Income Determination Model (Pratik Negi)Presentation Transcript
Income Determination Model USAID Reform Project Dr. Brijesh C. Purohit
Fiscal Policy: It comprises of deliberate use of budgets (of central and state govts.) To achieve macroeconomic objectives, in particular stabilization And growth Fiscal Policy is a term reserved for the policy government has in balancing Government Spending with Tax Revenues. (Net) Taxes (T) = Leakage (Withdrawal) from the CFoI Government Spending (G) = Injection to CFoI
Is the Government spending more than it raises in taxes (G > T)? If so, then the Government is running a budget deficit , and the effect will be to expand or reflate the economy - increase the circular flow of income, and increase GDP (at least in nominal or current terms)
Or, is the Budget in surplus (T > G)? Then the effect of Fiscal Policy is to deflate or contract the CFoI, and reduce national income (nominal national income will tend to fall).
Taxes remove income from the circular flow of income - that is,
act as a leakage from the circular flow (like imports and savings),
and other things being equal, will reduce incomes through
the multiplier process, and deflate the economy.
Government Expenditure, on the other hand, is an injection
into the circular flow and will tend to reflat e the economy.
There is often a conflict between Fiscal Policy - designed to manage economic cycles - and the other reasons and objectives of Government spending and taxation.
an increase in the budget deficit will increase the money supply ,
which will tend to increase current or nominal GDP, but may also
give rise to inflation.
However, a more prudent government would borrow the difference
between G and T
In order to persuade the public to lend this requirement to the government
(through buying Government Bonds and Stocks), the government must
offer some reward - the rate of interest paid on the loans
(government bonds) - the more it wants to borrow, the higher will
have to be the rewards offered - the higher the interest rates will
have to be.
So expansionary Fiscal Policy ( G > T ) tends to lead to higher interest rates, which in turn tend to reduce private investments and private consumption, and thus reduce the expansionary effect of the fiscal policy, and increasing the tendency for government spending to crowd out private spending.
What do increased interest rates do? - deflate the economy
(lowering growth rates and tending to increase unemployment) by:
encouraging saving (reducing consumption) and discouraging
increasing borrowing costs (making businesses more difficult to
manage), and discouraging borrowing both for consumption
(consumer durables like cars, furniture, white goods, etc. and
especially houses and house improvements) and for businesses
tend to hurt borrowers (often the poorer) and help net savers
(often the better-off)
tends to lead to exchange rate appreciation (encouraging
capital to flow into the country and discouraging capital exports
How are interest rates determined?
And what effects will Fiscal Policy (changes in G and T) have on
The answer is that interest rates are determined in the Money Market
which is how Monetary Policy (control of money supply
or interest rates) works.
The IS curve shows the equilibrium relationships between the rate of interest (established in the money market) with the level of national income , assuming that the remaining injections and withdrawals (G, T, X and IM) stay as before. If these other ( exogenous ) injections and withdrawals change , then the IS curve itself will shift .
Thus, if government spending (G) is increased (and/or taxes (T) are reduced) - an expansionary Fiscal Policy - and the IS curve will shift to the right - because an expansionary fiscal policy will increase levels of national income for each and all levels of savings and investment, each and all levels of the interest rate.
The IS Curve slopes downwards because lower interest rates (r down) encourages investment and consumption and thus increases national income (Y). It thus represents the combinations of r and Y which are consistent with equilibrium in the goods and services markets (the circular flow of income). Note this. The CFoI is, in effect, a description of equilibrium in the markets for goods and services (and factors of production) -equilibrium in the 'real' (non money) part of the economy.
The relationship between income and the interest rate through the money market is represented as the L-M curve – the L iquidity preference (demand for money) and M oney supply relationship: The LM curve shows all those combinations of Y and r which are consistent with an equilibrium in the Money Market ( given a fixed money supply and a constant velocity of circulation)
The LM curve will shift to the right if the money supply is increased, or if interest rates are reduced, in the money market through monetary policy . An expansionary monetary policy shifts the LM curve to the right. A contractionary monetary policy shifts the LM curve to the left. Notice, too, the effect of inflation (an increase in the price level (P)) on this relationship. If the price level increases in the economy, then the stock of money in the economy cannot finance the same level of real transactions as before. We will need more money for any given level of Y at higher price levels than at low price levels. With a fixed supply of money, the greater demand for money at a higher price level means a higher rate of interest at a higher price level for any given Y. So inflation shifts the LM curve to the left.
IS and LM interactions The IS curve captures the essential relationship between the rate of interest and income in the markets for goods and services (the circular flow of income). The LM curve captures the essential relationship between the rate of interest and income in the money market. For the two markets to be consistent with each other - the same rate of interest ruling in both the goods and services market and in the money market - there can only be one equilibrium level of national income (Y*), shown by the intersection of the IS curve with the LM curve .
Links between Monetary and Fiscal Policy
We now have the effects of:
Fiscal Policy captured in the IS curve (where an expansionary
fiscal policy shifts the IS curve to the right , and vice versa );
Monetary Policy captured in the LM curve (where an
expansionary Monetary policy shifts the LM curve to the right ,
and vice versa )
Expansionary Fiscal Policy - shifts IS right: will tend to
increase Y and also increase the interest rate ( r )
Contractionary Fiscal Policy - shifts IS left: will tend to
reduce both Y and r
Expansionary Monetary Policy - shifts LM right - reduces r
and increases Y
Contractionary Monetary Policy - shifts LM left
- increases r and reduces Y
Money defined as a generally acceptable means of payment or of settling debt. It has three main functions: a) medium of exchange between buyers and sellers b) unit of account ( for accounts, debt, financial assets etc.) c) store of value or purchasing power enabling income earners to set aside a part of their income to yield future consumption Medium of Exchange: Currency and demand deposits (readily drawn) with the commercial banks Store of value: Time deposits of Commercial banks (as if to store its value)
Four measures of money supply: M1= Currency (currency notes and coins) with the public+ demand deposits with banks (commercial and cooperatives)+ other deposits with RBI M2= M1+ Post office savings bank deposits M3= M1+ time deposits with banks (commercial and cooperatives) M4= M3+ total deposits with the post office saving organisation Degree of Liquidity and comprehensiveness
Over time, a large and continuous rise in money supply Trends in M1: During 50s….50% ……… .60s…two times ……… .70s…three times ……… ..80s…four times ……… ..90s… about three times Trends in M3: During 70s…..five times ……… ..80s….four times ………… 90….three times
Factors affecting Money supply: Deficit financing bank credit Foreign exchange reserves: if FE receipts exceed payment in FE: FE is surrendered to bank in return for Rs. FE falls short of payment in FE: money is paid to banks to get FE to meet obligation
Monetary policy also known as Money and Credit Policy: It concerns itself with the supply of money as also credit to economy Till 1998-99: It was announced twice in a year: Oct….for Oct..March….to coincide with busy season April…for April to Sept…to coincide with lean season of agri. With decline in agri. And rise in industrial credit since 1999-2000 in April RBI makes an annual policy statement and a review in Oc t
Monetary policy provides: a) an overview of economy b) specifies measures that RBI intends to take to influence such key factors like…money supply….interest rates….inflation c)lays down norms for financial insts. Like banks, fin.cos.etc. relating to CRR, capital adequacy
Since 1951 and till 1990s…. Two sets of objectives pursued… a)controlled expansion of money b)sectoral deployment of funds Done keeping in mind plan priorities Special attention… Core industries (coal, iron, steel and engg.) foodgrains (rice, wheat etc.) priority sectors ( agri., SSI) weaker sections of population
In general, the interaction between monetary and fiscal policy occurs
To control inflationary or deflationary impact of fiscal policy
For instance, a substantial multi-year rise in the deficit need not cause an increase in inflation was demonstrated in USA:
Between 1979-85……budget deficit rose from 2.7% of GDP to 5.1% of GDP……national debt rose from 26% of GDP to 36% of GDP
However, GDP price inflation fell from 8.2 % to 3.2% This due to a tough anti-inflationary monetary policy pursued by the Federal Reserve.
In India, for instance, In 90s… growth of economy remain primary aim control of inflation urgent concern (91….double digit….17%) 8th (92-97)…aimed at achieving trend rate of inflation 5% MP of 90s favored…process of stabilization and structural adjustment initiated in 91
Various measures used by RBI include:
Rate of interest (or price of money)
Quantity or supply of money
Access to or demand for money
One imp. Instrument is bank rate or discount rate..
Rate at which RBI lends to the banking system…
Through it: short term interest
long term rates
level of economic activity
international capital inflows
Second imp. Instrument is sale or purchase of govt. securities
(by sale of securities banks’ resources reduce and vice versa
Third imp. Instrument… Cash Reserve Ratio: Banks’ Cash Holding/Total Deposit Liabilities Fourth Imp. Instrument is Statutory Liquidity Ratio(SLR)… RBI imposes an obligation on banks to buy govt. Securirties (of Low interest rates)(25% at present) To achieve the objective of sectoral deployment of credit.. Direct (Quantity)… Reserve ratios Quantitative controls on RBI lending to banks and commercial sector Quantitative credit controls Indirect Instruments… administrative setting of various interest rates: e.g. RBI lending commercial bank lending deposits
In 1960s .. Emphasis was on indirect measures with little variation in reserve ratios In1970s… Emphasis shifted to direct approaches and persisted since then Shift from indirect to direct measures was prevalent more due to rising deficit or inflation Monetary instrument in India, both direct and indirect, operate Through administrative controls or fiat The crisis like droughts, oil crisis in 1966,1969, 1973 were dealt with effectively by cutting down domestic credit
One of the main problem area in the monetary policy lie with the
Exogenous element in reserve money.
Reserve money comprise of:
Increased RBI lending to govt. (relates to fiscal deficit)
Increased RBI lending to commercial banks
Growth of net foreign exchange of RBI
RBI can control only b) by prescribing high SLR
Monetary control has been reasonably successful inspite of rising
Fiscal deficit because of aggressive use of the reserve ratios
In a sense reserve ratios have not been genuinely monetary policy
Instrument but rather acted as fiscal policy instrument
Major developments in 1980s … Increasing deficit … to control money supply: … .SLR..up to 38.5% by 1990 … ..CRR up to 15% >>>net RBI credit to GOI was given as a separate estimate since 1987 RBI attempted estimates of demand for money: relationship between reserve money and money supply real income increases income elasticity of demand for money acceptable increase in price level
In 1980….inflation…7.1%….aimed to 5% In second half of 1980s: steps towards expanding and activating money market in short term securities e.g. treasury bills of 182 days discount and finance house of India was set up instruments like certificates of deposits, commercial papers, participation certificates etc. These acted as transmission channel for MP
rates on govt. securities was raised
maturity of long term bonds was reduced to prevent govt. from
getting locked into high rates
in 1985 freedom was given to banks to fix int. rate subject to
maximum of 8% on deposits up to one year..later withdrawn
complex lending rate structure was simplified with six slabs
banking sector reform in terms of selective branch expansion
and expansion of staff
in 1989-90…gross fiscal deficit…8.05% of GDP
inflation was 9.1%
90-91……….inflation orse by 12.1%
devaluation of rupee in 1991
bank rate raised from 10 to11%
min. lending rate raised to 20%
int. rate on deposits raised to a max. of 13%
SLR reduced to 30%
Inflation ..down to 7%
incremental CRR discntd.
Following Narsimhan Committee:
efforts to develop govt.securities market
introduction of 364 days and 91 days TB
auction of dated securities and REPO auction
unified market determined ER
min. lending rate down frm 17..15%
SLR..from 30.to 25%
overall improvement in economy..GDP grew by 7.8%
agreement between RBI and GOI to phase out system of ad-hocTB
in next three years
large capital inflows in FE..NRI deposits were under CRR
RBI reduced lending rates of scheduled commercial banks for credit
limit over Rs. 2lakhs
long trem borrowing rate down to 12.35%
CRR raised..to 11%
inflation touched 10.8%
stability in ER did not remain…net sales by RBI and stability
CRR was reduced
investment demand high
bank credit increased
CRR reduced to 10%
inflation remained at 5.4%
slackening of economy
in April bank rate was linked to several interest rates making it
a signal interest rate
bank rate reduced from 12 to 11 to 10% in June and 9% in Oct
trend in decline in interest rate interrupted to stabilize FE market
bank rate raised to 11%
CRR raised to 10.5%
In 1998-99 & 1999-2000…
low inflation rate
softening of interest rate
borrowing rate of govt. declined
bank rate brought down to 7%
Bank rate raised and brought back to 7%
To sum up…Key themes in the reform of institutional framework
and operational procedures for MP have been:
Phased reduction in the reserve requirement ratios of CRR and SLR
phased liberalization of interest rates
elimination of direct credit controls
development of money and financial markets, beginning with those for
government securities and bills
restraints on automatic monetization of budget deficits
activation of open market operations (OMO) by RBI to influence liquidity
policy focus on inter-linkages across various segments of financial markets
restoration of bank rate as a signaling instrument for MP
What objectives should be pursued?
Objective of MP cannot be different from overall objective of
mainly thus our MP had pursued:
to maintain a reasonable degree of price stability
to accelerate the rate of economic growth
What was the dominant objective?
Price stability a means (not an end)
to achieve sustained growth
What level of inflation do adverse consequences begin to set in?
e.g. Chakravarty committee regarded 4% as acceptable inflation
Rangarajan gave it to be 5-6%
Reasonable relationship exists between..
coordination between fiscal and monetary policy is yet another aspect
more open market operations lead to gradual delinking of