Fixed exchange rate system

China's case (China’s Renminbi: “Our Currency, Your Problem”)

 
An important part of Chinese economic policy was the decision in 1994 to peg the value of
the Chinese currency, the yuan, to the dollar at a fixed rate of 8.28 yuan to the dollar.
Pegging against the dollar ensured that Chinese exporters would face stable dollar prices for
the goods they sold in the United States. By the early 2000s, many economists argued that
the yuan was undervalued against the dollar, possibly significantly so. Many U.S. firms
claimed that the undervaluation of the yuan gave Chinese firms an unfair advantage in
competing with U.S. firms. The Chinese government was reluctant to revalue the yuan,
because it believed high levels of exports were needed to maintain rapid economic growth.
 
When it is believed a depreciation of the currency is needed to balance trade, we will say
the currency is overvalued.
When it is believed an appreciation of the currency is needed to balance trade, we will say
the currency is undervalued. A currency pegged at a value below the market equilibrium
exchange rate is said to be undervalued.
 
A reduction in the value of a currency (currency weakens) that is set under a fixed exchange
rate regime is called a devaluation (depreciation in flexible). An increase in the value of a
currency (currency strengthens) that is set under a fixed exchange rate regime is called a
revaluation. A devaluation, like any depreciation, makes domestic goods cheaper in terms of
foreign currency, which leads to higher exports. At the same time, it makes foreign goods
more expensive in terms of domestic currency, which reduces imports. The effect is to
increase the balance of payments on current account.
 
Sterilized Intervention: Under a fixed exchange rate regime, central banks can counteract
the effects of purchase and sale of foreign exchange on domestic money supply through
sterilized intervention. A sterilized intervention is the purchase or sale of securities (or the
purchase or sale of foreign currency) by a central bank to influence the exchange value of
the domestic currency, without changing the monetary base.
 
 
Macroeconomic adjustment under fixed exchange rate regime:
Case 1. If overall balance (current account + capital account) is positive. (BoP surplus,
China’s case)
Total inflow of foreign exchange is greater than the total outflow (supply of foreign
exchange is greater than the demand of foreign exchange)
The price of foreign exchange will fall in relation to domestic currency
There will be pressure on domestic currency to appreciate. Since this is a fixed exchange
regime, the central bank will not allow the domestic currency to appreciate.
The adjustment takes place as follows.
The central bank will buy foreign exchange from the open market. This leads to an increase
in the monetary base (since reserves increases). The money supply increases (by a multiple
‘m’, money multiplier). This has two effects.
 
Impact through Current   Impact through Capital
Account Account
Money supply increases   Money supply increases
Interest rate falls   Interest rate falls
GDP growth increases   Relative rate falls
(investment increases)
Net exports (X-M) deteriorates   Capital outflow
because: (i) the demand for (since domestic interest rates
imports increases; become unattractive relative
(ii) increase in the price level to other countries)
(domestic products become
costlier than imported
products, exports become
expensive)
A higher demand for foreign   Supply of foreign exchange
exchange compared to supply (inflow) reduces
of foreign exchange; the
pressure on the domestic
currency to appreciate comes
down
  Currency (domestic)  
Appreciation Arrested

Case 2. If overall balance (current account + capital account) is negative (BoP deficit).

Consider the opposite situation…………………………
 
 
Impact through Current   Impact through Capital
Account Account
Money supply decreases   Money supply decreases
Interest rate rises   Interest rate rises
GDP growth slows down   Relative rate rises
(investment declines)
Net exports (X-M) improves:   Capital Inflow
(i) since the demand for (since domestic interest rates
imports slows down; become attractive relative to
(ii) price level slows down other countries)
(domestic products become
cheaper than imported
products, exports become
inexpensive)
The demand for foreign   Supply of foreign exchange
exchange comes down; the (inflow) increases
pressure on the domestic
 currency depreciate comes
down
  Currency (domestic)  
Depreciation Arrested

Balance of Payments (BoP)

BoP is a summary statement that systematically summarizes the economic transactions of
an economy with the rest of the world for a specific period. The Reserve Bank of India (RBI)
is responsible for compilation and dissemination of BoP data.
BoP comprises of: current account, capital account, errors and omissions, and monetary
movements.
A transaction, which increases the supply of foreign exchange is recorded as a credit entry.
Any transaction that uses up foreign exchange is recorded as a debit.
 
Current account: Under current account of the BoP, transactions are classified into
merchandise (visible) and non-merchandise (invisible).
Merchandise: exports and imports of visible items/goods. Merchandise credit relates to
export of goods while merchandise debit represent import of goods.
Non-merchandise transactions are further classified into three categories:
Services: Travel & tourism, transportation, insurance, government, miscellaneous (software,
communication, construction, news agency).
Income: Investment income (in the form of interest, dividend, profit), Compensation of
employees
Transfers: Foreign aid, Gifts, and Remittances
 
Capital account: There is no export or import of goods and/or invisible items between
countries. There is only inflow (credit) and outflow of capital. The main components of the
capital account include foreign investment, loans and banking capital.
Foreign investment, comprising Foreign Direct Investment (FDI) and Portfolio Investment.
Loans can be on government or private sector accounts.
Banking capital comprises of three components: (a) foreign assets of Commercial Banks; (b)
foreign liabilities of Commercial Banks; and (c) others.
 
Overall balance: It shows the aggregate numbers after adding up all the items in current and
capital accounts and adjusting for errors and omissions.
 
Monetary movements: It reflects the nature of financing of the deficit or surplus. It has two
components:
IMF:  Drawing from IMF is a credit item (i.e., if a country is running in the BoP deficit and
takes a loan from the IMF to pay for the deficit). Repayments are debit items.
Foreign exchange reserves: Increase or decrease in foreign exchange reserves. If a country is
running in the BoP deficit and pay for the deficit using the foreign exchange reserves held by
the central bank leading to a decrease in the reserves. The decrease in the reserves is a
credit entry. On the other side, when a country runs in the BoP surplus, foreign exchange
reserves go up and this is a debit entry.
When all the components of BoP are taken together, the BoP should be in balance.
 
Currency Convertibility: Currency of a country can be freely converted into foreign exchange
at market determined rate of exchange. For example, convertibility of rupee means that
those who have foreign exchange (e.g. US dollars, etc.) can get them converted into rupees
and vice-versa at the market determined rate of exchange.  In India, we have, by and large,
full current account convertibility. We do not have full capital account convertibility.
 
A. CURRENT ACCOUNT
  I. MERCHANDISE
  II. INVISIBLES (a+b+c)
    a) Services
    b) Transfers
    c) Income
  Total Current Account (I+II)
B. CAPITAL ACCOUNT
  1. Foreign Investment (a+b)
    a) Foreign Direct Investment
    b) Portfolio Investment
  2. Loans
  3. Banking Capital
  4. Other Capital
  Total Capital Account (1 to 4)
C. Errors & Omissions
D. Overall Balance (A+B+C)
E. Monetary Movements (i+ii)
      i)  I.M.F.
      ii) Foreign Exchange Reserves
         ( Increase - / Decrease +)

Exchange Rate
Nominal Exchange Rate: The value of one country’s currency in terms of another country’s
currency. It tells us how much domestic (foreign) currency we can obtain with one unit of
foreign (domestic) currency.
Appreciation (strengthen): Increase in the market value of a currency.
Depreciation (weaken): Decrease in the market value of a currency.
Real Exchange Rate: The price of foreign goods in terms of domestic goods. It tells us how
much of a foreign good we can get in exchange for one unit of a domestic good.
Real exchange rate= Nominal exchange rate* (Price of foreign goods/ Price of domestic
goods)
 
Determinants of Exchange Rate: Relative income change; Relative price changes; Taste and
preferences; Expected change in exchange rate/speculation
 
Flexible exchange rate system: A country that allow demand and supply to determine the
value of its currency.
Fixed exchange rate system: A fixed exchange rate system is one under which countries
agree to keep the exchange rates among their currencies fixed for long periods.
Managed float exchange rate system: The value of most currencies is determined by
demand and supply, with occasional government intervention.
 
When currency of a country (say Indian rupee) depreciates (or devalued), the prices of
Indian exports in terms of foreign currency (for instance, dollar) will fall. This will cause an
increase in quantity demanded of Indian exports. As a result, Indian exports will increase.
Also, the depreciation (or devaluation) of the currency will make imports from foreign
countries more expensive (in terms of rupees). Therefore, higher prices of imports mean
that Indian will import less. Thus, as a result net exports of India improves.
 
Fixed exchange rate: It eliminates uncertainties associated with international business
transactions (trade). Businessmen would prefer it!
To support a fixed exchange rate system, the central bank must have adequate foreign
exchange reserves or access to foreign capital.
Flexible Exchange Rate: It enables countries to formulate their macroeconomic policies
independent of other countries.
There is no overvaluation or undervaluation of the currency.
It increases the uncertainty regarding the future exchange rates, thus may affect adversely
the volume of world trade.

International Trade and Macroeconomics

Production possibilities frontier (PPF): A curve showing the maximum amounts of two
outputs that society could produce from given resources, over a given time period.

Comparative advantage: The ability to produce a good at a lower opportunity cost than
others.
Absolute advantage: The ability of a country to produce a specific good with fewer
resources (per unit of output) than other countries.
 
Examples using PPF:  Please see your class notes…
·         Draw the PPFs.
·         Find out the opportunity costs of goods in each country.
·         Absolute Advantage versus Comparative Advantage.
 ·        A country has a comparative advantage in producing a good if it can produce the
good at the lowest opportunity cost. A country can have an absolute advantage in
producing both goods.
·         Terms of trade
·         Production and consumption before trade (Pre-trade)
·         Production after trade (Post-trade)
·         Consumption after trade
·         Gains from trade.
 
Terms of trade:  The rate at which goods are exchanged. The amount of good A given up to
get good B in trade. A country won’t trade unless the terms of trade are better than making
the goods at home. This is true for both trading countries. The two will trade if they agree to
a swap that lies somewhere between their respective opportunity costs of producing the
goods at home.

Inflation...
A rise in the general level of prices. Inflation rate: [(Pt - Pt-1)/ Pt-1]*100.
 
Deflation and Disinflation: When there is a fall in the general price level in the economy
(when the inflation rate falls below zero, i.e., a negative inflation rate), the economy is said
to be in a state of deflation. Disinflation is a situation when the rate of inflation tends to fall
over time but remains positive.
 
Three Strains of Inflation
Low inflation: It is characterized by prices that rise slowly and predictively (a single digit
annual inflation rate).
Galloping inflation: Inflation in the double-digit or triple-digit range of 20, 100 or 200% per
year (very high inflation).
Hyperinflation: Hyperinflation doesn't have a precise definition, but a common rule-of-
thumb is that it occurs when the rate of price inflation exceeds 50% per month.
 
Demand-pull inflation: If aggregate demand is growing faster than aggregate supply. A
particular damaging form of demand-pull inflation occurs when governments engage in
deficit spending and rely on the monetary printing press to finance their deficits. The large
deficits and the rapid money growth increase aggregate demand, which in turn increases
the price level.
Cost-push inflation or Supply-shock inflation: Increases in (business) costs rather than
because of increases in demand, putting pressure on suppliers to push up prices (oil shocks,
farm price shocks). It often leads to stagflation (stagnation with inflation).
Cost-push inflation poses a policy dilemma: output declines at the same time as inflation is
rising. Monetary and fiscal policies can be used to change aggregate demand (use the AD-AS
framework and see what happens to price and output). Monetary or fiscal expansion would
offset the decline in output but raise prices further (i.e., the inflation rate would increase).
On the other side, tightening monetary policy (to curb inflation) would only lower output
even further (and therefore unemployment would increase). [use: AD-AS and see what
happens?]
 
Inflation Targeting:  A framework for conducting monetary policy that involves the central
bank announcing its target level of inflation (usually a low one). One of the primary
objectives of monetary policy should be to ensure low and stable inflation. Inflation
Targeting offers a framework to achieve this objective in a credible and sustainable manner.
Advantages: Easier for firms and households to form expectations about future inflation,
improving their planning. Promotes central bank accountability- provides a yardstick against
which performance can be measured.
Limitations: Reduces the central bank’s flexibility to address, and accountability for, other
policy goals. Assumes that the central bank can correctly forecast inflation rates, which may
not be true.
 
India formally adopted flexible inflation targeting (FIT) in June 2016. RBI will have to achieve
4% CPI inflation (applicable till March 2021) with an upper tolerance level of 6% and lower
limit of 2%.

AD-AS model
A model that explains short-run fluctuations in real GDP and the price level.
Aggregate demand (AD) curve:  A curve that shows the relationship between the price level
and the quantity of real GDP demanded by households, firms, and the government.
Short-run aggregate supply (SRAS) curve: A curve that shows the relationship in the short
run between the price level and the quantity of real GDP supplied by firms.
 
Why is the Aggregate Demand Curve Downward Sloping?
The Wealth Effect: How a Change in the Price Level Affects Consumption
The Interest-Rate Effect: How a Change in the Price Level Affects Investment
The International-Trade Effect: How a Change in the Price Level Affects Net Exports
(Suppose the price level in India rises. As this happens, Indian goods become relatively more
expensive than foreign goods. As a result, both Indians and foreigners buy fewer Indian
goods. Our exports will become relatively more expensive. Indian exports will fall and Indian
imports will rise, causing net exports to fall).
 
Variables That Shift the Aggregate Demand Curve
The variables that cause the aggregate demand curve to shift fall into three categories:
• Changes in government policies: Monetary policy (by increasing and decreasing money
supply through monetary policy tools and changing interest rates) and Fiscal policy (increase
or decrease in government expenditure or taxes). For example, if income taxes rise,
disposable income decreases. When people have less take-home pay to spend, consumption
falls. Consequently, aggregate demand decreases.
• Changes in the expectations of households and firms
• Changes in foreign variables:
If firms and households in other countries buy fewer Indian goods or if firms and households
in India buy more foreign goods, net exports will fall, and the aggregate demand curve will
shift to the left.
Exchange rate effect: Depreciation in a nation’s currency makes foreign goods more
expensive.
 
Why is the SRAS curve upward sloping?
In the short run, as the price level increases, the quantity of goods and services firms are
willing to supply will increase. The main reason firms behave this way is that, as prices of
final goods and services rise, prices of inputs such as the wages of workers or the price of
natural resources rise more slowly.
• Contracts make some wages and prices “sticky.”
• Firms are often slow to adjust wages.
• Menu costs make some prices sticky: Consider the effect of an unexpected increase in the
price level. In this case, firms will want to increase the prices they charge. Some firms,
however, may not be willing to increase prices because of menu costs. Because their prices
are now lower relative to competitors, these firms will find their sales increasing, which will
cause them to increase output.
 
Variables That Shift the Short-Run Aggregate Supply Curve
Increases in the labor force and in the capital stock
Technological change, Productivity (An increase in labor productivity means businesses will
produce more output with the same amount of labor).
Unexpected changes in the price of an important natural resource,
Changes in nominal wages
Supply shock: An unexpected event that causes the short-run aggregate supply curve to
shift.
Negative supply shocks shift the SRAS curve leftward, and positive supply shocks shift it
rightward (unusually good weather leading to increased production of a food staple). For
instance, an increase in the price of an important natural resource will shift the supply curve
left because firms face rising costs and they will supply the same level of output only if they
receive higher prices. Negative supply shocks pose a dilemma for policymakers. Policy
makers can achieve either price stability or economic activity stability, but not both. [Use
AD-AS and check].
We call a situation of rising inflation but a falling level of aggregate output stagflation (a
combination of the words stagnation and inflation).
 
The long-run aggregate supply curve is vertical as in the long-run output is determined by
potential output and is independent of the price level. In the long run, the level of real GDP
is determined by the number of workers, the capital stock including factories, office
buildings, and machinery and equipment, and the available technology.
 
Short-run Equilibrium: The condition that exists in the economy when the quantity
demanded of Real GDP equals the (short-run) quantity supplied of Real GDP. This condition
is met where the aggregate demand curve intersects the short-run aggregate supply curve.
An increase in aggregate demand increases the price level and Real GDP. An increase in
short-run aggregate supply decreases the price level and increases Real GDP. A decrease in
short-run aggregate supply increases the price level and decreases Real GDP.  Suppose there
is an adverse supply shock in the economy. This will shift the SRAS curve leftward. Nothing
has changed on the demand side of the economy, so the AD curve remains stable. A
leftward shift in the SRAS curve in the face of an unchanged AD curve ends up increasing the
price level and decreasing Real GDP.

A note on the IS-LM model (first session)

The IS-LM model, a short-run macro-model, in which it is assumed that the interest rate can vary
while the price level is still fixed. This model is used to analyze the interaction of the goods and
money markets, and it gives an understanding of the role of interest rates as an additional
determinant of aggregate demand. As a result, we will be able to assess how the composition of
aggregate demand changes as interest rates fluctuate. This, in turn, allows for a more
comprehensive analysis of the short-run effects of fiscal and monetary policy changes on the level of
output demanded.
 
The IS-curve is derived as a logical extension of the Keynesian cross diagram. In the Keynesian cross
diagram, the interest rate is assumed to be constant; but now it is allowed to fluctuate. When the
interest rate falls, it becomes more profitable to increase the existing capital stock, so planned
investment spending increases. In other words, the [C+I+G]-line of the Keynesian diagram shifts up.
Why the IS-curve is downward sloping: lower interest rates lead to more investment spending and
therefore a higher level of output. The IS-curve shows all combinations of output levels and interest
rates at which the goods market is in equilibrium.
 
The LM-curve shows all combinations of interest rates and income levels at which the money market
is in equilibrium, that is, at which aggregate money demand is equal to money supply. The demand
for real money balances (L) is positively related to the level of income (Y). The equation for real
money demand can be written as: L = kY – hi (with k > 0 and h > 0). The equation of the LM-curve is
derived in the following way: L = kY - hi = (M/P). The variable M represents the nominal money
supply, P is the price level, and M/P is the real money supply.
As income increases, people tend to hold more money to finance the increased expenditures that
come with higher income. Given the money supply, this increase in the demand for money leads to
an increase in the equilibrium interest rate.
Why the LM-curve is upward sloping: Equilibrium in the money market implies that an increase in
income leads to an increase in the interest rate (through the increase in money demand; money
supply remains the same). [Use money demand and money supply equilibrium to check!]
 
Shifts of the IS and LM curves:
For a given interest rate, an increase in taxes leads to a decrease in output. An increase in taxes
shifts the IS curve to the left. The same would hold for a decrease in government spending.
An increase in the money supply shifts the LM curve down; a decrease in the money supply shifts the
LM curve up.
 
The IS–LM Model (the IS and the LM Relations Together)
Equilibrium in the goods market implies that an increase in the interest rate leads to a decrease in
output. This is represented by the IS curve. Equilibrium in money market implies that an increase in
output leads to an increase in the interest rate. This is represented by the LM curve. Together, they
determine both output and the interest rate (i.e., both goods and money markets are in
equilibrium). This occurs at the point of intersection of the IS and LM curves.

IS-LM (second session)

Policies in IS-LM model
Fiscal Policy: Suppose the government decides to increase government expenditure (fiscal
expansion) to boost the economy. The IS curve shifts to the right. (What happens to the LM curve
when government expenditure is increased?: Nothing) The new equilibrium is at the intersection of
the new IS curve and the unchanged LM curve. Output increases, and the interest rate increases.
Thus, as the IS curve shifts, the economy moves along the LM curve. The increase in government
expenditure leads to higher income/output. At the same time, the increase in income raises the
demand for money, leading to an increase in the interest rate.
 
Monetary Policy: Suppose that the central bank increases the money supply, M, through an open
market operation. The money supply does not directly affect either the supply of or the demand for
goods. In other words, M does not appear in the IS relation. Thus, a change in M does not shift the IS
curve. An increase in the money supply shifts the LM curve down. The economy moves along the
IS curve. Output increases and the interest rate decreases. The increase in money supply leads to a
lower interest rate. The lower interest rate leads to an increase in investment and, in turn, to an
increase in demand and output.
The Effects of Fiscal and Monetary Policy
  Shifts of Shifts of Movement in Movement in
IS LM output interest rate
Increase in Taxes Left None Down Down
Increase in Right None Up Up
government  Spending
Increase in money supply None Down Up Down
 
The combination of monetary and fiscal policies is known as the monetary–fiscal policy mix, or
simply the policy mix. Sometimes, the right mix is to use fiscal and monetary policy in the same
direction. This was the case for example during the recession of 2001 in the United States, where
both monetary and fiscal policy were used to fight the recession.
 
Fiscal policy and crowding out: Suppose government decides an expansionary fiscal policy to
stimulate aggregate demand/output, and/or combating unemployment in the economy. Crowding
out occurs when expansionary fiscal policy (an increase in govt. expenditure or tax cut) causes
interest rates to rise, thereby reducing private spending, particularly investment [draw IS-LM to
check this]. The increase in government expenditure crowds out investment.
This crowding out can be avoided if the monetary authorities accommodate (known as monetary
accommodation) the fiscal expansion by an increase in the money supply (so that the LM shifts down
and decreasing the interest rate). Therefore, it prevents interest rates from increasing and no-
crowding out. (The central bank is said to “accommodate” fiscal policy).
The central bank can hold the level of income/output constant by decreasing the money supply (for
instance, in a period of inflation).
 
The liquidity trap, a situation in which the public is prepared, at a given interest rate, to hold
whatever amount of money is supplied (it could be because the nominal interest rate on short-term
assets is close to zero). This implies that the LM curve is horizontal and that changes in the quantity
of money do not shift it. In that case, monetary policy carried out through open market operations
has no effect on either the interest rate or the level of income. In the liquidity trap, monetary policy
is powerless to affect the interest rate.
The Classical Case: The polar opposite of the horizontal LM curve is the vertical LM curve. The LM
curve is vertical when the demand for money is entirely unresponsive to the interest rate. Shifts in
the IS curve do not affect the level of income when the LM curve is vertical. Thus, when the LM curve
is vertical, monetary policy has a maximal effect on the level of income, and fiscal policy has no
effect on income. The vertical LM curve, implying the comparative effectiveness of monetary over
fiscal policy, is sometimes associated with the view that “only money matters” for the determination
of output. If the LM curve is vertical, an increase in government spending has no effect on the
equilibrium level of income and increases only the interest rate. Therefore, there is full-crowding out
(because the increase in interest rates crowds out private spending equal to the increase in
government spending).
 
In the case of the liquidity trap the LM curve is horizontal, fiscal policy has its maximum strength,
and monetary policy is ineffective. In the classical case the LM curve is vertical, fiscal policy has no
effect on output, and monetary policy has its maximum strength.

Fisher’s Equation: Real interest rate = Nominal interest rate – Inflation rate

Money
Money represents the stock of assets that are used to carry out transactions. It includes currency-
rupees and coins—as well as other assets, such as bank accounts. Money has several functions
including acting as a means of payment, a unit of account, and a store of value.
Components of Money
M Currency in circulation + Bankers’ deposits with the RBI + ‘Other’ deposits with the RBI
0 (Monetary Base, High-powered Money or Reserve Money)
M Currency with the public + Demand deposits with the banking system + ‘Other’ deposits
1 with the RBI. (Narrow Money)
M
3 M1 + Time deposits with the banking system (Broad Money)
 
The Money Demand Function
Md = P * L(Y, i); Md is nominal money demand, P is the price level, L is the money demand
function, Y is real income or output, i is the nominal interest rate
 
Quantity Theory of Money
Quantity equation:  M*V= P*Y
It provides a simple way to think about the relation between money, prices, and output. The money
supply (M) multiplied by the velocity of money (V) equals the price level (P) multiplied by  real output
(Y).
Quantity theory explanation of inflation
We can transform the quantity equation from M * V = P * Y to m + v = p + y
Growth rate of the money supply + Growth rate of velocity = Growth rate of the price level (or
inflation rate) + Growth rate of real output
Inflation rate = Growth rate of the money supply + Growth rate of velocity - Growth rate of real
output.
If velocity is constant, then the growth rate of velocity will be zero. This assumption allows us to
rewrite the equation: Inflation rate = Growth rate of the money supply - Growth rate of real output.
In the long run, inflation results from the money supply growing at a faster rate than real GDP. If the
central bank allows the money supply to grow rapidly, it may lead to a rapid inflation.
 
100-Percent-Reserve Banking: If there were no banks in the economy, there would be no demand
deposits, and so the money supply would simply equal the amount of currency. The same is true if
all the currency was deposited in banks and the banks did not make any loans. Such banks would be
operating under a system of 100-percent-reserve banking.
Fractional-Reserve Banking
In the real world, banks make loans. Since banks do not anticipate that all their depositors will want
to withdraw all their money at once, they do not need to hold reserves equal to the amount of
deposits. Instead, they only hold a fraction of their deposits as reserves and loan out the rest. This is
known as the fractional-reserve banking.
 

Money Supply Process

Three groups affect the money supply in the economy:

(i) The central bank is responsible for monetary policy. It affects the most important component of
money supply (bank deposits)
(ii) Depository institutions (commercial banks) accept deposits and make loans. Credit creation
(iii) The public (people and firms) holds money as currency or as bank deposits. Choice between
currency and deposits.
 
M= Money Supply, C= Currency in circulation, D= (Total) Bank deposits
The money supply consists of currency held by the public and deposits.
M= M3 (Broad money), M = C + D.
Some of the economy’s notes and coin—the monetary base—is in general held by the public (C) and
some is held by banks as reserves (R). Letting MB denote the monetary base, we have, by definition,
MB = C + R.
Now define the currency–deposit ratio (c) as [c = C/D] and the reserve–deposit ratio is [r = R/D].
M= m*MB… (Money Supply)
The term (c + 1)/(c + r) is known as the money multiplier (m), since it shows how each rupee/dollar
of the Monetary Base (MB) is multiplied up to give a larger value for the money supply.
1. The money supply is proportional to the monetary base. Thus, an increase in the monetary base
increases the money supply by the same percentage.
2. The lower the reserve–deposit ratio, the more loans banks make, and the more money banks
create from every rupee of reserves. Thus, a decrease in the reserve–deposit ratio raises the money
multiplier and the money supply.
3. The lower the currency–deposit ratio, the fewer rupees of the monetary base the public holds as
currency, the more base rupees banks hold as reserves, and the more money banks can create. Thus,
a decrease in the currency–deposit ratio raises the money multiplier and the money supply.
[The money multiplier (m) decreases when either the currency–deposit ratio, c, or the reserve–
deposit ratio, r, increases].
 
The Instruments of Monetary Policy
Open market operations (outright buying or selling government securities; and repo or reverse repo
transactions): The central bank uses open market operations to control the money supply. RBI as a
market regulator buys/sells government securities from/to banks and private individuals through its
open market window. When the central bank uses money to purchase government bonds from the
public, thus raising the money supply, it is said to have conducted an open-market purchase. When
RBI buys securities, the reserves of the commercial bank receiving the payment increase (it affects
MB not m; recall MB= C+R and here R will increase not C; It also means that the reserve ratio is
unchanged by the open-market operation, but actual reserves are increased by this payment). The
bank will now have excess reserves which may be used for making loans, leading to an increase in
money supply.
The central bank can control the money supply by changing the discount rate (Bank rate in India)
(the rate the central bank charges banks when it lends them reserves). If the central bank wants to
increase the money supply, it will lower the bank rate, and vice versa. At a lower rate, banks will
borrow more. (Again like securities MB will change and not m, R will increase; because central bank
will deposit the amount in Banks’ reserve account with the central bank).
The central bank can also control the money supply by changing the required reserve ratio (CRR in
India). Lowering the required reserve ratio (here m will change because of R/D and not MB)
increases the money supply, and vice versa.
 
Expansionary Monetary Policy: When the central bank uses its tools to stimulate the economy (the
central bank will lower the CRR/Repo/Bank rate or will buy securities). That increases the money
supply, lowers interest rates, and increases aggregate demand.
The economy’s money supply curve shows the total money supply. This line is vertical because once
the central bank sets the money supply, it remains constant until the central bank changes it. Open
market purchases of bonds inject reserves into the banking system and shift the money supply curve
rightward. Open market sales have the opposite effect.
[Recall: Money demand and money supply curve, that I used to show the effect of an increase in
money supply on the interest rate]
 
In the short run the equilibrium interest rate is determined in the money market (money demand=
money supply). The point where the money demand curve intersects with the money supply curve.
When the central bank increases the money supply, the equilibrium interest rate falls and spending
on plant and equipment, new housing, and consumer durables increases. This produces a multiplier
effect that increases equilibrium GDP, and unemployment falls. Decreasing the money supply has
the opposite effect.

A note on unemployment
Total Population= Employed + Unemployed + Out of labor force
Unemployed: An individual who is not currently at work but who is available for work and
who has actively looked for work.
Labor force: Those people who have a job or who are looking for one. The sum of employed
and unemployed workers in the economy.
Unemployment rate: The percentage of the labor force that is unemployed.
UR= [No of unemployed persons/(No. of employed + No. of unemployed)]*100, or
 [No of unemployed persons/(Labor force)]*100
Similarly, one can define the labor-force participation rate.
 
Frictional unemployment: The unemployment that arises as workers search for suitable jobs
and firms search for suitable workers is called frictional unemployment (generally short
spells of unemployment).
Structural unemployment: Unemployment caused by a mismatch between the skills of job
seekers and the requirements of available jobs (longer spells of unemployment).
Cyclical unemployment: Unemployment caused by a decline in economic activity or a
recession (a lack of demand in the economy). The demand for products decreases and
workers get laid off.
 
Discouraged workers: People who are available for work but have not looked for a job
because they believe no jobs are available for them. These discouraged workers are counted
as being out of the labor force and do not show up in unemployment statistics.
Underemployment: People who want full-time work in their field but can find only part-time
work or work at jobs below their capability.
 
In addition to above we also discussed the case: Why did unemployment rise less in Europe
than in the US after 2007? We discussed the innovative policy measure (for example “work-
sharing” policies) taken by the German government and the benefits of this intervention.