Coursework: Macroeconomics

IMT Ghaziabad
By
Dr. Manas Paul
Term I PGDM 2022-24
 Impact of multiplier and interest rate
sensitivity
• What does a higher Keynesian multiplier imply for IS curve
slope?

• Does interest rate sensitivity affect AD and hence the IS

curve in any way?

• …if it does then does it have implications for responsiveness

of equilibrium output to changes in monetary policy?
The following equations describe an economy. (Think of C,I,G, etc as being
measured in INR billion at constant prices and ‘i’ as a percentage; a 5% interest
rate implies i=5):
𝐶 = 0.8 1 − 𝑡 𝑌
𝑡 = 0.25
I = 900 -50i
𝐺 = 800
𝐿 = 0.25𝑌 − 62.5𝑖
𝑀
=500
𝑃

a. What is the equation that describes the IS curve?

b. What is the general definition of IS curve?
c. What is the equation of LM curve?
d. What is the general definition of LM curve?
e. What are the equilibrium levels of income and interest rates?
f. What would be the value of the Keynesian multiplier?
g. By how much does an increase in govt spending ∆𝐺 increase the level of income in
this model which includes money market? Explain the change if any…
h. By how much does the change in government spending ∆𝐺 affect equilibrium interest
rates?
 IS-LM impact of autonomous spending
•
on equilibrium
Suppose there is a rise in autonomous
component of spending? [Insert Figure 10-12 here]
• i.e. autonomous G, I or NX has changed…
• Impact on AD curve?
• Impact on eqlm output in Keynesian
multiplier model?
• Will it be the same in IS-LM model? Explain
• Adjustment path?

Autonomous Investment  ==>

Y  ==> the IS-curve shifts right
==> md 
==> i 
Y  AD  A  c(1  t )Y  bi
==> I 
A Y
==> Y  from level of initial rise IS _ Curve : i  
b  Gb

CROWDING OUT EFFECT & flatter IS and steeper LM curve

 IS-LM impact of tax policy cut

Tax policy: A tax cut IS

LM
i
• Will eqlm income in IS-LM model i
be same as in model of Keynesian
multipliers?
Y Y Y’
• What will be the impact
on AD curve?
Consumers save a part of the
• What will be the impact tax cut, so the initial boost in
spending is smaller for the tax
on IS curve?
cut than for an increase in G.
• Will the impact on output
due to tax cut be same as Y  AD  A  c(1  t )Y  bi
that of increase in G? A Y
IS _ Curve : i  
• What would the adjustment b  Gb
path be?
IS-LM impact of money supply on equilibrium
Monetary policy: An increase in M
i
1. ΔM > 0 shifts the LM curve down
(or to the right)
(i/k)Δ (M/P)
2. …causing the interest rate to fall i1

3. …which increases investment, causing i2

output & income to rise.

4. What would the adjustment process be?

Ms  ==> the LM-curve shifts right
==>i  M
 kY  hi
==> I  P
==> Y 
==> md  1 M
i  kY  
==> i  from the initial level of the fall h P 
 Policy choice: Money supply Vs setting
Interest rate
Choice between i & M are equivalent if => Positions of LM & IS curves are known
Why????

Suppose target interest rate is i*

Given the IS curve we get Y* plugging that value of i* in IS equation
Since we have i* & Y* then from the LM equation we can get
corresponding level of money supply
Suppose IS curve shifts up due an increase in autonomous spending
IS (position) changes i.e. new equation
In the new IS equation we can plug in the value of i* to get Y’
Plugging i* & Y’ in the LM equation we get the level of money supply to maintain i at i*
IS IS
LM LM
I’
i* i*

Y* Y* Y’
 1. Assume the following IS-LM model:
expenditure sector: money sector:
AD = 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

a. Calculate the equilibrium values of private domestic investment (I), tax revenues
(TA), and real money demand (md).
b. b. How much of private domestic investment (I) will be crowded out if government
purchases are increased by G = 100?

AD = C + I + G + NX = 110 + (2/3)(Y - TA + TR) + 250 - 5i + 130 – 30 = 500 + (1/2)Y - 5i

In eqlm. Y = AD ==> Y = 500 + (1/2)Y - 5i ==>Y = 2(500 - 5i)
==> Y = 1,000 - 10i IS-curve
From (M/P) = md ==> 500/1 = (1/2)Y + 400 - 20i ==> (1/2)Y = 100 + 20i
==> Y = 200 + 40i LM-curve
Eqlm: i = 16 ==> Y = 840
==> I = 250 - 5*16 = 170 & TA = (1/4)840 + 20 = 230
Since (M/P) = md ==> md = 500
Check: md = (1/2)840 + 400 - 20*16 = 500
b. How much of private domestic investment (I) will be crowded out if government
purchases are increased by G = 100?

If government purchases are increased by G = 100, the IS-curve will shift by

IS = α(∆G) = 2*100 = 200, and the new IS-curve is of the form Y = 1,200 - 10i

LM curve remains the same

New values for i & Y : ==> i = 20 ==> Y = 1,000

Since i = 4 ==> I = - 4*5 = - 20
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:

intended spending: AD = C + I + G + NX = 400 + (3/4)Y - 10i.

Calculate the equilibrium levels of Y and i, and indicate 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).
ms = md ==> 600 = (1/4)Y + 400 - 15i ==> (1/4)Y = 200 + 15i
==> Y = 4(200 + 15i) ==> Y = 800 + 60i LM-curve

Y = C + I + G + NX ==> Y = 400 + (3/4)Y - 10i ==> Y = 1,600 - 40i IS-curve

From IS = LM: ==> i = 8 ==> Y = 1,280

If government purchases increase by G = 50…

….the IS-curve will shift to the right by IS = 4*50 = 200. {Multiplier 1/((1-(3/4)) = 4}
new IS-curve is: Y = 1,800 – 40i.
Interest rate is kept constant at previous level i.e. new i = 8
Given i = 8 from new IS-curve “Y = 1,800 – 40i” we can get “new Y”
plugging i=8 in IS curve
new Y = 1800-40*8 = 1480
Given “new Y” we can find the “new ms” from the LM curve
ms = md = (1/4)Y + 400 - 15i = (1/4)*1480 +400 -15*8 = 650
“old ms = 600 & “new ms =650” from the LM curve
Money supply should increase by 50
3. Assume the equation for the IS-curve is: Y = 1,200 – 40i
and the equation for the LM-curve is: Y = 400 + 40i.
a. Determine the equilibrium value of Y and i.
b. If this is a simple model without income taxes, by how much will these
values change if the government increases its expenditures by G = 400, financed by
an equal increase in lump sum taxes (TAo = 400)?

Solving the IS & LM curve we have: i = 10 & Y = 800

According to the balanced budget theorem, the IS-curve will shift horizontally by the
increase in government purchases, that is, IS = G = TAo = 400

Therefore the new IS-curve is of the form: Y = 1,600 - 40i.

Solving the new IS and the given LM Curve :

New eqlm i = 15 & New eqlm Y = 1,000
Why interest rate not money supply?
Easier to measure

Central Banks belief about prevalence of LM

shocks
..hence interest rates stabilizes income better than
targeting money supply

Strictly for use of students of IMT only and

not for any other purpose
Monetary Transmission Mechanism
1. Central Bank announces short term interest rate that
depends upon its objectives and state of the economy
2. Central Bank undertakes daily operations to meet its
interest-rate target
3. Central Bank’s new interest rate target and market
expectations about future financial conditions help
determine the entire spectrum of short and long term
interest, asset prices and exchange rates
4. Changes in interest rate, credit conditions, asset prices,
and exchange rates affect investment, consumption and
net exports
5. Changes in investment, consumption, and net exports
affect the path of output and inflation through AS-AD
mechanism
 Impediments To:
Monetary Policy Transmission in India
 Statutory SLR
 Lazy Banking
 Low credit demand
 Rising NPA’s
 Fiscal dominance
 Small savings schemes
Post office deposits, PPF, Savings Certificates
 Interest rate subventions, debt waiver/relief
 Tax saving mutual funds
Strictly for use of students of IMT only and
not for any other purpose
 Financial System
• Financial System: Circulatory System that links
together goods, services, and finance in domestic and
international markets
• It is through money and finance that households and
firms borrow from and lend to each other in order to
consume and invest
• Financial System comprises: Market and firms, other
institutions, which carry out the financial decisions of
households, businesses, and governments….
• ….money market, markets for fixed interest assets like
bonds or mortgages, stocks markets for ownership of
firms, foreign exchange markets…
 Households purchases Firms sell bonds or has
government bond or initial public offerings
stocks Financial
(IPO) of stocks
Markets

Savers Investors

Financial
Intermediaries

Household deposits Small and big

monthly salary into businesses borrows
checking account from banks to invest
Savers & investors transfers funds across time, space and sectors through financial markets
and intermediaries
Some flows goes directly through financial markets (like buying stocks), while others
(purchasing units of MFs, or depositing money in checking accounts) go through financial
intermediaries
Major Financial Institutions
Commercial
Banks

Security Insurance
Financial
brokers, and pension
dealers…etc Institutions funds

Money
Market and
Mutual
funds
 Functions of Financial Systems
1. Transfers resources across time, sectors, regions
2. Manages risks for the economy – transferring
risks from those who need to reduce their risks
to others who are better suited to weather them
3. Pools and subdivides funds
4. Function as clearing house – facilitates
transactions between payers (purchasers) and
payees (sellers)…write a check to buy a new
computer, a clearinghouse will debit your bank
and credit the bank of the company selling the
computer
 Major Financial Assets
• Financial Assets: Claims by one party against another party
• Money: Very special asset – medium of exchange, unit of account & store
of value,
• Savings Accounts: deposits with bank or credit institutions, at times
guaranteed by government, with fixed principal value and interest rate
that could be fixed or variable
• Credit Mkt Instruments: Bonds and instruments of varied degrees of risks
• Common Stocks: Ownership right to Companies
• Money Mkt funds and MFs : funds held in short term assets or stocks
those could be subdivided into fractional shares and bought by small
investors
• Pension Funds: Long term investments drawn down during retirement
years
• Financial Derivatives: Whose value is derived from an underlying asset
 Special Case of Money
• Each currency note or coins has minimal intrinsic value
• They are useless unless we get rid of it
• However, money is anything by useless…
• …monetary policy is one of two most important tools
to stabilize business cycle
• The central bank uses its control over money, credit,
and interests rate to encourage growth when the
economy slows …..
• …..and slow growth when inflationary pressure rise
• In a well managed financial system output grows
smoothly and prices are stable
 Evolution of Money: Barter
• Money is anything that serves as a commonly accepted medium of
exchange
• During a world tour during the 1880s by the French singer,
Mademoniselle Zelie, one stop was a theater in the Society Islands,
part of French Polynesia in the South Pacific. She performed for her
usual fee, which was one-third of the receipts. This turned out to be
three pigs, 23 turkeys, 44 chickens, 5000 coconuts, and
"considerable quantities of bananas, lemons and oranges." She
estimated that all of this would have a value in France of 4000
francs… As Mademoiselle could not consume any considerable
portion of the receipts herself, it became necessary in the
meantime to feed the pigs and poultry with the fruit.
• Exchange through barter contrasts with exchange through money,
as pigs, turkey and lemons are not generally acceptable monies that
we or Mademoniselle Zelie can use for buying things….
 Disadvantages of Barter
• Barter is better than no trade at all…but face
grave disadvantages….
• …cannot operationalize an elaborate division of
labour, hence specialization and trade
• Not divisible into small change
• Moreover, in a barter system there has to be a
double coincidence of wants….
• …unless a hungry rickshaw puller happens to find
a farmer who has both food as well as the desire
to ride, under barter no one can make a direct
trade
Evolution of Money: Commodity
• Money as a medium of exchange first came into
human history in the form of commodities..
• A great variety of commodities served as money
at one time or the other: cattle, olive oil, beer,
wine, copper, iron, silver, gold, diamonds,
cigarettes and whether you believe it or not even
“Ramen”
• https://www.youtube.com/watch?v=PLt9fRYT92
M&ab_channel=Vox
 Issues with Commodity Money
• Commodity money had both some advantages and disadvantages…
• Cattle are not divisible into small change…Beer does not improve with
keeping…
• Olive oil can be a nice liquid currency minutely divisible but rather messy
to handle
• By 18th century money was almost exclusively limited to metals like gold
and silver…
• …meant these forms of money had intrinsic value in themselves…unlike
paper currency did not need any government guarantee
• But metallic currencies had their own shortcomings…needed scarce
resources to dig it out....
• ….moreover it might become abundant simply because of discoveries of
ore deposits…leading to unstable currency system
• Advent of monetary control by Central Banks, has led to a much more
stable currency system….
• Intrinsic value of currency is now the least important feature…
 Modern Money: Paper Currency
• Age of commodity money gave way to paper
money…devoid of intrinsic value
• Now money is not wanted for its own sake but the things it
can buy…
• We use money by getting rid of it…
• It is has become widespread because it is a convenient
medium of exchange…
– Easily carried and stored
– Value can be protected from counterfeiting by careful engraving
– Pvt individuals can not create money keeping it scarce
– Given this limitation on supply it has its value
• Paper money issued by Govts was gradually overtaken by
bank money – Checking Accounts
 Ultramodern Money
• Move towards cashless society….
• Rising importance of Electronic Money
• Digital currencies…are they true money?
• As the Governor of the Bank of Japan, Mr. Haruhiko Kuroda, once
said: “Bitcoin is being traded for investing or for speculation”.
Similar opinion was also expressed by the vice president of the
European Central Bank (ECB), Mr. Vitor Constancio, who said that
“bitcoin is not a currency but sort of a tulip”, alluding to the price
bubble of the Dutch tulip mania in the 17th century… Jens
Weidmann, the President of the Deutsche Bundesbank, highlighted
that the development of bitcoin has a noticeably speculative
character. Australia’s RBA Governor, Philip Lowe, was certainly the
harshest in expressing negative position on bitcoin arguing that the
asset is more likely to appeal to criminals than consumers (Lam,
2017).
 Are digital currencies true money?
• Unlike with fiat money they have a high cost of production reflecting the
need for large amount of energy needed to power computers those solves
cryptographic puzzles
• Main function of money is a means of payment, have digital currencies
taken over this function….
• Moreover, no monetary authority or government stands behind bitcoin or
any other crypto currency…there exists not protection in case of relevant
technological platform malfunction either…
• …payments in these currencies are minor….
• Digital currencies still do not perform the function of the measure of value
as we do not have products who value is expressed in digital currencies….
• Moreover, it also lacks the other function of money the store of
value…when you have money you can expects its value to remain nearly
the same excluding inflation in the near future, whereas the value of
digital currencies in future cannot be estimated by anyone….

Nikola Fabris: Cashless Society – The future of Money or a Utopia? Journal of Central Banking
Theory and Practice, 2019, 1, pp. 53-66
 Components of Money Supply
• Main component of money supply M1 also known as
Transactions Money…
• Generally it consists of…
• 1. Currency: Coins and paper money held outside the
banking system. It is not backed by gold or silver hence
they are fiat money. However they are legal tender
which must be accepted for all debt public and private.
• 2. This is the other component which is Bank Money.
This consists of funds, deposited on banks and other
financial institutions on which one can write checks
and withdraw money on demand…. i.e. demand
deposits
 Are Credit Cards Money?
• Credit Card is an easy but expensive way to
borrow money. When paying with a credit
card you are promising to pay the credit card
company – with money – at a later date
 Now lets look at Money Supply…
• Money supply is the outcome of the
interaction between Central Bank and
Commercial Banks
• Commercial Banks play a crucial step in the
monetary transmission process…
• A first step to understand the process is to
understand the balance sheets of Central Bank
and Commercial Banks
 Example: BS of Commercial Banks
Assets Liabilities and net worth
Reserves 43 Checking deposits 629
Loans 6250 Savings & Time 5634
Deposits
Investments 2265 Other Liabilities 2643
Other Assets 1404 Net Worth (Capital) 1056
Total 9961 Total 9961

Checking deposits are an important component of M1

Reserves are held primarily to meet legal requirements
Ratio of liabilities to networth is called the leverage ratio
Highly leveraged financial institutions produce systematic risk if the value of their
assets deteriorate
NOTE RESERVES ARE A FRACTION OF TOTAL DEMAND AND TIME LIABILITIES
Money Supply : How it is Defined ?  may temporarily hold RBI profits
M1 = Currency with the Public + Demand Deposits  Subscription to State govt loans
pending allotment
with Banks + “Other Deposits” with RBI • Post office deposits with RBI

M3 = M1 + Time Deposits with Banks

( i.e., currency with public + all bank deposits )
Expositions about money supply here onwards, centers around
M3 .

There is also M2 and M4

M2 = M1 + post office saving deposits
M4 = M3 + all post office deposits
But post office deposits are not treated as part of money supply in the
discussion that follows.
“Other Deposits” with RBI comprises of demand deposits held with the RBI
by international agencies, financial institutions, state governments etc.
This is a very small amount– so small, that it can be ignored.

20th October 2015 33

 Money Supply Process
• To simplify the discussion on the money supply process, we
will ignore “other deposits” from the definition of money .
• The simplified definition of money supply will then be as
follows : M = C + D , where M is money supply, C is
currency ( notes and coins ) held by the public, and D stands
for bank deposits.
• If ‘a’ is the fraction of money held by the public in the form
of currency, then 1-a is the fraction that constitutes bank
deposits i.e. M = C (=aM) + D(=(1-a)M)
∆𝑀 𝑠 : 𝑅𝑒𝑙𝑎𝑡𝑒𝑑 𝑡𝑜 𝐶ℎ𝑎𝑛𝑔𝑒𝑠 𝑖𝑛 𝑅𝐵𝐼 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦

Balance Sheet of Reserve Bank of India (RBI)

Assets Liabilities
Monetary
Financial Assets Monetary Liabilities base (MB)

a. Net RBI Credit to the Government a. Currency

b. RBI Credit to Banks - In circulation with Public
c. RBI Credit to Commercial Sector - Vault Cash
d. Net Foreign Exchange Assets of RBI b. Reserves (Banks’ Deposits with RBI)
-Statutory Reserves
- Excess Reserves

Other Assets Non-Monetary Liabilities

https://newsroom24x7.com/liabilities-of-reserve-bank/
 Monetary Base = High Powered Money
• Monetary Base (MB) / ‘high-powered money”/ reserve money
= currency in circulation with the public + reserves .
• Reserves are equal to vault cash + banks’ deposits with RBI.
• That is, MB is nothing but “monetary liability of RBI” in the RBI’s
balance sheet.
• RBI can increase or decrease MB by increasing or decreasing its
financial assets .
• An increase in MB leads to a further increase in money supply
through the banking system such that the final increase in M3
is a multiple of the increase in MB.
 Value of money multiplier
M = C + D ; where M is broad money, M3 , C is currency in
circulation , D is bank deposits
This equation can be rewritten as :
M = (C/D + 1) D (1)
MB = C + R , where MB is monetary base , C is currency in
circulation, R is reserves ( vault cash + banks’
deposits with RBI )
MB = ( C/D + R/D ) D (2)

• C/D = currency deposit ratio is a behavioural parameter. In a developing

country like India, this ratio would tend to come down, with financial sector
development.

• R/D is a policy variable , i.e. CRR

 Value of money multiplier…..cont..
M = (C/D + 1) D (1)
MB = ( C/D + R/D ) D (2)
Then money multiplier “m”:
m = M / MB = (C/D + 1) / ( C/D + R/D ) (3)
An increase in C/D reduces ‘m’ ; an increase in R/D also lowers ‘m’
A decrease in C/D increases ‘m’ ; a decrease in R/D also increases ‘m’
M = m x MB (4)
That is, M is a multiple ‘m’ of MB
Given ‘m’ , an increase in MB accelerates growth in M.
Given MB, an increase in ‘m’ can accelerate growth in M.
• For C/D = 0.20 and R/D = 0.10 ,
m = (C/D + 1) / ( C/D + R/D ) = 1.20 /0.30 = 4.00
• Hence, for a Rs 100 increase in MB , the increase in M is of
Rs 400 ( and not Rs 1000, which would be the case
if C/D was equal to zero. )
 How can 𝑀𝐵 Change?
RBI decides to increase Balance Sheet of Reserve Bank of India (RBI)
Monetary Base has
Money supply by OMO of
increased by Rs. 100 Assets Liabilities
Rs. 100
Financial Assets Monetary Liabilities

a. Net RBI Credit to the Government a. Currency

b. RBI Credit to Banks - In circulation with Public
c. RBI Credit to Commercial Sector - Vault Cash
d. Net Foreign Exchange Assets of RBI b. Reserves (Banks’ Deposits with RBI)
RBI receives Govt Bond -Statutory Reserves
RBI credits Bank A’s
from a financial - Excess Reserves
account with it by Rs. 100
institution against a Other Assets Non-Monetary Liabilities

cheque of Rs. 100 (RBI Liability goes up by

Rs. 100)
(RBI asset goes up)

The institution deposits

its receipt with its Bank A deposits the
commercial Bank : cheque with RBI for
clearance
Bank A
 ∆MB kicks in money multiplier

Suppose CRR is 10% so it Recipients of Rs. 90

Bank A’s Reserve
is excess reserves of Rs. deposits its in their bank
increases by Rs. 100
90 which it loans out say Bank B

Bank B now finds At the end of trading

holding excess Reserves period, RBI debits Bank
of Rs. 81 which it loans A’s balances with Rs. 90
…and the process goes and credits bank B’s
on balances with Rs. 90

We started with 100 as deposits; then added 90, then added 81 and so on….
The total is given by the sum: 100 + 100 x 0.9 + 100 x 0.92 + 100 x 0.93 +…..
= 100[ 1+ 0.9+ 0.92 + 0.93 + 0.94 +……………+ 0.9n +……..]
= 100[ 1/(1-0.9)] = 100[1/0.1] = 1000
 FractionalChanges
Reserve & Money Creation
in Commercial Banks’ Balance Sheet
Commercial Banks’ Balance Sheet (10% Reserve Requirements)
Assets Liabilities
Reserves 10 Demand & Time 100
Deposits
Loans /investments 90
Total 100 Total 100

What happens after this?

Businesses taking the loan for 90, deposits this amount into their loan account

It finds it way back in the banking system enhancing systemic demand and time
liabilities to similar extent

It emerges as excess reserves on the asset side available for lending

Changes in the Commercial Banks Balance Sheet post the lending
Assets Liabilities
Reserves 100 (10 + 90) Demand & Time 190
Deposits
Loans/Investments 90

Total 190 Total 190

Now the Banking system now needs to keep only 10% of 190 for reserves i.e. 19
…..it can now lend the remaining 171….which again flows back into the banking
system as banking deposit….

This process of deposit, relending, and redeposit goes continues in a chain of

dwindling expansions….
 Finally the system settles at
Changes in the Commercial Banks Balance Sheet post the lending
Assets Liabilities
Reserves 100 Demand & Time 1000
Deposits
Loans/ Investments 900

Total 1000 Total 1000

 What if reserves are at 100%???
A 100% reserve banking system has a neutral effect on money and the
macroeconomy, because it has not effect on money supply

Introduction of fractional reserve system was a tiny first step on the road
towards the vast financial system existing today
 Some Caveats Though…
• All money does not get deposited.
• Public holds part of the money as cash outside the banks, the extent
depending upon public’s preferences for currency over deposit.
• In the money supply process then, in each round, some of the extra
money will leak out of the banking system, and the overall money
multiplier will come down.
• In the extreme case, if the entire increase in the MB of Rs 100 is
held in the form of currency and nothing is deposited in the banks,
there is no money for banks to lend out. Then M3 = MB .