Managerial

Economics
RBI/Government Sector & Economics
May-June 2019
 Government and its influence on
Economic Conditions

• Macro factors impacting us

• Role of RBI

• Inflation and Employment

• Growth of the economy

• Incentives and dis-incentives

First let us understand Inflation

Inflation is the persistent increase in general prices or the persistent decrease in the
real income of people.
How is Inflation Measured ?

Consumer Price Index (CPI):

The CPI consists of 448 goods and
services that are used by consumers

Wholesale Price Index (WPI):

The WPI basket includes 676
commodities; all of these are only
goods and whose prices are captured
at the wholesale /producer level.

GDP Deflator:
Ratio of GDP at current prices to GDP
at constant prices.
Types of Inflation
Inflation

Price Inflation Money Inflation

Steady increase in Excess currency in

prices circulation- Deficit
Financing or Excess
flow of Foreign
Exchange in form of
Capital, Tourism and
other incomes
The Quantity Theory of Money

In the early twentieth century, Irving Fisher, an economist at Yale, formalized the connection
between money and prices by using the quantity equation:
M × V = P × Y

The quantity equation states that the money supply (M) multiplied by the velocity of money (V)
equals the price level (P) multiplied by real output (Y).

Fisher defined the velocity of money, often referred to simply as “velocity,” as the average
number of times each dollar of the money supply is used to purchase goods and services
included in GDP.

Assumptions: In the short run V constant. V is fixed because ease of transactions stays constant
in the short run. Ease of transaction is related to density of banks, number of ATM machines
etc., in a nation.
As they increase they affect the V in a positive manner.
The Quantity Theory Explanation of Inflation

We can transform the quantity equation from

M × V = P × Y

to

Growth rate of the money supply + Growth rate of velocity = Growth rate of the price level (or
inflation rate) + Growth rate of real output.

Implies,
Inflation rate = Growth rate of the money supply + Growth rate of velocity − Growth rate of
real output
The Quantity Theory Explanation of Inflation

If Irving Fisher was correct that velocity is constant, then the growth rate of velocity will be
zero.

That is, if velocity is, say, always eight, then its percentage change from one year to the next
will always be zero. This assumption allows us to rewrite the equation one last time:

Inflation rate = Growth rate of the money supply − Growth rate of real output.

This equation leads to the following predictions:

• If the money supply grows at a faster rate than real GDP, there will be inflation.
• If the money supply grows at a slower rate than real GDP, there will be deflation. (Recall
that deflation is a decline in the price level.)
• If the money supply grows at the same rate as real GDP, the price level will be stable, and
there will be neither inflation nor deflation.
The Quantity Theory Explanation of Inflation

Very high rates of inflation - in excess of 100 percent per year - are known as hyperinflation.

Hyperinflation is caused by central banks increasing the money supply at a rate far in excess
of the growth rate of real GDP. A high rate of inflation causes money to lose its value so
rapidly that households and firms avoid holding it.

If, as happened in Zimbabwe, the inflation becomes severe enough, people stop using paper
currency, so it no longer serves the important functions of money discussed earlier in this
chapter.

Economies suffering from high inflation usually also suffer from very slow growth, if not
severe recession.
Methods to control the Economy

Inflation
Unemployment
Economic Growth
MONETARY
FISCAL POLICY Exchange Rate
POLICY
Sovereign Rating
Investments
Economic Climate Monetary Policy
Fiscal Policy is involves changing
controlling taxes the interest rate to
and government influence the
spending to amount of money
influence aggregate supply. This is
demand. usually carried out
by the country’s
central bank.
Effect of Interest on Money Supply

If interest rates are high the demand for holding loose cash is low.
If interests rates are low people would rather hold cash or spend,
hence demand is higher.

Hubbard, Glenn P., Anthony O'Brien. Macroeconomics, 4th Edition. Pearson Learning Solutions,
2012-01-01. VitalBook file.
Effect on Interest Rate when Money Supply Changes

Hubbard, Glenn P., Anthony O'Brien. Macroeconomics, 4th Edition. Pearson Learning Solutions,
2012-01-01. VitalBook file.
Effect of Interest rates on Aggregate Demand

 
Effect of Monetary Policy on Real GDP

Hubbard, Glenn P., Anthony O'Brien. Macroeconomics, 4th Edition. Pearson Learning Solutions,
2012-01-01. VitalBook file.
An example of fighting inflation with Monetary Policy

Hubbard, Glenn P., Anthony O'Brien. Macroeconomics, 4th Edition. Pearson Learning Solutions,
2012-01-01. VitalBook file.
Measures of Money
M0 RESERVE MONEY
• TOTAL CURRENCY IN CIRCULATION
• ALL BANKER’S DEPOSITS WITH RBI
• OTHER DEPOSITS WITH RBI

M1 MONEY- RBI
• CURRENCY WITH PUBLIC EXCLUDING CASH IN HAND WITH BANKS
• DEMAND DEPOSITS WITH BANKS EXCLUDING INTERBANK DEPOSITS
• OTHER DEPOSITS WITH RBI WHICH ARE CURRENT DEPOSITS OF FOREIGN CENTRAL BANKS,
FINANCIAL INSTITUTIONS, QUASI FINANCIAL INSTITUTIONS SUCH AS IDBI, IFCI etc.

M2 MONEY
• M1 PLUS POST OFFICE SAVINGS

M3 MONEY – BROAD MONEY

• M1 PLUS TIME DEPOSITS MINUS INTERBANK TIME DEPOSITS

M4
• M3 PLUS ALL POST OFFICE DEPOSITS BOTH TIME AND SAVINGS

High powered money - The total liability of the monetary authority of the country, RBI, is called
the monetary base or high powered money. It consists of currency ( notes and coins in
circulation with the public and vault cash of commercial banks) and deposits held by the
Government of India and commercial banks with RBI.
How Banks Create Money
EXPANDED
BANKA BANKB BANKC BANKD BANKE BANKF CREDIT
DEPOSITBASE 1,000.00 1,000.00
RESERVES@10% 100.00
CAN LOAN OUT 900.00 900.00
ADDITION DEPOSIT 900.00
ADDITIONALRESERVES 90.00
CAN LOAN OUT 810.00 810.00
ADDITION DEPOSIT 810.00
ADDITIONALRESERVES 81.00
CAN LOAN OUT 729.00 729.00
ADDITION DEPOSIT 729.00
ADDITIONALRESERVES 72.90
CAN LOAN OUT 656.10 656.10
ADDITION DEPOSIT 656.10
ADDITIONALRESERVES 65.61
CAN LOAN OUT 590.49 590.49
ADDITION DEPOSIT 590.49
ADDITIONALRESERVES 59.05
CAN LOAN OUT 531.44 531.44
5,217.03
In other words, the expanded credit availability would be 1000 + 900 (90% of 1000) + 810 (90% of
900) + 729 (90% of 810) + (90% of 729) +…
This summation finally would be equivalent to 1/10% of 1000, which is Rs. 10,000. Thus, in our
example, the initial deposit is capable of multiplying itself out 10 times — this multiple is called
the money multiplier, denoted by ‘m’. As a formula, m = 1/RR (in our example, 1/10% = 10).
In practice, though, people hold a combination of both cash and deposits, so the multiplier is
slightly more involved than the above. And the related formula would be m = C+D/LC; where, C
is cash, D is deposits, and LC is the most liquid and acceptable form of cash. Regardless, the
functioning logic remains the same as explained earlier.
Multiplier in India FOR 2013 WAS 5.5
Concept of a Central Bank

● A fallout from the failures of individual banks in early

times.
● The Central Bank normally bails out individual banks and
● Controls the Money Supply
● Maintains Stability of the Currency
● Regulates Banks to ensure fair practices
● Acts as a Banker to the Govt
● There may be other functions which vary from country to
country.

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RBI

➢ RBI was established in 1935 and Nationalised in 1949

➢ Plays the role of regulator of the banking system in India
➢ The Banking Regulation Act of 1949 and the RBI Act of 1953 gives
RBI the power to regulate the banking system

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Function of RBI

21
How does RBI influence Monetary Policy ?

CRR – 4%
SLR – 20.75%
REPO – 6.5%
REVERSE REPO- 6%
Bank Rate- 7% 23
MSF rate-7%
Fiscal Policy

● Fiscal policy are the changes in government Spending and Taxes that
are aimed at achieving the macro goals.
● Automatic Stabilisers vs Discretionary Policies
● Automatic Stabilisers are factors on which the Govt. has no
control
● GDP grows, unemployment reduces, unemployment dole
decreases.
● GDP grows collection from taxes increase.
● Some non planned expenditures.
● Discretionary Policies is when governments change their spending
or change tax rates.

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Effect of Fiscal Policy on GDP

Hubbard, Glenn P., Anthony O'Brien. Macroeconomics, 4th Edition. Pearson Learning Solutions,
2012-01-01. VitalBook file. 25
The National Budget

● The National Budget is a report card on how the Government has

managed its affairs in the past year and how it proposes to raise
funds and deploy them in the coming year.
● It lays down the governments fiscal policies and taxation details as
well as its approach to economic management.

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http://indiabudget.nic.in/glance.asp

Budget at a Glance
2014-2015 2015-2016 2015-2016 2016-2017
Actuals @ Budget Revised Budget
Estimates Estimates Estimates

1 Revenue Receipts 1101472 1141575 1206084 1377022

2 Tax Revenue (net to centre) 903615 919842 947508 1054101
3 Non-Tax Revenue 197857 221733 258576 322921
4 Capital Receipts (5+6+7)$ 562201 635902 579307 601038
5 Recoveries of Loans 13738 10753 18905 10634
6 Other Receipts 37737 69500 25312 56500
7 Borrowings and other liabilities * 510725 555649 535090 533904 This is Fiscal Deficit
8 Total Receipts (1+4)$ 1663673 1777477 1785391 1978060
9 Non-Plan Expenditure 1201029 1312200 1308194 1428050
10 On Revenue Account 1109394 1206027 1212669 1327408
of which,
11 Interest Payments 402444 456145 442620 492670
12 On Capital Account 91635 106173 95525 100642
13 Plan Expenditure 462644 465277 477197 550010
14 On Revenue Account 357597 330020 335004 403628
15 On Capital Account 105047 135257 142193 146382
16 Total Expenditure (9+13) 1663673 1777477 1785391 1978060
17 Revenue Expenditure (10+14) 1466992 1536047 1547673 1731037
18 Of Which, Grants for creation of Capital Assets 130760 132472 132004 166840
19 Capital Expenditure (12+15) 196681 241430 237718 247023
20 Revenue Deficit (17-1) 365519 394472 341589 354015
(2.9) (2.8) (2.5) (2.3)
21 Effective Revenue Deficit (20-18)# 234759 268000 209585 187175
(1.9) (2.0) (1.5) (1.2)
22 Fiscal Deficit {16-(1+5+6)} 510725 555649 535090 533904
(4.1) (3.9) (3.9) (3.5) % of GDP
23 Primary Deficit (22-11) 108281 99504 92469 41234
(0.9) (0.7) (0.7) (0.3)
Definition of 'Non-plan
Expenditure'
Definition: This is largely the revenue
expenditure of the government, although it
also includes capital expenditure. It covers
all expenditure not included in the Plan
Expenditure.
Definition of 'Plan Expenditure'
Definition: This is essentially the budget support
to the Central Plan and the Central assistance to
State and Union Territory plans. Like all budget
heads, this is also split into revenue and capital
components.

Description: A major part of the Non-Plan Description: Plan Expenditure is aimed at

Expenditure is obligatory in nature, like bolstering the productive capacity of the
interest payments, pensions, statutory economy. It includes expenditure on electricity
transfers to States and Union Territories generation, infrastructure, education, and other
governments. productive areas of our economy.

Non-Plan Expenditure constitutes the biggest

proportion of the of the government's total
expenditure. The biggest items of Non-Plan
Expenditure are interest payments and debt
servicing, defence expenditure and
subsidies. For defence services, both
revenue and capital expenditure are
incurred.