bankers and
indicates the minimum percentage of deposits that the bank has to maintain
in form of gold, cash or other approved securities. Thus, we can say that it
is ratio of cash and some other approved securities to liabilities (deposits) It
regulates the credit growth in India.
Every bank is required to maintain at the close of business every day, a
minimum proportion of their Net Demand and Time Liabilities as liquid
assets in the form of cash, gold and un-encumbered approved securities.
The ratio of liquid assets to demand and time liabilities is known as
Statutory Liquidity Ratio (SLR). RBI is empowered to increase this ratio
up to 40%. An increase in SLR also restrict the banks leverage position
to pump more money into the economy.
3. Cash reserve ratio
CRR means Cash Reserve Ratio. Banks in India are required to hold a
certain proportion of their deposits in the form of cash. However, actually
Banks dont hold these as cash with themselves, but deposit such case with
Reserve Bank of India (RBI) / currency chests, which is considered as
equivalent to holding cash with RBI.
This minimum ratio (that is the part of the total deposits to be held as cash)
is stipulated by the RBI and is known as the CRR or Cash Reserve Ratio.
Thus, When a banks deposits increase by Rs100, and if the cash reserve
ratio is 6%, the banks will have to hold additional Rs 6 with RBI and Bank
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will be able to use only Rs 94 for investments and lending / credit purpose.
Therefore, higher the ratio (i.e. CRR), the lower is the amount that banks
will be able to use for lending and investment.
This power of RBI to reduce the lendable amount by increasing the CRR,
makes it an instrument in the hands of a central bank through which it can
control the amount that banks lend. Thus, it is a tool used by RBI to
control liquidity in the banking system.
RBI uses CRR either to drain excess liquidity or to release funds needed
for the growth of the economy from time to time. Increase in CRR means
that banks have less funds available and money is sucked out of
circulation. Thus we can say that this serves duel purposes :
a. Ensures that a portion of bank deposits is kept with RBI and is
totally risk-free,
b. Enables RBI to control liquidity in the system, and thereby,
inflation by tying the hands of the banks in lending money.
4. Open Market Operations
The Central Bank buys or sells ((on behalf of the Fiscal Authorities (the
Treasury)) securities to the banking and non-banking public (that is in the
open market). One such security is Treasury Bills. When the Central Bank
sells securities, it reduces the supply of reserves and when it buys (back)
securities-by redeeming them-it increases the supply of reserves to the
Deposit Money Banks, thus affecting the supply of money.

5. Repo rate and Reverse Repo rate


The rate at which the RBI lends money to commercial banks is called repo
rate. It is an instrument of monetary policy. Whenever banks have any
shortage of funds they can borrow from the RBI. A reduction in the repo
rate helps banks get money at a cheaper rate and vice versa.
Reverse Repo rate is the rate at which the RBI borrows money from
commercial banks. Banks are always happy to lend money to the RBI since
their money are in safe hands with a good interest.
An increase in reverse repo rate can prompt banks to park more funds with
the RBI to earn higher returns on idle cash. It is also a tool which can be
used by the RBI to drain excess money out of the banking system.

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Thus, we can conclude that Repo Rate signifies the rate at which liquidity
is injected in the banking system by RBI, whereas Reverse repo rate
signifies the rate at which the central bank absorbs liquidity from the banks
The reverse repo rate will be kept 100 basis points lower than the repo
rate. On the other hand Marginal Standing Facility (MSF) rate will be kept
100 basis points higher than the repo rate.
6. Marginal Standing Facility
Marginal standing facility is the rate at which scheduled banks can borrow
overnight from RBI against approved securities. Banks can borrow up to
2% of their Net demand and time liabilities.
Banks can borrow funds through MSF during acute cash shortage. This
measure has been introduced by RBI to regulate short term asset liability
mismatch more effectively. This policy has been implemented from May
2011. MSF is pegged 100 business points or 1% above Repo Rate.
Presently it is 9 %
7. Market stabilization scheme
RBI introduced the Market Stabilization scheme in April 2004 to mop up
the excess liquidity.
The MSS operates mainly through Treasury bills (T-bills). The
Government will issue T-bills by way of auctions by the RBI in addition to
its normal borrowing requirements, for moping up excess liquidity.
The amount raised through this scheme is to be held in a separate account
with the RBI and would be used only for the purpose of redemption or
buyback of the T-bills

Selective credit regulation


This refers to regulation of credit for specific purposes or branches of
economic activity. They relate to the distribution or direction of
available credit policies.
The Banking Regulation Act empowers the RBI to give directions to
banking companies, with regards to:
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Purposes for which advances may or may not be made.


Margin to be maintained for secured advances
Ceiling on the amounts of credit for certain purposes
Discriminatory rates of interest charged on certain types of advances.
Direct action: RBI may refuse to rediscount bills etc.
Moral Suasion: In addition to the above mentioned methods of credit
control, it may be noted that the use has also been made in this
country of moral suasion wherein letters are issued to banks urging
them to exercise control over credit in general or advances against
particular commodities etc.

Fiscal Policy
Otto Eckstein defines fiscal policy as
Changes in taxes and expenditures which aim at short run goals of
full employment and price level stability.
By using Fiscal policy the government uses its outlay and revenue programs to
produce desirable effects and avoid undesirable effects on the national earnings,
manufacturing, and employment.
Objectives of Fiscal Policy
Fiscal policy deals with the financial management of the state with
certain predetermined objectives. Taxation, public expenditure, public
debt management, budgetary management are the techniques through
which the government achieves several national objectives.
Following are the objectives of fiscal policy:
1. Mobilization of Resources
The objective of fiscal policy is to promote economic growth and
development. This objective of economic growth and development is
attained through mobilization of resources.
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The central and the state governments in India have used fiscal policy to
mobilize resources.
The financial resources can be mobilized through
Taxes: By optimizing direct and indirect taxes revenue can be
maximized. Tax system shall be progressive but also acceptable to
public.
Surplus: The government can generate public savings by reducing
government expenditure and increasing surpluses of public sector
enterprises.
Domestic Savings: Savings can be mobilized by offering incentives
to household sector. The incentives can be tax incentives and
various forms of financial instruments.
2. Regulation of private investment:
The Government can regulate private investment by providing
incentives to priority sectors. By providing proper investment avenues,
private investment can be encouraged. Special Economic Zones,
Technology parks, export processing zones help in attracting private
investment in priority sectors.
3. Reduction in inequalities of Income and Wealth
Progressive tax can help in reducing income inequalities by collecting
larger tax from the rich. At the same time spending on poorer sections
of the society, the gap between the rich and poor can be reduced. This
is means of achieving social justice. In a country like India there are
several programs for people below the Poverty Line
4. Control of Inflation
Suitable fiscal policy can control inflation and stabilize price. Inflation
needs to be controlled in such a manner that the investment and output
are not affected. Counter cyclical fiscal policy can bring about stability
in prices, investment, and output.
5. Employment
Employment generation is an important objective. Investment in
infrastructure can lead to employment. Incentives for labor intensive
industries and small scale industries can promote employment.

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6. Balanced Regional Development


Fiscal policy can bring about balanced regional development. Various
incentives like backward area benefits, cash incentives, tax incentives,
centralized infrastructure can help in developing backward areas.
7. Reducing the Deficit in the Balance of Payment
Fiscal policy can encourage exports by offering tax exemption. The
foreign exchange can also be saved by providing fiscal incentives for
import substitution.
Earning on exports and saving of foreign exchange by way of import
substitutes will help in solving balance of payments problem.
8. Capital Formation
Fiscal policy can increase the rate of capital formation and accelerate
the rate of economic growth. To do this the fiscal policy will encourage
savings and discourage spending.
9. Increasing National Income
Increase in national income is growth. It can be achieved through better
capital formation. This results in economic growth, which in turn
increases the GDP, per capita income.
10. Development of Infrastructure
Government can encourage infrastructure development for the purpose
of achieving economic growth. Taxation generates revenue to the
government. The revenue can be used for financing infrastructure.
Together, tax concessions to infrastructure industries help in developing
infrastructural development.
11. Foreign Exchange Earnings
Fiscal policy encourages exports by measures like, exemption of
income tax on export earnings, exemption of sales tax and excise, etc.
Foreign exchange can also benefit to import substitute industries. The
foreign exchange earned by way of exports and saved by way of import
substitutes helps to solve balance of payments problem.
12. Inclusive Growth
The basic objective of fiscal policy is t promote inclusive growth. The
growth which is sustainable and the benefits of growth reach to all
sections of the society. Emphasis on resource conservation and
environmental protection will make growth holistic.

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Instruments of Fiscal policy


1. Taxation
Direct taxation is levied on income, wealth and profit. Direct taxes
include income tax, inheritance tax, national insurance contributions,
capital gains tax, and corporation tax.
Indirect taxes are taxes on spending such as excise duties on fuel,
cigarettes and alcohol and Value Added Tax on many different goods
and services
2. Government Spending
Government spending (or public spending) can be classified into three
main areas:
a. Transfer Payments: These are welfare payments made
available through the social security like unemployment
insurance, Pension, subsidies on food and fertilizers etc.
b. Current Government Spending: i.e. spending on stateprovided goods & services that are provided on a recurrent
basis eg. health, education, rural development etc.
c. Capital Spending: Capital spending includes infrastructure
spending on highways, hospitals, schools and prisons. This
investment spending adds to the economys capital stock and
can have important demand and supply side effects in the
long term.
Government spending can be justified as a way of promoting equity.
Well targeted and high value for money public spending is also a
catalyst for improving economic efficiency and macro performance.
3. Debt management
The total stock of government bonds and interest payments outstanding,
from both the present and the past, is known as the national debt.
Debt can raised for financing infrastructure, national calamity, war, or
repaying an earlier debt.
Disposable income of the higher income groups can be reduced by
soliciting debt. The government can issue such instruments which will
be a part of portfolio for the rich an also reduce disposable income.

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4. Budgetary management
When government expenditure exceeds government tax the budget will
have a deficit for that year. The budget deficit, which is the difference
between government expenditures and tax revenues, is financed by
government borrowing; the government issues long-term, interestbearing bonds and uses the proceeds to finance the deficit.
a. Expansionary fiscal policy: an increase in government
expenditures and/or a decrease in taxes that causes the
government's budget deficit to increase or its budget surplus
to decrease.
b. Contractionary fiscal policy : a decrease in government
expenditures and/or an increase in taxes that causes the
government's budget deficit to decrease or its budget surplus
to increase.
c. In the case where government expenditure is exactly equal
to tax revenues in a given year, the government is running
a balanced budget for that year.
5. Counter cyclical fiscal policy

a. Expansionary fiscal policy: an increase in government expenditures


and/or a decrease in taxes that causes the government's budget deficit to
increase.
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b. Contractionary fiscal policy: a decrease in government expenditures


and/or an increase in taxes that causes the government's budget deficit
to decrease.
5. Pump priming
During periods of economic depression, the government adopts
currency expansion for financing employment generation projects. Such
currency expansion is called pump priming. Though pump priming may
increase employment, it s highly inflationary.
6. Price support policy
The government may offer certain minimum support price to stabilize
prices during harvest. It helps the farmers in getting a fair price for their
produce.
7. Subsidies
The government may offer subsidy to farmers while buying farm inputs.
It reduces the cost of farming, thus granting higher profits to farmers.
Similar subsidies can be offered on purchase of food grains to poorer
sections to support consumption.

IS and LM Curves
The theory given by Hicks and Hansen is an improvement over the Keynesian
theory. Hicks and Hansen developed model considering the goods well as
money markets. It is the equilibrium between the two markets which determines
growth.
Keynesian theory of effective demand considered the goods market to draw the
equilibrium. The equality between, ADF and ASF determined the short run
equilibrium.

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Aggregate demand, Y=C+I+G, where, Aggregate demand is made up of C, I,


and G explains the effect of goods market.
Similarly, the money market is determined by, the liquidity demand for money
and interest rate, given elastic supply of money from the central bank.
IS curves deal with Goods market and LM curves deal with money market.
Relationship between good market and money market:

MEC and interest determine Investment


The money market determines interest
Investment determines income
Income determines consumption and again
Consumption determines investment

Derivation of IS Curves

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It can be seen that at a point where ASF=ADF, the equilibrium E1 is drawn.,


Further, the rate of interest at that level of income Y is found on the lower
diagram.
Similarly, with a shift in the ADF, the equilibrium will shift to E2. The
equilibrium is drawn on the lower diagram with corresponding rate of interest.
By joining E1 and E2 in the lower diagram, the IS curve is drawn.

Shifts in IS Curve

On the IS curve, the region above the curve, right of the curve, represents,
excess supply, caused by increasing government expenditure.
Similarly, the region below the curve, left of the curve, represents, excess
demand, caused by increasing consumer spending.

Derivation of LM Curve
L1 and L2 are the liquidity schedules showing a negative relationship between,
liquidity preference and rate of interest. The supply of money is inelastic
(constant). It depends on the fiduciary system of the central bank.

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With a shift in the liquidity schedule, the rate of interest increases. These
changes are drawn on the right diagram and the corresponding incomes are
identified.
Thus the LM curve is drawn and positive function between rate of interest and
real income.
The region above the LM curve shows excess supply of money and the region
below denotes excess demand for money.

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Interaction between IS and LM Curves

The interaction between IS and LM curves show that:


In the upper quarter there will be excess supply of goods and excess money. The
income and interest rates shall decrease.
In the lower quarter there will be excess demand for goods causing excess
demand for money. The income and rate of interest increase.
In the left quarter there will be excess demand for goods excess supply of
money, causing income to increase and rate of interest to decrease.
In the right quarter, there will be excess supply of goods and excess demand for
money causing income and interest rate to increase.

Effects of Fiscal and Monetary Policy on interest and incomes


Fiscal policy: Increase in Government spending increases the income by
multiplier effect. However, an increase in the Government investment may lead
to a decrease in the rate of interest and the output may remain same.

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Monetary policy: The increase in the money supply by the Central bank will
decrease interest rates and increase investment and output.
The monetary policy will be called ineffective if

IS curve is inelastic, where changes in rate of interest does not


effect output.
With liquidity trap, the increase in money supply fails to
decrease rates of interest or increase investment and output.

The monetary and fiscal policy shall be used in a combination depending on the
responsiveness of demand for money, investment, income, and interest rates.

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