Macroeconomics Module RBI 2024-pages-4.pdf

Summing up –so far Price level GDP Rog Y1 Y2 Y/ Output Time i Y1 Y2 Y External Sector Open Economy Macroeconomics Foreign Exchange Market: 1. Demand for Foreign Exchange: Imports,...

Summing up –so far Price level GDP Rog Y1 Y2 Y/ Output Time i Y1 Y2 Y External Sector Open Economy Macroeconomics Foreign Exchange Market: 1. Demand for Foreign Exchange: Imports, transfers abroad, purchase of assets abroad, speculation in currency; 2. Supply of Foreign exchange: Exports, Capital inflows (FDI, FII), Loans and grants to govt and loans by private sector, Transfers from abroad including remittances, speculation in currency. Price per unit of USD Supply USD 85 75 65 Demand USD’ Demand USD Quantity External Sector Open Economy Macroeconomics Appreciation, Depreciation, Revaluation, Devaluation: 1. Increase in the price of foreign currency in terms of domestic currency is depreciation 2. Decrease in the price of foreign currency in terms of domestic currency is appreciation Price per unit of USD Supply USD Depreciation 75 Appreciation Demand USD’ Demand USD Quantity External Sector Open Economy Macroeconomics Exchange rate regime: 1. Fixed exchange rate: Gold standard 2. Adjustable peg 3. Wider peg 4. Managed float 5. Flexible exchange rate regime External Sector Open Economy Macroeconomics Exchange rates : 1. Purchasing power parity (PPP): When a unit of domestic currency can buy the same basket of goods at home and abroad. In the very long run PPP consideration should determine the exchange rate, in the short term it could be managed and depends on the nature of th exchange rate regime. 2. Real exchange rate: R= ePf/P; where e is exchange rate, Pf is price level abroad and P is domestic price level. If R =1 it implies currencies are at purchasing power parity. If R>1 it means goods are more expensive abroad, so the market adjusts either P rises or e falls to get to PPP, but it is a slow process. 3. We must remember that between two countries goods produced are not the same, of same quality, there are barriers to movement of goods and factors of production, especially labour. Viz EU External Sector Open Economy Macroeconomics Aggregate demand is: C +I +G +NX NX = (X- Q); X(Yf, R) –Q(Y,R) or NX (Y,Yf, R) If Yf rises: It improves home country trade balance or raises its agg. demand through higher exports. If R rises, real depreciation of home country exchange rate, it improves trade balance If Y rises, it raises imports so worsens trade balance. Modifying IS LM: IS curve: DS (Y,i) + NX(Y, Yf, R): LM (Y, i) BoP: NX (Y, Yf, R) + CF(i-if) Capital mobility depends on the interest rate differentials, exchange rates risks, political risks (nationalisation)  Modified ISLM Surplus & unemployment Surplus & Overemployment Y A D i Iforeign if E* BoP=0 X B C Deficit & unemployment Deficit & Over employment Y* Y output/income Concept of External and Internal balance  Modified ISLM Surplus & unemployment Surplus & Overemployment A D i iforeign E* E’ C E Deficit & Over employment Deficit & unemployment B Yf Y output/income Concept of External and Internal balance  Open Economy: Mundell Fleming Model Assumptions: Perfect capital mobility & Fixed exchange rates A B LM LM LM’ LM’ i if BoP=0 i IS’ IS IS Y Y Y1 Y2 There cannot be an independent monetary policy but fiscal policy is effective or Mss is endogenous. In A let Mss , iif, so K inflows or Mss , LM shifts to right so FP is effective.  Open Economy: Mundell Fleming Model Assumptions: Perfect capital mobility & Flexible exchange rates A B LM LM LM’ i if BoP=0 i IS’ IS’ IS IS Y Y1 Y Y1 There can be an independent monetary policy but fiscal policy is ineffective. In A let Mss , iif, so K inflows or R , Q cheaper or shift from domestic to foreign goods so IS shifts back to original position or FP is effective. Similar logic for G increase  Lecture 6 Monetary Policy 161 Monetary Policy: Overview What is monetary policy and why do we need one? What are the objectives of monetary policy and how are they evolving? What is the institutional framework for conducting monetary policy in India? What are the monetary policy instruments and how are they used? What is the role of banking system in the working of the monetary policy? How effective is the monetary authority in India in conducting its monetary policy? 162 1. What is Monetary Policy It is the process by which a central bank, in our case the Reserve Bank of India, controls either the volume of money or the price of money to meet its objective, typically ensuring price stability in the economy.  Demand for Money and Stock of Money What is Money? Money is what money does Anything that is accepted as a medium of exchange Why do we need money? In the absence of money there must be double coincidence of wants to facilitate exchange of goods; If there is no common medium of exchange and common unit of value, exchange is restricted. There is need for store of value for future consumption or exchange; and There is need for standard of deferred payments for facilitating all future transactions Demand for Money and Stock of Money Functions of Money: Serves as medium of exchange by being a common unit of value; Serves as a store of value; Serves as standard of deferred payments; Types of money? Full bodied money; Fiat money: that is money under order of the government or the monetary authority i.e. by fiat; Fiduciary money: that is money which is accepted purely on trust, promissory notes, credit cards and bank deposits etc. Demand for Money and Stock of Money Money Supply: total amount of money available with public at any given point of time. It is therefore a stock and not a flow concept. The public includes all actors other than the government and the banking system Mo = Currency(C) + Reserves (Deposits with RBI + OD) M1 = Currency(C) + Demand Deposits (DD) + Other Deposits (OD): OD are deposits with Central Bank but not of commercial banks M2 = M1 + Savings Deposits with Post Office (PO) M3 = M1 + net Time Deposits of Banks M4 = M3 + Total demand & Time Deposits with PO Money multiplier= 1/R or reserves As one moves from M1 to M4 we move from a narrow definition of money to a broader and less liquid money. 2. Objectives of Monetary Policy What are the Objectives of Monetary Policy ▪ Price Stability ▪ Financial Stability Ultimate objective of Monetary Policy (indeed all economic policy) ▪ Economic Growth What is Price Stability ? Low (but not zero) and stable inflation Both high inflation and low inflation impose costs on economy: ▪ Loss of output ▪ Misallocation of resources ▪ Distributional consequences for people What is an appropriate level of inflation? This is subjective ▪ 2% for developed economies ▪ 4% for India Effectively boils down to a subjective call on whether current and expected inflation is ‘appropriate’ for desired growth. What is Financial Stability ? Financial System – Institutions, Markets, Prices – should not potentially destabilize the economy  It can be observed only in its absence Financial system  often prone to ‘overshoot’ in the short run  occasionally create bubbles - asset bubbles How do we ensure stability?  Orderly market conditions  Primarily promote market efficiency  But contain overshooting Banking system is the key to financial stability  Inherently unstable because of its very nature of business  Circular Flow of Income or Money Transactions between economic agents in an economic system generates flow of income and spending on goods and services. This is described as circular flow of income. In the circular flow, money moves from households to firms/ producers, both domestic and foreign, and to the government and back again, creating an endless loop of flows. In short, an economy is never-ending circular flow of money. Money helps in facilitating transactions that leads to growth.  Economic Transactions in an Economy Remittances & Payments Goods & Services Imports Rest of the world Export of labour Goods & Services Exports K- K+ Labour Wages savings Investment Financial Households System Firms Goods &Services Consumption Expenditure Public Borrowings Debt Service Taxes Taxes Government Govt. spending on services, goods, transfers & subsidies Withdrawals /leakages = Injections Savings+ taxes +Imports = investment + Govt. Spending+ Exports Role and importance of money in an economic system 171  Conditions for Stability of the Circular Flow There are some conditions to be met for the stability of the circular flow in an economic system. All withdrawals from the circular flow must be matched by injections. Withdrawls includes savings, taxes and imports, which must be matched by injections namely investments, government spending and exports. Financial system, government and the RoW play a vital role in expanding transactions and maintaining the stability of the economic system. Money facilitates transactions in an economic system. Growth in transactions leads to economic growth.  Output Gap: Potential and Actual Output Peak Peak GDP Growth Rate Trough Trough Trough Time 173  What is a Business Cycle? A business cycle is the periodic expansion (recovery) and contraction (recession) in a nation's economy, around the path of trend or average growth, measured by its GDP. There are four stages of a business cycle: expansion, peak, contraction, and trough, as we shall shortly see. Actual output is often different from potential output, which is output corresponding to full employment of resources at a point in time. Inflation, economic growth and unemployment are related through the business cycle.  Business Cycles and Output Gap Trend line has a conceptual and a statistical interpretation. Conceptually it represents the capacity of the economy to supply goods and services, thus reflects the potential output. Statistically, it is interpreted as an average growth of GDP over the period, estimated using a time- trend regression. Actual growth represents the level of spending or aggregate demand in the economy.  Business Cycles and Output Gap There is inflation when actual output/spending is more than the potential output. There is deflation leading to unemployment of resources, especially labour, and underutilisation of installed capacity when actual output/ spending is less than potential output. Distinction in the use of the terms: economic slowdown, recession and depression. Economic slowdown refers to decline in the pace of growth, recession is actual contraction in output for two successive periods and prolonged recession over multiple periods becomes a depression. Output Gap: Potential and actual output; Short and long-term GDP Growth Rate Stabilisation Long-term growth 1991 2010 Time 177 Evolution of Monetary Policy Intermediate Targeting ▪ Target Money Supply: If there is a stable relation with inflation –> Control of Inflation Inflation targeting ▪ Target the objective itself Signaling Monetary Stance ▪ Control short rates – through ‘expectations’ transmit to lending and borrowing rates – influence inflationary expectations  Evolution of Monetary Policy - India  Up to mid-1980s – Inflation commodity driven  Selective Credit Controls  Channel bank funds to sensitive commodities  Contain speculation  Mid 1980s – Noting monetary expansion (largely through monetization of fiscal deficit) also contributed to Inflation  M3 target to control inflation  1990s – Currency Shocks and Capital flow shocks – weakened control of M3 – Simultaneously interest and exchange rates were increasingly market determined  Multiple Indicator Approach – April 1998  Signaling Stance through control of short rates 3. Institutional Framework for Monetary Policy in India RBI as the Monetary Authority Independence of monetary authority and the reforms undertaken Monetary Policy Committee FSDC: Financial Stability and Development Council Set-up in 2010, is an autonomous body dealing with macro prudential and financial regularities in the entire financial sector of India. An apex-level FSDC is not a statutory body.  4. Monetary Policy Instruments Money creation- high powered money and capital flows; Open Market Operations; Cash Reserve Ratio (CRR); Statutory Liquidity Ratio (SLR); Policy Rate : Repo and reverse repo; Moral suasion: persuasion to lend to priority sector Reduce margin requirements for loans, personal, housing, margin money;  Monetary Policy – How Does it Work?  RBI controls the interbank overnight (Call Money) market to influence  Quantity - By increasing/decreasing supply of liquidity in the banking system  Rate - By increasing/decreasing the rate at which RBI lends (borrows) overnight money to (from) the banking system  Expectations – Signal monetary stance  The impulse to overnight market gets transmitted  Quantity Channel: M0 -> M3 -> Inflation  Rate Channel: Policy rate -> Overnight rate –> G-Sec rates –> Lending/Borrowing Rates ->Inflation  Expectations Channel: Policy Signal -> Markets adjust rates as per expectations of future policy moves –> economic agents adjust consumption -> Inflation  Monetary Policy Operational Framework - I  Liquidity Adjustment Facility - LAF  Everyday, RBI stands ready to lend to or borrow from the banks unlimited amounts as per banks’ requirements at fixed interest rates  Reverse Repo Rate: Rate that RBI borrows money at  Repo Rate: Rate at which RBI lends money  RevRepo rate – Acts as floor to call money rate since RBI is willing to borrow unlimited amounts at this rate  Repo rate – Acts as ceiling to call money rate since RBI is willing to lend unlimited amounts at this rate Call Money Rate is thus constrained within the LAF Corridor Monetary Policy Operational Framework -II RBI can also increase/decrease overnight rates by increasing/decreasing the corridor rates Say RBI wants to bring down inflation expectation: Raise Repo/Reverse Repo rate -> Overnight rates go up -> Transmission through rate and expectation channel -> Increased interest rates -> Demand eases ->Pressure on Inflation goes down Opposite action if RBI wants to reflate the economy to deal with recession Interest rates in the economy thus react to RBI policy action through LAF rates  Quantitative Policy Tools  How does RBI increase or decrease liquidity in the system  Open Market Operations (OMOs) Purchase/Sale of G-Secs by RBI from/to banks Effective, but constrained by stock of securities with RBI  Cash Reserve Ratio (CRR) Increase/Decrease cash deposits of banks with RBI Generally considered a blunt instrument because in effect a tax on banks & its impact is ambiguous Example – An increase in CRR reduces availability of liquidity immediately -> Rates up Eventual Impact: increases M0 -> Increases M3 -> rates down; It reduces Multiplier -> Reduces M3 -> Rates up Why then use CRR : Largely a lack of choice  Market Stabilization Scheme (MSS)  What is MSS?  An instrument to absorb liquidity – Govt. issues securities, money received is sequestered in an account with RBI-not available for Govt spending  Effectively absorbs liquidity from banking system  Why MSS: Usually RBI can sterilize using OMOs  Shortage of G-Secs necessitated MSS  Why is MSS not identified as a Monetary tool?  Conceptually it is an instrument for sterilization  It neutralizes the Rupee impact of exchange market intervention, So RBI can keep its monetary policy independent of its exchange rate policy  In that sense sterilization is independent of monetary policy operation.  Impossible Trinity  Three interconnected variables – monetary policy, capital flows and exchange intervention  Managing all three brings RBI face-to-face with Impossible Trinity - it is not possible to simultaneously satisfy all three following conditions  Free capital flows, Monetary policy independence and Fixed (Managed ) exchange rate  With free capital flows and a managed exchange rate one cannot have monetary policy independence  If surge in capital inflows -> RBI buys Dollars -> need to sterilize if monetary policy is to be effective -> but RBI may run out of securities to sterilize  It either let exchange rate go or control capitalinflows  RBI manages by striking a balance – partly exchange rate adjust- partly control capital flows – partly augment securities through MSS Thank you