Macroeconomics_lecture 4- Islm Model

Narsee Monjee Institute of Management Studies

Macroeconomics Monetary & Fiscal Policy - ISLM Framework

Dipankar De Mumbai, November 2007

The Structure of the IS-LM Model INCOME

Assets Market Money Market

Goods market

Bond Market

Demand

Demand

Supply

Supply

Aggregate Demand Output

INTEREST RATES

Monetary Policy

Fiscal Policy

Shift in the IS Curve  The IS curve is shifted by changes in autonomous spending.

An increase in autonomous spending, including an increase in government expenditure, shifts the IS curve to the right r

IS0

IS1

Effect of increase in Govt. expenditure

Y

The LM Curve 

3 possible segments –

Normal positive slope

–

Liquidity Trap

–

Liquidity Gate r

r max

Liquidity Gate Zone, slope zero Speculative demand for money is perfectly inelastic w.r.t change in interest rate

r min Liquidity Trap zone, Speculative demand for slope infinity money is infinitely elastic w.r.t change in interest rate Y

Monetary & Fiscal Policy

Monetary Policy • Monetary policy may be defined as a policy employing the central bank’s control of the supply of money as an instrument for achieving the objectives of general economic policy • Monetary policy acts through influencing the cost & availability of credit & money • Effectiveness of monetary policy depends on the institutional framework that is available for transmitting the impulses released by the central bank • Objectives: 1. Ensuring economic growth with price stability 2. To maintain a stable external value of the domestic currency 3. To maintain continuously low rates of interest 4. To create market for govt. securities, develop financing

Instruments of Monetary Policy - I Bank rate is the rate at which commercial banks borrow from the central bank

•It operates by altering the cost of credit & acts as a signaling device/ benchmark for all money interest rates in India. A rise in Bank Rate leads to rise in all types of interest rates. Cost of borrowing by CBs from the RBI increases

Rise in lending rates by the CBs

Demand for commercial credit falls

Contraction in Bank credit

BR Increase

Rise in interest differential b/n India & foreign country

Attractive for foreign funds to come in India & capital inflow into India

Rise in FOREX reserves

Appreciation of rupee

Instruments of Monetary Policy - II Open Market Operations (OMO) is the purchase & sale of government securities by the central bank

•Major instrument for RBI intervention in the market •Under inflationary situations, if the central bank finds that there are more money in the hands of public, it performs OMO, i.e. OM sales •When the RBI sells govt. securities, it mops up liquidity from the system •Commercial banks draws down its reserves, that leads to overall contraction in credit in the economy

Instruments of Monetary Policy - III Variable Reserve Ratio - To control the level of required reserves against their deposits by the commercial banks, reserve ratio is varied

•Examples are Statutory Liquidity Ratio (SLR), Cash Reserve Ratio (CRR) •When the central bank adopts monetary expansionary policy, it would reduce reserve requirements by the commercial banks (CBs) •A part of the existing reserves then becomes ‘excess reserves’, and consequently become available for credit creation by the CBs •Opposite happens when the central bank decides for contractionary monetary policy It is estimated that 0.5% rise in CRR leads to absorption of Rs. 14,000 crores from the system

Money Supply in India

Expansionary Monetary Policy: ISLM Model 

An increase in the nominal money supply (given the price level) raises the real money balances & shifts the LM curve to the right.



Equilibrium income increases & interest rate declines. r

LM0 LM1 Any increase in the money supply shifts the LM Curve to the right

E1 r2

E2

IS1 Y2

Y

Adjustment process to Monetary Expansion 

At the initial equilibrium, increase in the (real) money supply generates a ‘portfolio disequilibrium’, i.e. at the initial interest rate & income, people are holding more money than they want.



This causes people to buy more of other assets, that raises the demand for other assets, say bonds. This leads to increase bond price, driving down the interest rate.



The fall in the interest rate has impact on the aggregate demand.



It stimulates the investment demand, thereby increasing the overall aggregate demand & output and Income.



The increase in output also increases the demand for money, and the interest has to rise to check the demand

Special cases 

The Liquidity Trap Case



In this situation, at a given interest rate, the public is prepared to hold whatever amount of money is supplied.



An expansionary monetary policy does not in this case lead to the right ward shift in the LM curve. The horizontal portion of the LM curve is unchanged



Thus, open market operation has no impact on the interest rate & the economy fails to move to higher level of income.

Special cases 

The Classical Case



In this situation, the demand for money is entirely unresponsive to the interest rate. This makes the LM curve Vertical.



This implies GDP depends on quantity of money only. i.e. people hold money for transactions purposes only. Money is not demanded for any other purposes



In this case, monetary policy has its maximum impact on the level of income.

Fiscal Policy • Fiscal policy comprises a mix of budgetary instruments that govt. can use to target particular economic goals such as higher economic growth or improve income distribution • Fiscal policy comprises govt. expenditure to help achieve its goals; and revenue from taxes & non-tax sources to pay for activities that facilitates achieving goals • If govt. spends more than its revenue, the difference has to be financed through money-creation or borrowing • Money creation could, in turn, lead to higher inflation than is desirable to maintain productive activities • Similarly, public borrowing in excess might result in a build-up of public debt, whose burden might have to be borne by the

Instruments of Fiscal Policy • Fiscal policy – ‘Budget’ ~ Union, State, Local government • Changes in tax rates, heads of expenditure, financing of deficit, etc • Various instruments would include: 4. Corporate income tax, personal income tax, expenditure tax, capital gains tax, Customs duties, central excise duties, 5. Sales tax, entertainment tax, stamp duty, 6. Octroi, education cess, property tax, etc • Govt. PSU income • Defense expenditure is central govt. expenditure

Fiscal Balance Sheet Receipts

Disbursements

A. Revenue Receipts 1. Tax Receipts

A. Revenue Expenditure R1

2. Non-Tax Receipts a) Interest earning

R2

b) Non-interest earning

R3

B. Financing Terms 1. Grants

E1

2. Non-Interest expenditure

E2

B. Capital Disbursements R4

2. Borrowings a) Foreign borrowings

1. Interest Expenditure

1. Capital expenditure

E3

2. Net Domestic Lending

E4

R5

b) Domestic Borrowings i) Other than 91-day T-Bill (internal debt + ‘other liabilities)

ii) 91 day T-Bill iii) Change in Cash Balance Aggregate Receipts = (R1+R2+R3) + (R4) + (R5+R6+R7+R8)

R6 R7 R8 R

Aggregate Disbursements

E

= (E1 + E2 + E3 + E4)

The difference between aggregate disbursements (revenue expenditure + capital expenditure + net domestic lending) and revenue receipts must necessarily be matched by the sum total of all financing items.

Budget Deficit • Traditional Deficit or Budget Deficit = (Revenue Expenditure + capital expenditure + net domestic lending) – (Revenue receipts + grants + Foreign borrowings + domestic borrowing excluding 91 day T-Bill) = (E1 + E2 + E3 + E4) – [(R1 + R2 + R3) + (R4 +R5 +R6)] = (R7 + R8)

• The traditional deficit depict only a part of the resource gap in current fiscal operations that is expected to be financed by 1. Issuing 91-day T Bills & 2. Running down on the govt.’s cash balances and the RBI • Thus, this concept is extremely narrow & does not capture the entire short fall of the govt.’s fiscal operations. To capture that we need a broader concept – Fiscal Deficit

Fiscal Deficit • Gross Fiscal Deficit = (Revenue Expenditure + capital expenditure + net domestic lending) – (Revenue receipts + grants) = (E1 + E2 + E3 + E4) – [(R1 + R2 + R3) + (R4 )] = (R5 +R6 + R7 + R8) = (Foreign borrowings + domestic borrowing) + running down on its cash holdings

Alternative expression: Fiscal deficit = Total Expenditure – (Revenue receipts + Recoveries of loans + other receipts) = Total Expenditure – Total Receipts + Borrowings & other laibilities

Total Expenditure = Non-plan + Plan Expendture Non Plan Expenditure = { (Revenue Account) + (Capital Account)} Plan Expenditure = { (Revenue Account) + (Capital Account)} Total Expenditure = Revenue expenditure + Capital expenditure

Primary Deficit • One important limitation of the fiscal deficit is that it does not necessarily reflect the extent to which the current discretionary fiscal actions improve on worsen govt.’s net indebtedness. • In particular, interest payments in the current period are obligatory, but reflect past budgets • Primary Deficit = Gross Fiscal deficit – ((interest payments – interest earnings) = (Revenue Expenditure + capital expenditure + net domestic lending) –

(Revenue receipts + grants) - (interest payments – interest

earnings) = (E2 + E3 + E4) – (R1 + R3 + R4)

Revenue Deficit • Revenue deficit = (Revenue Expenditure) – = (E1 + E2) – (R1 + R2 + R3)

(Revenue receipts)

Fiscal Deficit & Deficit Financing • In the short run, fiscal deficit (FD) can stroke fires of inflation due to their expansionary effects on the monetary base & money demand • In the long run, it may lead to build up of public debt that would cause worry to generations to come in the future

• Govt. can finance its deficit by two ways – 1. Borrowing from the central bank, commercial banks 2. Borrowing from non-bank sources – both home & abroad

• Borrowing from CB implies money can simply be printed for govt. to spend at zero cost

Fiscal Deficit & Deficit Financing • Borrowing from commercial banks would mean the CBs demand for credit from the central bank must rise. Thus, there will be an associated inflationary pressure • If the CB does not meet CBs demand for additional credit, then loanable funds available for the private sector needs to be curtailed. • Interest rate would tend to rise, as there is now competing demand for the same supply of funds. This, in turn, could have dampening effect on the economy & its growth prospects via the so called ‘crowding out effect’

Fiscal Deficit & Deficit Financing • Non-Bank financing comprises borrowing through govt. securities, which has little impact on the monetary base. But it tends to increase interest rates, while competing down the ability of the private sector to borrow

• Excessive borrowing from abroad has the potential of falling in a foreign debt crisis (e.g. Latin America, East Asia, etc) • Under such circumstances, the currency may be depreciated to improve export performance & improve the ability to service the debt. • But, in the mean time, the burden in terms of domestic currency