Académique Documents
Professionnel Documents
Culture Documents
PGPEx, 2015
Sudip Chaudhuri
2nd Part
(Topics 4 to 6)
1
Topics
1.
2.
3.
4.
Overview of Macroeconomics
National Income Accounting
Business Cycles and Multiplier
Financial system, Money and Monetary
Policy
5. Fiscal Policy and Fiscal Deficit
6. Balance of Payments, Foreign Exchange
Rates and income determination in open
economy
2
Topic 4
Financial System, Money
and Monetary Policy
Financial system
Includes the institutions involved in
moving savings from households and
firms whose income exceeds their
expenditures and transferring it to
other households and firms who
would like to spend more than their
current income flows
Financial markets
Where financial assets - claims by one
party over another party - are bought
and sold
Types of financial assets:
Money: a very special asset
Loans
Bonds
Stocks
Etc
5
Financial intermediaries
Institutions which transform funds
gathered from many individuals into
financial assets:
Banks
Life insurance companies
Pension funds
Mutual funds
Etc
6
Interest rates
Price paid for borrowing money
Wide range of interest rates depending on
financial assets:
Money market: market for short term funds
ranging from overnight to one year
Interest rates
Government securities market
Treasury bills
Long term securities
RBI:
Repo rate
Reverse repo rate
Etc
8
What is Money?
Money is what money does - a financial
asset that can be easily used to purchase
goods and services
Money plays three major roles:
Medium of exchange:
an asset that individuals acquire for the purpose of
trading rather than for their own consumption.
A store of value:
means of holding purchasing power over time
A unit of account:
measure used to set prices and make economic
calculations
9
Evolution of Money
Barter: exchange of goods for other goods
Commodity money: commodities such as
cattle, copper, silver, gold, diamonds etc
functioning as money
Modern money:
Paper currency:
India: minimum reserve system since 1956 (Rs
400 crores of forex reserves and Rs 115 crores of
gold)
Bank money
10
Note:
(Other deposits with RBI (= deposits of UTI, IDBI etc; deposits
of foreign central banks/governments etc) are also a part of
M1; statistically very small)
11
Modern banks
As banking developed, banks
realized that that they need not keep
100 percent of deposits as reserves
since all the customers will not
withdraw their deposits at the same
time
Under the modern fractional reserve
banking, banks actually create
money since total bank deposits is a
multiple of bank reserves
12
Assume:
Cash reserve ratio = 10%
Asset
Reserves
Total
Liabilities
Rs 1000
Deposits
Rs 1000
Total
Rs 1000
Rs 1000
Liabilities
Asset
Reserves
Rs 100
Loans
Rs 900
Total
Deposits
Rs 1000
Total
Rs 1000
Rs 1000
13
Asset
Reserves
Total
Liabilities
Deposits
Rs 900
Rs 900
Total
Rs 900
Liabilities
Asset
Reserves
Rs 90
Loans
Rs 810
Total
Rs 900
Rs 900
Deposits
Total
Rs 900
Rs 900
14
15
Money Multiplier
Starting with an initial deposit of Rs 1000,
Total deposits generated with r as CRR
= Rs 1000 + Rs 1000 (1-r) + Rs 1000 (1-r)2 + . . .
= Rs 1000 (1 + (1-r) + (1-r)2 + . . .
= Rs 1000( 1/(1-(1-r))
= Rs 1000 (1/r)
= Rs 1000(10) , if r = 0.1
= Rs 10000
Money multiplier = 1/r
16
Banks:
Create money through multiple
expansion of bank deposits based on
cash reserves
17
Money Multiplier
The monetary base is the sum of currency in circulation and cash
reserves of banks (cash in vaults plus deposits with RBI) .
It is different from the money supply, bank deposits plus currency in
circulation. Each rupee of bank reserves backs several rupees of bank
deposits, making the money supply larger than the monetary base.
The money multiplier is the ratio of the money supply to the monetary
base.
18
Monetary Policy
19
Functions of RBI
20
23
Bank rate:
Dormant: Currently Bank Rate acts as the
penal rate charged on banks for shortfalls in
meeting CRR/SLR
Bank Rate is also used by several other
24
25
26
Repo/Reverse repo
(Re-purchase arrangements)
Repo:
The rate at which banks barrow from RBI
against collateral
Reverse repo:
The rate at which banks place their funds with
the RBI and receive collateral
27
Bank rate
Repo rate
8.25%
7.25%
6.25 %
8.25%
4%
21.5 %
28
29
Effectiveness of Monetary
Policy
May not be effective during
recession/depression, for example
when:
The central bank cannot reduce interest
rate as in the case of liquidity trap when
interest rates approach zero
Banks dont reduce lending rates and/or
dont want to lend more
Households and firms dont borrow more
even when lending rates fall
31
Quantitative Easing
Phrase used earlier in Japan and now in
USA, UK etc
Unconventional monetary policy
instrument used when the conventional
instrument of influencing the short term
federal funds rate (as in USA) fails
Increasing directly the quantity of money
into the economy by the central bank by
buying financial assets from financial
institutions
32
Topic 5
Fiscal Policy and Fiscal Deficit
33
Fiscal Policy
Operates through changes in
government expenditure and
revenue
34
35
36
37
Financing of government
expenditure
Taxes:
Income taxes reduce disposable income and
hence weaken the expansionary impact of
government expenditure
(But if taxes are raised from super-rich with
MPC zero or close to zero, neither C nor I may
fall) (see Warren Buffet, New York Times, Aug
14, 2011)
38
Fiscal Deficits
39
Budget Documents
(see: http://indiabudget.nic.in)
40
Expenditure classification
Plan/Non-Plan classification
Economic classification
Functional classification
41
Economic Classification
Expenditure
Capital
Revenue (= current)
Transfers
Direct
capital
formation
Consumption
(Pension,
expenditure
Subsidy,
etc)
Financial
Assistance
Goods and
(investments,
Salaries
loans,
and wages
grants)
Services for
current use
Functional Classification
Expenditure
Developmental
Non-developmental
Social
Services
General services
(health,
(administration,
education etc)
defence etc)
Economic
services
Un-allocable
(interest,
pension, consumer subsidy etc)
Total revenue
Revenue receipts
Capital receipts
Non-tax
Tax
Direct
(personal income,
corporation etc)
Indirect
(excise, customs duty etc)
Capital receipts
External loans
Internal
(net)
loans
Recoveries
Disinvestment
of loans
receipts
Internal loans
Others
(Small savings,
Financial sector
PF, Etc)
Commercial Banks
RBI
and
Others
Fiscal deficit:
Revenue deficit:
= Revenue expenditure revenue receipts
Primary deficit:
= Fiscal deficit interest payments
Monetised deficit:
= Loans from RBI to finance expenditure
Fiscal Deficit
Arguments against:
Inflation
Crowding out due to higher interest rates
Burden of government debt
Arguments for:
Increase in price level and interest rates depend on
whether goods and credit markets are demand or supply
constrained
In a demand-constrained economy, crowding in more likely
than crowding out
Printing of money; additional employment and income in
a demand constrained economy to finance government
debt
49
Topic 6
Balance of payments and
foreign exchange rates and
income determination in open
economy
50
Open Economy
Is one where buying and selling take
place between residents* of an
economy and the rest of the world of:
Goods and services (Current Account)
Capital assets (Capital or Financial
Account)
(*
52
Credit
Debit
Net
A) Current Account
A.1) Merchandise
A.2) Invisibles
B) Capital Account
B.1) Foreign Investment
B.2) Loans
B.3) Banking Capital
B.4) Rupee Debt Service
B.5) Other Capital
C) Errors and Omissions
D) Overall Balance
E) Monetary Movements
E.1) I.M.F
E.2) Foreign Exchange
Reserves (decrease)
53
Current account
Merchandise - Goods
Invisibles
Services (Software, tourism, shipping,
insurance etc)
54
Capital account
Foreign investment:
Foreign direct investment
Foreign portfolio investment (e.g., FIIs)
Loans:
External assistance
Commercial borrowings (MT & LT)
Short-term
55
Debit item:
Any transaction that takes out foreign
exchange from the country, for example
imports, external assistance to another
country.
56
BOP Deficits
Trade deficit:
Excess of Imports of (merchandise) goods over
exports of goods
Overall balance:
Aggregate figures after adding up all the current
and capital accounts adjusting for errors &
omissions
57
Monetary movements
When overall balance is negative (as in
India in 2011-12), deficit can be financed by:
Loan from IMF: credit entry under IMF in BOP
table or
Using forex reserves: credit entry under forex
reserves
58
Credit
551838
318607
233231
511823
Debit
584235
466216
118019
463035
Net
-32397
-147609
115212
48787
246766
134836
108049
220380
127071
82601
26386
7765
25448
0
22171
52
32932
-52
-10761
887
1064548
1769
1049040
-882
15508
E) Monetary Movements
E.1) I.M.F
0
0
15508
0
-15508
0
15508
-15508
59
Managing BOP
Managing Current Account
Exports
Imports
Loans
External commercial borrowing
Short term
Long term
External assistance:
Bilateral
Multilateral
Managing Crisis
Role of IMF
60
India now
Almost fully convertible in Current
Account:
Practically no restrictions on exports and
imports of goods and services
Flexible Regimes:
Independently floating
Managed floating:
Market determined with official intervention
to influence the rate
Devaluation/Revaluation
Devaluation:
Depreciation (reduction) in the value of
the currency under a fixed exchange
rate regime, e.g., $/Rs (i.e., Rs/$ )
Revaluation:
Appreciation (increase) in the value of
the currency under a fixed exchange
rate regime
Rupee devalued in 6 June, 1966: Forex rate changed from Rs 4.76 to Rs 7.5
Market determined from December 1993
30
20
10
0
65
Capital flight:
Non-residents pull out assets from India: D$ , (Rs/$)
Inflation:
Rising prices in country X makes imports from country Y
more attractive: D$ , (Rs/$)
Interest rate:
If rising interest rate in country X leads to more lending
to the country: S$ , Rs/$
Rs/$
Rs 60
Rs/$
D
Rs/$
D
Exchange market
intervention
Government (central bank) can
maintain the exchange rate at a
target level below or above the
market clearing level by:
Buying /selling foreign exchange in the
market
Foreign exchange controls
Economic policies to influence
demand/supply of foreign exchange
Rs/$
Rs 60
Target, Rs 55
S
Rs/$
Rs 60
Target, Rs 55
S
Shortage
Rs/$
Rs 60
Target, Rs 55
S
Shortage
Rs/$
Target, Rs 65
Rs 60
Rs/$
D
Surplus
Target, Rs 65
Rs 60
Disadvantages:
Effective when the country has large and
stable forex reserves
Independent Monetary Policy becomes difficult
if capital account is convertible
Impossible Trinity
(Trilemma)
Convertible Capital account: no restrictions on
capital inflows (and outflows)
Depending on the domestic rate of interest, external
loans may become attractive leading to capital inflows
and causing the forex rate to move downwards
78
79
Rs/$
S
D
Rs 65
Rs 60
D
S
D
$
81
But as RBI sells $, domestic liquidity falls blunting the impact of fiscal expansion
Rs/$
S
S
Rs 60
$
82
83
C+I +G +Ex
E
2
C+I+G
E
1
45
Potential output
84
C+I+G
2
E
1
45
Potential output
85
C+I+G
C+I +G +X
E
1
45
Potential output
86
Assumptions
C = C(Y)
I=I
G+G
Imports (M) depend on:
Domestic production and income
Relative prices of domestic and foreign goods
We assume: M = M (Y) at given relative prices
Thus
Slope of (C+I+G) = slope of C = MPC
=b = change in total spending in
closed economy when income
changes by a unit
Slope of (C+I+G+X) = (MPC MPm)
= (b-m) = change in total spending
in open economy when income
changes by a unit
It follows, slope of the later (= b-m)
is less than that of the former (b)
88
Production (= Y)
= G (1/(MPS + MPm)
b : marginal propensity to consume
MPS = marginal propensity to save = 1-b
m = MPm = marginal propensity to import
90