MACRO ECOCOMICS Notes

MEP: Session 9 & 10

Submitted By: S. Jain

SESSION 9
We started with the question why currency in circulation is liability for Central Bank?

All currency is akin to a promissory note, it promises to pay a certain specified value. And since Central
banks (RBI in case of India) are the sole issuer of these promissory notes, they print this currency notes and
distribute it when it loans out to commercial banks or when it purchases govt. bonds. So currency is nothing
but an obligation on behalf of a central bank as it is a promise to pay in future (to the bearer). That’s why it’s
a liability.

Open Market Operations: OMO refers to buying and selling of government securities by the Central Bank
from/to the public and commercial banks. Sale of securities by the Central Bank decreases the money supply
in the economy, whereas purchase of securities by the Central Bank increases the money supply in the
economy since the circulation of money goes up.

Effect in Central Banks’ balance sheet when it purchases govt, bonds:

Liabilities Side: Currency in circulation goes up

Assets Side: Credit to govt. goes up

So OMO is a tool through which the Central Bank regulate the money supply in the economy.

Operation Twist: Sometimes govt. in order to bring parity in interest rates of bonds with different time
periods, uses OMO to regulate that.

Then, we discussed the Balance sheet components of Commercial Banks and then we made the combined
balance sheet for the whole economy including Banking System, private sector and the govt.

We arrived at Money Supply = Currency in Circulation + Deposits with pvt. Sector = Credit to Govt. +
Loans to pvt. Sector + Forex Asset - Non Monetary Liab. (NML)

Then we discussed various measures of money supply

Mo = Monetary Base i.e. Total Money Stock RBI has created. This is also called as High powered money.
Mo is not the measure of money supply because basically its just the stock of money.

M1 , M2, M3 are measures of money supply. And as we keep moving from M1 to M3, the measure of money
supply becomes broader as more and more items and assets class are introduced.

M1 = Cash + CA/SA

M2= M1 + Time deposits with maturity less than a year

M3= M2 + Time deposits with maturity more than a year

The issue with this is then which is the right measure of money supply. Because nowadays FD Deposits are
also liquid because we can break it quickly and get our money back.
Then we discussed about the Money Market (LM Curve). We learnt that demand for money (L) increases,
when overall consumption (Y) increases. And the Demand for Money (L) decreases when interest rate (i)
increases.

And the point where the IS and LM curve intersects, that’s the point where money market and goods market
is at the equilibrium.

SESSION 10
In this session we discussed how the equilibrium of money market and goods market changes with the
change in money supply.

So, when money supply is increased, then the interest rate falls. So the cost of borrowing comes down. And
because of which the demand for investment goes up. Therefore, the AD increases and thus to maintain it
the output also increases.

Higher the elasticity of demand, flatter the curve. Lower the elasticity of demand, steeper the curve. If the
ISLM Curve is flatter, then the change in LM curve will have a much larger effect. i.e. the output increased
will be much higher.

Situation of Liquidity Trap:

When LM Curve is flat, which means I (Interest Rate) is fixed, then the change in money supply won’t
decrease the interest rate. Thus, this situation is called Liquidity trap as the chain would break and output
won’t increase.

Zero Lower Bound Problem: In this case money supply Central Bank keeps on increasing the money supply
in the economy. And eventually interest rate becomes zero. Now, after this increasing the money supply
won’t be effective because interest rate can’t be reduced further, and so output won’t increase.