Monetary Policy Class Note

MONETARY POLICY CLASS NOTES SUMMARY (LECS 15-16)

DR. TULSI JAYAKUMAR

1. Where does monetary policy enter the national income accounting identity? Or, how does Monetary policy affect output and prices?

• It affects AD through two routes – Look at Y=C+I+G+X-M.
• A) it affects invt (I) through rates of interest
• B) When roi increases (say), there is greater inflow of capital into the Net Capital and Financial Account Balance in say dollar terms.  Hence, the rupee appreciates. This would cause Net exports (X-M) to decrease (Xs become costlier and imports cheaper).

1. How are interest rates determined?

• Interest rates determined by the intersection of the money demand and money supply curves. (diagram). The RBI can push interest rates down and increase AD in the economy . It can do so by increasing Ms. This can continue the economy hits the Liquidity Trap region. Beyond this, int rates can’t be reduced further through changes in Ms.

1. What determines the demand for money and the ss of money?

MONEY DEMAND- Has three components- Transactions demand for money (depends on income, positive function), Precautionary demand for money (depends on income, positive function), speculative demand for money (depends on int rate, negative function).

So Md=f(Y, i)

MONEY SS- Autonomous . depends on the monetary authorities, public and banks.

Related to the reserve money or H through the formula

Ms=mH

Distinguish between H and M

H=C+R (it refers to the monetary liabilities of the RBI)

M=C+DD of banks+TD of banks +other Deposits (M3)

Understand how an increase in H leads to a multiple increase in Ms.

1. How does monetary policy in turn get affected /constrained  by the external sector?

While the monetary policy and changes in the monetary policy affect the external sector (see 1 above), in turn, the overall balance in the Balance of Payments too affects the money supply in the economy. For instance, a surplus in the overall balance (say=100 cr USD) implies negative monetary movements ( if the RBI absorbs this surplus). This adds to the forex reserves of the RBI. The RBI’s assets increase (net foreign exchange  assets  component, valued in Rs. terms). At the same time, since 100 cr USD of forex reserves is absorbed by the RBI in lieu of 60 * 100cr INR= 6000 cr INR, hence the amount of currency in the economy goes up by INR 6000cr. The liabilities side of the RBI’s balance sheet (remember this currency is RBI’s liability) swells by Rs. 6000 cr.

• Imbalances in the external sector and the RBI’s intervention in the external sector causes an increase in the RBI’s financial assets.
• The change in our example is +6000 cr.
• In turn, this leads to an increase in the RBI’s monetary liabilities ( in our example currency in circulation by 6000 cr.). It is this Monetary liabilities of the RBI’s balance sheet that constitutes High Powered Money- H or Mo.
• When H increases, Money supply Ms or M3 increases by a multiple amount- Ms=mH.
• If the money multiplier value  (m=1+c/ c+r) is 5.4, Ms increases to 5.4*6000= 32400cr.
• The reverse happens whe there is an overall deficit in India’s BOP=100 cr USD. The money ss goes down by 32400 cr.

1. How does money supply get affected by fiscal policy?

The govt may try to finance its expenditure by issuing govt. securities – say for infrastruc purposes. The RBI , in its role as the govts debt manager purchases these securities = say 100 cr INR. Its financial assets increase by 100 cr (through the component net RBI credit to the govt.).  In lieu it gives the govt 100 cr worth of cash. The RBI’s liabilities then increase by 100 cr.

Thus, the govt’s debt=100 cr has created RBI’s monetary liabilities = 100 cr.

The govt gives this money to the contractor, who spends it etc. The ultimate increase in money supply as a result of 100 cr worth of govt debt = mH.