Extended IS-LM

IS
MET BRC-2
BRC
  The Financial Sector
 The economy consists of the government, central bank,
commercial banks, firms, and households

 The government takes loans only from the central bank,

The Model for a and the central bank in its turn lends only to the
government
Closed  Only firms take loans from the commercial banks and
Economy commercial banks receive deposits only from the
households who hold their entire wealth or savings in
the form of bank deposits and currency
 Households are the ultimate lenders and do not take
any loans
  The source of supply of new commercial bank loans is
the new deposits they receive
 The new deposits in turn come from the part of the
saving that households hold in the form of bank
deposits.

 We assume for the present that the households hold all

Supply of Loans their saving in the form of bank deposits and it is the
only source of bank deposits
 Households’ saving is given by

 Supply of new commercial bank loans denoted LS is,

therefore, given by
  We assume that in the real sector aggregate output is
determined by aggregate final demand for goods and
services.
 The price level is fixed, and it is taken to be unity.
 Aggregate planned consumption demand is given by

 We assume for simplicity that consumption is financed

from income and not with loans.
The Real Sector  Aggregate planned investment demand is given by

 Investment is financed entirely with loans taken from

commercial banks.
 Investment is the only source of demand for commercial
bank credit
 Hence, the credit market is in equilibrium when
  Government consumption, G, is, as we assume here,
financed with loans from the central bank.
 Thus,
 dLgc denotes new loans taken from the central bank by
the government.
 We assume for simplicity that the increase in the stock
The Real Sector of high-powered
high money denoted dH is solely due to the
new loans taken by the government from the central
bank.
 The goods market is in equilibrium when
  We have

Model Derivation of the equilibrium values of Y and r

 Fiscal Policy:
Government
Expenditure Financed
by Borrowing from the
Central Bank
  Taking total differential

 Hence,

Fiscal Policy:
Government  Also,
Expenditure Financed
by Borrowing from the
Central Bank
  The model presented above clearly shows how the
processes of generation of money, credit, spending,
income, and saving are closely interwoven
 It shows how the creation of high-powered
high money and
credit by the central bank leads to spending on goods
Fiscal Policy: and services
Government
Expenditure Financed  This expenditure in turn generates income
by Borrowing from the  The saving made out of that income leads to the
Central Bank creation of more money and credit, which leads to
another round of generation of spending, income, and
saving, and this process goes on until the additional
income that is generated in each round eventually falls
to zero.
  To examine the impact of monetary policy, we
consider a cut in rc by the central bank
 As rc is cut, the banks are able to extend new
loans out of their outstanding deposit
 The excess supply in the loan market at the initial
equilibrium r will drive down r until I goes up
 This will raise Y
Monetary Policy
 This process of expansion will continue until the
additional saving generated in each successive
round eventually falls to zero
  Here, people want to hold all their saving in the form of
bank deposits or money
 Saving constitutes the only source of demand for new
money
 We have

Irrelevance of  The LHS of the above equation gives the aggregate

the Money planned saving of the households.

Market  The RHS on the other hand gives aggregate supply of

new money in real terms.
 Thus, in this model, the money market need not be
considered separately.
  One of the most important results of Keynesian theory is
that the autonomous component of aggregate
expenditure is a major determinant of GDP
 An item of aggregate expenditure is truly autonomous
or not depends crucially on how it is financed
Mode of  Adding an autonomous component in the investment
Financing and function

Autonomous  However, if the entire expenditure is financed with new

Expenditure bank credit, it will cease to be a determinant of Y in the
flexible interest rate regime
 In equilibrium, the credit market will clear and the
following condition should hold:
  Therefore, the goods market equilibrium condition will
be given by
 Hence, Y will be given by

Mode of
Financing and
 Thus, ceases to be a determinant of Y.
Autonomous
 will play a role in the determination of Y if investors
Expenditure finance it by drawing down their bank deposits.
 In such a scenario, credit market equilibrium condition
 Mode of  Accordingly, the goods market equilibrium condition
Financing and and the equilibrium Y are given, respectively, by

Autonomous
Expenditure
  The fall in bank deposits by I reduces banks’ supply of
new loans by (1 − ρ)I .
 Thus, in the net, aggregate investment goes up by I −(1
Mode of − ρ)) = ρ .
Financing and  This sets off the multiplier process and generates
Autonomous production and income

Expenditure  This will generate new saving, and therefore, new bank
deposit
 This restores bank deposits to their initial level
  Similarly, if the government finances G with new loans
Mode of from commercial banks or income tax, it will cease to

Financing and be a determinant of Y

 For G to be a determinant of Y, the government has to
Autonomous finance it either with new loans from the central bank or
Expenditure by drawing down its deposit with the central bank
  The banking sector is an oligopoly and the interest
rates that the banks charge are rigid on account of
oligopolistic interdependence among banks
 Banks fix their interest rates on the basis of cost and
meet at the given interest rates all the demand for
Interest Rate credit that they consider creditworthy

Rigidity and the  There are two sources of fund for the banks: deposits
and loans from the central bank.
Behavior of the  The interest rate at which the central bank lends to the
Economy commercial banks is the policy rate of the central bank
rc
 Banks fix their lending rates by applying a markup to rc
and fix the deposit rates suitably below the lending
rates to ensure a reasonable rate of profit
  We do not distinguish between the deposit rate and
Interest Rate lending rate at this stage and denote both by r and
Rigidity and the make it an increasing function of rc

Behavior of the
Economy
  We assume for simplicity that only firms need loans to
finance their investment and they finance their entire
investment expenditure with new bank credit
 The goods market equilibrium condition now is

The Case of No
 Investors’ expectations regarding the future prospect of
Credit Rationing their businesses, which we denote by E
 We assume as before that government finances G by
borrowing from the central bank.

 The credit market equilibrium is given by

  b denotes banks’ borrowing from the central bank
 Given our assumptions, there are two sources of
generation of high-powered
high money in this model,
namely G and b

The Case of No
 In this model, people do not hold currency
Credit Rationing  Therefore, the money supply in this model, i.e., the
amount of money in the hands of the people is given by
the stock of bank deposits only

 The increase in money supply (denoted m) is given by

  The model consists of these four key equations, in four endogenous variables
Y, b, dH/P
/P , and dD.
 Comparative static exercises
 An Improvement in the Expectations (Animal Spirits) of the Investors
 Following an increase in E, aggregate investment rises
 Investors’ demand for new bank credit rises
 Banks extend this additional loan by borrowing from the central bank.

The Case of No  Hence, in the first round b increases

 The increase in investment will set off the multiplier process and raise Y
Credit Rationing  This increase in Y will raise saving and bank deposit
 This additional bank deposit will enable the banks to extend additional loan
 The banks will extend this loan to the central bank.
 Thus, the stock of high-powered
high money in the economy rises by the net
increase in b
 From the text books of macroeconomics, we know that when there is no
currency in circulation, money multiplier is 1/ρ.
1/ Here also, the money
multiplier is the same
  An Increase in G Financed by Borrowing from the
Central Bank
 Following an increase in G financed by borrowing from
the central bank, the multiplier process sets into motion
and Y increases
 This increase in Y raises saving and bank deposit
 Hence, banks can extend new loans which they have to
The Case of No lend to the central bank
Credit Rationing  b falls
 On the asset side, net credit to government rises while
domestic credit falls
 Net total asset rises
 On the liabilities side, banks reserve increases
 Monetary Policy  The conventional monetary policy of a cut in rc
in the Case of No What will happen?
Credit Rationing
  risk-free
free bonds and risk-free
risk deposits
 In the absence of speculation, therefore, interest rates
on bank loans (denoted r) and bonds (denoted rb)
should be equal.

 We assume that r is rigid

 given our assumptions
Incorporation of  We also assume for simplicity that people do not
Bonds directly buy bonds, but banks do.
 Given the interest rates (which are equal in
equilibrium), banks invest α fraction of their deposits in
bonds and the rest they lend out
 Thus, the value of new loans raised by selling new
bonds, which we denote by B, is given by
  Assuming no credit rationing by banks, the equilibrium
condition in the bank credit market is given by

 Here, given our assumptions,

Incorporation of  The goods market equilibrium condition is, therefore,

given by
Bonds  Assuming G to be financed by borrowing from the
central bank, the increase in the stock of high-powered
money is given by

 Thus, incorporation of bonds does not make any

difference to the model