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Monetary policy is the process by which the central bank or monetary authority of a country controls the supply of money, often targeting a rate of interest. Monetary policy is usually used to attain a set of objectives oriented towards the growth and stability of the economy. These goals usually include stable prices and low unemployment. Monetary theory provides insight into how to craft optimal monetary policy. Monetary policy is referred to as either being an expansionary policy, or a contractionary policy, where an expansionary policy increases the total supply of money in the economy rapidly, and a contractionary policy decreases the total money supply or increases it only slowly. Expansionary policy is traditionally used to combat unemployment in a recession by lowering interest rates, while contractionary policy involves raising interest rates to combat inflation. Monetary policy is contrasted with fiscal policy, which refers to government borrowing, spending and taxation. An attempt to achieve broad economic goals by the regulation of the supply of money.
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Cost of money or rate of interest , in order to attain a set of objectives oriented towards the growth and stability of the economy. Monetary theory provides insight into how to craft optimal monetary policy.
Monetary policy is referred to as either being an expansionary policy, or a contractionary policy, where an expansionary policy increases the total supply of money in the economy, and a contractionary policy decreases the total money supply. Expansionary policy is traditionally used to combat unemployment in a recession by lowering interest rates, while contractionary policy involves raising interest rates in order to combat inflation. Monetary policy is contrasted with fiscal policy, which refers to government borrowing, spending and taxation
WHY IT IS NEEDED?
What monetary policy at its best can deliver is low and stable inflation, and thereby reduces the volatility of the business cycle. When inflationary pressures build up, it is monetary policy only which raises the short-term interest rate (the policy rate), which raises real rates across the economy and squeezes consumption and investment. The pain is not concentrated at a few points, as is the case with government interventions in commodity markets.
Monetary policy in India underwent significant changes in the 1990s as the Indian Economy became increasing open and financial sector reforms were put in place. In the 1980s, monetary policy was geared towards controlling the quantum, cost and directions of credit flow in the economy. The quantity variables dominated as the transmission Channel of monetary policy. Reforms during the 1990s enhanced the sensitivity of price signals from the central bank, making interest rates the increasingly Dominant transmission channel of monetary policy in India.
Balance of payment
BOP The two principal parts of the BOP accounts are the current account and the capital account. The current account shows the net amount a country is earning if it is in surplus, or spending if it is in deficit. It is the sum of the balance of trade (net earnings on exports minus payments for imports), factor income (earnings on foreign investments minus payments made to foreign investors) and cash transfers. It is called
the current account as it covers transactions in the "here and now" - those that don't give rise to future claims. The Capital Account records the net change in ownership of foreign assets. It includes the reserve account (the foreign exchange market operations of a nation's central bank), along with loans and investments between the country and the rest of world (but not the future regular repayments/dividends that the loans and investments yield; those are earnings and will be recorded in the current account). The term "capital account" is also used in the narrower sense that excludes central bank foreign exchange market operations: Sometimes the reserve account is classified as "below the line" and so not reported as part of the capital account. Expressed with the broader meaning for the capital account, the
BOP identity assumes that any current account surplus will be balanced by a capital account deficit of equal size - or alternatively a current account deficit will be balanced by a corresponding capital account surplus:
The balancing item, which may be positive or negative, is simply an amount that accounts for any statistical errors and assures that the current and capital accounts sum to zero. By the principles of double entry accounting, an entry in the current account gives rise to an entry in the capital account, and in aggregate the two accounts automatically balance. A balance isn't always reflected in reported figures for the current and capital accounts, which might, for example, report a surplus for both
accounts, but when this happens it always means something has been missedmost commonly, the operations of the country's central bankand what has been missed is recorded in the statistical discrepancy term (the balancing item).
An actual balance sheet will typically have numerous sub headings under the principal divisions. For example, entries under Current account might include:
Especially in older balance sheets, a common division was between visible and invisible entries. Visible trade recorded imports and exports of physical goods (entries for trade in physical goods excluding services is now often called the merchandise balance). Invisible trade would record international buying and selling of services, and sometimes would be grouped with transfer and factor income as invisible earnings.
The Reserve Bank of India is responsible for formulating and implementing Monetary Policy. For explanation of monetary policy, the whole period has been divided into 4 sub periods a) Monetary policy of controlled expansion (1951 to 1972) b) Monetary Policy during Pre Reform period (1972 to 1991) c) Monetary Policy in the Post-Reforms (1991 to 1996) d) Easing of Monetary policy since Nov 1996
DEREGULATION OF CREDIT:
The reforms in credit regulation which began in the mid-1980, intensified in the 1990s with a shift in focus from micro regulation towards macro management of credit. These included a scaling down of pre-emptions in the form of statutory stipulations to expand the pool of lendable resources, rationalization of priority sector requirements, phasing out direct credit programmes and relaxation of balance sheet restrictions to improve the credit delivery system
Quantum channel: money supply and credit (affects real output and price level through changes in reserves money, money supply and credit aggregates).
Interest rate channel. Exchange rate channel (linked to the currency). Asset price.
Monetary decisions today take into account a wider range of factors, such as:
short term interest rates; long term interest rates; velocity of money through the economy; exchange rate credit quality bonds and equities (corporate ownership and debt) government versus private sector spending/savings
international capital flow of money on large scales financial derivatives such as options,swaps and future contracts etc.
Preparation of Reserve Bank's Annual Policy Statement and its Reviews in each quarter.
Conduct of Technical Advisory Committee meetings on Monetary Policy in each quarter before the announcement of Policy Statement/Reviews or at any other time as and when needed.
Conduct of pre-policy consultation meetings with the bankers, market participants, trade bodies, self-regulatory organisations and economists and journalists to facilitate the policy formulation process.
Periodical meetings with banks on resource management. Conduct of Governors meetings with banks to announce Policy. Policy regarding monetary policy framework and instruments - Design and Operations.
Monetary projections and preparation of monetary budget. Monitoring and review of developments in macroeconomic conditions, prices and inflation, key monetary and banking aggregates, financial markets including interest rates.
Monitoring and review of maintenance of CRR and SLR by scheduled commercial banks.
Monitoring of relevant global developments, including monetary policy developments in select major economies.
Issue of Master Circular on Export Credit Refinance Facility every year in July.
Preparation of a Memorandum for the Central Board of Directors twice a year reviewing the monetary and credit developments and policy measures taken during the period.
It increases the total supply of money in the economy Used to overcome a depression gap. Is mainly introduced when demand falls It decreases the cost & increases availability of credit in the money market thereby improving economy.
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Concept of Money
Money defined as a generally acceptable means of payment or of settling debt, fulfils three main functions; as a medium of exchange between buyers and sellers; as a unit of account (for accounts, debts, financial assets, etc.) involving no exchange; and as a store of value or of purchasing power, enabling income-earners to set aside a part of their income to yield future consumption.
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These components of money supply, when expressed in the Indian context, are constituted of the following. Currency consists of notes and coins. From it one should exclude the cash on hand with the banks. As a result, one is left with currency with the public.
Four Measures:
The Reserve Bank of India uses four measures of money supply. These are designated as M1, M2, M3, M4. M1: It consists of currency(currency notes and coins) with the public, demand deposits with banks and other deposits with the Reserve Bank of India. M1= Currency (currency notes and coins) with the public+ demand deposits with banks (commercial and cooperatives)+ other deposits with RBI M2: It constitutes of M1 plus post office savings and banks deposits. M2= M1+ Post office savings bank deposits M3: It is made up of M1 and time deposits with banks. M3= M1+ time deposits with banks (commercial and cooperatives) M4: It is M3 plus total deposits with the post office savings organization. M4= M3+ total deposits with the post office saving organisation
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Reserve requirements
The monetary authority exerts regulatory control over banks. Monetary policy can be implemented by changing the proportion of total assets that banks must hold in reserve with the central bank. Banks only maintain a small portion of their assets as cash available for immediate withdrawal; the rest is invested in illiquid assets like mortgages and loans. By changing the proportion of total assets to be held as liquid cash, the Federal Reserve changes the availability of loanable funds. This acts as a change in the money supply. Central banks typically do not change the reserve requirements often because it creates very volatile changes in the money supply due to the lending multiplier.
Interest rates
The contraction of the monetary supply can be achieved indirectly by increasing the nominal interest rates. Monetary authorities in different nations have differing levels
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of control of economy-wide interest rates. The Federal Reserve can set the discount rate, as well as achieve the desired Federal funds rate by open market operations. This rate has significant effect on other market interest rates, but there is no perfect relationship. In the United States open market operations are a relatively small part of the total volume in the bond market. One cannot set independent targets for both the monetary base and the interest rate because they are both modified by a single tool open market operations; one must choose which one to control. In other nations, the monetary authority may be able to mandate specific interest rates on loans, savings accounts or other financial assets. By raising the interest rate(s) under its control, a monetary authority can contract the money supply, because higher interest rates encourage savings and discourage borrowing. Both of these effects reduce the size of the money supply.
Currency board
A currency board is a monetary arrangement which pegs the monetary base of a country to that of an anchor nation. As such, it essentially operates as a hard fixed exchange rate, whereby local currency in circulation is backed by foreign currency from the anchor nation at a fixed rate. Thus, to grow the local monetary base an equivalent amount of foreign currency must be held in reserves with the currency board. This limits the possibility for the local monetary authority to inflate or pursue other objectives. The principal rationales behind a currency board are three-fold: 1. To import monetary credibility of the anchor nation; 2. To maintain a fixed exchange rate with the anchor nation; 3. To establish credibility with the exchange rate (the currency board arrangement is the hardest form of fixed exchange rates outside of dollarization). In theory, it is possible that a country may peg the local currency to more than one foreign currency; although, in practice this has never happened (and it would be a more complicated to run than a simple single-currency currency board).
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Assets of the reserve bank of India(RBI) rose from USD 15.1 billion in the march 1994 To over USD 140 billion by march 15,2005.these changes have affected liquidity and Monetary management. Monetary policy has responded continuously to changes in Domestics and international macroecomic conditions. In this process, the current monetary operating framework has relied more on outright open market operations and Daily repo and reserve repo operations than on the use of direct instruments. Overnight Rate are now gradually emerging as the principal operating target. The Monetary and Credit Policy is the policy statement, traditionally announced twice a year, through which the Reserve Bank of India seeks to ensure
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price stability for the economy. These factors include - money supply, interest rates and the inflation.
Objectives:The objectives are to maintain price stability and ensure adequate flow of credit to the Productive sectors of the economy. Stability for the national currency (after looking at prevailing economic conditions), growth in employment and income are also looked into. The monetary policy affects the real sector through long and variable periods while the financial markets are also impacted through short-term implications. There are four main 'channels' which the RBI looks at: Quantum Channel: Money supply and credit (affects real output and price level through changes in reserves money, money supply and credit aggregates).
Bank Rate: Bank rate is the minimum rate at which the central bank provides loans to the commercial banks. It is also called the discount rate. Usually, an increase in bank rate results in commercial banks increasing their lending rates. Changes in bank rate affect credit creation by banks through altering the cost of credit. Cash Reserve Ratio: All commercial banks are required to keep a certain amount of its deposits in cash with RBI. This percentage is called the cash reserve ratio. The current CRR requirement is 8 per cent. CRR, or cash reserve ratio, refers to a portion of deposits (as cash) which bank have to keep/maintain with the RBI. This serves two purposes. It ensures that a portion of bank deposits is totally risk-free and secondly it enables that RBI controlling equidity in the system, and thereby, inflation. Besides the CRR, banks are required to invest a
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portion of their deposits in government securities as a part of their statutory liquidity ratio(SLR) requirements. The government securities (also known as gilt-edged securities or gilts) are bonds issued by the Central government to meet its revenue requirements. Although the bonds are long-term in nature, they are liquid as they can be traded in the secondary market. Since 1991, as the economy has recovered and sector reforms increased, the CRR has fallen from 15 per cent in March 1991 to 5.5 per cent in December 2001. The SLR has fallen from 38.5 per cent to 25 per cent over the past decade. Bank rate: CRR; Repo rate: Reverse Repo rate; 6 % 8 % 7.75% 6 %
National income and saving play vital role on formulation of monetary policy. As the income increases the spending will also increase, thus monetary will be less intensively required and same is the case with increase in saving .chart shows how the finance systems generate the real money and nominal money .The existence of longrun equilibrium relationship among money and income represented by a money demand function also has significant implications for monetary policy.
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markets
for securing macroeconomic and, in particular, financial stability while simultaneously pursuing greater credit penetration and financial inclusion. To respond swiftly with all possible measures as appropriate to the evolving global and domestic situation impinging on inflation expectations and the growth momentum.
Financial markets are unperturbed: with the flattening of yield curves, the compression of risk spreads and the search foryields continues unabated. Global imbalances have actually increased with no fears of hard landing, but with some sense of readying for a bumpy soft landing. Movements in major exchange rates are not reflecting fundamentals in an environment of generalised elevation in asset prices and abundant liquidity. Strong global economic growth could be accompanied by emerging pressures on core inflation the challenge facing us is to judge the compatibility of the current pace of growth with non-accelerating inflation. In the event of a judgment that the current growth momentum is more cyclical than structural, the stance of monetary policy would need to reflect a sensitivity to the
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inevitability of a downturn. On the other hand, the judgment that structural factors predominate would warrant a different policy stance. An overriding concern faced by the Reserve Bank is the persistently high growth of bank credit, with attendant worries relating to the quality of bank credit The sharp increase in credit to sectors such as housing, commercial real estate and retail loans have also been worrisome on account of the vulnerability of banks to credit concentration risks. It is difficult to arrive at a clear judgment as to what rate of credit growth is too high in relation to potential growth. Some of the models integrate policy behavior with the banking system, the demand for a broad monetary aggregate, and a rich array of goods and financial market variables, providing a more complete understanding of the monetary transmission mechanism. Weak economic assumptions and large models combine to reveal difficulties with sorting out policy effects that other approaches fail to bring out
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The various instruments of monetary policy that the RBI has and can use are:
A. Quantitative measures: 1. Open Market operations: Here, the RBI enters into sale and purchase of government securities and treasury bills. So the RBI can pump money into circulation by buying back the securities and vice versa. In absence of an independent security market (all Banks are state owned), this is not really effective in India. 2. Bank rate policy: Popularly known as repo rate and reverse repo rate, it is the rate at which the RBI and the Banks buy or exchange money. This resuts into the flow of bank credit and thus effects the money supply. 3. Cash Reserve ratio (CRR): This is the percentage of total deposits that the banks have to keep with RBI. And this instrument can change the money supply overnight. 4. Statutory Liquidity Requirement (SLR): This is the proportion of deposits which Banks have to keep liquid in addition to CRR. This also has a bearing on money supply. B. Qualitative measures: 1. Credit rationing: Imposing limits and charging higher/lower rates of interests in selective sectors is what you see is being done by RBI. 2. Moral suasion: We hear of RBI's directive of priority lending in Agriculture sector. Seems more of a directive rather than persuasion.
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While the exchange rate has depreciated recently as capital inflows have cooled, the hot button issue just a few months ago was whether the exchange rate should be kept from appreciating. Some economists argued for preventing exchange rate appreciation, and managing the inflationary impact of capital inflows by selling government bonds, thus soaking up excess liquidity. Others favored an exportcompetitive exchange rate policy, but also argued that monetary policy was irrelevant as current inflationary symptoms were arising from temporary supply-side shocks. The radical position (at least by Indian policy standards) has been that the RBI should focus on fighting inflation, but give itself more room to do so by allowing the exchange rate to adjust to market conditions. One version of this stance is that raising the interest rate is less effective as an inflation-fighting policy than allowing the rupee to appreciate, as financial repression and underdeveloped financial markets keep interest rate changes from rippling through the economy strongly enough. There are several empirical analyses of the monetary transmission mechanism in India. These suggest that the interest rate channel of monetary policy has strengthened since 1998, which should not come as a surprise since there has been considerable financial liberalization, accompanied by a revision of the RBIs policy approach. This result comes out in an interesting fashion in a 2005 IMF study.The responses of firms to monetary tightening vary by size and, while greater in the period 1998-2003 versus
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the prior half-decade, seem to involve a reversal of initial cutbacks in corporate debt. Still, interest rates do affect firm borrowing behavior.
A better feel for the aggregate impacts of monetary policy comes from an economy wide analysis. This suggests the interest rate is an effective inflation-fighting tool in India even though, as the authors say, the financial market in India is not yet matured.
The results even indicate that output recovers with a lag in the face of such interest rate increases. All this sounds quite good from the perspective of what policymakers are currently doing, though there is no modeling of inflation expectations in India. Indian monetary policy is still very accommodative and interest rates need to rise more to prevent global supply-side shocks from seeping into the broader economy. Wholesale price inflation, the most widely watched measure in India, touched 8.24 percent in mid-May, far above the central bank's comfort zone of 5.5 percent for 2008/09. The central bank held off outright rate increases for a year, opting instead to keep cash availability tight, as prices pressures largely came from supply constraints and record commodity prices rather than demand. The twin objectives of monetary policy in India have evolved as maintaining price stability and ensuring adequate flow of credit to facilitate the growth process.
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through its influence over the supply of and demand for balances at the Reserve Banks. The FOMC sets the federal funds rate at a level it believes will foster financial and monetary conditions consistent with achieving its monetary policy objectives, and it adjusts that target in line with evolving economic developments.
A change in the federal funds rate, or even a change in expectations about the future level of the federal funds rate, can set off a chain of events that will affect other short-term interest rates, longer-term interest rates, the foreign exchange value of the dollar, and stock prices. In turn, changes in these variables will affect households and businesses spending decisions, thereby affecting growth in aggregate demand and the economy.
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deposits. The initial deposit of $100 is thus multiplied 10 times. With a lower (higher) ratio, the multiple involved is larger (smaller), and more (less) reserves can be created. Reserve requirements are not used as often as the other policy tools. Since funds grow in multiples, it is difficult to administer small adjustments in reserves with this tool. Also, banks always have the option of entering the federal funds market for reserves, further limiting the role of reserve requirements.
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two months, during which the U.S. economy experienced a solid and consistent growth with only minor inflation. From October to November 1998, the Fed cut the rate twice, first to 4.75 percent and then to 4.5 percent, anticipating the threat from the global financial crisis that had began in Asia in mid-1997 (data from "United States Monetary Policy," 1999).
Open-Market Operations
The most important and flexible tool of monetary policy is open-market operations (i.e., trading U.S. government securities in the open market). In 1997, the Fed made $3.62 trillion of purchases and $3.58 trillion of sales of Treasury securities (mostly short-term Treasury bills). As of September 1998, the Fed held $458.13 billion of Treasury securities, roughly 8.25 percent of the total Federal debt outstanding The FOMC directs open-market operations (and also advises about reserve requirements and discount-rate policies). The day-to-day operations are determined and executed by the Domestic Trading Desk (the Desk) at the FRB of New York. Since 1980, the FOMC has met regularly eight times a year in Washington, D.C. At each of these meetings, it votes on an intermeeting target federal funds rate, based on the current and prospective conditions of the economy. Until the next meeting, the Desk will manage reserve conditions through open-market operations to maintain the federal funds rate around the given target level. When buying securities from a bank, the Fed makes the payment by increasing the bank's reserves at the Fed. More reserves will then be available in the federal funds market and the federal funds rate falls. By selling securities to a bank, the Fed receives payment in reserves from the bank. Supply of reserves falls and the funds rate rises. The Fed has two basic approaches in running open-market operations. When a shortage or surplus in reserves is likely to persist, the Fed may undertake outright purchases or sales, creating a long-term impact on the supply of reserves. However, many reserve movements are temporary. The Fed can then take a defensive position and engage in transactions that only impose temporary effects on the level of reserves.
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A repurchase agreement (a repo) allows the Fed to purchase securities with the agreement that the seller will buy back them within a short time period, sometimes overnight and mostly within seven days. The repo creates a temporary increase in reserves, which vanishes when the term expires. If the Fed wishes to drain reserves temporarily from the banking system, it can adopt a matched sale-purchase transaction (a reverse repo), under which the buyer agrees to sell the securities back to the Fed, usually in less than seven days.
Australia - Inflation targeting Brazil - Inflation targeting Canada - Inflation targeting Chile - Inflation targeting China - Monetary targeting and targets a currency basket Eurozone - Inflation targeting Hong Kong - Currency board (fixed to US dollar) India - Multiple indicator approach New Zealand - Inflation targeting Norway - Inflation targeting Singapore - Exchange rate targeting South Africa - Inflation targeting Switzerland - Inflation targeting Turkey - Inflation targeting United Kingdom - Inflation targeting, alongside secondary targets on 'output and employment'.
United States - Mixed policy (and since the 1980s it is well described by the "Taylor rule," which maintains that the Fed funds rate responds to shocks in inflation and output).
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Interaction between monetary and fiscal policiesHow is monetary policy affected by Fiscal Policy
Fiscal policies have a significant impact on economic growth and inflation. It is therefore important for monetary authorities to follow fiscal policy developments closely. There are many channels through which fiscal policy affects the economy and prices. The level and composition of government expenditure and revenue, as well as budget deficits and public debt, are key variables in this process. Budgetary policies remain the exclusive competence of the Member States in Stage . In particular, the Treatys excessive deficit procedure, further developed and clarified in the Stability and Growth Pact, aims to limit the risks to price stability that might otherwise arise from national fiscal policies. For example, an excessive increase in government spending at a time when the economy is already operating at close to full capacity could, by stimulating aggregate demand, lead to bottlenecks and generate inflationary pressures. Fiscal imbalances, with large budget deficits and mounting public debt, have characterized many inflationary episodes in history. Fiscal discipline is therefore a basic component of macroeconomic stability. As well as unbalanced budgets, high levels of government debt can also be detrimental. If a government has to meet sizeable interest expenses every year, the fiscal situation can become unsustainable and this may endanger price stability .High levels of debt may also have adverse effects on the real economy and the financial environment. In particular, excessive recourse to capital markets by governments tends to raise the cost of capital and this may reduce private investment (crowding out). Given the potential problems associated with fiscal imbalances, the avoidance of excessive deficits represents an important commitment to maintaining fiscal policies conducive to overall macroeconomic stability.
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Fiscal policies affects the monetary policies in elements of transmission in short term. In long term it affects the sustainability of monetary policies. In monetary transmission include the following transmission channels
Domestic demand:
In every household the spending for total year has been decided and if in this situation if the fiscal policies has been changed by the government then the there will be change in household spending and change in domestic demand. So the change in fiscal policies affect the monetary transmission channel in short run. Thus the spending effects the interest rates .
Capital market :
If from the capital market money is taken by the government in big way ,then it leads to increase in return on investment on new projects .Thus, the private firm will become disinterested to fund the new projects . Indirect taxes: If government increases the taxes on indivaiual then it will lead to increase in the interest rates and inflation will also rise.The rise in inflation will lead to decrease in the demand .The government has to come to rescue the people by consolidation of economy.The consolidation will be done by the higher wages and lower nominal interest rates .Thus inflation rise causes extra pressure on wages.
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MUNDELLFLEMING MODEL
The MundellFleming model, also known as the IS-LM-BoP model, is an economic model first set forth (independently) by Robert Mundell and Marcus Fleming. The model is an extension of the IS-LM Model. Whereas the traditional ISLM Model deals with economy under autarky (or a closed economy), the Mundell Fleming model describes an open economy. The MundellFleming model portrays the short-run relationship between an economy's nominal exchange rate, interest rate, and output (in contrast to the closedeconomy IS-LM model, which focuses only on the relationship between the interest rate and output). The MundellFleming model has been used to argue that an economy cannot simultaneously maintain a fixed exchange rate, free capital movement, and an independent monetary policy. This principle is frequently called the "impossible trinity," "unholy trinity," "irreconcilable trinity," "inconsistent trinity" or the "MundellFleming trilemma."
Basic set-up
Variables
This model uses the following variables:
Y is GDP C is consumption I is physical investment G is government spending (an exogenous variable) M is the nominal money supply P is the price level i is the nominal interest rate L is liquidity preference (real money demand) T is taxes
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Equations
The MundellFleming model is based on the following equations. The IS curve:
A higher interest rate or a lower income (GDP) level leads to lower money demand. The BoP (Balance of Payments) Curve:
where BoP is the balance of payments surplus, CA is the current account surplus, and KA is the capital account surplus. IS components
where E() is the expected rate of inflation. Higher disposable income or a lower real interest rate (nominal interest rate minus expected inflation) leads to higher consumption spending.
where Y-1 is GDP in the previous period. Higher lagged income or a lower real interest rate leads to higher investment spending.
where NX is net exports, e is the nominal exchange rate (the price of domestic currency in terms of units of the foreign currency), Y is GDP, and Y* is the combined GDP of countries that are foreign trading partners. Higher domestic income (GDP) leads to more spending on imports and hence lower net exports; higher foreign income leads to higher spending by foreigners on the country's exports and thus
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higher net exports. A higher e (more expensive domestic currency in terms of foreign currency, and equivalently less expensive foreign currency in terms of domestic currency) leads to more purchasing of foreign goods due to the lesser cost of acquiring the foreign currency to pay for them, and also leads to less purchasing of the country's exports by foreigners since they find it more costly to acquire the country's currency with which to pay for them; for both reasons, higher e leads to lower net exports.
where CA is the current account and NX is net exports. That is, the current account is viewed as consisting solely of imports and exports.
where
flows, z is the interest-sensitive component of capital flows, and the derivative of the function z is the degree of capital mobility (the effect of differences between domestic and foreign interest rates upon capital flows KA). This derivative is positive if there is any capital mobility (since a higher relative domestic interest rate makes funds more prone to flow into the country), and it is infinitely positive if there is perfect capital mobility.
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Under both types of exchange rate regime, the nominal domestic money supply M is exogenous, but for different reasons. Under flexible exchange rates, the nominal money supply is completely under the control of the central bank. But under fixed exchange rates, the money supply in the short run (at a given point in time) is fixed based on past international money flows, while as the economy evolves over time these international flows cause future points in time to inherit higher or lower (but pre-determined) values of the money supply.
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lead to the shifting of the IS curve (which is Y = C + I + G + NX) to the right, partially or entirely mitigating the initial decline in the domestic interest rate. At the same time, the BoP curve shifts rightward, since with a depreciated currency it takes a lower interest rate or higher income level to give a zero balance of payments surplus (which is what the curve describes). The combined effect of these three curves shifting is to increase the economy's income. A decrease in the money supply causes the exact opposite process. Changes in government spending An increase in government expenditure shifts the IS curve to the right. The shift causes both the local interest rate and income (GDP) to rise. The increase in the local interest rate causes increased capital inflows, and the inflows make the local currency stronger compared to foreign currencies. On the other hand, the higher GDP increases spending on imports, tending to make the currency weaker. Assuming the BoP curve is not as steep as the LM curve (i.e., assuming that capital mobility is relatively strong), the former effect will dominate and the currency will become stronger. The stronger exchange rate also makes foreign goods cheaper compared to local goods. This encourages greater imports and discourages exports, so net exports become lower. As a result of this exchange rate change, the IS curve shifts back toward its original location. The stronger currency also shifts the BoP curve upward, as higher levels of the interest rate would now be consistent with a zero payments surplus in the presence of the stronger currency exchange rate. The LM curve is not at all affected in the short run. The net effect of all this is that, if there is perfect capital mobility, the level of income of the local economy is unchanged from originally, while it has gone up if capital is less than perfectly mobile. A decrease in government expenditure reverses the process. Changes in the global interest rate An increase in the global interest rate shifts the BoP curve upward and causes capital flows out of the local economy. This depreciates the local currency and boosts net exports, shifting the IS curve to the right. Under less than perfect capital mobility, the
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depreciated exchange rate shifts the BoP curve somewhat back down. The net effect is an increase in income and the local interest rate. Under perfect capital mobility, the BoP curve is always horizontal at the level of the world interest rate. When the latter goes up, the BoP curve shifts upward by the same amount, and stays there. The exchange rate changes enough to shift the IS curve to the location where it crosses the new BoP curve at its intersection with the unchanged LM curve; now the domestic interest rate equals the new level of the global interest rate. A decrease in the global interest rate causes the reverse to occur. Under a fixed exchange rate regime In a system of fixed exchange rates, central banks announce an exchange rate (the parity rate) at which they are prepared to buy or sell any amount of domestic currency. Thus net payments flows into or out of the country need not equal zero; the exchange rate e is exogenously given, while the variable BoP is endogenous. Under the fixed exchange rate system, the central bank operates in the foreign exchange market to maintain a specific exchange rate. If there is pressure to depreciate the domestic currency's exchange rate because the supply of domestic currency exceeds its demand in foreign exchange markets, the local authority buys domestic currency with foreign currency to decrease the domestic currency's supply in the foreign exchange market. This keeps the domestic currency's exchange rate at its targeted level. If there is pressure to appreciate the domestic currency's exchange rate because the currency's demand exceeds its supply in the foreign exchange market, the local authority buys foreign currency with domestic currency to increase the domestic currency's supply in the foreign exchange market. Again,this keeps the exchange rate at its targeted level. Changes in the money supply In the very short run the money supply is normally predetermined by the past history of international payments flows. If the central bank is maintaining an exchange rate that is consistent with a balance of payments surplus, over time money will flow into the country and the money supply will rise (and vice versa for a payments deficit). If
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the central bank were to conduct open market operations in the domestic bond market in order to offset these balance-of-payments-induced changes in the money supply a process called sterilization, it would absorb newly arrived money by decreasing its holdings of domestic bonds (or the opposite if money were flowing out of the country). But under perfect capital mobility, any such sterilization would be met by further offsetting international flows. Changes in government expenditure
An increase in government spending forces the monetary authority to supply the market with local currency to keep the exchange rate unchanged. Shown here is the case of perfect capital mobility, in which the BoP curve (or, as denoted here, the FE curve) is horizontal. Increased government expenditure shifts the IS curve to the right. The shift results in an incipient rise in the interest rate, and hence upward pressure on the exchange rate (value of the domestic currency) as foreign funds start to flow in, attracted by the higher interest rate. However, the exchange rate is controlled by the local monetary authority in the framework of a fixed exchange rate system. To maintain the exchange rate and eliminate pressure on it, the monetary authority purchases foreign currency using domestic funds in order to shift the LMcurve to the right. In the end, the exchange rate stays the same but the general income in the economy increases. In the IS-LM-BoP graph, the IS curve has been shifted exogenously by the fiscal authority, and the IS and BoP curves determine the final resting place of the system; the LM curve merely passively reacts.
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The reverse process applies when government expenditure decreases. Changes in the global interest rate To maintain the fixed exchange rate, the central bank must accommodate the capital flows (in or out) which are caused by a change of the global interest rate, in order to offset pressure on the exchange rate. If the global interest rate increases, shifting the BoP curve upward, capital flows out to take advantage of the opportunity. This puts pressure on the home currency to depreciate, so the central bank must buy the home currency that is, sell some of its foreign currency reserves to accommodate this outflow. The decrease in the money supply resulting from the outflow, shifts the LM curve to the left until it intersect the IS and BoP curves at their intersection. Once again, the LM curve plays a passive role, and the outcomes are determined by theIS-BoP interaction. Under perfect capital mobility, the new BoP curve will be horizontal at the new world interest rate, so the equilibrium domestic interest rate will equal the world interest rate. If the global interest rate declines below the domestic rate, the opposite occurs. The BoP curve shifts down, foreign money flows in and the home currency is pressured to appreciate, so the central bank offsets the pressure by selling domestic currency (equivalently, buying foreign currency). The inflow of money causes the LM curve to shift to the right, and the domestic interest rate becomes lower (as low as the world interest rate if there is perfect capital mobility).
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and it may be able to sterilize balance-of-payments-induced changes in the money supply (as discussed above). In the IS-LM model, the domestic interest rate is a key component in keeping both the money market and the goods market in equilibrium. Under the MundellFleming framework of a small economy facing perfect capital mobility, the domestic interest rate is fixed and equilibrium in both markets can only be maintained by adjustments of the nominal exchange rate or the money supply (by international funds flows).
Example
The MundellFleming model applied to a small open economy facing perfect capital mobility, in which the domestic interest rate is exogenously determined by the world interest rate, shows stark differences from the closed economy model. Consider an exogenous increase in government expenditure. Under the IS-LM model, the IS curve shifts upward, with the LM curve intact, causing the interest rate and output to rise. But for a small open economy with perfect capital mobility and a flexible exchange rate, the domestic interest rate is predetermined by the horizontal BoP curve, and so by the LM equation given previously there is exactly one level of output that can make the money market be in equilibrium at that interest rate. Any exogenous changes affecting the IS curve (such as government spending changes) will be exactly offset by resulting exchange rate changes, and the IS curve will end up in its original position, still intersecting the LM and BoP curves at their intersection point. The MundellFleming model under a fixed exchange rate regime also has completely different implications from those of the closed economy IS-LM model. In the closed economy model, if the central bank expands the money supply the LM curve shifts out, and as a result income goes up and the domestic interest rate goes down. But in the MundellFleming open economy model with perfect capital mobility, monetary policy becomes ineffective. An expansionary monetary policy resulting in an incipient outward shift of the LM curve would make capital flow out of the economy. The central bank under a fixed exchange rate system would have to instantaneously intervene by selling foreign money in exchange for domestic money to maintain the
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exchange rate. The accommodated monetary outflows exactly offset the intended rise in the domestic money supply, completely offsetting the tendency of the LM curve to shift to the right, and the interest rate remains equal to the world rate of interest.
Conclusion:To sum up, despite sound fundamentals and no direct exposure to the sub-prime assets, India was affected by global financial crisis reflecting increasing globalization of the Indian economy. The policy response has been swift. While fiscal stimulus cushioned the deficiency in demand, monetary policy augmented both domestic and foreign exchange liquidity. The expansionary policy stance of the Reserve Bank was manifested in significant reduction in CRR as well as the policy rates. The contraction of the Reserve Banks balance sheet resulting from the decline in its foreign assets necessitated active liquidity management aimed at expanding domestic assets, which was ensured through OMO including regular operations under the LAF, unwinding of MSS securities, introduction of new and scaling up of existing refinance facilities. In addition, sharp reductions in CRR besides making available primary liquidity raised the money multiplier and ensured steady increase in money supply. The liquidity injection efforts of the Reserve Bank could be achieved without compromising either on the eligible counterparties or on the asset quality in the Reserve Banks balance sheet. Moreover, the Reserve Banks balance sheet did not show any unusual increase, unlike that of several other central banks. At present, the focus around the world and also in India has shifted from managing the crisis to managing the recovery. The key challenge relates to the exit strategy that needs to be designed, considering that the recovery is as yet fragile but there is an up tick in inflation, though largely from the supply side, which could engender inflationary expectations. Thus, the Reserve Bank has initiated the first phase of exit in its October 2009 Review of monetary policy in a calibrated manner mainly by withdrawal of unconventional measures taken during the crisis.
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