SYBCom Semster III Business Economics 2014-15

SYBCom : Semester III

Ranga Sai Vaze College, Mumbai

June 2013

Business Economics Paper II, Semester III [III Edition 2013]

Ranga Sai

SYBCom – Semester III University of Mumbai Business Economics Paper II (Macroeconomics: Theory and Policy)

With effect from June 2013

Objectives This course is designed to present an overview of macroeconomic issues and introduces preliminary model for the determination of output, employment, interest rates, and inflation. Monetary and fiscal policies are discussed to illustrate policy application of macroeconomic theory.

1. Macroeconomics: Theory of Income and employment Circular flow of incomes : closed ( two and three sector models) and open economy models – Trade cycles : Features and phases – Concept of Aggregate Demand – Keynes’ Theory of Income distribution – Theory of Multiplier – Acceleration Principle – Super multiplier. 2. Monetary Economics Concept of Supply of Money – Constituents and determinants of Money supply – velocity of circulation of money : Meaning and factors determining – demand for money : Keynes’ Theory of demand for money – Keynes theory of interest, rate of interest – Inflation : concept and rate of inflation – demand pull and cost push inflation – Philips curve – causes, effects and measures to control inflation.

3. Banking and integration of product and money market equilibrium Commercial banking: assets and liabilities of commercial bank – tradeoff between Liquidity and profitability _ Money multiplier – Monetary policy: objectives and instruments Fiscal Policy: Objectives and instruments – IS-LM Model: framework, impact of fiscal and monetary policy changes.

SYBCom Business Economics Semester III

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CONTENTS

1. Macroeconomics: Theory of Income and employment Circular flow of incomes Trade cycles Keynes’ Theory of Effective demand Theory of Multiplier Acceleration Principle Super multiplier 2. Monetary Economics Concept of Supply of Money Constituents and determinants of Money supply Velocity of circulation of money Factors determining – demand for money Liquidity preference theory Inflation: inflationary gap Rate of inflation Demand pull and cost push inflation Philips curve Inflation: Causes, effects and measures

3. Banking and integration of product and money market equilibrium Assets and liabilities of commercial bank Tradeoff between Liquidity and profitability Money multiplier Monetary policy: objectives and instruments Fiscal Policy: Objectives and instruments IS-LM Model: Derivation IS-LM Model: impact of fiscal and monetary policy changes. `


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Dear Student friends… Thanks for granting 3000 hits per month. We gratefully acknowledge your response to earlier editions and offer the revised III Edition of SYBCom Paper II Semester III. During these days of commercialization it becomes very difficult to find information on web which is relevant, authentic as well as free. We believe that knowledge should be free and accessible to all those who need. With this intention the notes, which are originally intended for the students of Vaze College, Mumbai, are made available to all, without any restrictions. These notes will be useful to all the S.Y.B.Com students of University of Mumbai, who will be writing their Business Economics Paper II examinations after June 2013. This is neither a text book nor an original work of research. It is simple reading material, complied to help the students readily understand the subject and write the examinations. We no way intend to replace text books or any reference material. This is purely for academic purposes and do not have any commercial value. Feel free to use and share. We solicit your opinions and suggestions on this endeavor. Dr. Prof. Ranga Sai [email protected] June 2013


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1. Macroeconomics: Theory of Income and employment Circular flow of incomes : closed ( two and three sector models) and open economy models – Trade cycles : Features and phases – Concept of Aggregate Demand – Keynes’ Theory of Income distribution – Theory of Multiplier – Acceleration Principle – Super multiplier.

Circular flow of Incomes Circular flow of incomes is a static macroeconomic model providing relationships between various macroeconomic variables. This is a classical model of macroeconomics. Circular flow of incomes was first developed by the Quesney a French Physiocrat in the 17th century. Later it was developed as a macroeconomic model of equilibrium. The model can be developed into a dynamic model by providing input output relationships. Such models help the economy in planning and regulation. The two sector model includes household and firms. It is equilibrium between consumption and expenditure. The industry provides the output for the households to consume and also provides incomes. The household sector spends the money at the markets to give back incomes to the firms. This is the circular flow of incomes between households and firms. The three sector model includes the banking sector, where the equilibrium includes Y=C+S The households save the income that is not spent. Further the savings become investment through the banking sector. Thus Y=C+I, where S=I


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Government sector will include tax and expenditure made on both the sectors. Y=C+I+G It is closed economy. By including the external sector, it becomes an equilibrium with open economy. Y=C+I+G+(X-M)

This is a macroeconomic model with five sectors: household, firms, banking, Government and the external sectors. The circular flow of incomes is an important model or estimating national income. It is useful in studying the interdependence between various sectors.

Trade Cycles Periodic changes in the level of economic acclivities in the long run are commonly termed as trade cycles. The level of economic activity periodically, increases and reaches a peak, shows a change in trend, decreases and bottoms out and finally, changes trend towards increase. Such cyclical changes in the level of economic activities constitute the trade cycle. Trade cycle is a neoclassical concept of macro economics which tries to explain the changes in the economic activities with respect to time. The concept of trade cycle was initially developed by Joseph Schumpeter. The different phases in the trade cycle are named in relation to the full employment level. SYBCom Business Economics Semester III

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Accordingly, there are six phases of trade cycle: 1. Inflation 2. Boom 3. Deflation 4. Recession 5. Depression, and 6. Recovery

1. Inflation: When the economic activity increases after full employment level, it is called inflation. During inflation, the demand pressures will be high. Increasing demand leads to increasing product prices, increasing demand for factors, higher wages and then increasing demand again. 2. Boom: Boom refers to the peak in the level of economic activity after full employment. The demand pressures will be at the peak. The price level will be very high. 3. Deflation: It is the downward trend in the economic activities after boom. At boom level the Government will take corrective measures due to which the economic activity will show a change in trend. 4. Recession: When the economic activity reduces below full employment It is called recession. The level employment will decreases, the prices will decrease and the economic activity shrinks. 5. Depression: This is the lowest level of economic activity. The markets collapse. Large scale unemployment will lead to poverty and suffering. The world experienced Great depression during 1929 and 1933. 6. Recovery: From the lowest levels of economic activity the markets recover due to positive Government policy. The economic activity will increase towards full employment. Three will be increase in the level of employment, incomes, investment and demand. SYBCom Business Economics Semester III

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The reasons for the occurrence for the trade cycle has been not yet explained satisfactorily. The Sun spot theory relates the level of economic activity with the number of sun spots. In absence of any other theory, the Sun Spot theory still holds valid.

Theory of Effective Demand The classical economists failed to provide policy solutions to economic problems. The classical theory believed in long run and full employment equilibrium. Criticisms of classical theories 1. Classical theories are long run theories: - According to Keynes theory should aim at short run problems and policies. Long run is imaginary. 2. Classical economists believed that economies could have equilibrium only with employment. But countries have equilibrium even with unemployment. 3. Increasing the level of employment is not possible by laissez faire policy. Full employment is not automatically 4. Savings do constitute leakage in classical system .It reduces demand. 5. Unemployment can not be solved by a wage-cut policy. Strong trade union movement will resist any decrease in wages. Keynesian economics is short run economics. According to the theory equilibrium is possible even with unemployment. There is no automatic system in long run, which will grant full employment. According to Keynes employment theory, it should provide short run solutions He assigns an active role to the Govt. This is a deviation from traditional laissez faire system. Keynesian theory is called the general theory of employment The private investment can create employment to a certain level. Therefore the govt. investment can help in increasing the level of employment.


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Factors Determining Effective Demand:There are two important factors determining effective demand. 1. Aggregate demand function and 2. Aggregate supply function Aggregate Demand function deals with the various amount of money the producers expect from the sale of output at different levels of employment. These are the receipts the producers expect. ADF is short run factor. So Keynes considers it for study in detail. The Effective demand is determined by ADF in the short run. ADF inturn is determined by Consumption, Investment and, Government investment or expenditure. Aggregate Supply function deals with the various amount of money the producers must receive from the sale of output at different levels of employment. These are costs the producers must receive. ASF on the other hand is a long run factor. Keynesian economics is short run economics, so it is kept as constant in the short run. ASF is determined by long run factors like Population, natural resources, cost structure, technology etc. Level of Employment (‘000) 100 200 300 400 500

Aggregate Demand (‘000) 1000 1500 3500 6000 4000

Aggregate Supply (‘000) 800 1400 3500 6200 4500

Relationship ADF>ASF ADF>ASF ADF=ASF ADF
Aggregate demand function represents receipt and Aggregate Supply Function the costs.

At a point where ADF = ASF the effective demand is determined. In turn the level of employment is found at Ē The level of employment can't increase above Ē because ADF < ASF and receipt < cost. If private investments cannot increase the level of employment then, the govt. investment can increase. This is the prescription for increasing the level of employment. The economy may have equilibrium even with unemployment. SYBCom Business Economics Semester III

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Aggregate supply function as a long run factor is represented as a 45-degree line cut at full employment. The proportionate increases do not affect the short run factors. ADF can be studied in terms of its components. C - Consumption expenditure, I - Investment expenditure and G - Government expenditure. National Income Y= C+I+G

C + I constitute ADF determining the equilibrium at Ē. The level of employment can be increased to the government expenditure. The increase in employment and income can be seen on X-axis.


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The Keynesian perception of government investment helped in generating employment during great depression (1929-33). It was adopted by the U.S. under New deal policy. The government invested in irrigation projects. Pump priming finances the activity of public expenditure. The money in circulation is increased the government investment generates employment increases incomes, demand and prices. Thereafter the private investments will take over. The fall out of Keynesian government investment is inflation. In the process of generating resources for employment; the government increases the money in circulation. This is also called as deficit financing. Deficit financing is highly inflationary. Hence inflation is purely post Keynesian occurrence. However government investment is found highly suitable for financing development employment and growth.

Investment Multiplier Investment Multiplier tells us about the changes in income for changes in the investment. The concept o Multiplier was developed by Kahn. With change in the investment here will be a change in the income, because the investment expenditure turns into income. There after the income induce the consumption to increase depending on the level of marginal propensity of consumption.

This way an increase in the consumption expenditure creates incomes in the second round. The induced income again increases the consumption. This cycle repeats and an increase in the investment generates income several times more. This is called as the multiplier effect.


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Multiplier Effect

The multiplier has a time lag. The multiplier works into the long run. Each year some income is added and consumption is generated. This may taper with time but it shall continue for ever, theoretically. This is called multiplier effect Propensity of Consumption The intensity of consumption whether aggregate or additional is called propensity of consumption. Propensity of consumption can be measured in two ways. Average propensity of consumption: APC is the ratio of consumption to Income. APC = C/Y. Marginal propensity of consumption: The MPC measures changes in consumption for changes in income. It is the measures of propensity of consume for an increment in income. MPC = ∆C / ∆P


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Derivation of Multiplier

Illustration For a given change in the Investment of Rs. 10,000 cr and a MPC of 0.5: Multiplier is the inverse of Marginal Propensity of Consumption. SYBCom Business Economics Semester III

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Then the multiplier value shall be 2. For the given illustration the Y will increase to Rs, 20,000 cr Working of Multiplier

Assumptions or Limitations or leakages in Multiplier 1. Multiplier effect lasts over a larger time period. There is time lag in the realization of multiplier effect. So in the short run only a part of the multiplier effect can be got. The remaining is considered as a leakage in the multiplier. 2. If the increased incomes are used in the repayment of old debts, the multiplier effect stops. 3. The increased incomes shall be spent on domestic consumption only. Money pent on imports will shift the multiplier effect outside the country. 4. With increased incomes the Government increases tax, the multiplier effect reduces. This is because the disposable income decreases each time. 5. There shall not be liquidity preference. If people hold cash balances with out spending the multiplier effect stops. 6. Investment in second hand securities and gold reduces multiplier effect. SYBCom Business Economics Semester III

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7. There should be excess capacity in the industry to produce goods with increasing demand for consumer goods.

Acceleration Principle The accelerator deals with changes in the investment for changes in the consumption. It is the continuation of multiplier effect. The multiplier indicated changes in Income for changes in the investment. With changes in the consumption, changes in the investment are given by acceleration principle.

Normally, assets last over a fixed life period. This is useful for the calculation of depreciation and capital consumption. At aggregate level, depreciation is treated as replace investment. Depending on the rate of depreciation, annually, certain investment is needed. This is called replacement investment. The capital output ratio tells us about the demand for investment for a certain output. For an increase in the consumption there will be certain need for investment. In addition there will be replacement investment. Together the total investment for the economy is computed. Assumptions of Acceleration Principle 1.

There is no excess capacity in the consumer goods industry 2. There is excess capacity at the capital goods industry 3. Increase in demand for consumer goods is permanent 4. Complementary resources are available 5. It is a case of less than full employment level 6. Capital output ratio remains constant

Super Multiplier Investment Multiplier tells us about the changes in income for changes in the investment. With change in the investment here will be a change in the income, because the investment expenditure turns into income. The simple multiplier means that investment determines output. The super multiplier combines the multiplier with the accelerator that is consumption SYBCom Business Economics Semester III

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demand inducing further investment. The multiplier effect now becomes a continuous process alternating with acceleration principle. The simple investment multiplier was given by Keynes considering only one time autonomous investment. The super multiplier effect is given by Hicks which includes the induced investment to trigger off super multiplier effect. Changes in investment will again trigger off the multiplier effect. In continuation, multiplier and acceleration effect repeat. This is called the super multiplier effect.

When the multiplier and the accelerator work in continuation it is called the super multiplier effect. The multiplier will initially create demand for consumption. The consumption will induce investment and the cycle repeats. Assumptions a. b. c. d. e.

Investment is induced due to increase in consumer demand There is no excess capacity in industry The marginal propensity of consumption remains same The tax structure is same so that the disposable income remains same. Consumption demand and demand for capital goods is fulfilled by domestic economy. f. The increase in the demand is permanent. g. The complementary resources for production are available h. The supply of capital goods is elastic.


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2. Monetary Economics

Concept of Supply of Money – Constituents and determinants of Money supply – velocity of circulation of money : Meaning and factors determining – demand for money : Keynes’ Theory of demand for money – Keynes theory of interest, rate of interest – Inflation : concept and rate of inflation – demand pull and cost push inflation – Philips curve – causes, effects and measures to control inflation.

Supply of Money Constituents of Money supply The supply of money is the State function. The Central bank possesses the monopoly of issue of currency. Traditionally the supply of constitutes coins and currency. There are several approaches to the constituents of money supply. 1. With ever expanding properties and functions of money the constituents of money has been rapidly changing. Since David Hume, the composition of money started including coins and currency together with demand deposits. The deposits which are chequable are as liquid as cash. So primarily, money supply should be made up of: Coins and currency + Demand deposits 2. Milton Friedman described money with wider coverage and functions. According to him money supply should comprise coins and currency, demand deposits and also time deposits. Time deposits are those which have a time obligation between the bank and the depositors. They are liquid but with a time prescription. Coins and currency + Demand deposits + Time deposits


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The spending of the house hold is influenced by the cash held by them. But the time deposits also enhance the spending decisions. Time deposits can function as liquidity preference thus allowing households exercise greater spending. Milton Friedman’s approach is accepted and followed all over the world as the standard of measuring money supply. This is similar to the measure M3 followed by Reserve Bank of India. 3. Gurley and Shaw offer the widest definition of money supply. According to them, money supply shall include all that can be converted into cash, depending on convertibility of asset. However, the assets shall be included in money supply based on their liquidity. E.g. Cash is cent percent liquid, where as time deposit has lesser liquidity, loans, securities, gold all have liquidity which gradually declines. These assets shall be included as per the weightages assigned to their liquidity. 4. Bank of England follows the method suggested by Radcliffe Committee. The method has wider coverage; it includes assets depending on liquidity and convertibility. Reserve Bank of India followed method similar to this upto 1977, when the II Working Group suggested an alternative and indigenous method of measuring money supply. 5. Reserve bank of India RBI’s Third Working Group 1998 The Third working group in 1998 recommended compilation of monetary aggregates which is simple, uncomplicated, comprehensive, and operationally feasible in terms of frequency of availability of information. Accordingly the group proposed compilation of following four measures of monetary aggregates: M0

= currency in circulation + bankers’ deposits with RBI + other deposits with RBI.

Narrow money: Narrow money deals with transactions demand for money. The constituents of narrow money are limited to the central bank and the central government and commercial and co-operative banks. SYBCom Business Economics Semester III

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M0 is essentially the monetary base, i.e. reserve money. It is compiled weekly. This measure denotes effects on the consumer price index. M1

= currency with public + demand deposits with the banking system + other deposits with RBI

M1 reflects the banking sector’s non-interest bearing monetary liabilities. It is compiled fortnightly. M2

= M1 + time liability of savings deposits with the banking system + certificates of deposit issued by banks + term deposits = currency with public + current deposits with the banking system + saving deposit with the banking system + certificates of deposit issued by banks + term deposits the banking system + other deposit with RBI

M3

= M2 + term deposits banking system + call borrowings from ‘Non banking financial corporations.

M3 is the international standard of money supply. IMF, World Bank and WTO use this measure, uniformly, for comparing different economies of the world. M3 is similar to Milton Friedman’s measure of money supply. M3 is the measure of aggregate liquidity in the economy. This is an important measure for monetary targeting by RBI. Liquidity measures for Broad money In addition, the Third Working Group proposed two liquidity measures for broad money for measuring overall economic activities (monthly and quarterly compilation). This measure brings out the importance of Non depository corporations (Non banking financial corporations).

L1 L2

L3

= M3 + all deposits with post office savings bank except NSC = L1 + term deposits with Term Lending Institutions and Refinancing Institutions (FIs) + term borrowing by FIs and Certificates of Deposits issued by FIs = L2 + public deposits of non banking financial companies


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Velocity of money Velocity of money is defined simply as the rate at which money changes hands. Velocity refers to how many times a given quantity of money is spent during the period under consideration, usually one year. If velocity is high, money is changing hands quickly, and a relatively small money supply can fund a relatively large amount of purchases. If velocity is low, then money is changing hands slowly, and it takes a much larger money supply to fund the same number of purchases. It is known that GDP = M x V; that is, GDP equals the quantity of money times its velocity. By dividing the Gross Domestic Product (GDP) by the Money Supply (M1) Velocity of Money can be derived.

Factors determining velocity of money 1. Money Supply: Velocity of money depends upon the supply of money. If the supply of money is less the velocity of money will increase and if the money supply is less, the velocity of money will fall. 2. Value of Money: The velocity of money is high during inflation and the velocity of money is low during deflation. 3. Credit Facilities: With larger credit facilities the velocity of money increases. 4. Volume of Trade: As the volume of trade increases the number of transactions and the velocity of money increases and as the volume of trade decreases, the velocity of money decreases. 5. Frequency of Transactions: With the increase in the frequency of transactions, the velocity of money increases. Similarly, with the decrease in the frequency of transactions, the velocity of money decreases. 6. Business Conditions: The velocity of money increases during the period of boom period and decreases during slump conditions. SYBCom Business Economics Semester III

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7. Payment System: The velocity of money is also determined by the frequency of wage payments. Velocity will increase with increasing frequency of payments. 9. Propensity to Consume: Larger the propensity of consumption higher will be the velocity of money. Lower the propensity to consume, lesser will be the velocity of money.

Demand for money Factors determining demand for money Traditionally, the demand for money is expected to be a function of value of money. There is a negative relationship between value of money and the demand for money. On the other hand value of money is a nominal concept. The value of money is measured as the inverse of price level. The demand for money is determined by several other factors. Following are the various factors determining demand: a. Interest rate: Interest rate is the price of holding money. It is the income foregone by holding cash. There is a negative relationship between rate of interest and demand for money. b. Aggregate income: Larger the level of income larger will be the demand for money. Larger income and output will need higher liquidity for mobility in the process of payments. c. Price level: Prices and the demand for money are inversely related. With prices rise, the demand for money will be higher. With decrease in prices the transaction demand for money falls. d. Transaction demand: This is the demand for transactions as defined by Keynes. Transaction demand depends on the level of income. d. Velocity of money: Velocity of money is the rate at which money performs transactions. Velocity of money is different for different monetary systems; banking, cash transactions etc. e. Hoardings: Demand for liquid cash for hoarding determines the demand for money. The demand for such cash balance depends on the rate of interest.


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f. Financial markets: Growth of financial markets and financial instruments provide incentives for dishoarding cash balances. Highly developed financial system will reduce demand for physical money. g. Buying pattern: Frequency of buying and buying pattern determine the demand for money. Increased frequency of buying increases demand for money. h. Banking system and innovations in mode of payment : Healthy banking system and innovations in the mode of financial payments and transactions will affect demand for money. Physical cash will be less in demand in those economies where banking system and habits have highly developed.

Demand for Money - Liquidity preference theory – Keynes There are three chief motives for which money is demanded. These are transactions, precaution and speculation. The first two motives are classical the third motive of speculation is introduced by Keynes. 1. Transactions Motive: Money is demanded for regular economic transactions. Both households and firms have to carry out a variety of transactions for which they need money. It is related to the size of the income and type of activities performed by individuals, households and firms. Demand for money to satisfy transactions motive is about 50 percent of the size of an individual or household income. 2. Precautionary motive: Money demanded to satisfy the precautionary motive is for meant for unforeseen circumstances. This amount of money kept aside can be used during times of uncertainty or emergency. It depends mainly on the size and responsibilities of the family and size of the


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income. In the short run these factors remain constant and hence demand for money also remains nearly constant. 3. Speculative motive: Keynes was the first to identify the role of speculative activities. Such demand is made to invest in capital market for buying shares, bonds, securities etc. when their prices are low. Keeping money in this idle form is known as hoarding of money. It all depends upon fluctuating prices and market conditions for securities. The total demand for money or liquidity can be classified into two parts:

Total demand for money = L = L1 + L2 L1 is that part of money or liquidity demanded to satisfy transactions and precautionary motives. Keynes calls this the demand for Active Cash balances or money. Active cash balances depend on the income of the households. The second part L2 is money demanded made to satisfy the speculative motive. Keynes has called this as demand for Passive Cash balances or money. Speculative demand depends upon the prices of securities.

The negative relationship between rate of interest and liquidity preference is found only up to a minimum interest rate. There after, the demand for money becomes infinity. The zone where the demand for money is infinity is called as the liquidity trap. Any increase in money supply at this level will not have any effect on the liquidity preference. At liquidity trap the demand for money tends to be infinity. SYBCom Business Economics Semester III

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The Relationship between Interest and Inflation Inflation is caused by money supply in an economy. The Government uses interest rate to control money supply and, consequently, the inflation rate. When interest rates are high, it becomes more expensive to borrow money and savings become attractive. When interest rates are low, banks are able to lend more, resulting in an increased supply of money. As interest rates drop, consumer spending increases and this in turn encourages economic growth. Change in interest rate can be used to control inflation by controlling the supply of money in the following ways: 1. A high interest rate affects consumption expenditure by shifting consumers from borrowing to saving. This in turn effects the money supply. 2. An increase in interest rate encourages savings. Low interest rates encourage investments in shares. The consumption demand gets affected. 3. A rise in the interest rate induces foreign investment. Foreign investors will find profitable to divert investment to countries with higher interest rates. Nominal and real interest rates Nominal interest is the rate of interest before adjustment for inflation. Real interest is the rate of interest an investor expects to receive after allowing for inflation. The nominal interest rate is the interest rate at bank. The nominal interest rate indicates the rate at which the saving is growing. The real interest rate corrects the nominal rate for the effect of inflation. This is the net growth of savings after considering inflation rate. Irving Fisher states that the real interest rate is independent of monetary measures, especially the nominal interest rate. The Fisher Effect is shown as: Rr = Rn − π .


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This means, the real interest rate (Rr) equals the nominal interest rate (Rn) minus rate of inflation (π). Or nominal interest rate = real interest rate + inflation rate. The Fisher Effect shows how the nominal interest rate moves according to inflation rate in the long run

Economics of Inflation According to neoclassical economics inflation refers to increase in the level of economic activity after full employment. Presently, inflation is found even with unemployment. This is called stagflation. Inflation • Inflation is post Keynesian concept. Primarily inflation is caused by indiscriminate expansion of money supply. • Inflation means too much money chasing too few goods. • Increase in monetary resources against stagnant real output leads to inflation. • Inflation is a monetary phenomenon. • Inflation is caused by excess demand pressures on the goods and factors of production due to increase in monetary resources. Inflationary Gap Inflationary gap arise when there is an increase in incomes and the pout put remaining same. The additional income is absorbed by the same out put, thus causing the prices to increase.


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In the diagram, with an increase in the income the consumption function will shift up wards. The equilibrium should move from E1 to E2. But E1 is a full employment situation; the equilibrium can not shift to E2 (to the right of ASF) but moves to E3. The additional income and expenditure is consumed by the same real output. E1to E3 is the inflationary gap. Classification inflation (Rates of Inflation)

Inflation can be classified in terms of rate of change. Inflation is classified in terms of years taken for the prices to double. There are four types of Inflation: 1. Hyper inflation 2. Running Inflation 3. Walking inflation, and 4. Creeping inflation SYBCom Business Economics Semester III

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Hyper inflation: It is said to be hyper inflation when the prices double within three years. The rate of inflation is more than 30 percent. This is also called galloping inflation. Running Inflation: If the prices double in eight to ten years it is called running inflation. The rate of inflation is between 10 to 15 percent. Walking inflation: If it takes fifteen years forth prices to double, it is called walking inflation. It is moderate inflation suitable or a rapidly growing economy. Creeping inflation: If it takes 20 years to double the prices, it is called creeping inflation. Such inflation may not promote high growth rates. The industry will show a growth rate of 4 percent and agriculture will e stagnant. Types of Inflation Inflation can be classified based on major causes. Accordingly, there can be four types of inflation Budgetary inflation: This is the inflation caused by expansion of money supply resulting out of Government’s budgetary activities. The Government may increase money circulation to meet the deficits in the budget for financing any contingency. If Government expands money for non productive purposes it leads to inflation. During Post Keynesian period, this has been a major cause for rapid increase in inflation all over the world. Wartime inflation: During the emergencies of war, the Government generates resources by currency expansion. In addition, the prices may incase due to scarcity followed by hoarding and black marketing. Such inflation is generally controlled after war. War time inflation is a common occurrence these days. Demand Pull Inflation Demand pull inflation is caused by increasing demand arising out of excess money supply and increase in demand for factors by the industry. SYBCom Business Economics Semester III

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Demand pull factors 1. Increase in money supply due to budgetary activity 2. Increase in demand for goods 3. Increase in demand for factors by the industry

According to Keynes, after full employment E if the aggregate demand increases to D1, D2, and D3, the real output can not increase and the equilibrium will be shifting only on the ASF to E1, E2, and E3. As a result the prices will increase to P1, P2, and P3. This is the inflation driven by demand pull factors Demand-pull factors in India a. The parallel economy creates demand pressures from unexpected sectors of the economy. b. The unorganized money markets pump in those additional resources which cause inflation. c. Increasing public expenditure creates large amount of incomes. Public expenditure, which constitutes 43 percent of GNP is a major source of income. d. Rapid monetary expansion leads to excess inflationary pressures. A monetary base of Rs. 2, 65,000 crore generates a large income and the following demand.


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e. Deficit financing create those resources which create inflation. The deficits create additional resources of around Rs.10,000 crores annually. f. Due to in appropriate taxation large disposable income is left causing high rates of inflation. Cost Push Inflation Cost push factors 1. Increasing prices 2. Decrease in the real income (purchasing power) 3. Decreasing in the standard of living. 4. Increase in demand for factors 5. Increase in demand for more wages 6. Wages increase due to strong trade union 7. Increase in the cost of production 8. The prices increase.

Under cost push inflation even with increasing demand the supply can not shift. Against an inelastic supply curve an increase in demand D1, D2, and D3 will shift the supply curve. The cost structure undergoes a change and the equilibrium will be found on the same inelastic supply curve. The real out put remains same and the value of out put increases to P1, P2, and P3. Hence the prices will increase. This is cost push inflation.


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Cost-push factors in India: a. Administered prices tend to be inflationary. The prices of coal and fertilizers affect agricultural prices and prices of power. b. The prices determined by the Bureau of Industrial costs also tend to be inflationary for inputs. With the cascading effect, the prices spiral upwards. c. The strong trade union movement always bargains higher wages. The politicized trade unions command larger bargaining power. d. Industrial strikes, lockouts lead to wastage of resources. e. The labor legislation always provides higher wage than productivity.

Effects of Inflation Inflation affects all sectors and al sections of the economy. These effects of inflation can be classified into four groups 1. Effects of inflation on Production Inflation effects production by bringing in changes in investment, output, factor markets, and financial markets a) Output: The output will remain stagnant or show a marginal rise. The value of output may increase but the real output will remain constant. b) Cost of production: The cost of production will increase due to increase in the factor costs lead by increase in demand. With increase in demand for inputs the quantity will remaining same. So the factor cost increase. c) Investment: The value of investment will increase but the real investment will remain same. d) Prices: The price level will increase. With increase in prices the standard of living will decrease. e) Business environment: There will be business optimism due to increasing prices


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2. Effects of inflation on Consumption a) Middle class: The fixed income groups will suffer a loss of standard of living. The salary incomes will not increase as fast as the business incomes. b) Trade unions: The trade unions will become stronger to fight for the workers welfare c) Wages: The trade unions will demand higher wage. The wages will increase due to strong trade unions d) Consumption expenditure: The value of consumption will increase. The consumption expenditure will increase where as the real consumption will remain same. 3. Effects of inflation on Monetary sector a) Surplus budget: The Government will adopt a surplus budget to reduce money supply b) Credit policy: The tight money policy will lead to a credit squeeze. c) Money markets: There will be boom in financial markets. There will be bullish trend leading to increase in share prices. d) Interests: Excess money supply will lower the interests in the money markets

Measure to control inflation Inflation can be caused by a variety of factors; accordingly there are several techniques to control inflation, each suitable to influence the kind of factors causing it. Following are the major methods of controlling inflation 1. Monetary measures 2. Fiscal measures 3. Real sector measures 1. Monetary measures There are several monetary measures employed in controlling the supply of money and credit. These are the basic components of monetary policy. a. Bank rate : Bank rate is the rate at which he central bank rediscount the bills presented b commercial banks. Bank rate helps in reducing supply and demand for credit. An increase in bank rate helps in making credit costly, thus reducing the demand for credit. Accordingly, increase in the interest rate will reduce the demand for credit. b. Statutory liquidity ratio: indicates the minimum percentage of deposits that the bank has to maintain. This rate is prescribed by the Central bank. By increasing the reserve requirement, the credit creation can be controlled. This method regulates the supply of credit. SYBCom Business Economics Semester III

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c. Open market operation: It refers to the purchase and sale by the Central Bank of a variety of assets, such as foreign exchange, gold, Government securities and company shares. In India, however it refers to the purchase and sale of Government securities. By way of open market operations, the central bank either increases or decreases the money supply in the country. To increase the money supply, the Central bank buys securities from commercial banks and public and vice versa. Open market operations are used to provide seasonal finance to banks. d. Repo and Reverse REPO: Repo and Reverse Repo are tools available in the hands of RBI to manage the liquidity in the system. It either injects liquidity into the market if the conditions are tight or sucks out liquidity if the liquidity is excess in the system through the Repo and Reverse Repo mechanism, besides a host of other measures. e. Interest rate mechanism: Certain central banks stipulate interest rates for certain markets and portfolio. This is a positive measure in controlling money supply. f. Monetary targeting: Central banks adopt monetary targeting for restricting the supply of money. Each year the central bank lays down target for monetary expansion. It enables the government to assess the level of monetary inflation.

2. Fiscal measures: a. Taxation: Progressive taxation is used for reducing disposable income. Progressive taxation helps in reducing demand by reducing disposable income of higher income groups. b. Public expenditure: Productive expenditure on developing infrastructure helps in increasing productivity and production. Third is regarding supply management. c. Debt management: Disposable income of the higher income groups can be reduced by soliciting debt. The government can issue such instruments which will be a part of portfolio for the rich an also reduce disposable income. d. Budgetary management: The government adopts surplus budget to withdraw monetary resources from the economy. Surplus budget has larger tax revenue than public expenditure.


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3. Real sector measures a. Import of capital goods: Import of capital goods will help in increasing the production capacity of consumer goods. This is supply side management. b. Better infrastructure: Development of infrastructure helps in increasing productivity and production. c. Technology up gradation: Larger expenditure outlays on research and development will help in increasing productivity. d. Public distribution system: Efficient public distribution system will help the poorer classes in maintaining their standard of living. PDS can deal with more and more consumer goods to counter act primary inflation. e. Price legislation: The Government can enact consumer legislation and price control act to peg prices of essential goods. f. Consumer movement: Effective consumer movement will counter act any act of price exploitation by the industry.

Module 3 Banking and integration of product and money market equilibrium

Commercial banking: assets and liabilities of commercial bank – tradeoff between Liquidity and profitability _ Money multiplier – Monetary policy: objectives and instruments Fiscal Policy: Objectives and instruments – ISLM Model: framework, impact of fiscal and monetary policy changes.

Assets and liabilities of a commercial bank Following are the various items appearing on the liabilities side of a balance sheet. 1. Checkable Deposits - (10%) a. Demand deposits (non-interest-bearing checking) b. NOW accounts - interest-bearing checking c. Money market deposit accounts (MMDAs) - money market mutual funds.


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Checkable deposits are payable on demand, you can write a check for any amount, including your entire balance. Checkable deposits are lowest cost source of funds for a bank, sometimes 0 (demand deposits), because people like the liquidity of checking accounts and will forego interest for convenience of checks.

2. Non-transaction Deposits are the Primary source of bank funds a. Savings accounts (passbook savings) b. Small-denomination Time Deposits (CDs, certificate of deposits), fixed maturity from several months to 10 years. Higher interest rates than passbook savings, penalties for early withdrawal, less liquid, are more costly for the bank. c. Large-denomination Time Deposits, bought by corporations, money market funds and other banks. Liquid, negotiable, marketable, can be resold in secondary market before they mature, like a corporate bond or T-bond. Alternative to commercial paper and T-bills. 3. Borrowings of bank funds: a. from other banks - Fed Funds Market - to meet reserve requirements b. from RBI- discount rate - to meet reserve requirements c. from parent companies - bank holding companies d. from corporations and from foreign banks - negotiable CDs and Eurodollar deposits 4. Bank capital, equity from issuing new stock or capital from retained earnings. Bank capital is also a cushion against a drop in the value of its assets, to protect against insolvency, bankruptcy. Banks are usually highly leveraged, very thinly capitalized. Asset side of a balance sheet: If liabilities indicate as to the source of funds, the liabilities indicate where the funds have gone. This is about deployment of resources A bank uses its deposits to acquire income-earning assets, to make profits, by earning more interest on assets than they pay out on liabilities. 1. Reserves : Deposits kept on account at the Fed (all banks have an account at the RBI) + Vault cash on hand at bank, stored in the vault overnight.


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2. Securities: Banks also hold securities like T-bills and mini bonds and government debt instruments. 3. Loans: Most bank profits come from Loans. Loans make a large part of bank assets: a. Commercial loans to businesses b. real estate loans (mortgages, home improvement loans, etc.) c. consumer loans (credit card, automobiles) d. interbank loans, Federal Funds market e. other loans Loans are less liquid than other assets (e.g. securities, T-Bills, etc.) because the assets tied up for the length of the loan, 30 years in the case of a typical mortgage. Loans are also more risky, higher default risk than securities. Because loans are more risky and less liquid, they earn more interest for banks. 4. Other Assets : Property, plant and equipment : Buildings, office equipment, computer systems, etc.

Conflicting Objectives of Liquidity and Profitability Banks are limited companies whose main aim is to create profit to its shareholders. Most of the profit comes out of lending the money, which is received from depositors, out to the customers. So the more the depositors, bank has the more it can lend out, thus it can make more profit and pay higher dividends to its shareholders. It follows that the banks try to be as attractive to potential savers as possible. They can offer two things: a high interest rate and a high liquidity. Both are very important, because depositors want to be able to draw their money out any time they want and have profit by receiving interest. A bank has to maintain liquidity as well as profitability. Liquidity is meant for maintaining the statutory responsibility to the depositors and profitability for its survival. So, a bank needs to maintain its portfolio in such a manner that it is able to honor the demands of the depositors as well as earn profits out of its deposits and other investments.


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In its operations, a commercial bank has to draw a balance between liquidity and profitability. The portfolio management of a commercial bank can be studied from the arrangement of assets in the balance sheet.

A bank arranges its assets in such a manner that the liquidity decreases down q wards in the asset side of the balance sheet. Liquidity is available at different levels without fore going the profitability. Now there is a clash for the bank between these two objectives. If they would want to maximize the liquidity they would keep their assets in cash, which is the most liquid form of assets, but the bank cannot earn any interest on that, so it cannot give any interest to its depositors. In portfolio management, a bank resolves the conflict of liquidity and profitability

• Due to security reasons of security and liquidity the banks to have some portion of their assets in cash. This money earns no interest. • The liquidity loss of keeping less cash is compensated by the interest bearing loans at call or short notice (the money can be received back immediately or after a week notice).


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• Discount houses deals with bills and so can provide the money immediately by selling some of them. • Treasury Bills which government issues every month for the period of 91 days and which are very secure and bills issued by other businesses. • Liquid assets form 9-12 percent of all the assets. They are unprofitable compared to the other type of assets that are less liquid: medium-term loans, investments and advances. • The main part of banks' assets is advances to its customers. They form more than 50 percent of total assets and are formed from overdrafts and loans of various types. • Government stocks are another very common type of profitable assets. They are loans to government, who issues interest-bearing bonds (e.g. Exchequer stock, Treasury stock), which banks can then buy. Banks have to make decisions which proportion of these assets described above to choose to make profits and maintain liquidity. They do not have choice, because great part of their liabilities is controlled by the Reserve Bank of India (eligible liabilities).

Credit creation by commercial banks The Commercial Banks crate credit out of their cash deposits. The banking system can create credit several times more than the amount of cash deposits received by them. This is called multiple credit creation or deposit multiplication.

The initial cash deposit made is called as rte primary deposit. The commercial bank will keep a part of the deposit for honoring the demands of the depositor and the balance is extended as credit. The advances are always made in cheque. So the borrower has to deposit the loan in a different bank. This way a loan creates a deposit. The second bank will again retain a part for honoring the demands of the depositors and the balance SYBCom Business Economics Semester III

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will be given as advance. This way, ‘every deposit creates a loan and every loan creates a deposit’. It can be seen that in this process a deposit creates loans several times more. This is called multiple credit creation. A single bank can not create credit it takes all the commercial banks to create credit. However, in the process if there are more cash withdrawals the credit creation stops. Money entering the banking system generates credit and cash withdrawals reduce credit. Though the credit is always extended as cheque cash deposits are essential. ‘Banks cannot create credit out of thin air, cash deposits are needed for honoring the demands of the depositors.’

Working of credit creation by commercial banks Illustration:

Initial primary deposit of Rs. 10,000, and a reserve ratio of 10 percent SYBCom Business Economics Semester III

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Credit creation by banks Banks.

Deposits

Reserves

Advances

A

10,000

1000

9,000

B

9,000

900

8,100

C

8,100

810

7,290

D

7,290

729

6,561

E “ The deposit multiplier is computed as Dm = 1 ϒ

Where, ϒ is the reserve ratio. Limitations of credit creation: For several reasons the deposits may not expand as [per the deposit multiplier. This is due to certain leakages and limitations of multiple credit creation. Following are the limitations of credit creation by commercial banks 1. Cash with drawls: Money entering the banking system creates credit and cash with drawls stop credit. 2. Liquidity reserve: Higher the liquidity reserve lower will be the credit created. The liquidity reserve is prescribed by the Central bank of a country. 3. Interest rate: Higher rates of interest reduce the demand for credit. 4. Liquidity preference of households: If households prefer larger liquidity, the cash deposits will decrease. 5. Banking habits: Healthy banking habits increase dependence on banks and lager credit can be created. SYBCom Business Economics Semester III

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6. Banking system: A strong banking system and network will encourage the usage of banking assets and products. 7. Collateral securities: If banks insist for larger collateral securities the demand for credit will decrease. 8. Loan appraisal procedures: If the loan appraisal takes longer duration, the dependence on institutional credit will decrease. 9. Credit control by Central bank: Finally, the Central bank of the country will determine the extent of credit to be created by the commercial banks. This is a part of the credit policy.

Monetary Policy Monetary Policy deals with changing money supply and rate of interest for the purpose of stabilizing the economy at full employment or potential output level by influencing aggregate demand The RBI makes use of instruments to regulate money supply and bank credit so as to influence the level of aggregate demand for goods and services. The monetary policy has to balance the objectives of economic growth and price stability. Economic growth requires expansion in the supply of money so that no legitimate productive activity suffers due to finance shortage. Price stability requires control the expansion of credit so that money supply does not cause inflation. Changes in the monetary policy can be made anytime during the year. The Central Bank may adopt an expansionary or contractionary policy depending on the general economic policy of the Government and conditions in the economy. Monetary policy may also be used to influence the exchange rate of the country’s currency. Objectives of monetary policy Control of Inflation: In a developing country like India, increase in investment activity puts a pressure on prices. A high degree of SYBCom Business Economics Semester III

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inflation has adverse effects on the economy. It raises the cost of living, makes exports costlier, reduces the incentive to save and encourages nonproductive investment. RBI increases the SLR which reduces availability of loanable funds with commercial banks. By increasing bank rate, the cost of bank loan is increased which in turn reduces money supply and credit which tend to reduce price rise. Price stability means a reasonable rate of inflation. Economic Growth: Accelerating economic growth so as to raise national income is another objective of the monetary policy. To promote economic growth availability of bank credit is increased and the cost of credit is reduced. Promotion of economic growth needs a liberal monetary policy. Exchange Rate stability: Until 1991 India followed fixed exchange rate system. The policy of floating exchange rate and globalization of the Indian economy have made the exchange rate volatile. The RBI attempts to ensure exchange rate stability. A tight policy will prevent fall in the value of rupee. Alternatively to prevent depreciation of rupee, the Reserve Bank releases more dollars from its foreign exchange reserves. A floating exchange rate or a flexible exchange rate is a type of exchange rate regime wherein a currency's value is allowed to fluctuate according to the foreign exchange market. A currency that uses a floating exchange rate is known as a floating currency Many economists think that, in most circumstances, floating exchange rates are preferable to fixed exchange rates. They reduce the shocks and foreign business cycles.

Instruments of monetary Policy 1. 2. 3. 4.

Bank rate Statutory liquidity ratio Cash reserve ratio Open Market Operations


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5. REPO and Reverse REPO 6. Marginal Standing Facility 7. Market stabilization scheme 1. Bank rate Bank Rate is the rate at which central bank of the country (in India it is RBI) allows finance to commercial banks. Bank Rate is a tool, which central bank uses for short-term purposes. Any upward revision in Bank Rate by central bank is an indication that banks should also increase deposit rates as well as Base Rate / Benchmark Prime Lending Rate. This is the rate at which central bank (RBI) lends money to other banks or financial institutions. If the bank rate goes up, long-term interest rates also tend to move up, and vice-versa. Thus, it can said that in case bank rate is hiked, in all likelihood banks will hikes their own lending rates to ensure that they continue to make profit. 2. Statutory Liquidity Ratio SLR stands for Statutory Liquidity Ratio. This term is used by bankers and indicates the minimum percentage of deposits that the bank has to maintain in form of gold, cash or other approved securities. Thus, we can say that it is ratio of cash and some other approved securities to liabilities (deposits) It regulates the credit growth in India. Every bank is required to maintain at the close of business every day, a minimum proportion of their Net Demand and Time Liabilities as liquid assets in the form of cash, gold and un-encumbered approved securities. The ratio of liquid assets to demand and time liabilities is known as Statutory Liquidity Ratio (SLR). RBI is empowered to increase this ratio up to 40%. An increase in SLR also restrict the bank’s leverage position to pump more money into the economy. 3. Cash reserve ratio CRR means Cash Reserve Ratio. Banks in India are required to hold a certain proportion of their deposits in the form of cash. However, actually Banks don’t hold these as cash with themselves, but deposit such case with Reserve Bank of India (RBI) / currency chests, which is considered as equivalent to holding cash with RBI. This minimum ratio (that is the part of the total deposits to be held as cash) is stipulated by the RBI and is known as the CRR or Cash Reserve Ratio. Thus, When a bank’s deposits increase by Rs100, and if the cash reserve ratio is 6%, the banks will have to hold additional Rs 6 with RBI and Bank SYBCom Business Economics Semester III

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will be able to use only Rs 94 for investments and lending / credit purpose. Therefore, higher the ratio (i.e. CRR), the lower is the amount that banks will be able to use for lending and investment. This power of RBI to reduce the lendable amount by increasing the CRR, makes it an instrument in the hands of a central bank through which it can control the amount that banks lend. Thus, it is a tool used by RBI to control liquidity in the banking system. RBI uses CRR either to drain excess liquidity or to release funds needed for the growth of the economy from time to time. Increase in CRR means that banks have less funds available and money is sucked out of circulation. Thus we can say that this serves duel purposes : a. Ensures that a portion of bank deposits is kept with RBI and is totally risk-free, b. Enables RBI to control liquidity in the system, and thereby, inflation by tying the hands of the banks in lending money. 4. Open Market Operations The Central Bank buys or sells ((on behalf of the Fiscal Authorities (the Treasury)) securities to the banking and non-banking public (that is in the open market). One such security is Treasury Bills. When the Central Bank sells securities, it reduces the supply of reserves and when it buys (back) securities-by redeeming them-it increases the supply of reserves to the Deposit Money Banks, thus affecting the supply of money.

5. Repo rate and Reverse Repo rate The rate at which the RBI lends money to commercial banks is called repo rate. It is an instrument of monetary policy. Whenever banks have any shortage of funds they can borrow from the RBI. A reduction in the repo rate helps banks get money at a cheaper rate and vice versa. Reverse Repo rate is the rate at which the RBI borrows money from commercial banks. Banks are always happy to lend money to the RBI since their money are in safe hands with a good interest. An increase in reverse repo rate can prompt banks to park more funds with the RBI to earn higher returns on idle cash. It is also a tool which can be used by the RBI to drain excess money out of the banking system.


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Thus, we can conclude that Repo Rate signifies the rate at which liquidity is injected in the banking system by RBI, whereas Reverse repo rate signifies the rate at which the central bank absorbs liquidity from the banks The reverse repo rate will be kept 100 basis points lower than the repo rate. On the other hand Marginal Standing Facility (MSF) rate will be kept 100 basis points higher than the repo rate. 6. Marginal Standing Facility Marginal standing facility is the rate at which scheduled banks can borrow overnight from RBI against approved securities. Banks can borrow up to 2% of their Net demand and time liabilities. Banks can borrow funds through MSF during acute cash shortage. This measure has been introduced by RBI to regulate short term asset liability mismatch more effectively. This policy has been implemented from May 2011. MSF is pegged 100 business points or 1% above Repo Rate. Presently it is 9 % 7. Market stabilization scheme RBI introduced the Market Stabilization scheme in April 2004 to mop up the excess liquidity. The MSS operates mainly through Treasury bills (T-bills). The Government will issue T-bills by way of auctions by the RBI in addition to its normal borrowing requirements, for moping up excess liquidity. The amount raised through this scheme is to be held in a separate account with the RBI and would be used only for the purpose of redemption or buyback of the T-bills

Selective credit regulation This refers to regulation of credit for specific purposes or branches of economic activity. They relate to the distribution or direction of available credit policies. The Banking Regulation Act empowers the RBI to give directions to banking companies, with regards to: SYBCom Business Economics Semester III

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• • • • • •

Purposes for which advances may or may not be made. Margin to be maintained for secured advances Ceiling on the amounts of credit for certain purposes Discriminatory rates of interest charged on certain types of advances. Direct action: RBI may refuse to rediscount bills etc. Moral Suasion: In addition to the above mentioned methods of credit control, it may be noted that the use has also been made in this country of moral suasion wherein letters are issued to banks urging them to exercise control over credit in general or advances against particular commodities etc.

Fiscal Policy Otto Eckstein defines fiscal policy as “Changes in taxes and expenditures which aim at short run goals of full employment and price level stability.” By using Fiscal policy the government uses its outlay and revenue programs to produce desirable effects and avoid undesirable effects on the national earnings, manufacturing, and employment.” Objectives of Fiscal Policy Fiscal policy deals with the financial management of the state with certain predetermined objectives. Taxation, public expenditure, public debt management, budgetary management are the techniques through which the government achieves several national objectives. Following are the objectives of fiscal policy: 1. Mobilization of Resources The objective of fiscal policy is to promote economic growth and development. This objective of economic growth and development is attained through mobilization of resources. SYBCom Business Economics Semester III

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The central and the state governments in India have used fiscal policy to mobilize resources. The financial resources can be mobilized through Taxes: By optimizing direct and indirect taxes revenue can be maximized. Tax system shall be progressive but also acceptable to public. Surplus: The government can generate public savings by reducing government expenditure and increasing surpluses of public sector enterprises. Domestic Savings: Savings can be mobilized by offering incentives to household sector. The incentives can be tax incentives and various forms of financial instruments. 2. Regulation of private investment: The Government can regulate private investment by providing incentives to priority sectors. By providing proper investment avenues, private investment can be encouraged. Special Economic Zones, Technology parks, export processing zones help in attracting private investment in priority sectors. 3. Reduction in inequalities of Income and Wealth Progressive tax can help in reducing income inequalities by collecting larger tax from the rich. At the same time spending on poorer sections of the society, the gap between the rich and poor can be reduced. This is means of achieving social justice. In a country like India there are several programs for people below the Poverty Line 4. Control of Inflation Suitable fiscal policy can control inflation and stabilize price. Inflation needs to be controlled in such a manner that the investment and output are not affected. Counter cyclical fiscal policy can bring about stability in prices, investment, and output. 5. Employment Employment generation is an important objective. Investment in infrastructure can lead to employment. Incentives for labor intensive industries and small scale industries can promote employment.


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6. Balanced Regional Development Fiscal policy can bring about balanced regional development. Various incentives like backward area benefits, cash incentives, tax incentives, centralized infrastructure can help in developing backward areas. 7. Reducing the Deficit in the Balance of Payment Fiscal policy can encourage exports by offering tax exemption. The foreign exchange can also be saved by providing fiscal incentives for import substitution. Earning on exports and saving of foreign exchange by way of import substitutes will help in solving balance of payments problem. 8. Capital Formation Fiscal policy can increase the rate of capital formation and accelerate the rate of economic growth. To do this the fiscal policy will encourage savings and discourage spending. 9. Increasing National Income Increase in national income is growth. It can be achieved through better capital formation. This results in economic growth, which in turn increases the GDP, per capita income. 10. Development of Infrastructure Government can encourage infrastructure development for the purpose of achieving economic growth. Taxation generates revenue to the government. The revenue can be used for financing infrastructure. Together, tax concessions to infrastructure industries help in developing infrastructural development. 11. Foreign Exchange Earnings Fiscal policy encourages exports by measures like, exemption of income tax on export earnings, exemption of sales tax and excise, etc. Foreign exchange can also benefit to import substitute industries. The foreign exchange earned by way of exports and saved by way of import substitutes helps to solve balance of payments problem. 12. Inclusive Growth The basic objective of fiscal policy is t promote inclusive growth. The growth which is sustainable and the benefits of growth reach to all sections of the society. Emphasis on resource conservation and environmental protection will make growth holistic.


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Instruments of Fiscal policy 1. Taxation Direct taxation is levied on income, wealth and profit. Direct taxes include income tax, inheritance tax, national insurance contributions, capital gains tax, and corporation tax. Indirect taxes are taxes on spending – such as excise duties on fuel, cigarettes and alcohol and Value Added Tax on many different goods and services 2. Government Spending Government spending (or public spending) can be classified into three main areas: a. Transfer Payments: These are welfare payments made available through the social security like unemployment insurance, Pension, subsidies on food and fertilizers etc. b. Current Government Spending: i.e. spending on stateprovided goods & services that are provided on a recurrent basis – eg. health, education, rural development etc. c. Capital Spending: Capital spending includes infrastructure spending on highways, hospitals, schools and prisons. This investment spending adds to the economy’s capital stock and can have important demand and supply side effects in the long term. Government spending can be justified as a way of promoting equity. Well targeted and high value for money public spending is also a catalyst for improving economic efficiency and macro performance. 3. Debt management The total stock of government bonds and interest payments outstanding, from both the present and the past, is known as the national debt. Debt can raised for financing infrastructure, national calamity, war, or repaying an earlier debt. Disposable income of the higher income groups can be reduced by soliciting debt. The government can issue such instruments which will be a part of portfolio for the rich an also reduce disposable income.


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4. Budgetary management When government expenditure exceeds government tax the budget will have a deficit for that year. The budget deficit, which is the difference between government expenditures and tax revenues, is financed by government borrowing; the government issues long-term, interestbearing bonds and uses the proceeds to finance the deficit. a. Expansionary fiscal policy: an increase in government expenditures and/or a decrease in taxes that causes the government's budget deficit to increase or its budget surplus to decrease. b. Contractionary fiscal policy : a decrease in government expenditures and/or an increase in taxes that causes the government's budget deficit to decrease or its budget surplus to increase. c. In the case where government expenditure is exactly equal to tax revenues in a given year, the government is running a balanced budget for that year. 5. Counter cyclical fiscal policy

a. Expansionary fiscal policy: an increase in government expenditures and/or a decrease in taxes that causes the government's budget deficit to increase. SYBCom Business Economics Semester III

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b. Contractionary fiscal policy: a decrease in government expenditures and/or an increase in taxes that causes the government's budget deficit to decrease. 5. Pump priming During periods of economic depression, the government adopts currency expansion for financing employment generation projects. Such currency expansion is called pump priming. Though pump priming may increase employment, it s highly inflationary. 6. Price support policy The government may offer certain minimum support price to stabilize prices during harvest. It helps the farmers in getting a fair price for their produce. 7. Subsidies The government may offer subsidy to farmers while buying farm inputs. It reduces the cost of farming, thus granting higher profits to farmers. Similar subsidies can be offered on purchase of food grains to poorer sections to support consumption.

IS and LM Curves The theory given by Hicks and Hansen is an improvement over the Keynesian theory. Hicks and Hansen developed model considering the goods well as money markets. It is the equilibrium between the two markets which determines growth. Keynesian theory of effective demand considered the goods market to draw the equilibrium. The equality between, ADF and ASF determined the short run equilibrium.


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Aggregate demand, Y=C+I+G, where, Aggregate demand is made up of C, I, and G explains the effect of goods market. Similarly, the money market is determined by, the liquidity demand for money and interest rate, given elastic supply of money from the central bank. IS curves deal with Goods market and LM curves deal with money market. Relationship between good market and money market: • • • • •

MEC and interest determine Investment The money market determines interest Investment determines income Income determines consumption and again Consumption determines investment

Derivation of IS Curves


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It can be seen that at a point where ASF=ADF, the equilibrium E1 is drawn., Further, the rate of interest at that level of income Y is found on the lower diagram. Similarly, with a shift in the ADF, the equilibrium will shift to E2. The equilibrium is drawn on the lower diagram with corresponding rate of interest. By joining E1 and E2 in the lower diagram, the IS curve is drawn.

Shifts in IS Curve

On the IS curve, the region above the curve, right of the curve, represents, excess supply, caused by increasing government expenditure. Similarly, the region below the curve, left of the curve, represents, excess demand, caused by increasing consumer spending.

Derivation of LM Curve L1 and L2 are the liquidity schedules showing a negative relationship between, liquidity preference and rate of interest. The supply of money is inelastic (constant). It depends on the fiduciary system of the central bank.


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With a shift in the liquidity schedule, the rate of interest increases. These changes are drawn on the right diagram and the corresponding incomes are identified. Thus the LM curve is drawn and positive function between rate of interest and real income. The region above the LM curve shows excess supply of money and the region below denotes excess demand for money.


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Interaction between IS and LM Curves

The interaction between IS and LM curves show that: In the upper quarter there will be excess supply of goods and excess money. The income and interest rates shall decrease. In the lower quarter there will be excess demand for goods causing excess demand for money. The income and rate of interest increase. In the left quarter there will be excess demand for goods excess supply of money, causing income to increase and rate of interest to decrease. In the right quarter, there will be excess supply of goods and excess demand for money causing income and interest rate to increase.

Effects of Fiscal and Monetary Policy on interest and incomes Fiscal policy: Increase in Government spending increases the income by multiplier effect. However, an increase in the Government investment may lead to a decrease in the rate of interest and the output may remain same.


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Monetary policy: The increase in the money supply by the Central bank will decrease interest rates and increase investment and output. The monetary policy will be called ineffective if • •

IS curve is inelastic, where changes in rate of interest does not effect output. With liquidity trap, the increase in money supply fails to decrease rates of interest or increase investment and output.

The monetary and fiscal policy shall be used in a combination depending on the responsiveness of demand for money, investment, income, and interest rates.

----------------------------------------SYBCom Business Economics Semester III

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