Income Determination Model

8/7/2019 Income Determination Model

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Income Determination ModelIncome Determination Model

USAID Reform Project

Dr. Brijesh C. Purohit


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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 beto 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).


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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 throughthe 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.


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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 difference

between G and T

In order to persuade the public to lend this requirement to the governmen

(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 willhave to be.


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So expansionary Fiscal Policy (G > T) tends to lead to

higher 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.


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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 tomanage), 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 (encouraging

capital to flow into the country and discouraging capital exports

or outflows)


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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.


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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 andwithdrawals (G, T, X and IM) stay as before. If these other

(exogenous) injections and withdrawals change, then the IS curve

itself will shift.


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Thus, if government spending (G) is increased (and/or taxes (T)

are reduced) - an expansionary Fiscal Policy - and the IS curve willshift 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.


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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.


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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) andMoney 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)


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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 ofreal 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.


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IS and LM interactions

The 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.


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Links between Monetary and Fiscal Policy

We 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)


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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


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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 sellers

b) 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)


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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


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Factors affecting Money supply:

Deficit financing

bank 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


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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.forOct..March.to coincide with busy season

Aprilfor April to Septto coincide with lean season of agri.

With decline in agri. And rise in industrial credit since 1999-2000

in April RBI makes an annual policy statement

and a review in Oc

t


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Monetary policy provides:

a) an overview of economy

b) specifies measures that RBI intends to take to influence such

key factors likemoney supply.interest rates.inflation

c)lays down norms for financial insts. Like banks, fin.cos.etc.

relating to CRR, capital adequacy


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Since 1951 and till 1990s.

Two sets of objectives pursued

a)controlled expansion of money

b)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


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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 1979-85budget deficit rose from 2.7% of GDP to 5.1% of

GDPnational 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.


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In India, for instance, In 90s

growth of economy remain primary aim

control of inflation urgent concern

(91.double digit.17%)

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

MP of 90s favoredprocess of stabilization and structural

adjustment initiated in 91


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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


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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 (of

Low interest rates)(25% at present)

To achieve the objective of sectoral deployment of credit..

Direct (Quantity)

Reserve ratios

Quantitative controls on RBI lending to banks and commercial sector

Quantitative credit controls

Indirect Instruments administrative setting of various interest rates:

e.g. RBI lending

commercial bank lending

deposits


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

in reserve ratios

In1970sEmphasis shifted to direct approaches and persisted since

then

Shift from indirect to direct measures was prevalent more

due to rising deficit or inflation

Monetary instrument in India, both direct and indirect, operateThrough administrative controls or fiat

The crisis like droughts, oil crisis in 1966,1969, 1973 were dealt with

effectively by cutting down domestic credit


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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 banks

c) Growth of net foreign exchange of RBI

RBI can control only b) by prescribing high SLR

Monetary control has been reasonably successful inspite of rising

Fiscal 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


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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 supply

real income increasesincome elasticity of demand for money

acceptable increase in price level


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In 1980.inflation7.1%.aimed to 5%

In second half of 1980s:steps towards expanding and activating money market in short term

securities

e.g. treasury bills of 182 days

discount and finance house of India was set up

instruments like certificates of deposits, commercial papers,participation certificates etc.

These acted as transmission channel for MP


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Interest rates:

rates on govt. securities was raised

maturity of long term bonds was reduced to prevent govt. fromgetting 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 expansionand expansion of staff


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In 1990s:

in 1989-90gross fiscal deficit8.05% 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.


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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


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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 95-96stability in ER did not remainnet 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%


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In 1997

slackening of economy

in April bank rate was linked to several interest rates making it

a signal interest ratebank 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%


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In 1998-99 & 1999-2000

low inflation rate

softening of interest rate

borrowing rate of govt. declined

bank rate brought down to 7%

CRR9%

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

CRR ..8%


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To sum upKey themes in the reform of institutional framework

and 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 deficitsactivation 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


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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 stability

to accelerate the rate of economic growth

What was the dominant objective?

Multiple objectives?Price stability a means (not an end)

to achieve sustained growth


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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..

Pricesincomemoney supply

coordination between fiscal and monetary policy is yet another aspect

more open market operations lead to gradual delinking of

debt management by RBI

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Income Determination Model