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Credit Policy
Central Bank may directly affect the money supply to control its growth. Or it might act indirectly to affect cost and availability of credit in the economy. In modern times the bulk of money in developed economies consists of bank deposits rather than currencies and coins. So central banks today guide monetary developments with instruments that control over deposit creation and influence general financial conditions. Credit policy is concerned with changes in the supply of credit. Central Bank administers both the Credit and Monetary policy
Contd..
Price Stability contributes improvements in the standard of living of people. It promotes saving in the economy while discouraging unproductive investment. Stable prices enable exports to compete in international markets and contribute to the strengthening of BoP. Price stability leads to interest rate stability, and exchange rate stability (via export import stability). It contributes to the overall financial stability of the economy.
Instruments
1. Discount Rate (Bank Rate) 2.Reserve Ratios 3. Open Market Operations
Intermediate Target
Monetary Aggregates(M3) Long term interest rates
Ultimate Goals
Total Spending Price Stability Etc.
Money Supply
Currency issued by government fiduciary supply Money supply is expressed in two broad measures Narrow money and Broad Money
Monetary Magnitudes
Reserve Money (M0): Currency in circulation + Bankers deposits with the RBI + Other deposits with the RBI M1: Currency with the public + Deposit money of the public (Demand deposits with the banking system + Other deposits with the RBI). M2: M1 + Savings deposits with Post office savings banks. M3: M1+ Time deposits with the banking system M4: M3 + All deposits with post office savings banks (excluding National Savings Certificates).
Currency Growth
Money supply
how the banking system creates money three ways the RBI can control the money supply why the RBI cant control it precisely
A few preliminaries
Reserves (R ): the portion of deposits that banks have not lent. To a bank, liabilities include deposits,
SCENARIO 1: No Banks
FIRSTBANKS balance sheet Assets Liabilities reserves deposits Rs.1000 reserves Rs.200 Rs.1000 loans Rs.800
The money supply now equals Rs.1800: The depositor still has Rs.1000 in demand deposits,
The money supply now equals Rs.1800: The depositor still has Rs.1000 in demand deposits,
But then Secondbank will loan 80% of this deposit and its balance sheet will look like this:
Total money supply = (1/rr ) v Rs.1000 where rr = ratio of reserves to deposits In our example, rr = 0.2, so M = Rs.5000
Cash Reserves R
B= C+R
! m vB
C D m ! B
C D
D D
! cr 1 C D ! ! C R C D
R D
cr rr
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If rr < 1, then m > 1 If monetary base changes by (B, then (M = m v (B m is called the money multiplier.
Money Supply
Y MS1 MS2
Rate of Interest
0 Money Supply
Money Demand
Y Md Rate of Interest i3 i2 i1 Md 0 M1 M2 M3 Quantity of Money X Two set economy 1.Currency in Hand + DD 2. Bonds If the interest rates are high high opportunity cost for holding cash bonds can earn higher returns than holding cash which does not pay any returns
Money Demand
Md2 Y Md1 Rate of Interest i3 i2 i1 Md1 0 M1 M2 M3 Quantity of Money X Md2 If the level of income increase the money demand curve will shift right
Money supply
Excess money supply at a given interest rate people buys bonds raises bonds decreases interest rates Increases the quantity of money demanded will be equal to money supply and vice versa
Interest Rate
E3 9 7 5 E1 E2
LO1
If there is excess money supply at a given interest rate people buys bonds raises bonds decreases interest rates It increases the quantity of money demanded will be equal to money supply
Interest Rate
9 7
E2 E1
LO1
LM Curve
1. Is derived from Keynesian theory 2. Greater the level of income greater the money held for transaction motive, the money Demand curve will be higher 3. Money supply has to match the higher money demand 4. LM curve is derived by connecting intersections different money demand curves and money supply curves corresponding to different levels of income
IS-LM Curve
1. Investment demand function 2. Consumption function 3. Money demand function 4. Quantity of money Saving and investment, productivity of capital and propensity to consume and save, demand for money and supply of money all these factors determine the rate of interest and level of income. Changes in the factors will shift the equilibrium of IS-LM Curves
If supply of money is high, interest rates will fall, LM curve will shift right
Inflation
In economics, inflation is a persistent rise in the general level of prices of goods and services in an economy over a period of time Inflation also reflects an erosion in the purchasing power of money a loss of real value A chief measure of price inflation is the inflation rate, the annualized percentage change in a general price index (normally the Consumer Price Index) over time.
Inflation
Negative effects - decrease in the real value of money and other monetary items over time, uncertainty over future inflation may discourage investment and savings, and high inflation may lead to shortages of goods if consumers begin hoarding out of concern that prices will increase in the future. Positive effects - ensuring central banks can adjust nominal interest rates (intended to mitigate recessions),and encouraging investment in nonmonetary capital projects.
Inflation
Inflation Price Inflation and Money inflation Excess money supply will lead to price inflation
Inflation
Headline inflation is a measure of the total inflation within an economy and is affected by areas of the market which may experience sudden inflationary spikes such as food or energy Inflationary Spikes - sudden price rise in some commodities Hyperinflation is inflation that is very high or out of control. Hyperinflation often occurs when there is a large increase in the money supply not supported by gross domestic product (GDP) growth
Inflation
Stagflation combination of stagnation and inflation Suppressed inflation govt. polices suppress inflation Disinflation keeping the inflation rates lower Deflation opposite to inflation prices fall persistently revenues for producers fall- low investments fall in demand fall in incomes An inflationary gap, in economics, is the amount by which the real Gross domestic product, or real GDP, exceeds potential GDP
Causes of Inflation
The quantity theory of inflation rests on the quantity equation of money, that relates the money supply, its velocity, and the nominal value of exchanges. Currently, the quantity theory of money is widely accepted as an accurate model of inflation in the long run. Consequently, there is now broad agreement among economists that in the long run, the inflation rate is essentially dependent on the growth rate of money supply.
Keynesian view Keynesian economic theory proposes that changes in money supply do not directly affect prices, and that visible inflation is the result of pressures in the economy expressing themselves in prices. There are three major types of inflation, as part of what Robert J. Gordon calls the "triangle model Demand pull inflation Cost push inflation Built-in-inflation
Demand-pull inflation is caused by increases in aggregate demand due to increased private and government spending, etc. Demand inflation is constructive to a faster rate of economic growth since the excess demand and favourable market conditions will stimulate investment and expansion. increase in money supply increase in disposable income increase in aggregate spending increase in population of the country
Cost-push inflation, also called "supply shock inflation," is caused by a drop in aggregate supply (potential output). This may be due to natural disasters, or increased prices of inputs. For example, a sudden decrease in the supply of oil, leading to increased oil prices, can cause cost-push inflation. Producers for whom oil is a part of their costs could then pass this on to consumers in the form of increased prices. Built-in inflation is induced by adaptive expectations, and is often linked to the "price/wage spiral". It involves workers trying to keep their wages up with prices (above the rate of inflation), and firms passing these higher labor costs on to their customers as higher prices, leading to a 'vicious circle'. Built-in inflation reflects events in the past, and so might be seen as hangover inflation.
Measuring Inflation
Generally the inflation is measured using price index Price index is a numerical measure that helps to compare prices of some class of goods and services between time periods Current years Price Price index = -----------------------------Base years Price
X 100
Producer price indices (PPIs) which measures average changes in prices received by domestic producers for their output consumer price index (CPI) measures changes in the price level of consumer goods and services purchased by households. Wholesale Price Index (WPI) is the price of a representative basket of wholesale goods. Some countries (like India and The Philippines) use WPI changes as a central measure of inflation.
Inflation rate
Inflation rate =
The percentage increase in the price of goods and services, usually annually.
Impact of inflation
Negatives Cost push Inflation wage spiral Hoarding Social unrests and revolts Hyperinflation Loss of allocative efficiency by producers Shoe leather costs more trips to banks Business cycles Positives Labor-market adjustments Room to maneuver to change interest rates Mundell-Tobin effect savers will be induced to lend portion of money reduces interest rates