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Macroeconomics
Monetary & Fiscal Policy - ISLM Framework
Dipankar De
Mumbai, November 2007
The Structure of the IS-LM Model
INCOME
INTEREST RATES
Y
The LM Curve
3 possible segments
– Normal positive slope
– Liquidity Trap
– Liquidity Gate
r min
Liquidity Trap zone, Speculative demand for
slope infinity money is infinitely elastic
w.r.t change in interest rate
Y
Monetary & Fiscal Policy
Monetary Policy
• Monetary policy may be defined as a policy employing the
central bank’s control of the supply of money as an instrument
for achieving the objectives of general economic policy
Bank rate is the rate at which commercial banks borrow from the central
bank
•It operates by altering the cost of credit & acts as a signaling device/
benchmark for all money interest rates in India. A rise in Bank Rate
leads to rise in all types of interest rates.
BR
Increase
It is estimated that 0.5% rise in CRR leads to absorption of Rs. 14,000 crores
from the system
Money Supply in India
Expansionary Monetary Policy: ISLM Model
r LM0
LM1
IS1
Y
Y2
Adjustment process to Monetary Expansion
At the initial equilibrium, increase in the (real) money
supply generates a ‘portfolio disequilibrium’, i.e. at the
initial interest rate & income, people are holding more
money than they want.
This causes people to buy more of other assets, that
raises the demand for other assets, say bonds. This leads
to increase bond price, driving down the interest rate.
= (R7 + R8)
• The traditional deficit depict only a part of the resource gap in current
fiscal operations that is expected to be financed by
1. Issuing 91-day T Bills &
2. Running down on the govt.’s cash balances and the RBI
• Thus, this concept is extremely narrow & does not capture the entire
short fall of the govt.’s fiscal operations. To capture that we need a
broader concept – Fiscal Deficit
Fiscal Deficit
• Gross Fiscal Deficit
= (Revenue Expenditure + capital expenditure + net domestic lending)
– (Revenue receipts + grants)
= (E1 + E2 + E3 + E4) – [(R1 + R2 + R3) + (R4 )]
= (R5 +R6 + R7 + R8)
= (Foreign borrowings + domestic borrowing) + running down on its cash
holdings
• Primary Deficit
= Gross Fiscal deficit – ((interest payments – interest earnings)
= (Revenue Expenditure + capital expenditure + net domestic lending)
– (Revenue receipts + grants) - (interest payments – interest
earnings)
= (E2 + E3 + E4) – (R1 + R3 + R4)
Revenue Deficit
• Revenue deficit
= (Revenue Expenditure) – (Revenue receipts)
= (E1 + E2) – (R1 + R2 + R3)
Fiscal Deficit & Deficit Financing
• In the short run, fiscal deficit (FD) can stroke fires of inflation due
to their expansionary effects on the monetary base & money
demand
• In the long run, it may lead to build up of public debt that would
cause worry to generations to come in the future
• If the CB does not meet CBs demand for additional credit, then
loanable funds available for the private sector needs to be
curtailed.