UNIT V AGGREGATE SUPPLY AND THE ROLE OF MONEY

13
Short-run and Long-run supply curve – Unemployment and its impact – Okun’s law –
Inflation and the impact – reasons for inflation – Demand Vs Supply factors –Inflation Vs
Unemployement tradeoff – Phillips curve –short- run and long-run –Supply side Policy and
management- Money market- Demand and supply of money – money-market equilibrium
and national income – the role of monetary policy.
 UNEMPLOYMENT

Unemployment occurs when a person who is actively searching for employment is unable to
find work. Unemployment is often used as a measure of the health of the economy. The
most frequently cited measure of unemployment is the unemployment rate. This is the
number of unemployed persons divided by the number of people in the labor force.

Unemployment can be defined as where an able bodied persons willing to work at the
prevailing wage rate do not find job.

Unemployment may be defined as a situation of less than full employment level. What is
full employment? The UN definition, “a situation in which employment cannot be increased
by an increase in effective demand and unemployment does not exceed the minimum
allowance that must be made for effects of frictional and seasonal factors.”

KINDS OF UNEMPLOYMENT

The unemployment may be classified as follows:

1. Frictional unemployment
2. Structural unemployment
3. Natural unemployment
4. Cyclical unemployment
5. Seasonal unemployment
1. Frictional unemployment:

Frictional Unemployment is always present in the economy, resulting from temporary

transitions made by workers and employers or from workers and employers having
inconsistent or incomplete information. It is caused because unemployed workers may
not always take the first job offer they receive because of the wages and necessary
skills. This type of unemployment is also caused by failing firms, poor job performance,
or obsolete skills. This may also be caused by workers who will quit their jobs in order
to move to different parts of the country.

Frictional unemployment can be seen as a transaction cost of trying to find a new job; it
is the result of imperfect information on available jobs. For instance, a case of frictional
unemployment would be a college student quitting their fast-food restaurant job to get
ready to find a job in their field after graduation. Unlike structural unemployment this
process would not be long due to skills the college graduate has to offer a potential
firm.
2. Structural unemployment:

Structural Unemployment, one of the three types of unemployment, is associated with

the mismatch of jobs and workers due to the lack of skills or simply the wrong area
desired for work. Structural unemployment depends on the social needs of the economy
and dynamic changes in the economy.

For instance, advances in technology and changes in market conditions often turn many
skills obsolete; this typically increases the unemployment rate. For example, laborers
who worked on cotton fields found their jobs obsolete with Eli Whitney's patenting of
the cotton gin. Similarly, with the rise of computers, many jobs in manual book keeping
have been replaced by highly efficient software. Workers who find themselves in this
situation find that they need to acquire new skills in order to obtain a new job.

3. Natural rate of unemployment:

Milton Friedman formulated the concept Natural rate of unemployment. It refers to a
certain rate of unemployment which is present in the state of full employment level in
the economy. At this rate of unemployment, the forces of demand-pull and cost-push
inflation are in balance and the rate of inflation is stable. Friedman calls this as non-
accelerating- inflation rate of unemployment (NAIRU). The natural rate of
unemployment is unavoidable. Therefore, at the natural rate of unemployment, the
economy is said to be at full employment.

4. Cyclical unemployment:
Unemployment that is attributed to economic contraction is called cyclical
unemployment. The economy has the capacity to create jobs which increases economic
growth. Therefore, an expanding economy typically has lower levels of unemployment.
On the other hand, according to cyclical unemployment an economy that is in a
recession faces higher levels of unemployment. When this happens there are more
unemployed workers than job openings due to the breakdown of the economy. This
type of unemployment is heavily concentrated on the business activity in the economy.
Basically, in two phases of business cycle i.e. recession and depression, unemployment
arises because of low business activities.

5. Seasonal unemployment
Seasonal unemployment is a type of working arrangement in which a person is
employed routinely for part of the year, but spends the remaining months or weeks
without a job. This situation is most commonly associated with temporary, weather-
dependant jobs like lifeguarding and some construction work. Tourism jobs related to
specific seasons, as well as more sporadic employment in seasonal groups like theater
companies, may also fall into this category. These sorts of jobs usually revolve around
fixed calendars such that employees both know and understand exactly when they will
 be out of work. In many cases, seasonal employees can collect government-sponsored
unemployment benefits in their off-seasons.
6. Disguised unemployment
Occurs when more people are engaged in work than required actually. Commonly in
agriculture sector in our country.

OKUN’S LAW
Arthur Okun, an economist member of President’s Council of Economic Advisrors in the
United States, was the first to bring out the relationship between output and
unemployment. Kun used output and employment data of 1950s and early 1960s to study
the relationship between output and employment. His study revealed that every one
percentage point increase in unemployment results in a 2.5% reduction in real GNP below
the natural output. This relationship between unemployment and output is known as
Okun’s Law. The 2.5 is called the ‘law coefficient’.
The law can also be stated as
100(YN-Y)/YN = LC (u-uN)
Where, Y = real actual GNP; YN=natural output; LC= Okun’s law coefficient;
u = unemployment; and uN = natural unemployment.
CAUSES OF UNEMPLOYMENT

 period of economic recession

 launching a new technology
 saturation of the market with long durable goods
 too high wage rate set by government as a minimum level

 The causes of unemployment can be split into two main types:

 Demand-side
 Supply-side
The first cause of unemployment (demand-side) is simply a lack of aggregate demand .
When there isn't enough demand employers will not need as many workers, and so
demand-deficient unemployment results. Keynesian economists in particular focus on
this cause.

Unemployment caused by supply-side factors results from imperfections in the labour

market. A perfect labour market will always clear and all those looking for work will be
working - supply will equal demand. However, if the market doesn't clear properly there
may be unemployment. This may happen because wages don't fall properly to clear the
market.
 Wages are initially too high and so unemployment of ab results (supply is greater than
demand). To get rid of this unemployment and clear the market wages should fall.
However, if they are 'sticky-downwards' this may not happen and the unemployment
may persist.

Supply-side unemployment may also happen because there is occupational or

geographical immobility . It may happen because there is poor information about job
opportunities. This will lead to people taking a long time looking for jobs, increasing the
level of frictional or search unemployment .

One final cause of unemployment which tends to be discussed less but is no less
important, is changes in the workforce. The workforce is made up of people who are of
working age and not currently in full-time education. Their number will change with the
demographic (age) structure of the population. If there is a baby-boom (a rapid increase
in the birth rate ) then these people will become of working age between 16 and 21
years later. They then join the work-force. If there are the same number of people
retiring from the work-force at the other end, then unemployment will stay the same.
However, following a baby boom there are often more joining the work-force than
leaving. This may increase unemployment, unless there are enough extra jobs created to
employ the extra people in the work-force. This was one of the causes of unemployment
in the early 1980s when people born in the baby-boom of the 1960s joined the work-
force.

IMPACT OF UNEMPLOYMENT
Effects on society
1. Loss of Human Resources:
The problem of unemployment causes loss of human resources. labourers waste their
maximum time in search of employment.
2. Increase in Poverty:
Unemployment deprives a man of all sources of income. As a result he grows poor.
Therefore, unemployment generates poverty.
3. Social Problems:
Unemployment breeds many social problems comprising of dishonesty, gambling,
bribery, theft etc. As a result of unemployment social security is jeopardized.
4. Political Instability:
Unemployment gives birth to political instability in country. Unemployed persons can
easily be enticed by antisocial elements. They lose all faith in democratic values and
peaceful means. They consider that Government is worthless which fails to provide
them work.
5. Exploitation of Labour:
In the state of unemployment, labourers are exploited to the maximum possible
extent. Those labourers who get work have to work under adverse condition of low
wages.
 All this tells upon the efficiency of labourers greatly influence the pattern of
employment opportunities in the country. Being poor, a person does not make any
gainful use of existing resources.
6. More Emphasis on Capital Intensive Techniques:
In India, capital is scarce and labour is available in surplus quantity. Under these
circumstances, the country should adopt labour intensive techniques of production.
But it has been observed that not in industrial sector, also in agriculture sector; there
is substantial increase of capital than labour.

In the case of Western countries, where capital is in abundant supply, use of

automatic machines and other sophisticated equipments are justified while in our
country abundant labour, results in large number of unemployment.
7. Defective Education System:
The education system in our country too has failed to respond to the existing inter-
generation gap. It simply imparts general and literary education devoid of any
practical content.
India's education policy merely produces clerks and lower cadre executives for the
government and private concerns. The open door policy at the secondary and
university level has increased manifold unemployment among the educated that are
fit only for white collar jobs.
8. Slow Growth of Tertiary Sector:
The expansion of tertiary sector comprising commerce, trade transportation etc. is
limited which could not provide employment even to the existing labour force, what
to think about new entrants. As a result of this, there is a wide scale of unemployment
among engineers, doctors, technically trained persons and other technocrats.
9. Decay of Cottage and Small Scale Industries:
The traditional handicraft has a glorious past and was the main source of employment
especially to the village crafts-men, artisans as well as non-agricultural workers.
Unfortunately, most of rural traditional crafts have been ruined or faded partly due to
the unfavorable policy of the foreign rulers and partly due to tuff competition from
the machine made goods. Consequently, these laborers were out of job. Most of them
turned as landless laborers.
10. Lack of Vocational Guidance and Training Facilities:
our education system is defective as it provides purely academic and bookish
knowledge which is not job oriented.
The need of the hour is that there must be sufficient number of technical training
institutions and other job oriented courses at village level. Most of the students in
rural areas remain ignorant of possible venues of employment and choice of
occupation.

11. Less Means for Self-Employment:

Another hurdle in generation of more employment opportunities is that there are
inappropriate means for self employment in rural and semi-urban areas of the
country. Like other developed countries, most of our engineers, technocrats and other
well qualified persons do not possess ample means for self employment. They go
about in search of paid jobs.
Impact on individual
1. Stress
2. Loss of self esteem
3. Income reduces
4. Consumption reduces
5. Health problems

Measures to overcome unemployment problem

 Government support to struggling industries in order to try to save jobs e.g.

airline industry
• Provide more training and education to the unemployed. This could help improve
computer skills and communication. These people will become more confident and
employable.
• Make more information available in job centres.
• Reduce unemployment benefits or cut benefits all together
• Try to bring the country out of a recession. The Government needs to try to create
demand in the economy. It could;
- Give grants to businesses to produce goods
- Have projects such as road building
- Cut interest rates to encourage spending
- Cut income tax to encourage spending
 INFLATION

DEFINITION

Inflation means a considerable and persistent rise in the general level of prices over a long
period of time.

 According to Pigou :

“Inflation exits when money income is expanding more than in proportion to

increase in earning activity”

 According to Crowther:

“Inflation is a state in which the value of money is falling,that is, price are
rising”

 According to Coulborn::
“Inflation is a situation of “too much money chasing too few goods”

MEASURE OF INFLATION

There are two measures of inflation:

1) Percentage change in Price Index Numbers (PIN), and

2) Change in GNP deflator

Measuring inflation through PIN

The formula to calculate the inflation rate is

PIN t  PIN t 1
Rate of inf lation  100
PIN t

Where PINt is the Price index number for time period t that is current year.
And PINt-1 is the Price index number for time period t-1 that is previous year.
The two widely used PINs are whole sale price index (WPI) and consumer price index (CPI).
WPI is used to measure the general rate of inflation and CPI is used to measure the rise in
the cost of living.

Measuring inflation by GNP deflator

The GNP deflator is the ratio of nominal GNP to the real GNP of the same year. The formula
is

No min al GNP
GNPdeflato r  where Nominal GNP is GNP at current prices and Real GNP
Re al GNP
is GNP at constant prices.
 TYPES OF INFLATION

There are 5 types of inflation

1. Creeping inflation
2. Walking inflation
3. Running inflation
4. Galloping inflation
5. Hyperinflation

1. Creeping inflation: Creeping or mild inflation is when prices rise 3% a year or less. When
prices rise 2% or less, it's actually beneficial to economic growth. That's because this mild
inflation sets expectations that prices will continue to rise. As a result, it sparks
increased demand as consumers decide to buy now before prices rise in the future. By
increasing demand, mild inflation drives economic expansion.

2. Walking inflation: This type of strong, or pernicious, inflation is between 3-10% a year. It is
harmful to the economy because it heats up economic growth too fast. People start to buy
more than they need, just to avoid tomorrow's much higher prices. This drives demand even
further, so that suppliers can't keep up. More important, neither can wages. As a result,
common goods and services are priced out of the reach of most people.

3. Running inflation: When prices rise rapidly like the running of a horse at a rate of speed of
10% - 20% per annum, it is called running inflation. Its control requires strong monetary and
fiscal measures.

4. Galloping inflation: If annual rate of inflation exceeds 20% to 100% it results in Galloping
Inflation. The inflation rates may rise to double or triple digits(in percent) per year in
Galloping Inflation. When inflation rises to ten percent or greater, it wreaks absolute havoc
on the economy. Money loses value so fast that business and employee income can't keep
up with costs and prices. Foreign investors avoid the country, depriving it of needed capital.
The economy becomes unstable, and government leaders lose credibility.

5. Hyper inflation: When the prices rise more than 100 percent per year it is called Hyper
Inflation. The prices rise every minute and may rise to above its limits. This cause difficulty
to measure the inflation rate and severe problems to economy like prices of goods become
in stable, Wages decrease, inequalities rise, purchasing power of goods becomes weak and
worse. Circulation of money becomes faster.

The types of inflation are illustrated in the graph

 Hyper inflation

120
Galloping inflation

100
%increase in price level
Running inflation

80
Walking inflation
60

40
0
20 Creeping inflation

0
1 2 3 4 5 6 7 8

Time in years

Trend in inflation rate in India

YEAR ANNUAL RATE OF INFLATION(%)

2002-2003 3.4

2003-2004 5.4

2004-2005 6.4

2005-2006 4.4

2006-2007 5.3

2007-2008 4.7

2008-2009 12.44

2009-2010 10.2

2010-2011 9.4

2011-2012 11.4

CAUSES OF INFLATION
Inflation may occur due to two main reason:

1) Increase in aggregate demand

2) Decrease in aggregate supply

Factors that influence aggregate demand to increase are:

1. Increase in consumption expenditure

2. Increase in income
3. Changes in taste and preferences
 4. Population increase
5. Increase in investment
6. Increase in exports

Factors responsible for decrease in aggregate supply

1. Increase in cost of production or input cost

2. Increase in productivity
3. Increase in wage rate
4. Unexpected factors like earthquake, flood, landslide, war etc.
5. Strikes and lockouts
6. Increase in indirect taxes
7. Decrease in subsidies
8. Expectation in the future price level of the product

ECONOMIC EFFECTS OF INFLATION

Inflation affects all those who depend on the market for their income supplies. The effects may be
low or high depending on the rate of inflation and favourable and unfavourable. The economic
effects of inflation is discussed on

1. Distribution of income
2. Distribution of wealth
3. Output and economic growth
4. Employment of labour

1. Inflation and distribution of income

Inflation initially activates the economy, and a rise in the price level shakes the
foundation of an economy. Distribution of income is impacted as a result of such shifts.
In general, inflation does affect distribution of income but not necessarily the level of that
income. The best example of inflation affecting the distribution side is the creditor/debtor
relationship. Debtors will be paying back loans in inflated dollars compared to the money
that is borrowed. In reality, this creates a situation where they are actually paying back less
than they borrowed and creditors are receiving less money than they loaned to the
individual. This occurs when inflation isn’t anticipated and helps to distribute income from
creditors to debtors.

2. Effect of inflation on distribution of wealth

The effect of inflation on the distribution of wealth depends on how inflation affects the
(assets-liabilities) networth of the different classes of wealth holders. The effect of inflation
on the net worth depends on how inflation affects the money value of the price-variable
assets. If prices of all price-variable assets increase at the rate of inflation, then there will be
no change in asset portfolio and no change in wealth distribution.

3. Effects of inflation on – some sections of society

i) Wage Earners: wages in organized sector rises more or less in step with prices. The
wage earners are compensated for the rise in price level by their employers due to
 labour union pressure. Therefore, they are not affected by the inflationary situation.
Wage earners in the unorganized sector are affected, as they are not compensated
for the rise in price level.
ii) Producers: whether producers gain or lose due to inflation depends, on the rates of
increase in prices they receive (the sale price) and the prices they pay (input prices
or the cost of production). In general, product prices rise first and faster than the
cost of production. Therefore, profit margin increases and producers gain.
iii) Fixed income class: the people of the fixed-income category are the net losers
during the period of inflation. The reason is that their income does not increase- it
remains constant- but the prices of goods and services they consume increase. As a
result, the purchasing power of their income reduces in proportion to the rate of
inflation.
iv) Borrowers and lenders: Borrowers gain and lends lose during the period of inflation.
For eg. Suppose a person borrows Rs. 5 million at 10 per cent simple rate of interest
for a period of 5 years to buy a house. Every 5 years the value of asset would
double, therefore the value of the asset would increase to 10 million. The borrower
after the 5 years pays 8 million to the lender, but the value of the asset is 10 million.
The borrower gains by 2 million and lender loses by the same amount.
v) The government: the government is net gainer during the period of inflation. The
government gain can be explained on the basis of taxation and as a net borrower.
The effect of taxation on tax revenue, inflation increases yields from both the direct
(personal and corporate income tax) and indirect taxes increases (excise duty,
customs duty, import and export duty). As a borrower the value of asset or property
increases over a period of time. The value will be high than the amount that has to
be returned.
4. Effect of inflation on economic growth
Inflation rate to some extent may help the economy to grow. During the period of inflation,
there is a time-lag between the rise in out put prices and rise in input prices, particularly the
wage rate. This time-lag between the rise in output prices and the wage rate is called wage-
lag. When the wage-lag persists over a long period o time, it enhances the profit margin.
The enhanced profits provide provide incentive and investible funds to the firms. This
results in an increase in investment, production capacity and a higher level of output.
Empirically, it is found that a high level of inflation affect the economic growth of the
country. The positive association between output and inflation appears to only temporary
relationship. The output decreases and price level increases due to decrease in the
aggregate supply (wage-push, profit-push inflation). Unemployment increases, interest rate
increases and investment reduces.
5. Effect on employment
Inflation affects the employment as it affects the economic growth. If inflation affects
growth variables-savings, investment and profits- favourably then it affects employment
favourably too. However, a very strong conflict arises between growth and employment at a
high rate of inflation. While a high rate of inflation increases employment, it affects growth
adversely.
 MEASURES TO CONTROL INFLATION

Economists agree that inflation beyond creeping inflation is bad and can often prove disastrous, and
therefore, it must be kept under control. Economists agree also that an appropriate mix of fiscal and
monetary policies can be helpful in controlling inflation. The various anti-inflation measures are
generally classified as under:
1. Monetary measures
2. Fiscal measures
3. Price and wage control
4. Indexation
1. Monetary measures

The main methods of controlling the credit creating capacity of banks are categorized as ;
a. Traditional measures
b. Non-traditional measures
a. Traditional measures: Bank rate policy, variable reserve ratio, ad open market
operation
i) Bank rate policy: it is the interest rate at which central bank lends money to
commercial banks. The central bank performs this function as the lender of the last
resort. The objective of the central bank is to control by increasing the bank rate.
This increases the cost of borrowing and, therefore, reduces banks’ borrowing from
the central bank. This reduces banks’ ability to create credit. As a result, flow of
money from the commercial banks to the public reduces.
ii) Variable reserve ratio: commercial banks keep a certain proportion of their total
demand and time deposits in the form of cash reserves. A part of this reserve is
maintained as cash in hand for meeting their dat-to-day payment requirements and
a part is maintained with the central bank as ‘statutory reserves’. The cash reserve
ratio (CRR) is determined and imposed by the central bank. Increasing the CRR
withdraws money from the circulation. When central bank raises the CRR, it reduces
the lending capacity of the commercial banks. As a result, flow of money from
commercial banks to the public decreases.
iii) Open market operations: it refers to sale and purchase of the government securities
and bonds by the central bank to and from public and commercial bank. The central
bank can sell the government securities and bond to public through authorized
commercial bank. By selling the government securities , the central bank withdraws
a part of the deposits available to the banks for lending. This causes a reduction in
the credit creation capacity of the commercial banks and in the flow of credit to the
public.
b. Non- traditional measures: statuory liquidity ratio, selective credit ratio, moral
suasion, and credit authorization scheme.
i) Statutory liquidity ratio (SLR): under this, the commercial banks are required to
maintain certain minimum proportion of their daily demand and time liabilities in
the form liquid assets (bonds, cash reserves, marketable securities). This is in
addition to the CRR. The central bank would increase the SLR rate to reduce the
 credit creating capacity of the commercial bank and thereby reducing the money
supply in the economy.
ii) Moral suasion: the central banks use moral suasion technique of persuasion and
pressure to control the inflation. The central bank use this technique through
discussions, letters, and speeches of the concerned authorities, especially when
traditional methods of monetary control do not work satisfactorily for any reason.
iii) Selective credit control (SCCs): the methods that RBI uses to regulate the distribution
of bank credit between the various sectors and the industries on selective basis is
called SCCs. The RBI use SCCs to prevent the commercial banks from advancing
money for the purpose of speculative hoarding of essential commodities like food
grains, oil seeds and agricultural raw materials.
iv) Credit authorization scheme(CAS): The CAS is used by the RBI to give credit to large
public and private sector borrowers. Under this scheme, commercial banks are
required to seek prior authorization of the RBI and to report later to the RBI with
regard to large credit facilities given to large private and public sector units.
2. FISCAL MEASURES

a) Decrease in public expenditure- One of the main reasons of inflation is excess public
expenditure like building of roads ,bridges etc. Government should drastically scale down
its non essential expenditure so that money supply can be reduced.

b) Delay in payment of old debts: Payment of old debts that fall due should be postponed
for sometime so that people may not acquire extra purchasing power.

c) Increase in taxes : Government should levy some new direct taxes and raise rates of old
taxes in order to reduce the consumption expenditure.
d)Over valuation of money: To control the over valuation of money it is essential to
encourage imports and discourage exports.
3. Price and wage control
Price control as a measure to control inflation is generally adopted during the war period
when inflation teds to gallop and even during normal situation when inflation threatens to
cause serious damage to the economy in general. When the government resorts to price
control, a maximum retail price of goods and services is fixed. In order to ensure a fair
distribution of the scarce commodity, rationing system is adopted.
Wage control is used to combat inflation when wages tend to rise much faster than the
productivity or the cost-of-living index’ or when wage-push is found to have used and
influenced inflation. Under this method, the government controls the wage-rise directly by
imposing a ceiling on the wage incomes in both private and public sectors.
4. Indexation
Indexing is a mechanism by which wages, prices and contracts are partially or wholly
compensated for changes in the general price level. It is a method of adjusting monetary
incomes so as to minimize the undue gains and losses in real incomes of the different
sections of the society due to inflation.
 DEMAND-PULL INFLATION

The demand –pull inflation occurs when the AD increases much more rapidly than the AS. The
demand-pull inflation due to increase in AD will be due to 2 reasons: 1) monetary factors and 2) real
factors. The demand-pull inflation caused by monetary and real factors are discussed in terms of IS-
LM framework.

1) Monetary factors: an increase in money supply in excess of increase in potential output. i.e.
Monetary expansion in excess of increase in real output is one of the most important
factors causing demand-pull inflation. The mechanism is illustrated in the the graph below.

Graph (a)
LM1

LM2
Interest rate

E1
i1

i2 E2

IS

0
Y1 Y2 Real GDP
Graph (b)

Price
level

P2 E3

P1 E1 E2

AD2
AD1

0
Y1 Y2 Real GDP

Let us suppose that, at a point of time, the IS and LM curves for an economy are given as IS and LM1,
resp. in graph(a). The IS and LM1 curves intersect at point E1 where the level of income is
determined at Y1 and interest at i1. At point E1, the economy is in general equilibrium. That is AD is
equal to AS at point E1, at price level P1 and Y1 income level.

Now let the money supply increase due to a discretionary change in monetary policy. As result, the
LM curve shifts from the position of LM1 to that of LM2. The curve LM2 intersects the IS curve at
point E2. Therefore, the interest rate decreases from i1 to i2. The decrease in the interest rate
causes an increase in investment and, thereby an increase in the level of income from Y1 to Y2.
Increase in income causes a rise in consumption expenditure. The rise in the aggregate expenditure
makes the AD curve shift from AD1 to AD2 in graph (b). The shift in the AD curve is exactly
proportional to the rise in the money stock.

Shift in AD to AD2 at Y2 income level, the price level will remain same at P1. But the economy is not
in full employment level, therefore in order to achieve the full employment level the price level has
to be increase from P1 to P2, and thereby reducing the output level to Y2 at equilibrium E2. Thus it
is proved that monetary expansion increases the price level in the economy and reduce the national
income.
2) Real factors:
The real factors that cause demand-full inflation are those that cause upward shifts in the IS
curve. The factors that cause upward shift in the IS curve are: increase in government
spending, decrease in tax, increase in investment, etc. The demand-pull inflation caused by
the real factors is illustrated in the graph below.

LM
E2
i2
Interest rate

E1
i1

IS2

IS1

0
Y1 Y2 Real GDP

Price
level

P2 E3

P1 E1 E2

AD2
AD1

0
Y1 Y2 Real GDP

Given the IS and LM curve, the equilibrium position is determined at E1. Therefore, the interest rate
is determined at i1 and national level at Y1. Correspondingly, the macro economic equilibrium is
achieved at E1, where AD and AS intersect each other (Graph (a)). The price level is P1 and national
 income is Y1 at the full employment level. Let us assume that the real factor influence the
Investment and savings, therefore there will be shift in the IS1 curve to IS2. The equilibrium position
changes to E2, where IS2 and LM intersect each other. Due to this There is increase in the interest
rate to i2 and real GDP to Y2. We will now look into the changes in price level due to increase in
national income and interest rate. In graph (b), it can be observed that for Y2 national income, there
is increase the AD curve to AD2, the price level remains same at P1, but the economy is not in full
employment level. Therefore, to achieve full employment level the price level has to be increased to
P2 and the national income reduces to Y1. It can be concluded that due to increase the investment,
there exist a inflationary situation in the economy.

COST – PUSH INFLATION

The cost-push inflation is caused by monopoly power exercised by some monopoly groups of the
society, like labour unions and firms in monopolistic and oligopolistic market setting. The cost-push
inflation may be classified on the basis of supply-side factors as follows.
1. Wage-push inflation
2. Profit-push inflation
3. Supply-shock inflation
1. Wage –push inflation: the strong labour union demand to increase the wage rate influences the
existing wage rate to increase causing prices to go up. The kind of rise in price level is called
wage-push inflation. Increase in money wage causes an equal increase in the cost of production.
(a) Wage rate & Price Level (d) Agg. Demand &supply and Price Level
LRAS
2
Price Level
Price Level

E2 E2
P2 P2
1 1
P1 E1 P1 E1

w2
AS2 AD
AS1
w1
0 0
R1 R2 Real wage Y2 Y1 Real GDP
SL Y=f(N,K̅)
Empt. Empt.
level level

N1 N1 E1
E1

N2 E2 E2
N2

DL

0 0
R1 R2 Real wage Y2 Y1 Real GDP
(b) Wage rate & Empt. Level (c) Wage rate & Price Level
 Thereby causing a change in the AS to shift left. The backward movement of AS causes an upward
movement in the price level. Wage-push inflation is illustrated in the graph above:
Let us suppose that the initial AD and AS1 curve in graph (d) are equal at E1 with P1 price level and
the real GDP is determined at Y1. Thus us the economy is at full employment level. Given the wage
rate at R1 (graph (a and b), N1 level of employment (graph b and c). Let us assume that Labour
union demand for increase in the wage rate, there is increase the nominal wage rate from w1 to w2.
Therefore, the price level increases to P2 and the real wage rate increases to R2 (graph a). Due to
increase in the real wage rate, there is corresponding change in the level of employment to N2
(graph b) because the producers feel their cost of production increase due to increase in wage rate
and therefore demand less number of employees. The subsequent change in the real GDP is shown
graph c, that is there is decline in the level of national income. Finally, there is decline in the AS to
AS2 (graph d). Due to decrease in AS, there is increase in the price level. This increase in price level
is due to increase in wage rate, hence it is called wage-push inflation.

PROFIT – PUSH INFLATION

The producers mostly monopolistic firms and oligopolistic firms, due to their association deliberately
increase the price level and reduce the output level, in order to increase their profit amount. This is
referred to as profit-push inflation. The profit-push inflation mechanism is illustrated in the graph
below.

(a) Wage rate & Price Level (d) Agg. Demand &supply and Price Level
LRAS
2
Price Level
Price Level

E2 E2
P2 P2
1 E1 1 E1
P1 P1

AS2 AD

w1 AS1
0 0
R2 R1 Real wage Y2 Y1 Real GDP
SL Y=f(N,K̅)
Empt. Empt.
level level

N1 E1 N1 E1

N2 N2 E2
E2
DL1

DL2

0 0
R2 R1 Real wage Y2 Y1 Real GDP
(b) Wage rate & Empt. Level (c) Wage rate & Price Level
With the assumption that the economy is in full employment level at E1, where AS1 and AD intersect
each other. With P1 price and income level at Y1 (graph d), W1 wage rate (graph a), and N1 level of
employment (graph b). Let us assume that the oliogopolistic firm increases the profit margin by
reducing the output. This reduces the demand for labour from DL1 to DL2 (graph b) as a result
number of employment reduces to N2. Subsequently, real wage reduces to W2 and price level
increases to P2 ( graph a). The lower level of employment leads to decrease in national income to
Y2 (graph c). Increase in price level and reduction in national income is due to shift in the AS curve to
AS2. Therefore, it is clear that increase in the profit margin reduces the national income and
increases the inflation rate by decrease in the aggregate supply.

SUPPLY-SHOCK INFLATION

Supply – shock is a sudden, unexpected disturbance in the supply position of some major
commodities or key industrial inputs. The supply-shock inflation occurs generally due to sudden
rises in the prices of high-weightage of items in price-index number, for eg, food prices due to crop
failure, and prices of some key industrial inputs like coal, steel, cement, oil, and basic chemicals. The
other reasons for the supply shock inflation are earthquake , monsoon, flood, cyclone, etc.

The mechanism of supply-shock inflation is same as in case of wage-push and profit inflation.
 12/19/2013

 1958 – Professor A.W. Phillips

 Expressed a statistical relationship
between the rate of growth
of money wages and unemployment
from 1861 – 1957
 Rate of growth of money wages
linked to inflationary pressure
 Led to a theory expressing a trade-off
between inflation and unemployment

1
 12/19/2013

 Phillipsrevealed that there exists an inverse

relationship between the wage rate and rate
of unemployment.
 He presented the inverse relationship
between the change in money wage rate and
the rate of unemployment in the form of a
curve , called Phillips curve (PC). The PC
was fitted on the data based on the British
economy from 1861-1957.
 The Phillips curve is presented in the graph
below:

PHILLIPS CURVE
Money
wage
rate

10

-2 PC

0 1 2 3 4 5 6 7 8 9 10

Unemployment rate
4

2
 12/19/2013

The PC shows that there is an inverse

relationship between money wage rate
and rate of unemployment.
When money wage rate increases, the
rate of unemployment decreases and vice
versa.
This result is based on the study by
Phillips covering a period of 52 years from
1861-1913.
5

 Phillips had traced the relation between the rate of

change in money wages and the rate of
eunemployment, it was later extended toe xamine
the relationship between the rate of inflation and
the rate of unemployment.
 The movements in wages and prices are interlinked
and they move in the same direction.
 Some economists have used the US data to verify
the PC in the short run of different duration. They
all find PC to be consistent with the US data in the
short run.
 There is positive relationship between inflation
rate and rate of unemployment
6

3
 12/19/2013

 The trade-off means that a certain rate of inflation

can be traded for some rate of unemployment.
 i.e. a lower rate of unemployment can be achieved
only at the cost of a higher rate of inflation.
 The trade-off between inflation and unemployment
has a very important policy implication.
 Given the inflation and unemployment rate
combinations, policy markers get a number of
trade-off points between inflation and
unemployment to choose from.
 The relationship between inflation, money wage
and unemployment rate is shown in the graph
below.
7

PHILLIPS CURVE : INFLATION AND UNEMPLOYMENT

Inflation Money
rate wage
rate
PC
9
7

8
6

5 7

6
4

3 5

4
2

3
1

2
0 1 2 3 4 5 6 7 8 9 10
Unemployment rate
8

4
 12/19/2013

 The vertical axis on the left measures the annual rate

of inflation and the horizontal axis measures the rate of
unemployment. The vertical axis on the right side
measures the money wage rate.
 The inflation rate on the left side is adjusted for an
assumed 2 % increase in the selling price due to
increase in wage rate as a result of increase in labour
productivity.
 If wages rise by 5% and labour productivity increases by
2%, then the rate of inflation due to wage-push is only
3%.
 The trade-off between inflation and uemployment is
explained through the graph
 A 2.5% (6.5 %– 4%) unemployment can be traded for a
2% (5-3%) inflation
9

 Economist have viewed that the recent evidence

prove that the Phillips curve relationship holds only
in the short run.
 In the short run, if AD increases, that increases real
GDP, therefore employment, so unemployment goes
down and we move on the SRPC so that inflation
goes up. If AD decreases, GDP falls, employment
falls, unemployment goes up, inflation goes down.

10

5
 12/19/2013

The Short-Run Phillips Curve

illustrates the Trade-off
between Inflation and
Unemployment that occurs
Inflation

..
B
as the AD increases and
decreases. If AD increases

. A
C
SRPC
the price level or rate of
inflation increases and
unemployment can be
reduced. If AD decreases
the inflation rate also
Unemployment
decreases and
unemployment rate
increases.

11

 SRPC can shift towards right due to changes

in wage rate.
Inflation rate

SRPC2
SRPC1

Unemployment rate

12

6
 12/19/2013

 Milton Friedman integrated the logic of he

SRPC into the macroeconomic theory and
explained the spiraling Phillips curve. He
constructed a long-run Phillips curve (LRPC)
 In the long run, he argues that there is only
one rate of unemployment whatever the rate
of inflation. This rate of unemployment he
calls the “natural rate of unemployment”
and also called as NAIRU ( Non-accelerating-
inflation rate of unemployment).
 Friedman’s derivation of Long run PC is
illustrated in the graph.

13

The long-
run Phillips
curve is a
vertical line
at the
natural
unemploym
ent rate.
In the long
run, there is
no
unemployment
-inflation
tradeoff.
14

7
 12/19/2013

LONG RUN PHILLIPS CURVE

LRPC
Interest rate

P3
E

D
P2 C
SRPC 3
B F

P1 SRPC 2
A
SRPC1

0 U Un
Unemployment rate

15

 The curves SPC1, SPC2, and SPC3 are the short-

run Phillips curves at different levels of
unemployment and inflation rates.
 LRPC is the vertical straight line indicating the
natural rate of unemployment
 Suppose that economy is at point A with
unemployment rate of Un and inflation rate of
i1. Any expansionary policies pushes up the
price level.
 When the price level rises, the real wages go
down. Under these conditions money wages lag
behind the price rise.

16

8
 12/19/2013

 As a result of fall in the real wages, employers

increase their demand for labour, employment
increases and unemployment decreases.
 With rising prices and decreasing unemployment,
the trade-of point A moves towards point B along
the short run Phillips curve SPC1. This shows a
decline in the unemployment rate from Un to U.
 Decrease in the unemployment rate below its
natural rate could be possible only if real wage
declines and there is a time lag between the
money wage catching up with the price rise.

17

 The inflation-unemployment combination at point B

is not sustainable. The workers demand for higher
wages to compensate for the rise in price level.
Therefore, the wages begin to rise and the economy
moves to a higher equilibrium point from B to C. At
C, inflation rate and unemployment rate has
increased due to shift in the SRPC2.
 As a result the economy reaches to natural rate of
unemployment Un., the inflation rises from P1 to
P2. this is a situation of stagflation when both
prices and unemployment increases simultaneously.
 The policy makers reconcile with the natural rate of
unemployment the system will stagnate at point C.
18

9
 12/19/2013

 Ifthey decide to unemployment rate, they have to

adopt an monetary policy say to increase money
supply.
 This would make the system move from point C
towards point D and from D to point E after a lapse
of time.
 Joining all the equilibrium points A,C, and E we get
long run Phillips curve.
 The LRPC means that there is no trade-off
between the unemployment and inflation rate in
the long run, and the natural rate of
unemployment is compatible with any rate of
inflation.
19

 P3 price level is found to be too high to be tolerated

and the government plans to reduce the rate of
inflation. They adopt anti-inflationary policy and
reduce the money supply.
 Decrease in money supply reduces the prices and
increases the real wages. As a result, employment cut
down the demand for labour. Unemployment
increases following decrease in the price level. This is
depicted by the movement from equilibrium point C
to F. To come back to natural unemployment rate,
economy reduces the price level to P1 and reach the
equilibrium position point A.
 Thus economy has reached the NARIU level. The
process will continue as the economic activity
progresses. 20

10
 MONEY
TYPES, FUNCTIONS,
CHARACTERISTICS,
SIGNIFICANCE,

MONEY
DEFINITION
MONEY can be defined as nay commodity that is
generally accepted as a medium of exchange
and a measure of value.
• H.G. Johnson has classified the approaches of
money into 4 categories:
• The Conventional approach
• The Chicago approach
• The Central bank approach
• The Gurley-Shaw approach

1
 The Conventional approach
• The conventional approach to the
definition of money is the oldest approach.
According to this approach, the most
important function of money in society is
to act as a medium of exchange.
• It pays for all the goods and services
transacted in the community.
Consequently anything is money which
functions generally as a medium of
exchange in the economy.

The Chicago approach

• The Chicago Approach to the concept of
money is associated with the views of
Prof. Milton Friedman and other monetary
theorists of the University of Chicago.
• The Chicago economists have adopted a
broader definition of money by including in
it besides the currency and chequable or
demand deposits, the commercial bank
time deposits—fixed interest-bearing
deposits placed with the commercial
banks.

2
 The Central bank approach
• According to John Gurley and Edward Shaw
approach, currency and demand deposits are
just two among the many claims against
financial intermediaries.
• They emphasise the close substitution
relationship between currency, demand
deposits, and commercial bank time deposits,
saving bank deposits, credit institutions’
shares and bonds etc. all of which are
regarded as alternative liquid stores of value
by the public.

The Central bank approach

• This approach which has been favoured by the
Central Banking authorities, take the broadest
possible view of money as though it were
synonymous with credit funds lent to the
borrowers.
• Money is identified with the credit extended by
a wide variety of sources. The reason for
identifying money with credit used in the
broadest possible sense of the term lies in the
Central Bank’s historic position that total credit
availability constitutes the key variable for
regulating the economy.

3
 KINDS OF MONEY
• THERE ARE 3 TYPES OF MONEY;
1.Metallic coins
2.Paper money
3.Private bank money (bank deposit)

Metallic money
• Metallic money today consists of the
various coins in circulation. At one
time gold and silver bullion was
considered money, but this no longer
exists . Both gold and silver have
been demonetized and hence are
looked upon as commodities, like
wheat or cotton. In the India the coins
in circulation today are issued by the
RBI.

4
 Paper money
• It is currency notes which is printed,
authenticated and issued by the central
bank of the country.
• The currency issued by the RBI is in the
form of promissory notes but enjoys the
status of a legal tender.

Demand deposits
• Demand deposits is sometimes
called checkbook money as well as private
bank money. It represents by far the bulk of
the money supply in the India today. Some of it
comes into existence when banks make loans,
and some when deposits are made. The
amount of checkbook money that banks are
permitted to create is carefully controlled by the
RBI. Banks must keep reserves behind these
deposits, and the total volume of checks is
regulated by controlling these reserves.

5
 Demand deposits
• Demand deposits is fully and
immediately convertible into currency
and coin-hence the term "demand
deposit." Most financial payments
today are made by way of these
deposits because they are easy,
convenient, and provide for flexibility
in making payments.

Functions of money
(i) Medium of exchange
(ii) Measurement of value;
(iii) Standard of deferred payments
(iv) Store of value.

6
 Medium of exchange
• Right from the beginning, money has been
performing an important function as medium of
exchange in the society. Money facilitates
transactions of goods and service as a medium
of exchange. Producers sell their goods to the
consumers in exchange of money.
• It has eliminated inconvenience which was
faced in barter transactions.
• Money operates as medium of exchange
because it is generally accepted by everybody.

Measurement of value
• Money works as unit of value or standard of
value.
• The value of various goods and services are
expressed in terms of money such as Rs. 10
per metre, Rs. 8/- per kilogram etc. In this way,
money works as common measure of value by
expressing exchange value of all goods and
services in money in the exchange market. By
working as a unit of value, money has facilitated
modern business and trade.

7
 Standard of deferred payments
• Modem economic setup is based on credit and
credit is paid in the form of money only. In
reality the significance of credit has increased
so much that it will not be improper to call it as
the foundation stone of modern economic
progress. Money, besides being the basis of
current transactions, is also the basis of
deferred payments. Only money is such a
commodity in whose form accounts of deferred
payments (credit time) can be maintained in
such a way so that both creditors and debtors
do not stand to lose.

Store of value
• People can store surplus pur-chasing power
and use it whenever they want.
• Saving in money is not only secure but its
possibility of being destroyed is very less.
• Besides, it can be used whenever need be.
• By facilitating accumulation of money, money
has become the only basis of promoting capital
formation and modern production tech-nique
and corporate business facilitated there from.

8
 Significance of money
• It eliminates the problems of a barter
economy
• Money works as a factor of production
• Money accelerates the pace of production
and growth speed
• Money is the life blood of a modern
economy
• It has evolved into money market and
credit system.

Characteristics of money
• Durable – needs to withstand everyday wear
and tear
• Portable – needs to be easily carried around
• Widely accepted as a means of payment –
everyone in the country must agree to accept it
as a medium of exchange
• Stable in value – must be worth the same over
time
• Easily divisible
• Difficult to counterfeit – maintains confidence in
the currency

9
SUPPLY OF MONEY

It is the amount of money available with the public at a point of time. The central bank is the main
source of money supply in the country. The money supplied by the central bank is called “High
powered money”. Commercial banks are also the main source of money supply, it is called as ‘credit
money’.

High powered money

The central banks of all the countries are empowered to issue the currency. It is called as ‘high
powered money’ because it is backed by supporting reserves ad guaranteed by the government and
is the source of all other forms of money. The money issued are liability to the central bank and is
backed by an equal value of assets consisting of gold and foreign exchange reserves.

In India, there are two sources of high power money supply:

1) The RBI, the central bank and 2) the government of India (GOI)
The RBI isses currency notes of rupees 2,5,10,20,50,100, and 500 denominations. The RBI calles it
the reserve money. The RBI issues currency of one rupees notes and coins and coins of smaller
denominations of behalf of the GOI.

Measure of High Power Money Supply in India

H=C+R+O,
where C is the currency held by the public , R is the cash reserves of the commercial banks, and O is
the ‘other deposits’ with RBI.
Since ‘other reserves account for 1% of the total money supply, it is ignored and it is measured as

H=C+R

Commercial banks and money creation

The money that commercial banks supply is called credit money. The money is created from their
process of working. Banks receive deposits from the public and the deposited money is lend to the
public. This process is called as credit creation from primary deposits.
On the basis of primary deposits banks create secondary deposits, called as derivative deposits.
The commercial banks cannot lend the entire deposit amount to the public. They have maintain two
kinds of reserves: 1) cash reserves 2) statutory liquidity reserve. This is to meet the cash demand by
the depositors.

The deposit multiplier

A primary deposit leads to the creation of secondary deposits, which is a multiple of the primary
deposit. A function that describes the amount of money created in a bank's money
supply. It is the ratio of total deposit creation (ΔTD) to the primary deposits with banks
(ΔD), that is, dm = ΔTD/ ΔD. This money is created by lending money that is in excess of
its required reserve to borrowers.
Calculated as:

Or dm=1/r, where r is the cash reserve ratio.

Credit multiplier
Credit multiplier is another useful concept used in the analysis of money supply. Let us first
make a distinction between the between the deposit multiplier and the credit multiplier.
Deposit multiplier, (dm) is the ratio of total deposit creation (ΔTD) to the primary deposits
with banks (ΔD), that is, dm = ΔTD/ ΔD. Similarly, credit multiplier Can be defined as the
ratio of additional credit creation (Δ CC) to the total cash reserves (Δ R). That is credit
multiplier (cm) can be measured as:

Credit multiplier (cm) = Δ CC/Δ R

Total credit income creation (Δ CC) by the banks = 4 million, and total reserves = 1 million.
Thus the credit multiplier can be obtained as

CM = Δ CC/Δ R = 4/1 = 4

MEASURE OF MONEY SUPPLY

RBI measurement of money supply is given as

M1 = C + DD + OD

M2 = M1+ SAVING DEPOSITS WITH POST OFFICES

M3 = M1 + NET TIME DEPOSITS WITH THE COMMERCIAL BANKS

M4 = M3 + TOTAL DEPOSITS WITH POST OFFICES (INCLUDING NSC)

WHERE C = Currency held by the public

DD = Net demand deposits with banks

OD = ‘other deposits’ with the RBI

NSC = National Savings certificates

THEORY OF MONEY SUPPLY

The theory of money supply makes a distinction between the two concepts of money
supply, ordinary money supply or the stock of money (M) and the high power money (H).
The ordinary money supply (M) includes the currency held by the public and the demand
deposits.

M =C +DD , where C is the currency held by the public and DD is the demand deposits.

The high power money (H) is defined as:

H = C+ R, where C is the currency with the public and R is the banks cash reserve.

The theory of money supply analyses the relationship between M and H and concludes that

M = mH,

Where m is the money multiplier and it is constant.

Therefore, M=H

The determinants of money multiplier

It can be grouped into two categories:

i) The proximate or immediate factors, and

ii) The ultimate factors

The proximate or immediate factors

1) Currency –deposit ratio (c)

2) Reserve-deposit ratio(r)
3) Time-deposit ratio(t)

The ultimate factors

1) The income level of the people

2) The interest rate
3) The development level of the banking system
4) Banking habits of the people
5) Savings pattern of the people
6) The black money held by the public

The money supply curve

It explains the relationship between interest rate and money supplied. The money supply in
the country at a point of time is considered to constant whatever be the interest rate.
Therefore, the money supply curve is perfectly inelastic. The money supply curve is show in
the graph.
Interest
rate

0
Ms Money

DEMAND FOR MONEY

The demand of money is the quantity of money people want to hold in their portfolio. The demand
for money depends on expected return, risk and liquidity. Macroeconomic variables that affect the
demand for money are price level, real income and interest rate.
KEYNESIAN THEORY OF DEMAND FOR MONEY
Keynes built his theory of demand for money - the liquidity preference theory’ on the Cambridge
cash-balance approach to the demand for money. According to Keynes, money is demanded for
three motives:
1. Transaction motive
2. Precautionary motive
3. Speculative motive
1. Transaction demand for money (TDM)

The money which is used for the purchase of goods and services is said to have transaction demand
for money. The transactions demand for money is positively related to real income and inflation. As
an individual's income rises or as prices in the shops increase, he will have to hold more cash to carry
out his everyday transactions. The quantity of nominal money demand is therefore proportional to
the price level in the economy.

The transaction demand for money function is expressed as:

Mt=f(Y)

Where Mt is the transaction demand for money and Y is the income. There is positive relationship
between income and TDM. As income increases the TDM also increases. Given the income and its
distribution, the short run relationship between income and TDM is expressed as:

Mt=kY, where k denotes a constant proportion if income demanded for transaction purpose.

This is shown a graph.

Mt=kY
Interest
rate

0
Quantity of money
The relationship between interest and TDM is also explained by Keynes. Whatever the rate of
interest people cannot stop paying grocer’s bill, house-rent, electricity and telephone bills, school
fees, and medical bills, etc. However, some economist argue that when the interest rate goes very
high, even in the short run, the demand for money starts declining. This situation is illustrated in the
graph.
Interest
rate

i3

i2

i1

0
Mt
Quantity of money

The graph explains the relationship between the interest rate and TDM. To a certain level of interest
rate (i1 to i3), the TDM remains constant. When interest rate increases above i3 the TDM starts
reducing. However, the TDM is assumed to be interest inelastic for further analysis.

2. PRECAUTIONARY DEMAND FOR MONEY (PDM)

This is money held to cover unexpected items of expenditure or unforeseen contingencies like fire,
theft, sickness, loss of job, accidents, death of the bread winner and market eventualities. The
money for this motive is called as PDM. The precautionary demand for money, is positively
correlated with real incomes and inflation. PDM and income are positively related and is expressed
as Mp= f(Y), where Mp is the precautionary demand for money.
Since both TDM and PDM are a function of income, Keynes summed them together and expressed
the total transaction demand for money as Mt=f(Y) =kY.
3. SPECULATIVE DEMAND FOR MONEY (SDM)

According to Keynes, people of their income in the form of idle cash balance for speculative
purpose. The speculative purpose arises from the desire to take advantage of the changes of the
money market. People may invest their money in bonds and other speculative investments. The
SDM is always related to interest rate. There is inverse relationship between interest rate and
SDM say bond prices. That is if interest rate increase, the price of bond reduces. If interest rate
decreases, there is increase in the bond prices.

This relationship can be expressed as

Msp =f(i) where i is the interest rate and Msp is the SDM. The relationship is graphically
illustrated below.
Interest
The Msp curve is the SDM. It shows an inverse
rate
relationship between rate of interest and the
speculative demand for money. That is when interest
i3
rate decreases to i2 and i3, the SDM reduces.

Liquidity Trap: the interest rate will not below i3 which

i2
is critical minimum level, and money market has
Liquidity Trap entered into a liquidity trap. It is a level below which
people prefer to hold cash balance and banks pull down
i1 Msp
their shutter.

0
Quantity of money

The total demand for money

According to Keynes, total demand for money consists of two components:
1) TDM (including PDM) (Mt) and
2) SDM (Msp)

Thus, the total demand for money (Md) can be expressed as

Md= Mt+ Msp

Since, Mt=kY and Msp= f(i), given the income and interest rate the total demand for money can
be expressed as

Md=kY + f(i)

The relationship between the total demand for money and the interest rate is crucial to the
theory of interest. The derivation of Md curve is illustrated in relation to the interest rate.

a b c
Interest Interest Interest
rate rate rate
i3 i3
i3

i2 i2
i2

i1 Md
i1
i1
Ms Ms
p p
0 Mt Qm 0 0 Mt
Qm Qm

Graph a shows the transaction demand for money(Mt) in relation to interest rate. TDM curve is
interest inelastic and drawn as a straight line. At i1,i2, and i3, TDM remains the same. In graph b the
speculative demand for money curve is drawn in relation to the interest rate. The Msp is inversely
related with the interest rate. Graph c, presents the total demand for money (Md). The total
money-demand curve the Md curve is a horizontal summation of Mt and Msp curves. Therefore Md
curve is drawn and it is clear that it is inversely related to interest rate. When there is fall in the
interest rate, the total demand for money will increase and vice versa.
 MONEY MARKET EQUILIBIRUM

MONEY MARKET

Definition: Money market refers to the interaction of demand for money and supply of money in
determining interest rate for a specific quantity of money. According to Keynes, market rate of
interest is determined by the aggregate demand for money and total supply of money. That is, the
equilibrium rate of interest is determined in the money market where

Mt + Msp = Ms or Md = Ms

In the Keynsian model, the supply of money (Ms) is assumed to remain constant in the short run. It
is because the supply of money in any country is determined by the central bank of the country in
view the overall monetary needs of the country. Central banks do not increase or decrease the
supply of money in response to the variation in the rate of interest. Therefore, the supply of money
in any time period is assumed to be given. That is Ms is interest-inelastic. The interaction of supply
and demand for money is explained through the graph below.
The graph shows, the money demand curve
Interest Ms (Md) and money supply schedule (Ms)
rate intersect each other at point E, at this point,
Ms=Md. Therefore, the equilibrium rate of
interest is determined at i1. This rate of
i2 A B interest is supposed to be stable. For at any
other rate of interest, Md≠Ms, there is
disequilibrium in the money market.
i1 E
If the interest rate rises to i2 for some reason
D
i0 Md in any period of time, Md will decrease by AB.
C
The equilibrium will be restored by decreasing
the interest rate.
0 Ms = Md Quantity of money

When the interest rate falls, for some reason, from i1 to i0, the speculative demand for money
increases because at a lower rate of interest the preference for cash holding increases. The
aggregate demand for money (Md) increases by CD. Consequently , demand for money exceeds
supply of money by CD. Since there is shortage of money in the money market, people begin to
ecpect a rise in the interest rate, and therefore demand for money beings to decrease and continues
to decrease until the equilibrium point E is restored.

CHANGES IN MONEY MARKET EQUILIBIRUM POSITION DUE TO

1) CHANGES IN DEMAND FOR MONEY

2) CHANGES IN SUPPLY OF MONEY

CHANGES IN DEMAND FOR MONEY

 Demand for money may change due to either change in transaction demand or change in
speculative demand or both.

Change in transaction demand for money (TDM): TDM may change due to increase in income, and
speculative demand for money remains constant. Due to this, there will be change in the
equilibrium interest rate. The effect is shown in the graph.
Interest Y1 Y2 Ms Gi ven the TDM (Mt1) at Y1 income and demand for
rate
money as Md1. The equilibrium interest rate (i1) is
determined at the intersection point of the supply of
money (Ms) at point E1.
i2 E2
Let us assume that there is increase in income to Y2 so
that the TDM increases to Mt2. The speculative demand
i1 E1
Md2 for money remains the same. The total demand for
money Md shifts towards right from Md1 to Md2. And
Md1 the new equilibrium interest rate is determined at E2,
with supply of money being interest – inelastic.
0 Mt1 Mt2 Ms=Md Money

CHANGES IN SPECULATIVE DEMAND FOR MONEY

Let us assume that there is change in speculative demand for money and all other things remaining
constant. Brings a change in the equilibrium interest rate which is shown in the graph

The changes in speculative demand for money is due

Interest Ms
rate to expectations regarding the changes in the normal
rate of interest. If the people expect a fall in the
interest rate, the speculative demand for money will
E2 increase. Due to this the total demand for money curve
i2
also increase as shown in the graph. The original
interest rate i1 increases to i2.
i1 E1

Md

0 Ms = Md Quantity of money

CHANGES IN MONEY SUPPLY AND INTEREST

An increase in the supply of money, given the demand for money, causes a decrease in the interest
rate and vice versa. This relationship is depicted in the graph.
 12/19/2013

Monetary policy

Monetary policy
 Definition
 Monetary action undertaken by the
monetary authority (Central Bank), to
control and regulate the money supply and
flow of credit to achieve macroeconomic
goals.

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Scope of monetary policy

 The scope of monetary policy is explained
in terms of 2 important factos:
 The level of monetization of the economy;
 The level of development of the capital
market

The level of monetization of the economy

 Make the money as the medium of
exchange
 To facilitate the production, consumption,
savings, investment and foreign trade
activities
 Gain economic growth (GDP), control
inflation, Balance of payments, etc.

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The level of development of the capital

market
 To develop financially strong commercial
banks, financial institutions, credit
organization,
 To control and regulate the credit creation
capacity of the commercial banks
 To develop the role of non-banking
financial institution
 To regulate the stock market

INSTRUMENTS OF MONETARY POLICY

 Instrument of monetary policy refers to the
tools that the central bank can change at
its discretion with a view to controlling and
regulating the money supply and the
availability of credit.
 Monetary instrument are classified into two
categories:
(i) quantitative measures and
(ii) qualitative or selective credit controls.
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Quantitative measures
 There are 3 important measures, they are:
1. Open market operations
2. Discount rate or bank rate(BR), and
3. Cash reserve ratio (CRR)

Open Market Operations (OMO)

 OMO refers to the sale and purchase of
government securities and treasury bills
by the central bank of the country.
 The central bank carries out its OMO
through the commercial banks.
 The buyers of the govt. bonds include
comm.banks, financial corporations, big
business corporations and individuals with
high savings.

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OMO contd.
OMO affects the supply of credit in the following
ways:
 When people buy the govt. bond through the
cheques drawn on the commercial banks in
favour of the central banks in favour of the
central bank. The money is transferred from
the buyers’ account to the central bank
account. This reduces the total deposits with
the comm.banks and also their cash
reserves. As a result, credit creation capacity
of comm. Banks decreases and, the flow of
bank credit to the society decreases.
9

OMO contd.
 When the comm. Banks decide to buy the
government bonds and securities
themselves, their cash reserves go down.
The fall in banks’ cash reserves reduces
their credit creation capacity further.
Therefore, there is fall in the flow of credit
to the public.

10

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OMO contd.
 The sale of bond by central bank to comm.
Bank reduces the demand for credit. The
prices of bond go down and interest rate
goes up.
 The purchase of bond by central bank
from comm. Bank, deposits and their cash
reserves increases. This increases the
credit creation and money supply in the
economy.

11

DISCOUNT RATE OR BANK RATE POLICY

 Bank rate is the rate at which central bank
charges the loan and advances to the
comm.banks. (bank rate as on 23/10/13 is
8.75%)
 Central bank can increase or decrease bank
rate depending on whether to expand or reduce
the flow of credit from the comm.bank.
 When it wants to increase the credit creation
capacity of the comm.banks, central bank will
reduce the bank rate and vice versa.
12

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BANK RATE POLICY

The changes in the bank rate affects the flow of
bank credit in 3 ways:
1. A rise in bank rate (increase in the interest
rate) leads to decrease in the net worth of the
government bond.(comm.bank should have
certain amount of govt.bond with them and
against these, they have to borrow money
from RBI). Therefore, the borrowing capacity
of the comm.bank reduces and thus reducing
the credit creation of comm.banks and
resulting in money supply.
13

BANK RATE POLICY

2. When RBI increases bank rate , comm.bank
also increase its interest rate. Thus, it leads to
decrease in investment from the business
firms(they will borrow less), hence reduction in
money flow.
3. Increase in bank rate, increases in deposit
rate, it will induce the people to save more,
and money flow in the economy reduces.
(deposit mobilization efffect.

14

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BANK RATE POLICY

 There are two more rates associated with
bank rate. They are:
1. Repo rate: rate at which the RBI lends
money to comm.banks by selling the
securities and at the samet ime agreeing
to repurchase them at a later date at a
predetermined price. ( 7.75% as on
29/10/13)
2. Reverse Repo rate: rate at which the RBI
borrows money from comm.banks.
(6.75% as on 23/10/13)
15

CASH RESERVE RATIO(CRR)

 Percentage of total deposits which comm.banks
are required to maintain in the form of cash
reserve with the central bank.
 Cash reserves are non-interest bearing
 CRR is 4% as on 9/2/13
 Changes in CRR, RBI can change the money
supply
 Increase in CRR, reduces the money flow in the
economy, it is explained with the help of an
example
16

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CRR
 Suppose total deposit(TD)= 100m
 And CRR is 5% (5m)
 Bank can grant loan against 95m.
 Comm. Bank can create a total credit of 2000m
(TDx dm, where dm is deposit multiplier
dm=1/r=1/.05=20, where r is the CRR, thus
100mx20=2000m)
And additional credit of 95mx20=1900m
Total credit creation=2000m+1900m=3900m

17

CRR
 Suppose total deposit(TD)= 100m
 And CRR is 6% (6m)
 Bank can grant loan against 94m (100m-6m).
 Comm. Bank can create a total credit of 1667m
(TDx dm, where dm is deposit multiplier
dm=1/r=1/.06=16.67, where r is the CRR, thus
100mx16.67=1667m)
And additional credit of 94mx16.67=1566.98m
Total credit creation=1667m+1566.98m=3233.98m
There fore when there is increase in the CRR the
credit creation capacity of the comm.banks reduces,
18
thus reducing the money supply

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Statutory liquidity requirement

 It is that proportion of the total deposits which
comm.banks are statutorly required to maintain
in the form of liquid assets(cash reserves, gold,
govt. bonds) in addition to cash reserve ratio.
 This measure was undertaken to prevent the
comm.banks from using liquid assets when
CRR is raised.
 SLR rate is 23% as on 29/10/13.

19

QUALITATIVE OR SELECTIVE CREDIT

CONTROLS

1. CREDIT RATIONING
2. CHANGE IN LENDING MARGINS
3. MORAL SUASION
4. DIRECT CONTROLS

20

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Credit rationing
 During recession and depression, priority
sectors and essential industries are starving of
fund while bank credit goes to the non-priority
sectors.
 In order to curb this tendency the RBI resorts to
credit rationing by
 Imposing of upper limits on the credit available
to large industry and firms.
 Charging a higher r progressive interest rate on
bank leans beyond a certain credit to the
weaker and affected party. 21

Change in lending margins

 The gap between the value of the mortgaged
property and amount advanced is called lending
margin. Eg.
 Value of the property= 10m
 Loan advance = 6m
lending margin 4m (40%)
Public mortage their property (land, building,
jewelry, share, etc.) for money generation.
Banks provide loans only upto a certain %age
of the value of the mortgaged property.
22

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Change in lending margins

 The RBI is empowered to increase the lending
margin with a view to decrease the bank credit.
 That is if the lending margin is increased, the
credit flow will be less and money supply will
reduce and vice versa.

23

MORAL SUASION
 It is persuading and convincing the
comm.banks to advance credit in accordance
with the directions fo the RBI in overall
economic interest of the country.
 The central bank use this technique through
discussions, letters, and speeches of the
concerned authorities.
 This technique is used especially when
traditional methods of monetary control do not
work satisfactorily.
24

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MORAL SUASION
 This method is used for controlling both quantity
and quality of credits.
 RBI uses moral suasion to urge the
comm.banks to keep a large proportion of their
assets in the form of government securities
 It helps the RBI in developing a broad-based
security market, and to cooperate in controlling
inflation.

25

DIRECT CONTROL

 When all other methods prove ineffective, the

monetary authorities resort to direct control
measures with clear directive to carry out
lending activity in a specified manner.

26

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Limitations and effectiveness of

monetary policy
1. The time lag: the time lost in chalking out the
policy action, its implementation and working
time. 2 types of time lag:
 Inside lag: refers to the time lost in identifying
the nature of the problem, source of the
problem, assessing the magnitude.
 Outside lag: refers to the time taken by the
households and the firms to react to the policy
action taken by the monetary authorities. 27

2. Problems of forecasting
 It is very difficult to assess the impact of
monetary policy and magnitude of impact
on the economic growth of the country.
 Prediction of outcome of a policy action
and formulation of an appropriate
monetary policy has remained an
extremely difficult task.

28

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3. Non-banking financial intermediaries

 The structural change in the financial market
has reduced the scope of effectiveness of this
policy.
 The increased role of non-banking financial
intermediaries including industrial financial
corporations, industrial development banks,
mutual saving funds, insurance companies, chit
funds, have reduced the share of the
comm.banks in the total credit.
29

Non-banking financial intermediaries

 Although financial intermediaries cannot create
credit through the process of credit multiplier,
their huge share in the financial operations
reduces the effectiveness of monetary policy
which works through the banking finance.

30

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4. Underdevelopment of money and capital

markets
 The effectiveness of monetary policy in the less
developed countries is reduced considerably
because of the underdeveloped character of
their money and capital markets.
 The money and capital markets are
fragmented, while effective working of monetary
policy required that money market and the sub-
markets of the capital market work
interdependently.
31

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Business Cycle

Business Cycle
– The Business Cycle is a periodic but irregular
up-and-down movement in the economic
growth.
• Basic purpose of macroeconomics is to
explain how and why economies grow and
what causes recurrent ups and downs
– How stable is a market-driven economy?
– What forces cause instability?
– What, if anything, can the government do to
promote steady economic growth?

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Phases of the Business Cycle

• Recovery
• Progress
• Peak
• Recession
• Depression
• Trough
• The Business cycle is shown in the figure
below

Business Cycle

Peak
Economic growth

0
Time

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Diagram explanation

• The business cycle starts from a trough

(lower point) and passes through a
recovery phase followed by a period of
expansion (upper turning point) and
prosperity. After the peak point is reached
there is a declining phase of recession
followed by a depression. Again the
business cycle continues similarly with ups
and downs.

Trough
• When the economic cycle reaches a
trough:
– Economy “bottoms-out” (reaches lowest point)
– High unemployment and low spending
– Stock prices drop

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Progress or Expansion
• During a period of progress or expansion:
– Wages increase
– Low unemployment
– People are optimistic and spending money
– High demand for goods
– Businesses start
– Easy to get a bank loan
– Businesses make profits and stock prices
increase

Progress
• When there is an expansion of output,
income, employment, prices and profits,
there is also a rise in the standard of living.
This period is termed as Prosperity phase.
• The features of prosperity are :-
• High level of output and trade.
• High level of effective demand.
• High level of income and employment.
• Rising interest rates.
• Inflation.

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Progress
• Large expansion of bank credit.
• Overall business optimism.
• A high level of MEC (Marginal efficiency of
capital) and investment.
• Due to full employment of resources, the
level of production is Maximum and there is a
rise in GNP (Gross National Product). Due to
a high level of economic activity, it causes a
rise in prices and profits. There is an upswing
in the economic activity and economy
reaches its Peak. This is also called as
a Boom Period.

To sustain in the progress

phase
• Control price rise by reducing the
government expenditure and consumption
expenditure.
• Motivate savings
• Continous development in the production
activities

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Peak
• When the economic cycle peaks:
– The economy stops growing (reached the top)
– GDP reaches maximum
– Businesses can’t produce any more or hire
more people
– Cycle begins to contract

Recession or Contraction
• During a period of recession or
contraction:
– Businesses cut back production and layoff
people
– Unemployment increases
– Number of jobs decline
– People are pessimistic (negative) and stop
spending money
– Banks stop lending money

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Recession
• The economic activities slow down.
• Demand starts falling, the overproduction
and future investment plans are also given
up.
• Steady decline in the output, income,
employment, prices and profits.
• The businessmen lose confidence and
become pessimistic (Negative). It reduces
investment.

Recession
• The banks and the people try to get
greater liquidity, so credit also contracts.
• Expansion of business stops, stock market
falls. Orders are cancelled and people
start losing their jobs.
• The increase in unemployment causes a
sharp decline in income and aggregate
demand. Generally, recession lasts for a
short period.

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Measures to overcome recession

• Government should give subsidy to business
firms to increase the output
• Encourage foreign investments (FII,FDI)
• Increase export subsidies
• Encourage research and development for
technology upgradation
• Reduce interest rate for improving
investments and increasing the credit
creation for the commerical banks
• Encourage development of small scale
industries

Depression
• When there is a continuous decrease of
output, income, employment, prices and
profits, there is a fall in the standard of
living and depression sets in. A recession
of more than one year is called a
depression.
• The features of depression are :-
• Fall in volume of output and trade.
• Fall in income and rise in unemployment.
• Decline in consumption and demand.

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Depression
• Fall in interest rate.
• Deflation.
• Contraction of bank credit.
• Overall business pessimism.
• Fall in MEC (Marginal efficiency of capital)
and investment.
• There is under-utilization of resources and
fall in GNP (Gross National Product). The
aggregate economic activity is at the lowest,
causing a decline in prices and profits until
the economy reaches its Trough (low point)

Measures to over come

depression
• Government should instil confidence
among individual, business firms and
foreign sector
• Price and wage control
• Strict monetary policy by central bank ro
regulate the commercial bank.
• Liberalization, privatisation and
globalisation

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Trough
• When the economic cycle reaches a
trough:
– Economy “bottoms-out” (reaches lowest point)
– High unemployment and low spending
– Stock prices drop

• But, when we hit bottom, no where to go

but up!

Recovery
• The turning point from depression to expansion
is termed as Recovery or Revival Phase.
• During the period of revival or recovery, there
are expansions and rise in economic activities.
When demand starts rising, production
increases and this causes an increase in
investment. There is a steady rise in output,
income, employment, prices and profits. The
businessmen gain confidence and become
optimistic (Positive). This increases investments.
The stimulation of investment brings about the
revival or recovery of the economy.

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Recovery
• The banks expand credit, business
expansion takes place and stock markets are
activated. There is an increase in
employment, production, income and
aggregate demand, prices and profits start
rising, and business expands. Revival slowly
emerges into prosperity, and the business
cycle is repeated.
• Thus we see that, during the expansionary or
prosperity phase, there is inflation and during
the contraction or depression phase, there is
a deflation.

Measures to sustain the

economic growth
• Reduce the lending rate (to increase
investment) and increase the borrowing
rate (to increase the savings)
• Encourage the foreign investment
• Develop the capital market
• Provide the infrastructure facilities to the
business firms and MNCs

11