Income Determination ModelIncome Determination Model

USAID Reform Project

Dr. Brijesh C. Purohit

Fiscal Policy:

It comprises of deliberate use of budgets (of central and state govts.)

To achieve macroeconomic objectives, in particular stabilization

And growth

Fiscal Policy is a term reserved for the policy government has in balancing Government Spending with Tax Revenues. (Net) Taxes (T) = Leakage (Withdrawal) from the CFoI Government Spending (G) = Injection to CFoI

•Is the Government spending more than it raises in taxes (G > T)?  If so, then the Government is running a budget deficit, and the effect will be to expand or reflate the economy - increase the circular flow of income, and increase GDP (at least in nominal or current terms)

•Or, is the Budget in surplus (T > G)?  Then the effect of Fiscal Policy is to deflate or contract the CFoI, and reduce national income (nominal national income will tend to fall).

Taxes remove income from the circular flow of income - that is, act as a leakage from the circular flow (like imports and savings), and other things being equal, will reduce incomes through the multiplier process, and deflate the economy.

•Government Expenditure, on the other hand, is an injection into the circular flow and will tend to reflate the economy.

There is often a conflict between Fiscal Policy - designed to manage economic cycles - and the other reasons and objectives of Government spending and taxation. 

•an increase in the budget deficit will increase the money supply,which will tend to increase current or nominal GDP, but may also give rise to inflation.

•However, a more prudent government would borrow the differencebetween G and T

•In order to persuade the public to lend this requirement to the government (through buying Government Bonds and Stocks), the government must offer some reward - the rate of interest paid on the loans (government bonds) - the more it wants to borrow, the higher will have to be the rewards offered - the higher the interest rates will have to be.

So expansionary Fiscal Policy (G > T) tends to lead tohigher interest rates, which in turn tend to reduce private investments and private consumption, and thus reduce theexpansionary effect of the fiscal policy, and increasing the tendency for government spending to crowd out private spending.

What do increased interest rates do? - deflate the economy (lowering growth rates and tending to increase unemployment) by:

•encouraging saving (reducing consumption) and discouraging investment spending;

•increasing borrowing costs (making businesses more difficult to manage), and discouraging borrowing both for consumption(consumer durables like cars, furniture, white goods, etc. and especially houses and house improvements) and for businesses

•tend to hurt borrowers (often the poorer) and help net savers (often the better-off) •tends to lead to exchange rate appreciation (encouragingcapital to flow into the country and discouraging capital exports or outflows)

How are interest rates determined? And what effects will Fiscal Policy (changes in G and T) have on interest rates? 

The answer is that interest rates are determined in the Money Market -which is how Monetary Policy (control of money supply or interest rates) works.

The IS curve shows the equilibrium relationships between the rate of interest (established in the money market) with the level of national income, assuming that the remaining injections and withdrawals (G, T, X and IM) stay as before. If these other (exogenous) injections and withdrawals change, then the IS curve itself will shift.

Thus, if government spending (G) is increased (and/or taxes (T) are reduced) - an expansionary Fiscal Policy - and the IS curve will shift to the right - because an expansionary fiscal policy will increase levels of national income for each and all levels of savings and investment, each and all levels of the interest rate.

The IS Curve slopes downwards because lower interest rates (r down) encourages investment and consumption and thus increases national income (Y). It thus represents the combinations of r and Y which are consistent with equilibrium in the goods and services markets (the circular flow of income). 

Note this. The CFoI is, in effect, a description of equilibrium in the markets for goods and services (and factors of production) -equilibrium in the 'real' (non money) part of the economy.

The relationship between income and the interest rate through the money market is represented as the L-M curve – the Liquidity preference (demand for money) and Money supply relationship:

The LM curve shows all those combinations of Y and r which are consistent with an equilibrium in the Money Market (given a fixed money supply and a constant velocity of circulation)

The LM curve will shift to the right if the money supply is increased, or if interest rates are reduced, in the money market through monetary policy. An expansionary monetary policy shifts the LM curve to the right. A contractionary monetary policy shifts the LM curve to the left. Notice, too, the effect of inflation (an increase in the price level (P)) on this relationship. If the price level increases in the economy, then the stock of money in the economy cannot finance the same level of real transactions as before. We will need more money for any given level of Y at higher price levels than at low price levels.  With a fixed supply of money, the greater demand for money at a higher price level means a higher rate of interest at a higher price level for any given Y.  So inflation shifts the LM curve to the left.

IS and LM interactionsThe IS curve captures the essential relationship between the rate of interest and income in the markets for goods and services (the circular flow of income). The LM curve captures the essential relationship between the rate of interest and income in the money market.

For the two markets to be consistent with each other - the same rate of interest ruling in both the goods and services market and in the money market - there can only be one equilibrium level of national income (Y*), shown by the intersection of the IS curve with the LM curve.

Links between Monetary and Fiscal PolicyWe now have the effects of:

•Fiscal Policy captured in the IS curve (where an expansionary fiscal policy shifts the IS curve to the right, and vice versa);

•Monetary Policy captured in the LM curve (where anexpansionary Monetary policy shifts the LM curve to the right, and vice versa)

•Expansionary Fiscal Policy - shifts IS right: will tend to increase Y and also increase the interest rate (r)

•Contractionary Fiscal Policy - shifts IS left: will tend to reduce both Y and r

•Expansionary Monetary Policy - shifts LM right - reduces r and increases Y •Contractionary Monetary Policy - shifts LM left- increases r and reduces Y

Money defined as a generally acceptable means of payment or of settling debt.

It has three main functions:a) medium of exchange between buyers and sellersb) unit of account ( for accounts, debt, financial assets etc.)c) store of value or purchasing power enabling income earners to set aside a part of their income to yield future consumption

Medium of Exchange:Currency and demand deposits (readily drawn) with the commercial banks

Store of value:Time deposits of Commercial banks (as if to store its value)

Four measures of money supply:M1= Currency (currency notes and coins) with the public+ demand deposits with banks (commercial and cooperatives)+ other deposits with RBI

M2= M1+ Post office savings bank deposits

M3= M1+ time deposits with banks (commercial and cooperatives)

M4= M3+ total deposits with the post office saving organisation

Degree of Liquidity and comprehensiveness

Over time, a large and continuous rise in money supply

Trends in M1:

During 50s….50%……….60s…two times……….70s…three times………..80s…four times………..90s… about three times

Trends in M3: During 70s…..five times………..80s….four times…………90….three times

Factors affecting Money supply:Deficit financingbank creditForeign exchange reserves:if FE receipts exceed payment in FE:FE is surrendered to bank in return for Rs.FE falls short of payment in FE:money is paid to banks to get FE to meet obligation

Monetary policy also known as Money and Credit Policy:

It concerns itself with the supply of money as also credit to economy

Till 1998-99:It was announced twice in a year:Oct….for Oct..March….to coincide with busy seasonApril…for April to Sept…to coincide with lean season of agri.

With decline in agri. And rise in industrial credit since 1999-2000in April RBI makes an annual policy statementand a review in Oct

Monetary policy provides:a) an overview of economy

b) specifies measures that RBI intends to take to influence suchkey factors like…money supply….interest rates….inflation

c)lays down norms for financial insts. Like banks, fin.cos.etc.relating to CRR, capital adequacy

Since 1951 and till 1990s….

Two sets of objectives pursued…a)controlled expansion of moneyb)sectoral deployment of funds

Done keeping in mind plan priorities

Special attention…Core industries (coal, iron, steel and engg.)foodgrains (rice, wheat etc.)priority sectors ( agri., SSI)weaker sections of population

•In general, the interaction between monetary and fiscal policy occurs To control inflationary or deflationary impact of fiscal policy

For instance, a substantial multi-year rise in the deficit need not cause an increase in inflation was demonstrated in USA:

•Between 1979-85……budget deficit rose from 2.7% of GDP to 5.1% of GDP……national debt rose from 26% of GDP to 36% of GDP

However, GDP price inflation fell from 8.2 % to 3.2%

This due to a tough anti-inflationary monetary policy pursued by the Federal Reserve.

In India, for instance, In 90s…

growth of economy remain primary aimcontrol of inflation urgent concern(91….double digit….17%)

8th (92-97)…aimed at achieving trend rate of inflation 5%

MP of 90s favored…process of stabilization and structural adjustment initiated in 91

Various measures used by RBI include:a) Rate of interest (or price of money)b) Quantity or supply of moneyc) Access to or demand for money

One imp. Instrument is bank rate or discount rate..Rate at which RBI lends to the banking system…Through it: short term interest long term rates level of economic activity international capital inflows

Second imp. Instrument is sale or purchase of govt. securities(by sale of securities banks’ resources reduce and vice versa

Third imp. Instrument…Cash Reserve Ratio: Banks’ Cash Holding/Total Deposit Liabilities

Fourth Imp. Instrument is Statutory Liquidity Ratio(SLR)…RBI imposes an obligation on banks to buy govt. Securirties (ofLow interest rates)(25% at present)

To achieve the objective of sectoral deployment of credit..

Direct (Quantity)…Reserve ratiosQuantitative controls on RBI lending to banks and commercial sectorQuantitative credit controls

Indirect Instruments… administrative setting of various interest rates: e.g. RBI lending commercial bank lending deposits

In 1960s.. Emphasis was on indirect measures with little variation in reserve ratios

In1970s…Emphasis shifted to direct approaches and persisted since thenShift from indirect to direct measures was prevalent more due to rising deficit or inflationMonetary instrument in India, both direct and indirect, operate Through administrative controls or fiatThe crisis like droughts, oil crisis in 1966,1969, 1973 were dealt with effectively by cutting down domestic credit

One of the main problem area in the monetary policy lie with the Exogenous element in reserve money.

Reserve money comprise of:a) Increased RBI lending to govt. (relates to fiscal deficit) b) Increased RBI lending to commercial banksc) Growth of net foreign exchange of RBI

RBI can control only b) by prescribing high SLR

Monetary control has been reasonably successful inspite of risingFiscal deficit because of aggressive use of the reserve ratios

In a sense reserve ratios have not been genuinely monetary policy Instrument but rather acted as fiscal policy instrument

Major developments in 1980s

…Increasing deficit…to control money supply:….SLR..up to 38.5% by 1990…..CRR up to 15%

>>>net RBI credit to GOI was given as a separate estimate since 1987

RBI attempted estimates of demand for money:

relationship between reserve money and money supplyreal income increasesincome elasticity of demand for moneyacceptable increase in price level

In 1980….inflation…7.1%….aimed to 5%

In second half of 1980s:steps towards expanding and activating money market in short termsecuritiese.g. treasury bills of 182 daysdiscount and finance house of India was set upinstruments like certificates of deposits, commercial papers, participation certificates etc.

These acted as transmission channel for MP

Interest rates:• rates on govt. securities was raised•maturity of long term bonds was reduced to prevent govt. from getting locked into high rates•in 1985 freedom was given to banks to fix int. rate subject to maximum of 8% on deposits up to one year..later withdrawn•complex lending rate structure was simplified with six slabs•banking sector reform in terms of selective branch expansion and expansion of staff

In 1990s:

in 1989-90…gross fiscal deficit…8.05% of GDP inflation was 9.1%90-91……….inflation orse by 12.1%

•devaluation of rupee in 1991•bank rate raised from 10 to11%•min. lending rate raised to 20%•int. rate on deposits raised to a max. of 13%•SLR reduced to 30%

In 92-93..•Inflation ..down to 7%•incremental CRR discntd.

Following Narsimhan Committee:•efforts to develop govt.securities market•introduction of 364 days and 91 days TB•auction of dated securities and REPO auction

1993:…•unified market determined ER•min. lending rate down frm 17..15%•SLR..from 30.to 25%

94-95…•overall improvement in economy..GDP grew by 7.8%•agreement between RBI and GOI to phase out system of ad-hocTBin next three years•large capital inflows in FE..NRI deposits were under CRR

In 1994…•RBI reduced lending rates of scheduled commercial banks for credit limit over Rs. 2lakhs•long trem borrowing rate down to 12.35%•CRR raised..to 11%•inflation touched 10.8%

In 95-96…•stability in ER did not remain…net sales by RBI and stability•CRR was reduced•investment demand high•bank credit increased

In 96-97•CRR reduced to 10%•inflation remained at 5.4%

In 1997…•slackening of economy•in April bank rate was linked to several interest rates making ita signal interest rate•bank rate reduced from 12 to 11 to 10% in June and 9% in Oct

In 1998…•trend in decline in interest rate interrupted to stabilize FE market•bank rate raised to 11%•CRR raised to 10.5%

In 1998-99 & 1999-2000…•low inflation rate•softening of interest rate•borrowing rate of govt. declined•bank rate brought down to 7%•CRR…9%

In 2000-01..•Bank rate raised and brought back to 7%•CRR ..8%

To sum up…Key themes in the reform of institutional frameworkand operational procedures for MP have been:•Phased reduction in the reserve requirement ratios of CRR and SLR•phased liberalization of interest rates•elimination of direct credit controls•development of money and financial markets, beginning with those for government securities and bills•restraints on automatic monetization of budget deficits•activation of open market operations (OMO) by RBI to influence liquidity•policy focus on inter-linkages across various segments of financial markets•restoration of bank rate as a signaling instrument for MP

What objectives should be pursued?•Objective of MP cannot be different from overall objective of economic policy•mainly thus our MP had pursued:to maintain a reasonable degree of price stabilityto accelerate the rate of economic growth•What was the dominant objective?•Multiple objectives?•Price stability a means (not an end)to achieve sustained growth

What level of inflation do adverse consequences begin to set in?•e.g. Chakravarty committee regarded 4% as acceptable inflation•Rangarajan gave it to be 5-6%

Reasonable relationship exists between..Prices…income…money supply•coordination between fiscal and monetary policy is yet another aspect•more open market operations lead to gradual delinking of debt management by RBI