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Narsee Monjee Institute of Management


Monetary & Fiscal Policy - ISLM Framework

Dipankar De
Mumbai, November 2007
The Structure of the IS-LM Model


Assets Market Goods market

Money Market Bond Market Aggregate Demand
Demand Demand
Supply Supply


Monetary Policy Fiscal Policy

Shift in the IS Curve

 The IS curve is shifted by changes in autonomous spending.

An increase in autonomous spending, including an increase
in government expenditure, shifts the IS curve to the right

Effect of increase in Govt.

IS1 expenditure

The LM Curve
 3 possible segments
– Normal positive slope
– Liquidity Trap
– Liquidity Gate

Liquidity Gate Zone,

slope zero
Speculative demand for money
is perfectly inelastic w.r.t
r max change in interest rate

r min
Liquidity Trap zone, Speculative demand for
slope infinity money is infinitely elastic
w.r.t change in interest rate
Monetary & Fiscal Policy
Monetary Policy
• Monetary policy may be defined as a policy employing the
central bank’s control of the supply of money as an instrument
for achieving the objectives of general economic policy

• Monetary policy acts through influencing the cost & availability

of credit & money

• Effectiveness of monetary policy depends on the institutional

framework that is available for transmitting the impulses
released by the central bank
• Objectives:
1. Ensuring economic growth with price stability
2. To maintain a stable external value of the domestic
3. To maintain continuously low rates of interest
4. To create market for govt. securities, develop financing
Instruments of Monetary Policy - I

Bank rate is the rate at which commercial banks borrow from the central

•It operates by altering the cost of credit & acts as a signaling device/
benchmark for all money interest rates in India. A rise in Bank Rate
leads to rise in all types of interest rates.

Cost of borrowing by CBs Rise in lending Demand for Contraction in

from the RBI increases rates by the CBs commercial credit Bank credit


Rise in interest Attractive for foreign funds Rise in FOREX Appreciation of

differential b/n India & to come in India & capital reserves rupee
foreign country inflow into India
Instruments of Monetary Policy - II

Open Market Operations (OMO) is the purchase & sale of government

securities by the central bank

•Major instrument for RBI intervention in the market

•Under inflationary situations, if the central bank finds that there
are more money in the hands of public, it performs OMO, i.e. OM
•When the RBI sells govt. securities, it mops up liquidity from the
•Commercial banks draws down its reserves, that leads to overall
contraction in credit in the economy
Instruments of Monetary Policy - III

Variable Reserve Ratio - To control the level of required reserves against

their deposits by the commercial banks, reserve ratio is varied

•Examples are Statutory Liquidity Ratio (SLR), Cash Reserve Ratio

•When the central bank adopts monetary expansionary policy, it
would reduce reserve requirements by the commercial banks (CBs)
•A part of the existing reserves then becomes ‘excess reserves’,
and consequently become available for credit creation by the CBs
•Opposite happens when the central bank decides for
contractionary monetary policy

It is estimated that 0.5% rise in CRR leads to absorption of Rs. 14,000 crores
from the system
Money Supply in India
Expansionary Monetary Policy: ISLM Model

 An increase in the nominal money supply (given the price

level) raises the real money balances & shifts the LM
curve to the right.
 Equilibrium income increases & interest rate declines.

r LM0


Any increase in the money

E1 supply shifts the LM Curve
to the right
r2 E2


Adjustment process to Monetary Expansion
 At the initial equilibrium, increase in the (real) money
supply generates a ‘portfolio disequilibrium’, i.e. at the
initial interest rate & income, people are holding more
money than they want.
 This causes people to buy more of other assets, that
raises the demand for other assets, say bonds. This leads
to increase bond price, driving down the interest rate.

 The fall in the interest rate has impact on the aggregate

 It stimulates the investment demand, thereby increasing
the overall aggregate demand & output and Income.
 The increase in output also increases the demand for
money, and the interest has to rise to check the demand
Special cases
 The Liquidity Trap Case
 In this situation, at a given interest rate, the public is
prepared to hold whatever amount of money is supplied.
 An expansionary monetary policy does not in this case
lead to the right ward shift in the LM curve. The horizontal
portion of the LM curve is unchanged
 Thus, open market operation has no impact on the
interest rate & the economy fails to move to higher level
of income.
Special cases
 The Classical Case
 In this situation, the demand for money is entirely
unresponsive to the interest rate. This makes the LM
curve Vertical.
 This implies GDP depends on quantity of money only. i.e.
people hold money for transactions purposes only. Money
is not demanded for any other purposes
 In this case, monetary policy has its maximum impact on
the level of income.
Fiscal Policy
• Fiscal policy comprises a mix of budgetary instruments that
govt. can use to target particular economic goals such as higher
economic growth or improve income distribution

• Fiscal policy comprises govt. expenditure to help achieve its

goals; and revenue from taxes & non-tax sources to pay for
activities that facilitates achieving goals

• If govt. spends more than its revenue, the difference has to be

financed through money-creation or borrowing

• Money creation could, in turn, lead to higher inflation than is

desirable to maintain productive activities

• Similarly, public borrowing in excess might result in a build-up

of public debt, whose burden might have to be borne by the
Instruments of Fiscal Policy

• Fiscal policy – ‘Budget’ ~ Union, State, Local government

• Changes in tax rates, heads of expenditure, financing of deficit,


• Various instruments would include:

4. Corporate income tax, personal income tax, expenditure tax,

capital gains tax, Customs duties, central excise duties,

5. Sales tax, entertainment tax, stamp duty,

6. Octroi, education cess, property tax, etc

• Govt. PSU income

• Defense expenditure is central govt. expenditure

Fiscal Balance Sheet
Receipts Disbursements
A. Revenue Receipts A. Revenue Expenditure
1. Tax Receipts R1 1. Interest Expenditure E1
2. Non-Tax Receipts 2. Non-Interest expenditure E2
a) Interest earning R2
b) Non-interest earning R3
B. Financing Terms B. Capital Disbursements
1. Grants R4 1. Capital expenditure E3
2. Borrowings 2. Net Domestic Lending E4
a) Foreign borrowings R5
b) Domestic Borrowings
i) Other than 91-day T-Bill
(internal debt + ‘other liabilities)
ii) 91 day T-Bill R7
iii) Change in Cash Balance R8
Aggregate Receipts R Aggregate Disbursements E
= (R1+R2+R3) + (R4) +
= (E1 + E2 + E3 + E4)
The difference between aggregate disbursements (revenue expenditure
+ capital expenditure + net domestic lending) and revenue receipts
must necessarily be matched by the sum total of all financing items.
Budget Deficit
• Traditional Deficit or Budget Deficit
= (Revenue Expenditure + capital expenditure + net domestic lending) –
(Revenue receipts + grants + Foreign borrowings + domestic borrowing
excluding 91 day T-Bill)

= (E1 + E2 + E3 + E4) – [(R1 + R2 + R3) + (R4 +R5 +R6)]

= (R7 + R8)

• The traditional deficit depict only a part of the resource gap in current
fiscal operations that is expected to be financed by
1. Issuing 91-day T Bills &
2. Running down on the govt.’s cash balances and the RBI

• Thus, this concept is extremely narrow & does not capture the entire
short fall of the govt.’s fiscal operations. To capture that we need a
broader concept – Fiscal Deficit
Fiscal Deficit
• Gross Fiscal Deficit
= (Revenue Expenditure + capital expenditure + net domestic lending)
– (Revenue receipts + grants)
= (E1 + E2 + E3 + E4) – [(R1 + R2 + R3) + (R4 )]
= (R5 +R6 + R7 + R8)
= (Foreign borrowings + domestic borrowing) + running down on its cash

Alternative expression: Fiscal deficit

= Total Expenditure – (Revenue receipts + Recoveries of loans + other


= Total Expenditure – Total Receipts + Borrowings & other laibilities

Total Expenditure = Non-plan + Plan Expendture

Non Plan Expenditure = { (Revenue Account) + (Capital Account)}
Plan Expenditure = { (Revenue Account) + (Capital Account)}
Total Expenditure = Revenue expenditure + Capital expenditure
Primary Deficit
• One important limitation of the fiscal deficit is that it does not necessarily
reflect the extent to which the current discretionary fiscal actions
improve on worsen govt.’s net indebtedness.

• In particular, interest payments in the current period are obligatory, but

reflect past budgets

• Primary Deficit
= Gross Fiscal deficit – ((interest payments – interest earnings)
= (Revenue Expenditure + capital expenditure + net domestic lending)
– (Revenue receipts + grants) - (interest payments – interest
= (E2 + E3 + E4) – (R1 + R3 + R4)
Revenue Deficit

• Revenue deficit
= (Revenue Expenditure) – (Revenue receipts)
= (E1 + E2) – (R1 + R2 + R3)
Fiscal Deficit & Deficit Financing

• In the short run, fiscal deficit (FD) can stroke fires of inflation due
to their expansionary effects on the monetary base & money

• In the long run, it may lead to build up of public debt that would
cause worry to generations to come in the future

• Govt. can finance its deficit by two ways –

1. Borrowing from the central bank, commercial banks

2. Borrowing from non-bank sources – both home & abroad

• Borrowing from CB implies money can simply be printed for govt.

to spend at zero cost
Fiscal Deficit & Deficit Financing

• Borrowing from commercial banks would mean the CBs demand

for credit from the central bank must rise. Thus, there will be an
associated inflationary pressure

• If the CB does not meet CBs demand for additional credit, then
loanable funds available for the private sector needs to be

• Interest rate would tend to rise, as there is now competing

demand for the same supply of funds. This, in turn, could have
dampening effect on the economy & its growth prospects via the
so called ‘crowding out effect’
Fiscal Deficit & Deficit Financing

• Non-Bank financing comprises borrowing through govt. securities,

which has little impact on the monetary base. But it tends to
increase interest rates, while competing down the ability of the
private sector to borrow

• Excessive borrowing from abroad has the potential of falling in a

foreign debt crisis (e.g. Latin America, East Asia, etc)

• Under such circumstances, the currency may be depreciated to

improve export performance & improve the ability to service the

• But, in the mean time, the burden in terms of domestic currency