Numerical Problems

Some problems: Problem I

 Assume a Hyundai dealership in Chicago bought 30 Hyundai
cars from Korea at a cost of $15,000 per car in September,
2012. By March 31, 2013, they had sold 20 of these cars at a
price of $18,000 each. The remaining cars were sold in April of
2013 at a price of $16,000 each. How exactly does this affect
the GDP in the U.S. in 2013 and 2014, and which components
of GDP (C, I, G, or NX) are affected?
Some problems: Problem II
GDP $6000
Gross investment 800
Net investment 200
Consumption 4000
Government purchases of goods and services 1100
Government budget surplus 30

What is:
a. NDP?
b. Net exports
c. Government taxes minus transfers
d. Disposable personal income
Some problems: Problem III
Suppose the consumption function is given by C = 100 +
0.8Y while investment is given by I = 50.
a) What is the equilibrium level of income?
b) What is the level of saving in equilibrium?
c) If for some reason, output is at the level of 800, what will
be the level of involuntary inventory accumulation?
d) If I rises to 100, what will be the effect on the equilibrium
income?
e) What is the value of the multiplier, α, here?
Session 11
Money Demand and Supply

The Demand and Supply for Money

... cont.
Measurement and Components of Money
Supply
 Following the recommendations of the Second Working Group on Money Supply
(SWG) in 1977, RBI publishes the following monetary aggregates i.e. components of
money

 Reserve Money (M0) = Currency in circulation + Bankers’ deposits with RBI +

‘Other’ deposits with RBI**
 Narrow Money (M1) = M0 + Demand deposits* (Current and Savings
Account/ CASA balances) with Banks
 Narrow Money (M2) = M1 + Demand deposits with Post-offices

 Broad Money (M3) = M1 + Time deposits with Banks

 Broad Money (M4) = M3 + Time & Demand deposits with Post-offices

These components include money of differing liquidities

** ‘Other deposits’ are deposits of RBI other than those held with the govt., and include deposits with
foreign central banks and governments, accounts of international agencies such as World Bank, IMF,
etc. These are a very proportion of the total money supply (i.e., usually < 1%).
* CASA is the cheapest source of finance for a commercial bank. These are net demand deposits of the
bank, i.e., excluding inter-bank deposits.
New Monetary Aggregates
 Following the recommendations of a Working Group on Money
(1998) led by Y. V. Reddy, RBI started publishing four new
monetary aggregates:
 There are two basic changes in the new monetary aggregates
 One, since post-offices are not a part of the banking system, post
offices are no longer included in money supply measures
 Two, aggregate deposits should be based on residency basis,
thereby excluding repatriable foreign currency fixed deposits held
by non-residents, such as FCNR deposits from the money supply.
 New Monetary Aggregates
(I) New Monetary aggregates:
 M1 = Currency with the Public + Demand Deposits with the Banking System +
‘Other’ Deposits with the RBI

 NM2 = M1 + Certificates of Deposit issued by Banks + Short-term Time deposits

of residents with a contractual maturity of up to and including one year with the
banking system
 NM3 = NM2 + Long-term Time Deposits of Residents + Call/Term Funding from
Financial Institutions (IDBI, ICICI, IFCI, NABARD, SIDBI, etc.)

* Includes NBFCs having public deposits of more than Rs. 20 crore

Money, Prices and Output Relationship
Quantity Theory of Money

M ×V = P × Y
Money, Prices and Output Relationship
Quantity Theory of Money
 Quantity theory of money is a theory about the connection between
money and prices assuming that the velocity of money is constant

M ×V = P × Y
 where M refers to nominal money supply, P is an index of aggregate
prices in the economy, Y is the real output
 The income velocity of money is the number of times the stock of
money is turned over per year in financing the annual flow of income
 It is equal to the ratio of nominal (real) GDP to the nominal (real)
money stock:

P ×Y Y
V≡ =
M M
P
Money, Prices and Output Relationship
Calculating the Income Velocity
Measuring the:
 Money supply (M) with M1,
 Price level (P) with the GDP deflator, and
 Level of real output (Y) with real GDP, so P×Y is nominal GDP,

We obtain the following value for velocity (V) in 2016:

$18.6 trillion
=V = 5.8
$3.2 trillion

We can always calculate V. But will we always get the same answer? The
quantity theory of money asserts that, subject to measurement error, we
will.
Money and Price Relationship
Classical Quantity Theory
 The quantity equation became the classical quantity theory of money
when it was argued that both V and Y were fixed
V ×M
P=
Y
 The classical quantity theory = theory of inflation

 The classical case assumes real output as fixed because in the

classical case (vertical AS) the economy is at full employment level

 If V and Y are fixed, it follows that the price level is proportional to

the money stock

 In the long run, inflation occurs when the supply of money exceeds the
rise in real incomes or the value of goods and services

 In such a situation, there is ‘too much money chasing too few goods’
Credit Creation
 Fractional-reserve banking & credit creation by commercial banks
 To find out how much money the original $1,000 in currency/
reserves will create, add up all of the deposits that are created:

$1,000 + [0.9 × $1,000] + [(0.9 × 0.9) × $1,000] + 

=
$1,000 + [0.9 × $1,000] + [0.92 × $1,000] + 

= $1,000(1 + 0.9 + 0.92 + )

 1 
= $1,000  
 1 − 0.9 
 1 
= $1,000  
 0.10 
= $1
=,000(10) $10,000
Deposits Multiplier
 1 
=
 $1,000  0.10 
 
= $1,000
= (10) $10,000

So the total increase in deposits is $1,000(10) = $10,000.

 The “10” here is the simple deposit multiplier: the ratio of the
amount of deposits created by banks to the amount of new
reserves
 The deposit multiplier is also referred to as the money multiplier (m)

Money multiplier (or deposit multiplier) = 1/ CRR

So with a 10 percent required cash reserve ratio (CRR), the simple
deposit multiplier is 10
Deposits Multiplier
 Thus, money multiplier (or deposit multiplier)

= 1
Cash Reserve Ratio (CRR)

Change of Money Supply

=
Change of Reserves (M0)
Relationship between Reserve Money and the
Money Stock
In the example we took for understanding fractional reserve banking, we assumed
that all money was held in the form of deposit, i.e., no one held money in the form of
currency. So we can re-define the money multiplier adding currency to both the
monetary base and money supply M3:

The broad money multiplier will be the ratio of reserve money or high-powered
money (M0), which is also known as the monetary base, and money supply (M):

𝐶𝐶 + 𝐷𝐷
𝑀𝑀𝑀𝑀𝑀 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚 =
𝐶𝐶 + 𝑅𝑅

Dividing both numerator and denominator by De:

𝐶𝐶 𝐷𝐷
+
𝑀𝑀𝑀𝑀𝑀 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚 = 𝐷𝐷 𝐷𝐷 = 𝑐𝑐 + 1
𝐶𝐶 𝑅𝑅 𝑐𝑐 + 𝑟𝑟
+
𝐷𝐷 𝐷𝐷

where, cu = Cu/De (currency-deposit ratio) and re = Re/De (reserve-deposit ratio)

Relationship between Reserve Money and the
Money Stock
The money multiplier (mm) is always greater than 1, which implies that any change
in the high-powered money will lead to a larger change in total money supply, that is,

∆M3 = [(1 + cu)/(re + cu)](∆M0) = mm(∆M0)

How to control Money Supply?
 RBI issues currency, which is a small fraction of the total money supply
 RBI cannot directly control money supply i.e. M1, M2, M3, M4 as a
large fraction of the money supply is in the form of bank’s demand/
time deposits that RBI cannot directly determine or control
 Similarly money multiplier (m) is not controlled by the RBI, i.e., it is
not a policy variable
 Thus, RBI ‘controls M0 to control M3’

 Money supply (M) = money multiplier (m) monetary base (M0)

M3
Broad money Multiplier =
Monetary Base(M0)
 Course: Macro Environment of Business

The Role of Banks in the Monetary System

The quantity of money is quite simply defined as the number of Rupees held by the public,
and it is assumed that it is the central bank that controls the supply of money by changing the
number of Rupees in circulation through open-market operations. However, this explanation
is incomplete as it completely ignores the role of the banking system in the process of money
supply (MS) creation.

It is important to understand that it is not just the central bank’s policy that determines money
supply but it is also the behaviour of households (that hold money) and the banking system
(where money is held) that plays a very important role in the process. We know that money
supply (the narrow definition) refers to the reserve money (i.e., currency, banks’ deposits
with the central bank) and demand deposits (i.e., CASA deposits) with the banks. We shall
learn that the banking system together with the central bank’s policy determines the
interaction between currency (C) and demand deposits (D).

MS = C + D

If there were no banks, the quantity of money would simply be the total currency in
circulation with the public. However, in a world of banks, a portion of the deposits received
by the will be given out as loans, for example, to families for buying cars or houses, or to
firms for investing in new plant and machinery. The remaining portion of the deposits that
banks receive but do not lend further is known as reserves. These reserves are held at the
central bank, or at the vaults of local banks throughout the country. In a world where banks
hold 100 percent of their deposits as reserves, the banking system will have no role in
influencing the money supply. However, since banks earn interest income through loans, they
have an incentive to lend. Thus, as a practice, banks keep only a fraction of their total
deposits as reserves that can act as a buffer if depositors want to make withdrawals. This
system is called as fractional-reserve-banking.

Assume that households make deposits of Rs. 1000 with Bank A and the reserve requirement
is 100 percent. In other words, Bank A makes no loan using the cash it receives against these
deposits. This would reflect in bank A’s balance sheet in the following way:

Bank A (100 percent reserves)

Assets (in Rs.) Liabilities (in Rs.)
Reserves 1000 Deposits 1000

Now let us assume that the reserve-deposit ratio (rr) is 20 percent, and see how it impacts the
balance sheet of Bank A when it accepts deposits and also makes a loan:

1
 Bank A (fractional-reserve banking)
Assets (in Rs.) Liabilities (in Rs.)
Reserves 200 Deposits 1000
Loans 800

Before Banks A makes a loan, the money supply (MS) was Rs. 1000. However, as the bank
makes a loan, the total MS rises to Rs. 1800, as the existing depositor still holds a deposit of
Rs. 1000, while the borrower receives Rs. 800 in currency. In other words, in the fractional-
reserve-banking system, banks create MS. However, MS creation does not stop with Bank A.
If the borrower deposits Rs. 800 in another bank, say Bank B, the process of money supply
creation would continue. The balance sheet of Bank B would look like this:

Bank B
Assets (in Rs.) Liabilities (in Rs.)
Reserves 160 Deposits 800
Loans 640

Bank B receives deposits of Rs. 800 and lends out Rs. 640 after keeping reserves of Rs. 160
at rr = 20%. Thus, Bank B creates MS of Rs. 640, and the total MS has now grown to Rs.
2440, i.e., Rs. 1800 (from the previous round) and Rs. 640 (by Bank B). If the borrower of
Rs. 640 loan deposits this sum at another Bank C, which in turn keeps 20% x Rs. 640 i.e., Rs.
128 as reserves and lends out the remaining Rs. 512, this is how the balance sheet of Bank C
will look like:

Bank C
Assets (in Rs.) Liabilities (in Rs.)
Reserves 128 Deposits 640
Loans 512

This process will go on and on. With each deposit and loan made, more money is created in
the economy. The process can continue forever but the total MS created can be calculated
easily as a finite quantity:

Initial deposit = Rs. 1000

Bank A = (1 – rr) x Rs. 1000

Bank B = (1 – rr)2 x Rs. 1000

Bank C = (1 – rr)3 x Rs. 1000

Total MS created = [1 + (1 – rr) + (1 – rr) + (1 – rr)….] x Rs. 1000

= 1/rr

Thus, if the reserve ratio, i.e., say, the cash reserve ratio prescribed the central bank is 20
percent, so the original Rs. 1000 deposit generates an MS of Rs. 5000.

2
It is to note that there are many financial institutions that facilitate allocation of savers money
to borrowers in the economy through a process called financial intermediation. However,
only banks have the ability to create checkable assets that form a part of the money supply.

Bank’s ability to lend: the role of capital requirements

There are certain factors that affect a bank’s ability to make loans. For example, it is true that
a bank primarily accepts deposits to make loans. However, banks also maintain some capital
that represents the equity of the bank’s owners. Bank capital serves as the resources required
to operate it. Therefore, any realistic bank’s balance sheet looks like the following:

Bank A
Assets (in Rs.) Liabilities (in Rs.)
Reserves 200 Deposits 750
Loans 500 Debt 200
Securities 300 Capital (owner’s equity) 50

A bank’s resources are made up by its capital from its owners, deposits from its customers,
and debt from its investors. In terms of use, these resources are used either to hold reserves,
or to make loans, and some are used to buy financial securities such as government bonds,
corporate bonds, etc. Banks undertake the decision to allocate their resources among different
asset classes such as these based on risk and return considerations and any financial
regulations that restrict the bank’s choices.

Bank’s leverage: We know that stated generally, leverage refers to the use of borrowed
money to supplement a business firm’s existing funds. A banking firm’s leverage is the
proportion of bank’s total assets (the total of the left hand side of the bank’s balance sheet) to
the bank’s capital. For Bank A, the leverage ratio will be Rs. 1000 (total assets) divided by 50
(capital) = 20. This suggests that for every 1 Re of its invested capital, the bank has assets of
Rs. 20, or deposits and debt of Rs. 19.

Why do financial regulators prescribe capital requirement norms for banks?

Consider that a portion of Bank A’s loan holders have defaulted, and consequently the value
of the bank’s assets 1 falls by 5 percent to Rs. 950. As the bank’s debt holders (i.e., providers
of debt to the bank) and depositors have the legal right to be paid first, the owner’s equity
capital would fall by Rs. 50. If due to some reason, the bank’s assets lose value by more than
5% or more than Rs. 50, bank capital would fall below zero, i.e. the banking entity would
have to be declared insolvent. Depositors realise that if their bank’s capital runs out and there
is no deposit insurance, they may not be repaid in full. This creates a sense of panic among
deposit holders leading to bank runs when there is no deposit insurance.

Bank runs can be extremely damaging for an economy. To prevent their possibility and
safeguard deposit holder’s interest, financial regulators require that banks hold sufficient
capital. For example, the Basel Committee on Banking Supervision under the Bank for
1
Note that the loans made by a bank are a part of its total assets in the balance sheet.

3
International Standards in Basel, Switzerland has implemented the Basel Accord, which deals
with various norms on capital requirements by banks across the world. The accord was
adopted by more than 100 countries including India. Currently, Basel-III norms are being
implemented by Indian banks. As a part of Basel-III guidelines, banks in India are required to
maintain a capital to risk-weighted assets ratio of 9 percent. Further, in India, financial
supervision and regulation of the financial sector (including those of banks and non-banking
financial companies) is undertaken by the Department of Regulation at the RBI.

4
 Course: Macro Environment of Business

Key Policy Rates of the RBI

To impact interest rates, the RBI employs a variety of key policy rates. The bank rate, the
repo rate, the reverse repo rate, the cash reserve ratio (CRR), and the statutory liquidity ratio
(SLR) are the key policy or 'signalling' rates used by the RBI. When there is more money in
the economy, or when too much money is chasing the same or fewer goods and services, the
RBI raises its main policy rates. When there is a liquidity constraint or a recession, on the
other hand, the RBI would cut its key policy rates to infuse more money into the economy.

1. Repo Rate (repurchase rate): It is the rate at which the Reserve Bank of India
makes loans to banks for brief periods of time. RBI uses the repo rate to pump money
into the system. This is accomplished by the RBI purchasing government bonds from
banks in exchange for a promise to sell these bonds back to the bank at a
predetermined rate. If the central bank wants to make borrowing money more
expensive for banks, it raises the repo rate. Similarly, if it wants to make borrowing
money cheaper for banks, it lowers the repo rate. It is simply a short-term liquidity
adjustment facility (LAF).

It's crucial to understand how the RBI's policy repo rate operates under LAF. It is not
a channel through which banks can obtain clean funds from the RBI in order to lend
to their clients. Rather, it's a channel through which the RBI can fund excess
government securities held by banks that exceed statutory restrictions. It allows banks
to put their deposits to better use by allowing them to lend. As a result, at a systemic
level, bank loans and statutory assets are funded by the bank's own capital and client
deposits, rather than obtaining funds from the RBI through the repo window. As a
result, bank deposit rates and/or the cost of capital must fall in order for loan interest
rates to fall.

2. Reverse-repo Rate: This is the interest rate at which the central bank borrows money
from other banks over a short-term. Reverse repo offers a mechanism by which the
central bank removes liquidity from the financial sector. The RBI sells government
bonds to banks with the promise to buy them back at a later date, similar to the repo.
The reverse repo facility allows banks to deposit and receive interest on short-term
excess cash with the central bank. By increasing the rate at which it borrows from
banks, RBI can limit liquidity in the financial sector. The increase in the repo and
reverse repo rates reduces liquidity and raises interest rates.

3. Marginal Standing Facility: This is the emergency lending window for banks that
do not have surplus government securities or have reached their repo borrowing
limits. The RBI had capped the amount that banks could borrow under overnight
repos at 0.25 percent of bank-wise net demand and time liabilities (NDTL) at the LAF
repo rate. Further, liquidity under 14-day term repos as well as longer term repos of
up to 3 percent of the banking system's NDTL through auctions as part of its measures

1
 with a view to providing comfort to banks on their liquidity requirements on March
27, 2020, and the same guidelines continue till date.

4. Cash Reserve Ratio: The CRR is the amount of funds that banks must deposit with
the RBI. All Scheduled Commercial Banks must maintain the required CRR based on
their net demand and time liabilities (NDTL) as on the previous fortnight's last Friday.
If the RBI decides to raise the CRR, the quantity of funds available to banks for
making loans will decrease. To impound surplus liquidity, the central bank raises the
CRR. CRR accomplishes two goals: first, it ensures that a part of bank deposits is
always accessible to fulfil withdrawal demand, and second, it allows the RBI to
regulate liquidity in the system, and hence inflation, by preventing the bank’s from
lending money. The rate of interest on CRR accounts is tied to the Bank Rate, which
is released by the RBI on a regular basis.

5. Statutory Liquidity Ratio: SLR refers to the minimal percentage of deposits that
banks are required to maintain in the form of gold, cash, government bonds, or other
recognised securities at the end of each business day. This is in addition to keeping a
portion of deposits with RBI as cash (i.e., referred to as the CRR). As on November
26, 2021, the SLR in India is 18 percent. To reach the mandated ratio, banks in India
invest in government bonds that have been notified by the RBI as qualifying for SLR.
An increase in the SLR requirement diminishes banks' lendable resources and raises
interest rates in times of high growth.

6. Bank Rate: The bank rate, unlike other policy rates, is merely a signalling rate, and
most interest rates are unrelated to it. The bank rate is also the indicative rate at which
the Reserve Bank of India loans money to other banks (or financial institutions). The
bank rate reflects the central bank's long-term interest rate expectation. Long-term
interest rates tend to rise when the bank rate rises, and vice versa.

2
 Concept Note 3

Monetary Transmission in India

Monetary Transmission Mechanism

Monetary policy predominantly works through its influence on aggregate demand (AD) in the
economy. Monetary policy changes affect various macroeconomic aggregates such as
aggregate investments, consumption, etc. in the short to medium term. However, in the long
run, monetary policy also determines the nominal or money values of goods and services, that
is the general price level. Monetary policy decisions affect economic activity and inflation
through several channels collectively known as the “transmission mechanism” of the
monetary policy. The effect of monetary policy on the economy is, however, not
instantaneous. The speed and strength at which the central bank’s policy rate changes traverse
to the entire economy vary widely from country to country depending upon the state of the
financial system.

 A critical topic concerning monetary policy is, in fact, the lags at which the central
bank’s policy rate cuts get transmitted to the rest of the economy
 Studies have shown that the real economy feels monetary policy actions of the central
bank with a lag of 2-3 quarters on output (Y) and with a lag of 3-4 quarters on
inflation (prices) and the impact usually lasts much longer, usually 2-3 years

Channels of Monetary Policy

There are four channels of transmission through which monetary policy affects AD:

The interest rate channel: This channel represents the traditional view, which suggests that
monetary policy affects AD primarily through interest rates. Each time RBI changes its key
policy rates, the immediate impact is realized on short-term money market rates, i.e., call
money rate, certificates of deposits, commercial papers, treasury bills. Changes in short-term
money market rates are followed by an impact on medium and long-term instruments, i.e.,
yields on government securities and corporate bonds. Policy rate cuts are undertaken with the
expectation that there will be a reduction in the bank’s cost of funds, in turn, in their lending
rates and the broad spectrum of market interest rates.

The credit channel: Lower lending interest rates of banks provide a boost to the demand for
bank credit from various segments of the society, for instance, from individuals and
households for loans for consumer durables (such as automobiles) and housing; and from
entrepreneurs for new or increased investment in plant and machinery. Increased demand for
automobiles, housing, and machinery generates increased demand for the inputs, including
labour in these industries, increasing the AD, incomes, and output in the economy. As this
process continues, it eventually puts upward pressure on labour wages and inputs prices,
hence raising inflation. Thus, a central bank that aims to maintain stable prices and high
economic growth faces a trade-off while lowering or raising its policy rate. The implicit
assumption behind bank lending or the credit channel of transmission is that bank balance
sheets are strong and able to quickly step up the supply of credit in response to lower funding
costs and higher demand for credit.

The asset price channel: Lower interest rates also boost asset prices such as housing and
equity prices since these can now be purchased at cheaper borrowing costs. Higher asset
prices boost household wealth and raise consumer spending in the economy, which

1
wouldultimately impact AD positively. This is the asset price channel of monetary
transmission. Higher asset prices can also enhance the value of the collateral or net worth of
the borrowers, interacting with the bank lending or credit channel, enhancing their capacity to
borrow more, further strengthening investment and AD in the economy.

Exchange rate channel: Finally, lower domestic interest rates could lead to a depreciation of
the domestic currency. On one hand, this makes exports more competitive in the global
market, adding to domestic demand and economic activity. On the other hand, this could also
raise the domestic currency prices of imported inputs, making imports (for example, crude
oil) costlier. This is the exchange rate channel of transmission.

All the channels described above – the interest rate channel, the bank lending or credit
channel, the asset price channel, and the exchange rate channel – are not stand-alone
channels. Instead, these work at the same time and may reinforce or interact with each other.

Transmission from Policy Rate to Bank Lending Rates: Issues in India

The transmission from policy rate changes to bank lending rates has remained slow and
muted in India. The lack of adequate monetary transmission remains a key policy concern for
the Reserve Bank as it blunts the impact of its policy changes on economic activity and
inflation. Ever since the deregulation of interest rates in the early 1990s (i.e., leaving the
interest rates to the marks, banks, financial, the RBI has made several attempts to increase the
effectiveness of the monetary pass-through by refining the process of setting lending
interest rates by banks

 In India, as in several other countries, a large proportion of loans is given by banks at

floating rates that are linked to some “benchmark rate” (which ideally varies over
time in line with the changing macroeconomic and financial conditions and, in
particular, with the central bank’s policy rate)

 Banks also charge a spread and the actual lending rate is the benchmark plus the
spread

 The benchmark could be internal or external; an internal benchmark will be based on

elements that are in part under the control of the bank, such as cost of funds, while an
external benchmark is outside the control of the bank (for example, it could be
market-determined rate such as Treasury Bill rate or Inter-Bank Offer Rate, or it could
simply be the central bank’s policy rate)

 The advantage of an external benchmark is that it is transparent and common across

banks. Besides, borrowers can compare various loan offers by simply comparing
spreads over the benchmark (all else, such as maturity of the loan, being equal)

 As market rates typically move in line with the central bank’s policy rate, an external
benchmark is globally considered and adopted as more appropriate than an internal
benchmark for transmitting monetary policy signals

 In India, because of the less than desired performance of the internal benchmarks
lending rate system (i.e., marginal cost of funds based lending rate or MCLR), there
was a need to shift to an external benchmarks lending rates system

2
 Thirteen possible market-determined interest rates were assessed as possible
candidates for a good external benchmark in India

 Finally, three rates were recommended: Treasury bills rates, certificate deposit rate,
RBI’s policy repo rate (retrospectively, since April 1, 2018)

 Besides, the decision regarding the spread over this external benchmark rate has been
left to the discretion of the bank. But the spread remains fixed over the term of the
loan

 Moreover, to reduce the rigidity of the deposits rate, banks were advised to accept
bulk deposits at floating interest rates that are also linked to the selected external
benchmarks

 So the cost of funds is going to be adjusted quickly with repo rate changes. This
would help in improving the monetary transmission

3
Sessions 12 – 13
Money, Interest and Income

The IS-LM Model

What is the IS-LM model?
 A general equilibrium model
 The model of output determination is incomplete without linking
money and interest rate with output
 Money and interest rate are determinants of AD
 Central bank does play a role in determining output and income
 Real (goods market) and monetary (money market) sectors are
not watertight compartments
 IS-LM provides the framework for achieving equilibrium in goods
and money markets and simultaneous determination of interest
rate and output
How are money and output related?
 Monetary policy works through the money market to affect output
and employment
 The composition of aggregate demand between I and C spending
depends on the interest rate
 Interest rate changes have an important side effect
 An expansionary fiscal policy tends to raise consumption through
the multiplier but tends to reduce investment because it increases
interest rates
 Pump priming will crowd out private investment
Structure of the IS-LM model
What is the IS curve?
 The IS curve is the schedule of combination of interest rate (i)
and Y such that the goods market is in equilibrium
 The IS curve is negatively sloped because an increase in the i
reduces planned I spending and therefore reduces AD, thus
reducing the equilibrium level of Y
 The smaller the multiplier and the less sensitive I spending is to
changes in the interest rate, the steeper the IS curve
 The higher the MPC, the flatter is the IS curve
 The IS curve is shifted by changes in autonomous spending. An
increase in autonomous spending, including G, shifts the IS
curve out to the right
Investment Function
Investment demand schedule

 Investment demand depends on the annual revenue

from an investment and cost of capital (i.e., interest
rate)
 Investment demand schedule is a downward sloping
function of interest rate
Investment and the Interest Rate
The investment spending
function can be specified as:
I = I − bi

where b > 0
i = rate of interest
b = responsiveness of
investment spending to
the interest rate
I = autonomous
investment spending
Investment Function
The position of the I schedule is determined by:

 The slope b
 If investment is highly responsive to i, the investment schedule is
almost flat
 If investment responds little to i, the investment schedule is close to
vertical
 Level of autonomous spending
 An increase in shifts the investment schedule out
 A decrease in shifts the investment schedule in
The Goods Market
 In the multiplier model, stock of money, interest rate and RBI
have no place.
 The model therefore needs to be broadened by introducing
interest rate as an additional determinant of aggregate
demand. The AD function can be modified to reflect the new
planned investment spending schedule
AD = C + I + G + NX
= [C + cT R + c(1 − t )Y ] + ( I − bi ) + G + NX
= A + c(1 − t )Y − bi
=
Interest Rate and AD: The IS Curve
 We can also derive the IS curve using the goods market
equilibrium condition:

Y = AD = A + c(1 − t )Y − bi ⇒
Y − c(1 − t )Y = A − bi
Y (1 − c(1 − t )) = A − bi
Y = αG ( A − bi )
1
where αG =
(1 − c(1 − t ))
The Slope of the IS Curve
 The steepness of the IS curve depends on:
 How sensitive investment spending is to changes in i
 The multiplier, αG

 Suppose investment spending is very sensitive to i → the

slope, b, is large
 A given change in i produces a large change in AD (large
shift)
 A large shift in AD produces a large change in Y
 A large change in Y resulting from a given change in i → IS
curve is relatively flat

 If investment spending is not very sensitive to i, the IS curve is

relatively steep
The Slope of the IS Curve
 The figure on the next slide shows AD curves corresponding to
different multipliers

 The MPC or the multiplier on the solid black AD curve is less

than the MPC or the multiplier on the dashed AD curve

 A given reduction in i1 to i2 raises the intercept of the AD curves

by the same vertical distance

 Because of the different multipliers, income rises to Y’2 on the

dashed line and Y2 on the solid line

 As it appears in the graph, larger the MPC or multiplier, flatter

the IS (meaning that a given change in interest rates would
result in larger changes in Y)
The Role of the Multiplier
 The larger the sensitivity of investment spending to the
interest rate and the larger the multiplier, the flatter the
IS curve
 This can be seen in the following equation that we solve
for i:
Y = α G ( A − bi )
Y − α G A = −α G bi
Y − αG A
i=
− αG b
A Y
= −
b αG b
 Hence, the slope of the IS curve is =
What is the LM curve?
 The LM curve is the schedule of combination of i and Y such that
money market is in equilibrium.
 Money market equilibrium implies that an increase in i is accompanied
by an increase in Y. An increase in i reduces the demand for real
balances. To maintain the demand for real balances equal to the fixed
supply, the level of Y has to rise.
 The LM curve is positively sloped. Given the fixed money supply, an
increase in Y which increases the quantity of money demanded, has to
be accompanied by an increase in the i.
 The LM curve is steeper when the demand for money responds
strongly to Y and weakly to i, i.e., when k is high and h is low.
 The LM curve is nearly vertical if the demand for money is relatively
insensitive to the i. If the demand for money is very sensitive to i, the
LM curve is close to horizontal.
 The LM curve is shifted by changes in the money supply. An increase in
the money supply shifts the LM curve to the right.
What Determines Interest Rate?
Demand for Money (Liquidity Preference Framework):

 Transactions Demand for Money:

 Precautionary Demand for Money:

 Speculative Demand for Money:

 Real Balance Equation:

Supply of money (Ms): Ms is exogenous

Money market equilibrium, Md=Ms

 What is the LM curve?

i2 i2

L2=kY2 - hi

i1
i1

L1=kY1 - hi
Equilibrium in the Goods and Money Market
 The IS and LM schedules
summarize the conditions that
have to be satisfied for the
goods and money markets to
the in equilibrium
 Assumptions:
 Price level is constant
 Firms are willing to supply
whatever amount of output
is demanded at that price
level
IS-LM Question 1
Assume the following IS-LM model:
Expenditure sector: Money sector:
Sp = C + I + G + NX M = 500
C = 110 + (2/3)YD P =1
YD = Y - TA + TR md = (1/2)Y + 400 - 20i
TA = (1/4)Y + 20
TR = 80
I = 250 - 5i
G = 130
NX = -30
Calculate the equilibrium values of private domestic investment (I), tax revenues
(TA), and real money demand (md).
Solution 1
Y = 1,000 - 10i IS-curve
 Y = 200 + 40i LM-curve
 i = 16 ==> Y = 840
 I = 250 - 5*16 = 170 and TA = (1/4)840 + 20 = 230
Deriving the AD Schedule
 The AD schedule shows the IS-LM
equilibrium, holding autonomous
spending and the nominal money
supply constant and allowing prices to
vary
 Suppose prices increase from P1 to P2
 M/P will decrease from M/P1 to
M/P2 and hence LM shifts from
LM1 to LM2
 Interest rates increase from i1 to
i2, and output falls from Y1 to Y2
 Corresponds to lower AD
Deriving the AD Schedule
 Derive the equation for the AD curve using the equations for
the IS-LM curves:
IS : Y = αG ( A − bi )
1 M
LM : i =  kY − 
h P 
 Substituting LM equation into the IS equation:

 b M 
Y = αG  A −  kY − 
 h P  (1)

hαG bαG M
= A+ (2)
h + kbαG h + kbαG P
bM
= γA + γ
h P
Deriving the AD Schedule
hαG bαG M
Y= A+ (3)
h + kbαG h + kbαG P

 The above equation is the AD schedule:

 It summarizes the IS-LM relation, relating Y and P for
given levels of autonomous spending and nominal
balances
 Since P is in the denominator, AD is downward sloping

 It shows that AD depends upon:

 Autonomous spending i.e. higher the level of
autonomous spending, higher is the income
 Real money stock i.e. higher the stock of real balances,
higher is the income
Session 14
Monetary Policy

Monetary Policy
Introduction
Now we use the IS-LM model to show how monetary and
fiscal policy work
 Fiscal policy has its initial impact in the goods market
 Monetary policy has its initial impact mainly in the assets
markets
 Because the goods and assets markets are interconnected,
both fiscal and monetary policies have effects on both the
level of output and interest rates
 Expansionary/contractionary monetary policy moves the LM
curve to the right/left
 Expansionary/contractionary fiscal policy moves the IS
curve to the right/left
Monetary Policy
 RBI is responsible for monetary policy in India
 The RBI affects money supply by performing open market
operations or by impacting key policy rates
 Open market operations refers to buying and selling of
government bonds
 RBI buys bonds in exchange for money. This increases
the stock of money in the economy
 RBI sells bonds in exchange for money paid by
purchasers of the bonds. This reduces the money stock
in the economy
How are Interest Rates Determined
Combining the Demand and Supply of Money
 An open market purchase shifts the supply of money to the right and
leads to lower interest rates, and vice versa

 Central bank determines the money supply, changing interest rates and
Investment, thereby affecting GDP, i.e., That is, when Ms ↑  i ↓  I ↑
 AD ↑  Y ↑
Money, Output and Prices
 Monetary Policy and Output
Open market purchase by RBI LM

interest LM1
The effects of a monetary rate
expansion can be
described (adjustment 1/k (∆M/P)
process) as follows: ri00 e1
ms ↑  i ↓  I ↑  Y ↑  ri11 e3
md ↑  i ↑  offsetting
impact on I until e3 is
reached e2

Effect: Y ↑ and i ↓. IS
Y0 Y1 Output
• Increased money supply reduces interest rate and thereby increases investment
• The steeper the LM schedule, the larger the change in output
Monetary Policy
Adjustment to the monetary expansion:
 Increase in money supply creates excess supply of money
 Public buys other assets
 Asset prices increase and yields decrease from point e1 to
point e2
 Decline in interest rate results in increased investment
spending, and hence increased aggregate demand
 Output expands and moves up the LM’ schedule to finally
reach point e3
Monetary Policy
Open Market operations (including
Repo & Reverse Repo)
INSTRUMENTS Marginal Standing Facility (MSF)
Bank Rate
Statutory Reserve Requirements (CRR)
Secondary Reserves (SLR)
RBI’s Credit to Development Banks
INTERMEDIATE Moral Suasion
TARGET
Exchange Rate
Money Supply
Interest Rate

ULTIMATE Stable Prices

Low Unemployment
OBJECTIVES
Rapid Growth of GDP
Monetary Policy
 The Fed is ultimately concerned with the overall performance
of the economy
 Achieving economic stability, however, is fairly difficult for the
Fed, since long lags exist between policy actions and their
desired effects on the economy
 Thus the Fed uses immediate and intermediate targets as
measures of progress toward its ultimate targets
Monetary Policy Instruments
 Among the three tools (instruments) of the monetary policy, open market
operations are used most often for obvious reasons
 They can be implemented on any business day, they affect the monetary base
(high-powered money) directly and to the desired degree, and any change in
bank reserves arises directly from the Fed's initiative
 Contrastingly, the Fed is not always able to accurately predict the exact change
that will result in bank reserves as a result of discount rate changes, since it
cannot predict how commercial banks will react
 Discount rate (the rate that the Fed charges banks for its loans in the US) and
Federal funds rate (the rate one bank charges another one for a loan in the US)
 Rather than the level of the discount rate, the difference between the discount
rate and the federal funds rate is more important for the Fed in controlling money
supply
 Reserve requirement changes are made very infrequently, since they have a
direct effect on the money multiplier and thus significantly affect money supply
The Monetary Transmission Mechanism
Monetary Transmission Channels
 The Interest Rate Channel
 The Credit or Lending Channel
 The Asset Price Channel
 The Exchange Rate Channel

(Refer to the concept note)

Monetary Policy Channels
The mechanism below is the interest rate/ credit channel of monetary policy
transmission:
Money Supply (Ms) ↑  interest rates ↓  Investment Spending ↑  AD ↑
Y↑
We also discussed how changes in Ms alter the entire spectrum of interest rates ranging from
call money rates, CDs of banks to bond yields

An asset price channel would work as follows:

Ms ↑  interest rates ↓  asset prices ↑  household wealth ↑  C ↑ 
AD ↑  Y ↑
Alternatively, or, at the same time:
Ms ↑  interest rates ↓  asset prices ↑  collateral /net worth of the
borrowers ↑  bank credit ↑  I ↑  AD ↑  Y ↑ Bond yields (i.e., bond interest rates) ↓
following a fall in the monetary rates 
bond price↑ (yields and prices on assets
are inversely related). Thus, wealth (bond
Next, look at the exchange rate channel: price x no. of bonds held) ↓

Ms ↑  interest rates ↓  (uncovered interest rate parity) capital

outflows  exchange rate depreciation  exports (X) ↑  AD ↑  Y ↑
Monetary Transmission
 The effect of monetary policy on the economy is not
instantaneous
 The speed and strength at which central bank’s policy rate
changes traverse to the economy varies widely from country to
country as well as on the state of the financial system
 In fact, a very important topic on monetary policy is the lags at
which central bank’s policy rate cuts get transmitted to the rest
of the economy
 Monetary policy actions of the central bank are felt by the real
economy with a lag of 2-3 quarters on output (Y) and with a
lag of 3-4 quarters on inflation (prices) and the impact usually
lasts much longer, usually 2-3 years
Sessions 15-16

Monetary and Fiscal Policies

Monetary Transmission Issues in India
 In India, as in several other countries, a large proportion of
loans is given by banks at floating rates that are linked to
some “benchmark rate” (which ideally varies over time in line
with the changing macroeconomic and financial conditions and,
in particular, with the central bank’s policy rate)
 Banks also charge a spread and the actual lending rate is the
benchmark plus the spread
 The benchmark could be internal or external; an internal
benchmark will be based on elements that are in part under
the control of the bank, such as cost of funds, while an
external benchmark is outside the control of the bank (for
example, it could be market-determined rate such as Treasury
Bill rate or Inter-Bank Offer Rate, or it could simply be the
central bank’s policy rate)
Monetary Transmission Issues in India
 The advantage of an external benchmark is that it is
transparent and common across banks. Besides, borrowers can
compare various loan offers by simply comparing spreads over
the benchmark (all else, such as maturity of the loan, being
equal)
 As market rates typically move in line with the central bank’s
policy rate, an external benchmark is globally considered and
adopted as more appropriate than an internal benchmark for
transmitting monetary policy signals
 In India, because of the less than desired performance of the
internal benchmarks lending rate system (i.e., marginal cost of
funds based lending rate or MCLR), there was a need to shift to
an external benchmarks lending rates system
 Thirteen possible market-determined interest rates were
assessed as possible candidates for a good external benchmark
in India
Monetary Transmission Issues in India
 Finally, three rates were recommended: Treasury bills rates,
certificate deposit rate, RBI’s policy repo rate (retrospectively,
since April 1, 2018)
 Besides, the decision regarding the spread over this external
benchmark rate has been left to the discretion of the bank. But
the spread remains fixed over the term of the loan
 Moreover, to reduce the rigidity of the deposits rate, banks
were advised to accept bulk deposits at floating interest rates
that are also linked to the selected external benchmarks
 So the cost of funds is going to be adjusted quickly with repo
rate changes. This would help in improving the monetary
transmission
When Monetary Transmission Fails Through the
Conventional Channel
The Liquidity Trap
 Liquidity trap is a situation in which the public is prepared, at
a given interest rate, to hold whatever amount of money is
supplied
 This implies that LM curve is horizontal i.e. changes in the
quantity of money do not shift it or, liquidity easing through
OMO has no effect on i and Y
 Slope of a horizontal LM is zero (i.e. small k and large h)
 In this situation, monetary policy has no impact on either the
interest rate or the level of income i.e. monetary policy is
powerless!
 Possibility of a liquidity trap at low interest rates is a notion
that grew out of the theories of English economist John
Maynard Keynes
 Liquidity trap occurs when money demand
function is horizontal: a change in the money
supply fails to impact the interest rates

Recall Md = kY – hi
ΔMd/ Δi = h
i.e., Δi / ΔMd = 1/h (slope of Md)
Or, reciprocal of h
i0 i0
Liquidity trap occurs when slope
of the Md = 0, i.e., when 1/h  0
i2 ori2when h∞

Real money balances Real money balances

Liquidity trap

A horizontal money demand function will result in a horizontal LM

curve
Monetary System
The role of the banking system in Ms creation

Indian Banking Sector Problems

Is there in fact a Four Balance Sheet problem in India? https://economictimes.indiatimes.com/budget-

faqs/what-is-four-balance-sheet-problem/articleshow/73550470.cms
How to control Money Supply?
 The reserve ratio is affected by both the trade-off that banks
face between profitability and safety and by changes in
banking regulations
 The payment habits of the public and the convenience and cost
of obtaining cash determine how much currency is held relative
to bank deposits
 One can clearly see that the money multiplier increases as the
reserve ratio or the currency-deposit ratio decreases
 This implies that the Fed can control money supply only
indirectly by influencing bank reserves through its control of
high-powered money (the monetary base)
 Therefore the stability of the money multiplier is crucial to the
Fed's ability to control money supply
 But the money multiplier is neither constant nor predictable
and can be greatly reduced, for example, by runs on banks
(and subsequent bank failures) like those that occurred in the
1930s.
When Monetary Transmission Fails Through the
Conventional Channel
Banks’ Reluctance to Lend
 The second situation that renders monetary policy powerless to
alter the economy is the reluctance of banks to lend

 Despite lower interest rates and increased demand for

investment, banks may be unwilling to make the loans
necessary for the investment purchases
 This breaks down the monetary transmission mechanism

 If banks made prior bad loans that are not repaid then they
may become reluctant to make more loans despite demand.
Banks may prefer instead to lend to the government (safer)

Money Multiplier is negatively impacted! Hence, Ms changes

are less than desired
When Monetary Transmission Fails Through the
Conventional Channel
Banks’ Reluctance to Lend
 In 1991, after unsuccessfully lowering the discount rate 15
times, the Fed finally lowered reserve requirements in its
attempt to stimulate the economy
 However, banks still did not respond immediately by extending
credit, since they were still a suffering from earlier losses
(many from commercial real estate loans)
 Instead banks purchased government securities in an
effort to reduce risk and increase earnings
 It should be noted, however, that the Fed may have had a dual
purpose in mind when it lowered reserve requirements
 The lowering of the reserve requirement freed up reserves,
which banks invested in interest-earning government securities
 At the time, no interest was paid on reserves held at the Fed,
so banks could increase profits this way while simultaneously
lowering their portfolio risk
Banking System Health and Effective
Monetary Transmission
 Runs on banks lead to disintermediation, that is, the inability of
banks to make loans to businesses or consumers
 This results in a severe contraction of money supply that can
then lead to a severe economic downturn like the Great
Depression of the 1930s
 During the Great Recession of 2007-09, banks sharply
increased their excess reserve holdings and, as a result, the
money multiplier decreased
 The Fed did massive intervention in credit markets by buying
large amounts of assets from financial institutions, resulted in
a dramatic increase in the monetary base, yet this was not
reflected in an equivalent increase in M-2
The Classical Case
 The opposite of the horizontal LM curve is the vertical LM
curve
 It implies that monetary policy has maximal effect on the
level of income and fiscal policy has no effect on income
 Demand for money is entirely unresponsive to the interest rate
M
= kY − hi
P
M = k(P ×Y ) (if h=0)

Does the equation look familiar?

 The vertical LM curve is called the classical case

 The classical case (i.e. the quantity theory of money) that
nominal GDP depends only on the quantity of money
The Classical Case
 When the LM curve is vertical, a given change in the quantity
of money has a maximal effect on the level of income
 Shifts in the IS curve do not affect the level of income
 Thus, vertical LM curve implies the comparative effectiveness
of monetary policy over fiscal policy
 “Only money matters” for the determination of output
 It requires that the demand for money be irresponsive to i
i.e. h is equal to zero
 Thus, the size of h is an important issue in determining the
effectiveness of alternative policies
 Fiscal Policy and Output
An increase in Govt. Spending
LM
Interest
rate

Crowding out
occurs when
expansionary e3
fiscal policy r1 The effect of crowding out
causes interest
rates to rise, r2 e2
thereby reducing e1
private investment
IS1
IS

Y0 Y1 Output
 Fiscal Policy and Output
An increase in Govt. Spending
LM
Interest
- If G increase, rate
equilibrium moves to
from E’ to E”
- The goods market is in
equilibrium at E”, but the e3
money market is not: r1 The effect of crowding out
 Because Y has increased,
the demand for money also r2 e2
increases → interest rate e1
increases
 Firms’ planned
investment spending IS1
declines and AD falls →
IS
move up the LM curve to E’
Y0 Y1 Output
 Fiscal Policy and Output
An increase in Govt. Spending
LM
Interest
rate
 Comparing E to E’:
increased government
spending increases income
and the interest rate e3
r1 The effect of crowding out
 Comparing E’ to E”:
adjustment of interest rates r2 e2
and their impact on AD e1
dampen expansionary
effect of increased G
IS1
 Income increases to Y’0
IS
instead of Y”
Y0 Y1 Output
G ↑ ==> Y ↑ ==> the IS-curve shifts right ==> md ↑ ==> i ↑
==> I ↓ ==> Y ↓.

Effect: Y ↑ and i ↑
Is Crowding out Important?

n
Is Crowding out Important?

3. When there is unemployment, interest rates might not rise at

all when government raises its spending. Monetary policy is
accommodative when, in the course of a fiscal expansion, the
money supply is increased in order to prevent rise in interest
rates. Monetary accommodation is referred to as monetizing the
fiscal deficits, meaning that the central bank reserves the right to
print money to buy the bonds with which government pays for its
deficit.
Crowding in or crowding out?
Discussion on articles:
Business Construction To Be Crowded Out By Federal
Infrastructure
https://www.forbes.com/sites/billconerly/2021/11/30/business-construction-to-be-crowded-out-by-federal-
infrastructure/?sh=53d7e187554d

Q1. What is crowding out?

Q2. Through which channels could crowding out happen in the aftermath of a fiscal expansion?
Q3. Which factors determine the extent of crowding out effects?
Q4. How would you show prices rising in the aftermath of a fiscal expansion in the IS-LM framework? What is the
resulting effect on interest rates?
Q5. What could be the consequences of monetising the fiscal deficit?
Q6. What role would the slope of LM play in determining the extent of interest rate rise (crowding out effects)?

High fiscal borrowings won’t crowd out private sector: CEA

https://www.thehindu.com/business/Economy/high-fiscal-borrowings-wont-crowd-out-private-sector-
cea/article35616159.ece

Q7. Are savings constant? What if savings rise as a result of the rise in the income effected by a fiscal package? Would
interest rates rise still? Could prices rise still?
Crowding in or crowding out?
High fiscal borrowings won’t crowd out private sector: CEA
https://www.thehindu.com/business/Economy/high-fiscal-
borrowings-wont-crowd-out-private-sector-cea/article35616159.ece

“On the contrary, the government’s increased capital spending would impart a
‘crowding-in effect’ spurring more investment, the CEA contended.”

“The flaw with this argument is that it relies on the pool of savings being
static,” the CEA responded. “There is now evidence that savings are pro-
cyclical with growth. When you have a pool that is growing and the
government takes a rupee out today for capital expenditure, and thereby
push growth and increase savings, the pro-cyclical behaviour of savings kicks
in. So this is the crowding-in effect of infrastructure, especially government-
led, capital spending,” he observed
Fiscal Policy Limitations
For several reasons, fiscal policy may be even less effective
than monetary policy at countercyclical stabilization:
 Timing fiscal policy is harder, due to:
 Legislative delay: Congress needs to agree on the
actions
 Implementation delay: Large spending projects may
take months or even years to begin, even once
approved.
 Government spending might crowd out private spending

Crowding out: A decline in private expenditures as a result

of an increase in government purchases
The Composition of Output and the Policy Mix
 The table summarizes effects of expansionary monetary and
fiscal policy on output and the interest rate
 Monetary policy operates by stimulating interest-responsive
components of AD
 Fiscal policy operates through G and t → impact depends upon
what goods the government buys and what taxes and transfers
it changes
The Composition of Output and the Policy Mix
 Policy problem of reaching full
employment output, Y*, for an
economy that is initially at
point E, with unemployment
Choices:
 Fiscal policy expansion, moving
to point E1, with higher income
and higher interest rates
 Monetary policy expansion,
resulting in full employment
with lower interest rates at
point E2
 A mix of fiscal expansion and
accommodating monetary
policy resulting in an
intermediate position
Effectiveness of Fiscal & Monetary Policies
 Keynesian range: Fiscal policy is highly effective

 Classical range: Monetary policy is effective not fiscal

policy

 Intermediate range: Monetary and fiscal policies are

less effective
Problem Set
Assume the money sector can be described by the following two equations:
md = (1/4)Y - 10i and ms = 400.

In the expenditure sector only investment spending (I) is affected by the

interest rate (i), and the equation of the IS-curve is:
Y = 2,000 - 40i

a. Assume the size of the expenditure multiplier is α = 2. What is the

effect of an increase in government purchases by ∆G = 200 on income
and the interest rate?
b. Can you determine how much investment is crowded out as a result of
this increase in government purchases?
c. If the money demand equation were changed to md = (1/4)Y, how
would your answers in a. and b. change?
Session 17
Fiscal and Monetary Policies

Numerical Problems on Fiscal and

Monetary Policies
Problem set 1
Assume the money sector can be described by the following
two equations:
md = (1/4)Y - 10i and ms = 400.

In the expenditure sector only investment spending (I) is

affected by the interest rate (i), and the equation of the IS-
curve is:
Y = 2,000 - 40i

a. Assume the size of the expenditure multiplier is  = 2.

What is the effect of an increase in government purchases
by G = 200 on income and the interest rate?
b. Can you determine how much investment is crowded out
as a result of this increase in government purchases?
c. If the money demand equation were changed to md =
(1/4)Y, how would your answers in a. and b. change?
Problem set 2
Assume that the money sector can be described by the
equations:

Money supply: ms = 600 and money demand: md = (1/4)Y

+ 400 - 15i

The expenditure sector can be described by the equation:

Aggregate Demand: C + I + G + NX = 400 + (3/4)Y - 10i

a. Calculate the equilibrium levels of Y and i

b. By how much the central bank will have to change money
supply if its goal is to keep interest rates constant after
government purchases are increased by G = 50. Show
your solutions graphically and mathematically.
Session 18
Understanding International Linkages

International Linkages
Introduction
Economies are linked through two broad channels:
Trade in goods and services
 A portion of country’s production is exported to foreign
countries, which raises the demand for domestically produced
goods
 Some goods that are consumed or invested at home are
produced abroad and imported, which is a leakage from the
circular flow of income

Finance
 Portfolio managers shop the world for the most attractive
yields
 As international investors move their assets around the world,
they link assets markets in various economies
 This affect income and exchange rates and the ability of
monetary policy to affect interest rates
The Balance of Payments and Exchange Rates
 Balance of Payments (BoP) is a summary statement of all economic
transactions between residents of that nation and residents of the
outside world that have taken place during a given period of time.

 There are two main accounts in a BoP:

 Current account: records trade in goods and services, as well as
transfer payments
 Capital account: records purchases and sales of assets, such as
stocks, bonds, and land, including FDI
BoP Imbalances and Exchange Rates Adjustments
 BoP Imbalances & Exchange Rate Adjustment International Monetary
Equilibrium

 Supply>demand for Re → depreciation (Intervention: Sell $)

 Supply<demand for Re → appreciation (Intervention: Buy $)

 BOP surplus can be corrected by variations in the exchange rate

 Hence, exchange rate fluctuations allow countries to control their own

money supply
 Case Discussion on

Exchange Rate Policy at the Singapore Monetary

Authority
Fixed Exchange Rates
 What is exchange rate?
Direct and Indirect Quotes of exchange rates (refer to classroom
discussion, page 293 of DFS)

 How it is determined?
• Fixed Exchange Rate System
• Floating Exchange Rate System
• Managed Floating System (dirty floating system, page 295 of DFS)
Fixed Exchange Rates
 In a fixed exchange rate system foreign central banks buy and sell
their currencies at a fixed price in terms of dollars
 Ensures that market prices equal to the fixed rates
 No one will buy dollars for more than fixed rate since they know
that they can get them for the fixed rate
 No one will sell dollars for less than fixed rate since they know
they can sell them for the fixed rate
 Foreign central banks hold reserves to sell when they have to
intervene in the foreign exchange market
 Intervention: the buying or selling of foreign exchange by the
central bank
Fixed Exchange Rates
 The balance of payments measures the amount of foreign exchange
intervention needed from the central banks
 Ex. If Korea were running a current account deficit vis-à-vis
India, the demand for Re in exchange for Korean Won
exceeded the supply of Re in exchange for Korean Won, the
Reserve Bank of India would sell Re and buy Korean Won
 Under a fixed exchange rate, price fixers must make up the
excess demand or take up the excess supply
 Makes it necessary to hold an inventory for foreign
currencies that can be provided in exchange for the domestic
currency
Fixed Exchange Rates
What determines the level of intervention of a central bank
in a fixed exchange rate system?
 With necessary reserves, central banks can continue to intervene in
foreign exchange markets to keep the exchange rate constant

 If a country persistently runs deficits in the balance of payments:

 The central bank eventually will run out of reserves on of
foreign exchange
 Will be unable to continue its intervention
 Before this occurs, the central bank will likely “devalue” the
currency
Flexible Exchange Rates
In a flexible (floating) exchange rate system, central banks allow the
exchange rate to adjust to equate the supply and demand for foreign
currency
Supposing the following happens:
 Exchange rate of the dollar against the yen is 0.86 cents per yen
Japanese exports to the U.S. increase
 Americans must pay more Yen to Japanese exporters
 This raises the demand for Yen
 Bank of Japan stands aside and allows the exchange rate to adjust
 Exchange rate rises to, say, 0.90 cents per yen (i.e., the Dollar
depreciates and Yen appreciates)
 Now, Japanese goods become more expensive in terms of dollars
 The demand for Japanese goods by Americans declines, so does the
demand for Yen
What determines ER in the Long Run?
 In the long run, the exchange rates will be determined so that the law
of one price holds

 The Law of one price states that the price of an identical good will be
the same throughout the world, regardless of which country produces
it

 To understand this better, let us consider an example

 Example: American steel costs $100 per ton, while Japanese steel
costs 10,000 yen per ton. The two steels are identical.
Exchange Rates in the Long Run

American Steel Japanese Steel

In U.S. $100
In Japan 10,000 yen

1 ton American steel sells at 10,000 yen in Japan (= price of Japanese steel),

1 ton Japanese steel sells at $100 in the US (= price of American Steel)

Exchange Rates in the Long Run

American Steel Japanese Steel

In U.S. $100 $100
In Japan 10,000 Yen 10,000 yen

1 ton American steel sells at 10,000 yen in Japan (= price of Japanese steel),
1 ton Japanese steel sells at $100 in the US (= price of American Steel)
For the law of one price to hold, the ER must be 100 yen/$.
At this ER, the price of the steel is identical in the two countries. And, in the
absence of transaction costs, it doesn’t matter where the steel is purchased
from.
Exchange Rates in the Long Run
Now, suppose that ER = 50 Yen/$,

American Steel Japanese Steel

In U.S. $100 $200
In Japan 5,000 Yen 10,000 Yen

 Because Japanese Steel is more expensive than American Steel in both

countries, the demand for Japanese Steel would go to zero

 The excessive supply of Japanese Steel will be eliminated only if either the
ER increases to 100 Yen/$ and the price of the steel is same across the
two markets.
The Exchange Rate in the Long Run
 The central bank can peg the value of a currency i.e. fix the ER for a
period of time
 But in long run, ER between pair of countries is determined by relative
purchasing power of currency within each country i.e. the law of one
price
 Two currencies are at purchasing power parity (PPP) when a unit of
domestic currency can buy the same basket of goods at home or abroad
 The relative purchasing power of two currencies is measured by the real
exchange rate (R)
 Real exchange rate is the ratio of foreign prices (Pf) to domestic
prices (P) measured in the same currency

ePf
R
P
The Exchange Rate in the Long Run

ePf
R
P

 If R =1, currencies are at PPP

 If R > 1, goods abroad are more expensive than at home
 If R < 1, goods abroad are cheaper than those at home
The Exchange Rate in the Long Run

ePf
R
P
 If R > 1, goods abroad are more expensive than at home. This
is suggestive of an increase in the competitiveness of our
products.
 As long as R >1, we expect the relative demand for domestically
produced goods to rise.
 Eventually, this should either drive up domestic prices or drive
down the exchange rate, moving us closer to purchasing power
parity.
 Market forces will prevent ER from moving too far from PPP or
from remaining away from PPP indefinitely.
Capital Mobility
 There is a high degree of integration among financial markets
i.e. a market in which bonds and stocks are traded
 In most industrialized countries, there is no restriction on
holding assets abroad
 If ER is fixed, taxes are same everywhere and foreign asset
holders never face any political risks (nationalization,
restrictions on transfer of assets, default risk by government)
we would expect all asset holders to pick the asset with
the highest return
 If interest rates in New York rose relative to those in Canada,
investors would turn to lending in New York, while borrowers
would turn to Toronto, yield will quickly fall into line
 Perfect capital mobility implies that investors can purchase
assets in any country they choose, quickly, with low
transaction costs and in unlimited amounts
Balance of Payments and Capital Flows
 Assume a home country faces a given price of imports, export
demand, and world interest rate, if, and capital flows into the
home country when the interest rate is above world rate
 Balance of payments surplus is:

BP  NX (Y ,Y f , R)  CF (i  i f )

where CF is the capital account surplus

 The trade balance is a function of domestic and foreign income
 An increase in domestic income worsens the trade balance
 The capital account depends on the interest differential
 An increase in the interest rate above the world level pulls
in capital from abroad, improving the capital account
Fiscal policy is reinforced by monetary policy
under fixed exchange rates
 The implications of perfect capital mobility are examined under
fixed and flexible exchange rate systems
 Under a system of fixed exchange rates, expansionary fiscal
policy is automatically reinforced by monetary policy, since
higher domestic interest rates and the resulting capital inflow
force the central bank to increase the money stock to maintain
the exchange rate
 Monetary policy, on the other hand, is powerless in such a
situation
 The inflow of capital and subsequent currency appreciation
simply force the central bank to reverse its initial policy action

(Refer to the diag. discussed in the class)

Mundell-Fleming Model
 The Mundell-Fleming model incorporates foreign exchange
under perfect capital mobility into the standard IS-LM
framework
 Under perfect capital mobility, the slightest interest differential
provokes infinite capital inflows
 And, the central bank is unable to conduct an independent
monetary policy under fixed exchange rates
Mundell-Fleming Model
 A country tightens money supply to increase interest rates:
 Portfolio holders worldwide shift assets into country
 Due to huge capital inflows, balance of payments shows
a large surplus
 The exchange rate appreciates and the central bank
must intervene to hold the exchange rate fixed
 The central bank buys foreign currency in exchange for
domestic currency
 Intervention causes domestic money stock to increase,
and interest rates drop
 Interest rates continue to drop until return to level prior
initial intervention
Monetary Expansion under fixed exchange rates
 In contrast, consider a monetary
expansion that starts from point E
 shifts LM down and to the right to
E’
 At E’ there is a large payments
deficit, and pressure for the
exchange rate to depreciate
 Central bank must intervene,
selling foreign money, and
receiving domestic money in
exchange
• Supply of money falls,
pushing up interest rates as
LM moves back to original
position
• Thus, monetary policy is
completely ineffective given
fixed exchange rate and
perfect capital mobility
Fiscal Expansion
 Monetary policy is infeasible, but fiscal expansion under fixed
exchange rates and perfect capital mobility is effective
 A fiscal expansion shifts the IS curve up and to the right 
increases interest rates and output
 The higher interest rates creates a capital inflow with the
tendency to appreciate the exchange rate
 To manage the exchange rate the central bank must
expand the money supply  shifting the LM curve to the
right
 This pushes interest rates back to their initial level, but
output increases yet again
The policy trilemma can be put up in the form of the following diagram:

The Policy Trilemma or the Impossible Trinity

Monetary Unions that work
towards common goals e.g. EU

Tight control of
Fully Flexible ER
capital flows e.g.
regime e.g. Japan Monetary Policy Independence China
and Canada