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Basic Introduction

Overall Demand and Capacity of an Economy Slowdown, Recession, and Depression Slowdown ± inflation rate decreases and unemployment rate increases (Philips curve!!) If AD>AS, it means boom and a rise in inflation Measure of Inflation in India ± WPI (one of the price indices) CPI is used to measure cost of living changes in the economy.






What is GDP?
y y

GDP refers to what is totally produced and not what is sold Nominal GDP vs. Real GDP (base year for India -1999-2000); GDP Deflator = Nominal GDP*100/Real GDP 3 methods of measuring GDP Expenditure method - total spending on domestically produced goods and services in economy ± C+I+G+X-M - GDP at market prices Income method - adds the incomes accrued to all factors of production - GDP at factor cost Output method - adds the value added at each stage of production


y y

Net Factor Income from abroad = Factor incomes earned by Residents abroad ± Factor Incomes earned by foreigners here. GNP = GDP + NFIA

China). crucial determinant of rate of increase in GDP NDP = GDP ± Depreciation National Income is factor incomes accrued to residents of country. domestic work. y y y y y y . etc. National Income = GNP (fc) ± Depreciation Disposable Personal Income What about transfer payments. transactions in Black market and second hand market.More about GDP y GDP at market prices = GDP at factor cost ?? GDP (mp) = GDP (fc) ± (Indirect taxes-Subsidies) GDP response to investment is called Incremental Capital Output Ratio (ICOR ± India Vs. unorganized sector.

when ±ve then surplus)\ Twin Deficit: Higher the fiscal deficit. then deficit. M>X implies decrease in forex which decreases opportunities for investing abroad T-G is called fiscal balance while M-X is current accounts balance (when +ve. government savings.Famous Twin Deficit Theory y NI = C+I+G+X-M.T Investment is sum of private savings. and foreign savings I = S + T-G + M-X X>M implies investment abroad by using excess foreign exchange. if I and S are stable (1991 economic crisis) y y y y . DP = NI . more it will spill over to current account deficit. DP = C+S.

e. people expect them to go low i.M1 = currency + chequable deposits. bond prices will rise from current low position. so invest in bonds (hence demand less money).Introduction to Interest rates and Money Supply y y Interest Rates ± price of money Real money demanded = Transaction demand (+ve function of GDP and ±ve function of interest rates) + precautionary demand (for unseen future) + speculative demand (varies inversely with interest rates) If interest rates are high. Supply for money . then large money chasing fewer goods. when means inflation If GDP < capacity. M3 = M1 + fixed and time deposits (broad money). then rise in money supply stimulates the economy by providing liquidity y y y y . M3 is money supply GDP depends upon M3 and velocity of circulation ± if money supply exceeds capacity.

Interest Rates (continued) y Real Interest rates = Nominal interest rates ± inflation rate In a period of slowdown. In booming economy reverse happens. Call Money market rates: rates at which one bank borrows from other bank in the short-term. interest rates fall as demand for money is low as well as expected inflation rate. ranging from call (repayable on demand) to 72 hours Rates on Treasury bills and long term government bonds refer to yields on short term and long term government securities Prime Lending Rate (PLR) is rate at which banks lend to their favored customers y y y y .

go up as foreign GDP increases or real exchange rate rises . Gain in competitiveness vis a vis real depreciation of currency y y y Real Effective Exchange Rate (REER) is a weighted geometric average of bilateral real exchange rates with weights equal to trade shares. y Net Exports go down if home GDP increases.Introduction to Exchange Rate y Demand for exports and imports ± exchange rate Recent trends in Indian exchange rate and Chinese peg against dollar (different exchange rate arrangements) Real Exchange rate = Nominal Exchange Rate * Foreign price / Domestic price.

If economy is operating near full capacity then price rise is steeper Cost Push Inflation ± rise in costs for firms without rise in productivity like labor costs.Inflation y Inflation is caused by 3 factors: Demand Pull inflation ± rise in C. material costs. This will raise prices along with decrease output. y y y y . Increase in money supply by government help in rising inflation Inflation leads to distribution of wealth from fixed income to those having real incomes and from lenders to borrowers. not one shot increase in prices. and X-M makes price and output rise. Inflation refers to continuous rise in prices. etc. I. High inflation lowers savings and people invest money in gold. which keep pace with inflation. they revise their prices which lead to actual inflation. land. G. Expectation Driven ± If people expect inflation to happen.

Since C. 1997) Marginal propensity to consume (mpc) = change in µC¶ in response to change in µDisposable Income¶ µC¶ has 2 components: induced component. and autonomous component driven by sentiment (not affected by policies) US slowdown (due to IT bubble burst) of 2001 and troubles of Japanese economy (due to manufacturing burst) Mr Chidambram¶s dream budget (1997-98) failed to take off because of stock market scam and real estate price crash preceding it y y y y . and X are all slowing so government is collecting less tax revenue and hence G will also slow down (East Asian Crisis. which can be induced by macroeconomic policy variables like interest rates and tax rates. so I for X decreases => less people are employed => C decreases.Introduction to economic linkages y As X decreases.I.

Receipts & Payments Balance of receipts is what the government borrows Direct taxes: progressive (go up as income rises).Fiscal Policy y Government expenditure (G) and T (taxes) ± most important policy variables of fiscal policy G ± revenue expenditure and capital expenditure. their share increases faster than rate of growth in GDP Indirect taxes: regressive whose share in income decreases as income rises Primary deficit = fiscal deficit .interest payments (a better measure of fiscal profligacy) Increase in G and lowering of T ± fiscal stimulants (effect on aggregate demand) y y y y y y .

G rises and falls automatically due to changing number of eligible beneficiaries. leading to appreciation of exchange rate y y y . it is called monetized deficit as it increases money supply in economy (RBI prints money) During times of slowdown and boom. increase in G is used in slowdown and increase in taxes used in boom Crowding Out Phenomenon: G can crowd out I as well as X if money supply is fixed ± rise in G leads to increase in interest rates which attracts more foreign currency. In state driven economies. Deficit increases in slowdown due to rise in G and fall in T In market driven economies. tax cuts are used during slowdowns while cuts in G are used during boom.Some concepts related to Fiscal Policy y When government deficit is financed through borrowings from RBI. T also falls and rises due to its progressive nature.

i. g = %rise in GDP¶ v = velocity of circulation and m = increase in money supply Demand will be more if person is paid weekly as compared to monthly. exchange rates and money supply ± important monetary policy variables Monetary policy changes first impact financial variables like interest rates.Monetary Policy y P = m-g + v where p = inflation.e. the velocity with which money changes hands is more Financial sophistication also brings down the demand for money Interest rates. exchange rates. They then affect C and I which then affect GDP and Prices y y y y .

Depreciation of local currency makes imports expensive and hence domestic spending increases y y y y . (US consumption bubble) Fall in interest rates means rise in disposable income for people in debt.Linkages related to Monetary Policy y If money supply increases. bonds and real estate to rise and hence people become wealthier. then people will demand bonds more and hence bond prices go up. For people not in debt. current consumption is more attractive than future. Vice versa is also true Decrease in interest rates causes prices of long lived assets like stocks. hence interest rates go down. Increase in asset prices makes individual feel wealthier and hence C rises. so C increases. The collateral which can be given against loan suddenly increase.

Bank rate / Call rate High powered money/reserve money = monetary base = currency in circulation with public + reserves Money Multiplication by Banks : concept of money multiplier Open Market Operations y RBI: forex swaps. repo/reverse repo transactions. buy/sell government securities y y y y . CRR. Due to rise in value of collateral. bank loans become easy SLR.More Concepts y Fall in interest rates encourages more investment by companies. Repo & Reverse Repo rate.

then balance between inflows and outflows will not be obtained as interest differential will remain there for FII to take advantage of. If it wants stable exchange rate. So both cannot happen simultaneously. RBI earns lower interest by deploying forex in securities abroad as compared to what it can earn by deploying rupee domestically. Problem is that if you are not allowing the money supply to rise (hence interest rates to decrease).Problems for RBI y Targets for RBI: interest rates or money supply or exchange rates When rupee is appreciating against dollar and RBI stabilizes that. Targets of RBI have been dynamic depending upon the economic conditions y y y y . it has to tolerate more inflation. money supply goes up and vice versa. Sterilization: FII inflow due to interest differential: RBI has to stabilize exchange rate but inflation rises.

then domestic GDP rises but foreign GDP comes down Balance of Payments is the difference between receipts of residents of country from foreigners and payments by residents to foreigners y Trade account: balance from export and import of merchandise y Invisibles: services.External Account y If government follows expansionist policies. But if increase in GDP is due to real depreciation in exchange rates. increase in domestic GDP means increase in imports so increase in foreign GDP. capital flows from that country. investment income & transfer payments y y y y Current account = trade account + invisibles Capital account includes export and import of capital If local interest rates fall in comparison to foreign country. Demand for foreign currency will rise and hence local currency will depreciate. .

Fixed Rate Regimes: Adjustable peg. RBI allows initial rate to be determined by market forces but later steps in to maintain its orderly behavior. Currency Board. Interest rate parity theory says that differential of interest rates determine future expected exchange rates. Unified Currency y y y . In managed float exchange rate regime.Exchange Rate y y Exchange rate can be determined by purchasing power parity theory: in long run. Crawling peg. Exchange rate will be in equilibrium when their domestic purchasing powers at that rate are equivalent. exchange rates adjust to reflect differences in countries¶ inflation rates.

. y If Money supply increase. y So GDP changes with no crowding out of private investment. RBI sells forex and hence decreases M. foreign capital goes out. So no effect on GDP. so balance improves y y y Sensitive issue of Capital Account Convertibility in India Fixed regime + complete mobility ± G rises -> GDP rises ->demand for money rises -> interest rates rise (as supply is fixed) -> foreign capital flows in -> pressure on rupee to appreciate -> central bank supplies money to mop up forex entering -> interest rates will go down. interest rates fall.Important Linkages Fixed Rate Regime & External Account is negative: pressure on rupee to depreciate -> RBI will sell forex to stop that -> monetary base decreases -> interest rates rise -> GDP slows down ->imports come down ->X-M improves y Rise in interest rates attracts more capital from outside. to maintain exchange rate.

rise in interest rates. y y y y . Money supply reduces to restore exchange rate -> interest rates rise more and crowd out private investment. rupee will appreciate in first case and hence X will be crowded out. So Monetary policy has increased GDP by lowering interest rates. so less influence on rise in GDP. Effect on GDP is rise in G less crowding out of private I due to rise in interest rates. so currency will depreciate to restore balance.More Linkages y With flexible regime. so ineffective policy in influencing GDP Flexible exchange rate and capital controls: GDP rises. so RBI will decrease money supply increasing interest rates . Expansionary monetary policy will lead to fall in interest rates and hence rise of GDP implying net exports worsen. So 2 opposing factors at work. Capital controls and fixed regime: rise in GDP (due to rise in G) worsens X-M as M increases. so increase in GDP effective. Money supply rises -> interest rates fall -> GDP rises -> imports rise -> X-M comes down putting pressure on currency. Rise in GDP worsens net exports and so currency will depreciate restoring the balance. rupee depreciates and hence X increases. With monetary policy.

MP to raise I and hence AD by cutting rates is not possible Money demand does not respond to change in interest rate ² excess liquidity Philips Curve ² Unemployment and inflation are inversely related Exceed Full employment tight labour market higher wages higher prices .Liquidity Trap and Philips Curve y y y y y When interest rates are close to zero. a further cut is not possible Hence.

US ± China Trade Problem y y y y y y y Chinese record trade surplus against US Yuan must appreciate against USD making Chinese exports less competitive Yuan pegged against USD till July 2005 Nominal revaluation of Yuan Then shift to peg against basket of currencies Fixing of band of 0.5% around which Yuan would move Fundamentals point to a weak dollar .

Current Scenario in global markets y y y y Asian savings being channeled to meet US Debt Weak dollar & high oil prices Growing Liquidity Crunch ² Risk appetite growing lower higher rates Recent slump in high-yield Asian equity markets Yield Curve and its signals y .

Introduction to Mortgages y Pool of home loans securitized together Securitization: cash flows from bundle of assets are distributed to liability owners according to some pre-determined rule Water Fall Structure Inputs to Mortgage Pricing Prime and Sub-Prime Mortgages y y y y .

Japan: Land of Setting Sun Asset Bubble (80s) Crash in asset prices Record dip in inflation Liquidity Trap Nominal Rates cut to simulate economy Failure of monetary policy Low growth No price pressures Bank Runs Bank Speculations Fiscal exp stopped due to high deficits .

5% Borrow in Yen to invest in high yield currencies like AUD (6.The Carry Trade y y y Japanese interest rates close to 0.75%) and other Asian currencies Borrow to invest in high yield assets like Chinese and Indian stock markets.5%). NZD(7. sub-prime mortgage US assets .

weak dollar .The Carry Trade y y y y y Earn interest yield differential Also when you buy high yield currency. it appreciates Yen depreciates Gains (Interest + Currency) Risks Japanese rates rise Global risk increases High yield asset defaults High oil prices.

Global Trade Cycle Payments Forex Reserves/ Savings US Goods Imports > Exports Debt Driven economy Twin deficits Asia Exports > Imports Excessive Savings channeled into dollar reserves .

Asian woes Pressure to appreciate Exports more expensive Lend to US + Buy FX Capital inflows Sterilized Intervention Sustainable ?? Raise CRR. Reverse Repo Sell Govt. securities Excessive liquidity Inflation .

US Sub-prime crisis Suby y Low Fed rates (1999-2003) spurred excessive lending Sub-prime borrower Poor credit history Incomplete documentation Second loan on same asset y y Defaults begin when Fed Rates get hiked Mortgages ² floating part of payment has begun .

hedge funds. pension funds Payment from home owner passed by Originator to I Bank to investor Fall in asset prices defaults Originators go bankrupt .US Sub-Prime Crisis y y y y y Mortgage Originators sold loan portfolios to IBanks Loans packaged into tranches and sold to investors.

bearish Asian equities Carry Trade adversely affected .US Sub-Prime Crisis y y y y y y Investors demand higher spreads or yields to compensate for higher risk Crisis spreads from sub-prime to prime securities to corporate bond markets LBOs more expensive Lower global risk appetite Weak dollar.