Macro economics by bhawani nandan prasad iim calcutta

1. Recession, Inflation and Monetary Policy
BHAWANI NANDAN PRASAD
SMP – IIM Calcutta
MBA – Stratford University
B.E. ( Computer Sc. IT )

2. Economic crises
• Recession
• Inflation
• Foreign exchange crisis
2

3. 3
Demand-constrained economy
(aggregate demand < potential output)
(Recession/depression)
Potential amount not producedAggregate demand
Potential
outputK

4. 4
Recession/depression
• Recession:
– Decline in output, income and employment
lasting more than few months
• Depression:
– a recession that is large in both scale and
duration

5. 5
Supply-constrained economy
(aggregate demand > potential output)
(Demand-pull inflation)
Potential
output
Aggregate demand
K

6. 6
Why is demand deficient and how can it be increased
Aggregate demand
Potential
outputK

7. 7
How demand can be managed to tackle
demand-pull inflation
Potential
output
Aggregate demand
K

8. 8
How K (and productivity etc) can be increased
to accelerate growth
Potential
outputK

9. Tools of Economic Policy
• Fiscal Policy:
– Government expenditure and taxes
• Monetary Policy:
– Money supply, credit, interest rates
9

10. We focus on
Monetary Policy
10

11. Evolution of Money
• Barter: exchange of goods for other goods
• Commodity money: commodities such as
cattle, copper, silver, gold, diamonds etc
functioning as money
• Modern money:
– Paper currency:
• India: minimum reserve system since 1956 (Rs
400 crores of forex reserves and Rs 115 crores of
gold)
– Bank money
11

12. Different forms of Money
In India:
M1 = Currency (notes & coins) with public +
demand deposits with banks (narrow money)
M3 = M1 + time deposits with banks (broad
money)
Note:
(„Other‟ deposits with RBI (= deposits of UTI, IDBI etc; deposits of
foreign central banks/governments etc) are also a part of M1;
statistically very small)
12

13. 13
Percent
Year
Money Supply per unit of GDP
M1/GDP M3/GDP

14. Modern banks
• As banking developed, banks realized that
that they need not keep 100 percent of
deposits as reserves since all the
customers will not withdraw their deposits
at the same time
• Under the modern fractional reserve
banking, banks actually create money
since total bank deposits is a multiple of
bank reserves
14

15. Who creates Money?
• RBI:
– Determines the monetary base (also known
as reserve money, base money, high
powered money)
• Banks:
– Create money through multiple expansion of
bank deposits based on cash reserves
15

16. Major Monetary Policy Instruments in
India
• Reserve requirements as % of NDTL (net
demand and time liabilities)
• Cash reserve ratio (CRR) – cash balance with RBI
• Statutory liquidity ratio (SLR) – safe & liquid assets
such as government securities, cash, gold
• Liquidity adjustment facility (LAF):
• RBI sets two rates - repo and reverse repo and
offers to buy securities or sell securities
respectively
16

17. Policy Rates and Reserve ratios
(www.rbi.org.in, 31/10/2012)
Repo rate 8 %
Reverse repo rate 7 %
17
Cash Reserve ratio 4.5 %
Statutory Liquidity ratio 23 %

18. Target of Monetary Policy
• Change interest rates and credit
availability to influence aggregate demand:
– Expansionary (“loose”/“easy”) monetary policy
in a demand constrained economy
(recession):
• ↓ CRR/SLR
• ↓ Repo
– Contractionary (“tight”) monetary policy in a
supply constrained economy (inflation):
• CRR/SLR
• Repo
18

19. Effectiveness of Monetary Policy
during recession
• Banks don‟t reduce lending rates and/or
don‟t want to lend more even when repo
and CRR reduced
• Households and firms don‟t borrow more
even when lending rates fall
• Fiscal policy – Keynes‟ argument
19

20. Problems of using Monetary Policy
to control inflation
• Demand pull inflation or Cost-push
inflation
• Risk of Stagflation
• Problem of sectoral inflation
• Growth vs inflation
• Question of Inflationary expectations
20

21. 21
Year-on-year Inflation - WPI

22. 22
Percent
Month/year
RBI rates
Repo CRR