1

MacroeconomicsPGPEx, 2015

Sudip Chaudhuri

2nd Part(Topics 4 to 6)

2

Topics1. Overview of Macroeconomics2. National Income Accounting3. Business Cycles and Multiplier4. Financial system, Money and Monetary Policy 5. Fiscal Policy and Fiscal Deficit6. Balance of Payments, Foreign Exchange Rates and

income determination in open economy

3

Topic 4

Financial System, Moneyand Monetary Policy

4

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

5

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

6

Financial intermediaries

• Institutions which transform funds gathered from many individuals into financial assets:– Banks– Life insurance companies– Pension funds– Mutual funds– Etc

7

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

8

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

9

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

10

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

11

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)

12

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

13

Asset Liabilities

Reserves Rs 1000 Deposits Rs 1000

Total Rs 1000 Total Rs 1000

Asset Liabilities

Reserves Rs 100

Loans Rs 900

Deposits Rs 1000

Total Rs 1000 Total Rs 1000

Bank 1 in initial position

Bank 1 in final position

Assume:

Cash reserve ratio = 10%

14

Asset Liabilities

Reserves Rs 900 Deposits Rs 900

Total Rs 900 Total Rs 900

Asset Liabilities

Reserves Rs 90

Loans Rs 810

Deposits Rs 900

Total Rs 900 Total Rs 900

Bank 2 in initial position

Bank 2 in final position

15

Bank deposit expansion

Round Bank deposit1 Rs 10002 Rs 9003 Rs 8104 Rs 729and so on

16

Money MultiplierStarting 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

17

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

18

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.

Money Multiplier

19

Monetary Policy

20

Functions of RBI

21

Traditional Instruments of Monetary Policyto 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

22

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

23

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 System’s (FED’s) 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.

24

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 organisations as a

reference rate for indexation purposes.

25

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

26

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

27

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!)

28

Policy Rates and Reserve Ratios(www.rbi.org.in, 2/6/2015)

Bank rate 8.25%Repo rate 7.25%

Reverse repo rate 6.25 %

Marginal standing facility rate

8.25%

Cash reserve ratio 4 %

Statutory liquidity ratio 21.5 %

29

RBI’s Monetary Policy to control inflation

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

30

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

31

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 don’t reduce lending rates and/or don’t want to lend more

– Households and firms don’t borrow more even when lending rates fall

32

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

33

Topic 5

Fiscal Policy and Fiscal Deficit

34

Fiscal Policy

• Operates through changes in government expenditure and revenue

35

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)

36

Impact of government expenditure

37

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

38

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

39

Fiscal Deficits

40

• 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

Budget Documents

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

41

Expenditure classification

• Plan/Non-Plan classification• Economic classification • Functional classification

Economic Classification

Expenditure

Capital Revenue (= current)

Direct

capital

formation

Financial

Assistance

(investments,

loans,

grants)

Consumption

expenditure

Transfers

(Pension,

Subsidy,

etc)

Salaries

and wages

Goods and

Services for

current use

Functional ClassificationExpenditure

Developmental Non-developmental

Social

Services

(health,

education etc)

Economic

services

General services

(administration,

defence etc)

Un-allocable

(interest,

pension, consumer subsidy etc)

Total revenue

Revenue receipts

Tax

Non-tax

(dividends, interest and other earnings)

Capital receipts

Direct

(personal income,

corporation etc)

Indirect

(excise, customs duty etc)

Classification of government revenue

Capital receipts

External loans

(net)

Internal

loans

Recoveries

of loans

Disinvestment

receipts

Internal loans

Financial sector

Others

(Small savings,

PF, Etc)

RBI

Commercial Banks

and

Others

Measures of government budget deficit• Fiscal deficit:

= Total new loans taken by the government to finance its expenditure

= Total expenditure - Revenue receipts – Non-debt 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

48

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

49

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

50

Topic 6

Balance of payments and foreign exchange rates and income

determination in open economy

51

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)

52

Balance of payments (BOP)

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

53

India’s BOP Table Credit Debit NetA) Current Account A.1) Merchandise A.2) InvisiblesB) 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 OmissionsD) Overall Balance

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

E.2) Foreign Exchange Reserves (decrease)

54

Current account

• Merchandise - Goods • Invisibles

– Services (Software, tourism, shipping, insurance etc)

– Unilateral transfers (Grants, gifts, NRI remittances etc)

– Income (Interest, dividends, Compensation of employees)

55

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)

56

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.

57

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

58

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

59

India’s BOP Table, 2013-14, US $ million Credit Debit NetA) Current Account 551838 584235 -32397 A.1) Merchandise 318607 466216 -147609 A.2) Invisibles 233231 118019 115212B) Capital Account 511823 463035 48787

B.1) Foreign Investment 246766 220380 26386 B.2) Loans 134836 127071 7765 B.3) Banking Capital 108049 82601 25448

B.4) Rupee Debt Service 0 52 -52 B.5) Other Capital 22171 32932 -10761

C) Errors and Omissions 887 1769 -882D) Overall Balance 1064548 1049040 15508

E) Monetary Movements 0 15508 -15508 E.1) I.M.F 0 0 0

E.2) Foreign Exchange Reserves (increase/decrease) 0 15508 -15508

60

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

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

65

1990-91

1992-93

1994-95

1996-97

1998-99

2000-01

2002-03

2004-05

2006-07

2008-09

2010-11

2012-130

10

20

30

40

50

60

70

Forex Rate (Rs/$)Rs

/$

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/$ ↓

$

Rs/$

S

SD

D

Foreign Exchange Demand & Supply curves

Response of imports and exports of goods and services to

changes in exchange rate, ceteris paribus

Market clearing exchange rate is Rs 45 per $

Rs 60

$

Rs/$

S

SD

D

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/$

S

SD

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

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/$

S

SD

D

Suppose India wants to keep Rupee overvalued

(i.e., $ undervalued)

Market clearing exchange rate is Rs 450 per $

Rs 60

Target, Rs 55

$

Rs/$

S

SD

D

Then, RBI can sell $ in the market

Market clearing exchange rate is Rs 45 per $

Rs 60

Target, Rs 55

Shortage

$

Rs/$

S

SD

D

Or enforce Foreign exchange controls to limit demand

Rs 60

Target, Rs 55

Shortage

$

Rs/$

S

SD

D

If India like China wants to maintain an undervalued

currency, i.e., overvalued $

Rs 60

Target, Rs 65

$

Rs/$

S

SD

D

Then RBI can buy $ from the market

Rs 60

Target, Rs 65

Surplus

Fixed exchange rate system

• Advantages:– Uncertainty is less– Induces the country to commit to anti-inflationary

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

78

“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 interest rates

79

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.

80

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

81

$

Rs/$

S

S

D

D

D’

D’

Rs 60

Rs 65

Expansionary Fiscal Policy

82

Rs 60

S’

S’

S

S

D

D

D’

D’

$

Rs/$

But as RBI sells $, domestic liquidity falls blunting the impact of fiscal expansion

83

Income Determination in Open Economy

84Y

C,I,

etcC+I +G

+Ex

Potential output

45°

Income Determination in Open Economy

(Ex > 0; M = 0)

C + I + G

E1

E2

85Y

C,I,

etc

C+I +G +X

Potential output

45°

Income Determination in Open Economy

(Ex > 0, M > 0; Ex > M)

C + I + G

E1

E2

86Y

C,I,

etc

C+I +G +X

Potential output

45°

Income Determination in Open Economy

(Ex > 0, M > 0; M > Ex)

C + I + G

E1

E2

87

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)

88

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)

89

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

90

Δ Govt exp = ΔG + (b-m) ΔG + (b-m)2 ΔG +…..(= Δ Demand)

Δ Production (= ΔY) = ΔG + (b-m) ΔG + (b-m)2 ΔG +…..

= ΔG (1+ (b-m) + (b-m)2 +…….)

= ΔG (1/(1- (b-m)) = ΔX (1/((1- b)+m)

= ΔG (1/(MPS + MPm)

b : marginal propensity to consumeMPS = marginal propensity to save = 1-bm = MPm = marginal propensity to import

Multiplier in Open Economy