MacroeconomicsMonetary & Fiscal Policy - ISLM Framework

Dipankar DeMumbai, November 2007

Narsee Monjee Institute of Management Studies

The Structure of the IS-LM Model

INCOME

Goods market

Aggregate Demand Output

Fiscal PolicyMonetary Policy

Assets Market

Money Market Bond Market

Demand Demand

Supply Supply

INTEREST RATES

The IS curve is shifted by changes in autonomous spending. An increase in autonomous spending, including an increase in government expenditure, shifts the IS curve to the right

Shift in the IS Curve

IS0

IS1

Effect of increase in Govt. expenditure

r

Y

3 possible segments

– Normal positive slope

– Liquidity Trap

– Liquidity Gate

The LM Curve

r

Y

Liquidity Gate Zone, slope zero

Liquidity Trap zone, slope infinity

r max

r min

Speculative demand for money is infinitely elastic w.r.t change in interest rate

Speculative demand for money is perfectly inelastic w.r.t change in interest rate

Monetary & Fiscal Policy

Monetary Policy

• Monetary policy may be defined as a policy employing the

central bank’s control of the supply of money as an instrument

for achieving the objectives of general economic policy

• Monetary policy acts through influencing the cost & availability

of credit & money

• Effectiveness of monetary policy depends on the institutional

framework that is available for transmitting the impulses

released by the central bank• Objectives:

1. Ensuring economic growth with price stability

2. To maintain a stable external value of the domestic currency

3. To maintain continuously low rates of interest

4. To create market for govt. securities, develop financing institutions…

Instruments of Monetary Policy - I

•It operates by altering the cost of credit & acts as a signaling device/ benchmark for

all money interest rates in India. A rise in Bank Rate leads to rise in all types of interest

rates.

Bank rate is the rate at which commercial banks borrow from the central bank

Rise in interest

differential b/n India &

foreign country

BR Increase

Cost of borrowing by CBs from the RBI increases

Rise in lending rates by the CBs

Demand for commercial credit

falls

Contraction in Bank credit

Attractive for foreign funds

to come in India & capital

inflow into India

Rise in FOREX

reserves

Appreciation of

rupee

Instruments of Monetary Policy - II

•Major instrument for RBI intervention in the market

•Under inflationary situations, if the central bank finds that there are

more money in the hands of public, it performs OMO, i.e. OM sales

•When the RBI sells govt. securities, it mops up liquidity from the system

•Commercial banks draws down its reserves, that leads to overall

contraction in credit in the economy

Open Market Operations (OMO) is the purchase & sale of government securities by the central bank

Instruments of Monetary Policy - III

•Examples are Statutory Liquidity Ratio (SLR), Cash Reserve Ratio (CRR)

•When the central bank adopts monetary expansionary policy, it would

reduce reserve requirements by the commercial banks (CBs)

•A part of the existing reserves then becomes ‘excess reserves’, and

consequently become available for credit creation by the CBs

•Opposite happens when the central bank decides for contractionary

monetary policy

Variable Reserve Ratio - To control the level of required reserves against

their deposits by the commercial banks, reserve ratio is varied

It is estimated that 0.5% rise in CRR leads to absorption of Rs. 14,000 crores

from the system

Money Supply in India

An increase in the nominal money supply (given the price level) raises the real money balances & shifts the LM curve to the right.

Equilibrium income increases & interest rate declines.

Expansionary Monetary Policy: ISLM Model

Any increase in the money supply shifts the LM Curve to the right

LM1

LM0r

Y

E1

E2

Y2

r2

IS1

At the initial equilibrium, increase in the (real) money supply generates a ‘portfolio disequilibrium’, i.e. at the initial interest rate & income, people are holding more money than they want.

This causes people to buy more of other assets, that raises the demand for other assets, say bonds. This leads to increase bond price, driving down the interest rate.

The fall in the interest rate has impact on the aggregate demand.

It stimulates the investment demand, thereby increasing the overall aggregate demand & output and Income.

The increase in output also increases the demand for money, and the interest has to rise to check the demand for money

Adjustment process to Monetary Expansion

The Liquidity Trap Case

In this situation, at a given interest rate, the public is prepared to hold whatever amount of money is supplied.

An expansionary monetary policy does not in this case lead to the right ward shift in the LM curve. The horizontal portion of the LM curve is unchanged

Thus, open market operation has no impact on the interest rate & the economy fails to move to higher level of income.

Special cases

The Classical Case

In this situation, the demand for money is entirely unresponsive to the interest rate. This makes the LM curve Vertical.

This implies GDP depends on quantity of money only. i.e. people hold money for transactions purposes only. Money is not demanded for any other purposes

In this case, monetary policy has its maximum impact on the level of income.

Special cases

Fiscal Policy • Fiscal policy comprises a mix of budgetary instruments that

govt. can use to target particular economic goals such as higher

economic growth or improve income distribution

• Fiscal policy comprises govt. expenditure to help achieve its

goals; and revenue from taxes & non-tax sources to pay for

activities that facilitates achieving goals

• If govt. spends more than its revenue, the difference has to be

financed through money-creation or borrowing

• Money creation could, in turn, lead to higher inflation than is

desirable to maintain productive activities

• Similarly, public borrowing in excess might result in a build-up

of public debt, whose burden might have to be borne by the

future generations

Instruments of Fiscal Policy

• Fiscal policy – ‘Budget’ ~ Union, State, Local government

• Changes in tax rates, heads of expenditure, financing of deficit,

etc

• Various instruments would include:

1. Corporate income tax, personal income tax, expenditure tax,

capital gains tax, Customs duties, central excise duties,

2. Sales tax, entertainment tax, stamp duty,

3. Octroi, education cess, property tax, etc

• Govt. PSU income

• Defense expenditure is central govt. expenditure

Fiscal Balance Sheet

Receipts Disbursements

A. Revenue Receipts A. Revenue Expenditure

1. Tax Receipts R1 1. Interest Expenditure E1

2. Non-Tax Receipts 2. Non-Interest expenditure E2

a) Interest earning R2

b) Non-interest earning R3

B. Financing Terms B. Capital Disbursements

1. Grants R4 1. Capital expenditure E3

2. Borrowings 2. Net Domestic Lending E4

a) Foreign borrowings R5

b) Domestic Borrowings

i) Other than 91-day T-Bill (internal debt + ‘other liabilities)

R6

ii) 91 day T-Bill R7

iii) Change in Cash Balance R8

Aggregate Receipts R Aggregate Disbursements E

= (R1+R2+R3) + (R4) + (R5+R6+R7+R8)

= (E1 + E2 + E3 + E4)The difference between aggregate disbursements (revenue expenditure + capital expenditure + net domestic lending) and revenue receipts must necessarily be matched by the sum total of all financing items.

Budget Deficit

• Traditional Deficit or Budget Deficit

= (Revenue Expenditure + capital expenditure + net domestic lending) –

(Revenue receipts + grants + Foreign borrowings + domestic borrowing

excluding 91 day T-Bill)

= (E1 + E2 + E3 + E4) – [(R1 + R2 + R3) + (R4 +R5 +R6)]

= (R7 + R8)

• The traditional deficit depict only a part of the resource gap in current

fiscal operations that is expected to be financed by

1. Issuing 91-day T Bills &

2. Running down on the govt.’s cash balances and the RBI

• Thus, this concept is extremely narrow & does not capture the entire

short fall of the govt.’s fiscal operations. To capture that we need a

broader concept – Fiscal Deficit

Fiscal Deficit• Gross Fiscal Deficit = (Revenue Expenditure + capital expenditure + net domestic lending) – (Revenue receipts + grants)= (E1 + E2 + E3 + E4) – [(R1 + R2 + R3) + (R4 )] = (R5 +R6 + R7 + R8)= (Foreign borrowings + domestic borrowing) + running down on its cash

holdings

Alternative expression: Fiscal deficit

= Total Expenditure – (Revenue receipts + Recoveries of loans + other

receipts)

= Total Expenditure – Total Receipts + Borrowings & other laibilities

Total Expenditure = Non-plan + Plan Expendture

Non Plan Expenditure = { (Revenue Account) + (Capital Account)}

Plan Expenditure = { (Revenue Account) + (Capital Account)}

Total Expenditure = Revenue expenditure + Capital expenditure

Revenue Receipts = Tax revenue + non-tax revenue

Primary Deficit• One important limitation of the fiscal deficit is that it does not necessarily

reflect the extent to which the current discretionary fiscal actions

improve on worsen govt.’s net indebtedness.

• In particular, interest payments in the current period are obligatory, but

reflect past budgets

• Primary Deficit= Gross Fiscal deficit – ((interest payments – interest earnings)

= (Revenue Expenditure + capital expenditure + net domestic lending)

– (Revenue receipts + grants) - (interest payments – interest

earnings)

= (E2 + E3 + E4) – (R1 + R3 + R4)

Revenue Deficit

• Revenue deficit= (Revenue Expenditure) – (Revenue receipts)

= (E1 + E2) – (R1 + R2 + R3)

Fiscal Deficit & Deficit Financing

• In the short run, fiscal deficit (FD) can stroke fires of inflation due

to their expansionary effects on the monetary base & money

demand

• In the long run, it may lead to build up of public debt that would

cause worry to generations to come in the future

• Govt. can finance its deficit by two ways –

1. Borrowing from the central bank, commercial banks

2. Borrowing from non-bank sources – both home & abroad

• Borrowing from CB implies money can simply be printed for govt.

to spend at zero cost

Fiscal Deficit & Deficit Financing

• Borrowing from commercial banks would mean the CBs demand

for credit from the central bank must rise. Thus, there will be an

associated inflationary pressure

• If the CB does not meet CBs demand for additional credit, then

loanable funds available for the private sector needs to be

curtailed.

• Interest rate would tend to rise, as there is now competing

demand for the same supply of funds. This, in turn, could have

dampening effect on the economy & its growth prospects via the

so called ‘crowding out effect’

Fiscal Deficit & Deficit Financing

• Non-Bank financing comprises borrowing through govt. securities,

which has little impact on the monetary base. But it tends to

increase interest rates, while competing down the ability of the

private sector to borrow

• Excessive borrowing from abroad has the potential of falling in a

foreign debt crisis (e.g. Latin America, East Asia, etc)

• Under such circumstances, the currency may be depreciated to

improve export performance & improve the ability to service the

debt.

• But, in the mean time, the burden in terms of domestic currency

of foreign currency debt would increase