SYBCom Semster III Business Economics 2014-15

Business Economics

Paper II, Semester III

[III Edition 2013]

SYBCom : Semester III

Ranga Sai

Vaze College, Mumbai

June 2013

Ranga Sai

SYBCom Business Economics Semester III 2

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.

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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


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.

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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

[email protected]

June 2013

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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)

Aggregate Demand

(‘000)

Aggregate Supply

(‘000)

Relationship

100 1000 800 ADF>ASF

200 1500 1400 ADF>ASF

300 3500 3500 ADF=ASF

400 6000 6200 ADF<ASF

500 4000 4500 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 Ē

The level of employment can't increase above Ē 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 Ē. 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. Investment is induced due to increase in consumer demand

b. There is no excess capacity in industry

c. The marginal propensity of consumption remains same

d. The tax structure is same so that the disposable income remains same.

e. 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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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 Friedman’s 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

RBI’s 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 sector’s 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 Friedman’s 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 = M3 + all deposits with post office savings bank except NSC

L2 = L1 + term deposits with Term Lending Institutions and

Refinancing Institutions (FIs) + term borrowing by FIs and

Certificates of Deposits issued by FIs

L3 = 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 − π.

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This means, the real interest rate (Rr) equals the nominal interest rate (Rn)

minus rate of inflation (π). 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

Government’s 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 – IS-

LM 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.

A

B

C

D

E

“

Deposits

10,000

9,000

8,100

7,290

Reserves

1000

900

810

729

Advances

9,000

8,100

7,290

6,561

The deposit multiplier is computed as

Dm = 1

ϒ

Where, ϒ 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

country’s 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. Bank rate

2. Statutory liquidity ratio

3. Cash reserve ratio

4. 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 bank’s 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 don’t 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 bank’s 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 state-

provided 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 economy’s 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, interest-

bearing 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

FFiissccaall ppoolliiccyy:: IInnccrreeaassee iinn GGoovveerrnnmmeenntt ssppeennddiinngg iinnccrreeaasseess tthhee iinnccoommee bbyy

mmuullttiipplliieerr eeffffeecctt.. HHoowweevveerr,, aann iinnccrreeaassee iinn tthhee GGoovveerrnnmmeenntt iinnvveessttmmeenntt mmaayy lleeaadd

ttoo aa ddeeccrreeaassee iinn tthhee rraattee ooff iinntteerreesstt aanndd tthhee oouuttppuutt mmaayy rreemmaaiinn ssaammee..

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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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SYBCom Semster III Business Economics 2014-15

Documents

money keynes theory

money constituents

money factors

keynes theory of demand

sybcom semester

instruments fiscal policy

monetary policy changes

edition of sybcom paper