Macroeconomics

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

Call/notice money market

Treasury bills
Commercial paper
Collateralized borrowing and lending obligation (CBLO)
Certificates of deposits
Etc
7

Interest rates
Government securities market
Treasury bills
Long term securities

Corporate bond market

Bank credit market:
Benchmark prime lending rate(BPLR)/base rate
Actual lending rate

Bank deposit rate:

Savings bank deposits
Fixed deposits

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

Different forms of Money

In India:
M1 = Currency (notes & coins) with public +
demand deposits with banks (narrow
money)
M3 = M1 + time deposits with banks (broad
money)

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

Bank 1 in initial position

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

Bank 1 in final position

13

Bank 2 in initial position

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

Bank 2 in final position

Rs 900

Rs 900

14

Bank deposit expansion

Round
Bank deposit
1
Rs 1000
2
Rs 900
3
Rs 810
4
Rs 729
and so on

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

Who creates Money?

RBI:
Determines the monetary base (also
known as reserve money, base money,
high powered money)

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

Traditional Instruments of Monetary

Policy
to influence credit and interest rate
Reserve requirements:
The minimum cash reserves required to be
maintained by banks

Bank rate (Discount rate in USA):

The rate which the central bank charges for loans
to banks

Open Market Operations:

Purchase and sale of government securities by the
central bank

Note: Central banks can create currency to lend

to banks or to buy government securities
21

Target of Monetary Policy

Change interest rates and credit availability
to influence aggregate demand:
Expansionary (loose/easy) monetary policy
in a demand constrained economy (recession):
Cash Reserve Ratio
Bank rate
Buy government securities

Contractionary (tight) monetary policy in a

supply constrained economy (inflation):
Cash Reserve Ratio
Bank rate
Sell government securities
22

In the United States

Open market operations to influence the federal
funds rate is the main monetary policy
instrument:
Federal funds market: a financial market that allows
banks that fall short of Federal Reserve Systems
(FEDs) reserve requirements to borrow funds usually
overnight from banks that hold excess reserves
Federal funds rate: the short term interest rate
determined in the federal funds market
FED influences the federal funds rate by buying or
selling government securities, i.e., supplying or
demanding funds.

23

Monetary Policy Instruments in

India
Reserve requirements as % of NDTL
(net demand and time liabilities)
Cash reserve ratio (CRR) cash balance with
RBI
Statutory liquidity ratio (SLR) safe & liquid
assets such as government securities, cash,
gold

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

Monetary Policy Instruments in

India
Open market operations:
Outright OMO:
Activated after Economic reforms with the development
of an active government securities market

Liquidity adjustment facility (LAF):

RBI sets two rates - repo and reverse repo and offers to
buy securities or sell securities respectively
New marginal standing facility (MSF) at 1% above repo
rate

Market stabilization scheme (MSS):

RBI permitted to issue treasury bills and dated securities
for sterilization purposes

25

Repos under Liquidity Adjustment

Facility
LAF introduced in June 2000
Under LAF, RBI sets its policy rates,
i.e., repo and reverse repo rates and
carries out repo/reverse repo
operations
Provides both liquidity and signals
interest rate changes

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

(Before October 2004, repos/reverse repos

were defined exactly the opposite way!)

27

Policy Rates and Reserve

Ratios
(www.rbi.org.in, 2/6/2015)

Bank rate
Repo rate

8.25%
7.25%

Reverse repo rate

6.25 %

Marginal standing facility

rate

8.25%

Cash reserve ratio

4%

Statutory liquidity ratio

21.5 %
28

RBIs Monetary Policy to control

inflation
Tracks inflation rate through CPI
Considers not only current inflation
rate but
Also Household inflation expectations

29

Problem of using Monetary Policy to control

inflation
Demand-pull/Cost-push
Demand pressures
Monsoon failure
International commodity prices
International oil prices
Rupee depreciation
Stagflation
Inflationary expectations
30

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

Expansionary Fiscal Policy

Upward shift of the aggregate demand
curve through:
Larger government expenditure on goods and
services (G )
Lower taxes on households (C )
Etc

Output goes up not only due to the initial

in expenditure but subsequent rounds of
increases (recall multiplier)

35

Impact of government expenditure

36

Fiscal Policy in Recession

Increasing government expenditure
was Keynes solution to the Great
Depression
Can play a very important role in
recession/depression when monetary
policy may not be very effective

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)

Keynes focused on deficit spending

38

Fiscal Deficits

39

Budget Documents
(see: http://indiabudget.nic.in)

Economic Survey (presented before the Budget)

Annual Financial Statement
Budget at a Glance
Budget Speech
Budget Highlights
Action Taken on Budget Speech
Receipts Budget
Finance Bill
Explanatory Memorandum
Appropriation Bill (vote on account before 31 March)
Demands for Grants (Expenditure budget)
FRBM Act, 2003 Statements
Detailed Demand for Grants

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)

Classification of government revenue

Total revenue

Revenue receipts

Capital receipts

Non-tax
Tax

Direct
(personal income,
corporation etc)

(dividends, interest and other earnings)

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

Measures of government budget

deficit

Fiscal deficit:

= Total new loans taken by the government to

finance its expenditure
= Total expenditure - Revenue receipts Nondebt capital receipts such as disinvestment
receipts

Revenue deficit:
= Revenue expenditure revenue receipts

Primary deficit:
= Fiscal deficit interest payments

Monetised deficit:
= Loans from RBI to finance expenditure

Fiscal Responsibility and Budget

Management
(FRBM) Act, 2003

Central Government to reduce by

2008-09:
Revenue deficit to zero (and build
surplus thereafter)
Fiscal deficit to 3 % of GDP
RBI prohibited from participating in
the primary government securities
market from April 2006
48

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)
(*

Residents individuals and enterprises:

Not based on nationality or legal criteria but on
Center of Interest in the economy)
51

Balance of payments (BOP)

Record of transactions between
residents and the rest of the world
during a specified period usually a
year.

52

Indias BOP Table

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)

Unilateral transfers (Grants, gifts, NRI

remittances etc)

Income (Interest, dividends, Compensation

of employees)

54

Capital account

Foreign investment:
Foreign direct investment
Foreign portfolio investment (e.g., FIIs)

Loans:
External assistance
Commercial borrowings (MT & LT)
Short-term

Banking capital (NRI deposits etc)

Other capital (e.g., leads & lags in export
receipts)

55

Credit & Debit in BOP Table

Credit item:
Any transaction that brings in foreign
exchange to the country, for example
exports, foreign institutional investment
in stock market

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

Current Account deficit (CAD):

Excess of Outflow of foreign exchange in both
goods and invisibles transactions over such
Inflow

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

When overall balance is positive, i.e., total

foreign exchange inflows > foreign
exchange outflows:
Forex reserves go up: debit entry in BOP table

58

Indias BOP Table, 2013-14,

US $ million
A) Current Account
A.1) Merchandise
A.2) Invisibles
B) Capital Account

Credit
551838
318607
233231
511823

Debit
584235
466216
118019
463035

Net
-32397
-147609
115212
48787

B.1) Foreign Investment

B.2) Loans
B.3) Banking Capital

246766
134836
108049

220380
127071
82601

26386
7765
25448

B.4) Rupee Debt Service

B.5) Other Capital

0
22171

52
32932

-52
-10761

C) Errors and Omissions

D) Overall Balance

887
1064548

1769
1049040

-882
15508

E) Monetary Movements
E.1) I.M.F

0
0

15508
0

-15508
0

E.2) Foreign Exchange

Reserves (increase/decrease)

15508

-15508

59

Managing BOP
Managing Current Account
Exports
Imports

Managing capital Account

Foreign investment
Foreign direct
Foreign portfolio
Foreign institutional

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

Not yet fully convertible in Capital

Account
Substantial liberalization but some
restrictions still exist

Exchange Rate Regimes

Fixed exchange rate:
Hard pegs (e.g., currency board
arrangements)
Soft pegs (crawling pegs, pegs within
bands etc)

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

India now: Managed Float

Rupee devalued in 6 June, 1966: Forex rate changed from Rs 4.76 to Rs 7.5
Market determined from December 1993

Forex Rate (Rs/$)

70
60
50
40
Rs/$

30
20
10
0

65

Foreign Exchange Rate

Depends on:
Demand for foreign exchange (debit
items in BOP) and
Supply of foreign exchange (credit items
in BOP)

If D > S, forex rate (Rs/$)

If S > D, forex rate

Exchange rate movements

(Some examples, ceteris paribus)
US recession:
Exports from India : S$ , (Rs/$)

Foreign Institutional investment

S$ , Rs/$

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/$

Foreign Exchange Demand & Supply curves

Response of imports and exports of goods and services to
changes in exchange rate, ceteris paribus

Rs/$

Rs 60

Market clearing exchange rate is Rs 45 per $

Shift of Forex Demand Curve

Given forex rate, when other things change, e.g.,
more capital flows out, more imports due to output expansion etc

Rs/$
D

Shift of Forex Supply Curve

Given forex rate, when other things change, e.g.,
more capital flows in, more exports due to world boom etc

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

Suppose India wants to keep Rupee overvalued

(i.e., $ undervalued)
S

Rs/$

Rs 60

Target, Rs 55
S

Market clearing exchange rate is Rs 450 per $

Then, RBI can sell $ in the market

Rs/$

Rs 60

Target, Rs 55
S
Shortage

Market clearing exchange rate is Rs 45 per $

Or enforce Foreign exchange controls to limit demand

Rs/$

Rs 60

Target, Rs 55
S
Shortage

If India like China wants to maintain an undervalued

currency, i.e., overvalued $
S

Rs/$

Target, Rs 65

Rs 60

Then RBI can buy $ from the market

Rs/$

D
Surplus

Target, Rs 65

Rs 60

Fixed exchange rate system

Advantages:
Uncertainty is less
Induces the country to commit to antiinflationary measures: if not, with inflation
exports suffer in fixed exchange rate system
(in a flexible system, with inflation as exports
suffer, Rs/$ rises to neutralize impact of
inflation)

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

Pegged currency: target a fixed foreign

exchange rate
Depending on the target foreign exchange rate, the
Central Bank of a country may want to intervene by
demanding foreign exchange leading to more liquidity in
the economy and making the inflation situation worse

Independent monetary policy: when controlling

inflation/recession is the more important objective
Depending on the inflation/recessionary conditions in the
country, the Central Bank may want to pursue a
tight/easy monetary policy leading to higher/lower

78

Trilemma: Examples from India

In India early 2000s, when FII was flowing
in and inflation rate was high, RBI allowed
the forex rate to float
In mid-2013 when forex rate accelerated
sharply, RBI gave more importance to
controlling forex rate than stimulating the
economy by easing monetary policy.

79

Difficulties of Expansionary Fiscal

Policy in Open economy
As govt expenditure , imports
necessarily due to more imports of C
goods as income rises and more imports of
raw materials
Exports do not necessarily (it does when
the rest of the world is also expanding)
As a result, trade deficit tends to leading
to a rise in Rs/$
To control import costs to control cost-push
inflation, if RBI intervenes in the forex
market to sell $, liquidity in the economy
blunting the expansionary effect
80

Expansionary Fiscal Policy

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

Income Determination in Open

Economy

83

Income Determination in Open Economy

(Ex > 0; M = 0)
C,I,
etc

C+I +G +Ex

E
2

C+I+G

E
1

45

Potential output

84

Income Determination in Open Economy

(Ex > 0, M > 0; Ex > M)
C,I,
etc
C+I +G +X

C+I+G
2

E
1

45

Potential output

85

Income Determination in Open Economy

(Ex > 0, M > 0; M > Ex)
C,I,
etc

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

Similarly Exports (Ex) depends on:

Production and income in the rest of world
Relative prices of domestic and foreign goods
We assume: Ex = Ex (i.e., exogenously given)
87

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

Demand Constrained Open

Economy
Ceteris paribus:
Higher exports better
Lower imports better

As marginal propensity to import

increases, the total spending curve will be
flatter
As export go up, the total spending curve
shifts upwards
Multiplier in closed economy greater than
that in an open economy
89

Multiplier in Open Economy

Govt exp
(= Demand)

= G + (b-m) G + (b-m)2 G +..

Production (= Y)

= G + (b-m) G + (b-m)2 G +..

= G (1+ (b-m) + (b-m)2 +.)
= G (1/(1- (b-m)) = X (1/((1- b)+m)

= G (1/(MPS + MPm)
b : marginal propensity to consume
MPS = marginal propensity to save = 1-b
m = MPm = marginal propensity to import

90