Repo Rate and Reverse Repo Rate

Repurchase Agreement(REPO Rate): It is the interest rate that central bank controls is called Repo Rate. It is the interest at which commercial banks can borrow from RBI up to a certain limit. This type of transaction is a collateralized transaction. In other words if the bank wants to borrow from RBI, it gives to the RBI a govt’s security. After certain period of time it purchases that same security at lower price. The difference in price is implicit interest rate which is termed as Repo Rate. Technically it is the rate at which liquidity is provided.

Reverse Repo Rate is the rate at which banks could lend to RBI.

Currently RBI sets only Repo Rate and RRR will be 100 basis points (1% less) less than the repo rate. RRR sets the floor for interest rates in the economy. (it means I cannot lend at less than RRR rate)

In between RR and RRR is Marginal Spending Facility Rate, this is 1% above RR and it is non collateralized transaction. Through this RBI has created a corridor for interest rates so that it will fluctuate within these boundaries.

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Monetary Policy Implementation

Monetary policy is operated in several channels. Most important are

  • banking systems
  • financial markets
  • exchange rates

In India major monetary policy channel is banking channel, that is why India often regulates Cash Reserve Ratio(CRR).

In banking systems, leverage ratios play prominent role. More on leverage ratios is blogged under financial accounting

leverage ratio = (debt/assets)/(capital/equity)

When a bank’s equity is very low, even a small shock/recession will make the banks bankrupt.

We will discuss more about exchange rates in further posts.

Money Supply, Monetary Base, CRR and Money Multiplier

Money supply in any economy is given as ‘Currency + Deposits’

Currency is the amount of money holding by the individuals. Deposits is the money holding by the bank. Holding 100% funds in currency form by the individuals OR in deposits form in the bank is unrealistic.

In reality we use fractional banking system.

what is fractional banking system? A bank is not required to hold all the money in form of reserves, it is under the assumption that not every account holder will show up at the bank for their cash at one time.

What is Cash Reserve Ratio?: Rule is set by the central bank that at any given point of time commercial banks should hold only a certain amount(20%) of deposits as reserves.

Example:
If say, 1000 Rs is deposited into the bank, then it should keep only 200 Rs with it and lend 800 Rs to others. This will create potential transactions of worth 1800 (1000 Rs which is initially deposited and 800 Rs which is newly created), so it could create economic activity of worth 1800 Rupees. And the remaining 20% (200 Rs) is CRR Cash Reserve Ratio. Others who have received 800 Rs will now deposit that money into another bank in which again 160 Rs (20%) is retained by the bank and remaining 640 Rs is lent to others and this goes on till the deposits reach 5000 Rs. How to arrive at this deposit level of 5000 rupees? is given by CRR itself.

What is Reserve Level?: Initial amount of deposit, i.e, 1000 in above example is called reserve level.

How to compute deposit level from CRR?: Deposit Level = (Reserve Level)/CRR

Reserve level of 1000 will be able to support a deposit level of 1000/0.2 = 5000

What is Monetary Base(MB): is the initial ‘amount of capital’/’Reserve Level’ that is injected into the economy (In above example it is 1000 Rs) It is defined as ‘Currency + Reserves’

The actual amount of money supply in the economy is much higher than the monetary base (In above example it is 5000 Rs). So the Actual Money Supply is a multiple of monetary base, this multiple is called Money Multiplier  (In above example it is 5)

What determines Money Multiplier(MM)? its CRR, the higher the CRR, the lower the MM because the banks cannot indulge in multiple deposit creation.

Now if the Central Bank (CB) wants to decrease the money supply in the economy, it should raise the CRR. This is one instrument CB uses to control liquidity in the economy.

It also depends on the individual on how much to hold the money in his hands in from of currency and how much to put in bank, so central bank has only partial role to control the liquidity through CRR.

Note: CB just sets the floor of CRR but it is up to the commercial banks to decide on the maximum cap of CRR, there is no limit.

During post crisis USA federal reserve’s problem: It can increase the MB as much as it wants. When it is increased by humongous amounts then prices should go up but it is not, because banks are not lending, and instead excess reserves are going up, money multipliers are falling down and hence it is not translating into higher availability of money in the market.

Today both Europe and USA facing similar banking crisis.

1929 Banking Crisis

In 1929 crisis analysis, pattern observed was currency holdings went up and CRR also went up and as a result credit availability in the economy decreased.

Great Depression in 1929 and Keynes explanation (Keynesian Economics)

Great Depression 1929 and Keynes explanation (Keynesian Economics)

In general, economists point of view is that; economies will always be close to the potential, there won’t be any slack in the economy because economies always believe that markets function perfectly.

Note: Economy of a country cannot stay down in the AD curve because its capacity/potential is lot more than output. Similarly economy of a country cannot stay up the AD curve because if it is less than the output, then supply is more than the demand which forces prices to fall and hence economy will always move back to potential. In fact a country’s economy can never be at any place other than its potential. And hence there is no role for monetary stabilization because prices themselves will take of everything, i.e. markets will always adjust and ensure themselves such that they are always near to the potential.

Note: When do an economy reaches its capacity?
If it is seen that increase in expenditure is always leading to higher prices then it indicates that economy has reached its capacity.
OR
Increase in money supply leads to increase in demand. Increase in demand, translates more into increase in price and less into increase in output, it is also an indication that economy has reached its capacity.

Exceptional case in 1929, the great depression, changed the economists view of the world; worldwide recession, weird state of the economy; on supply side because of excess supply, farmers were burning their crops and on the demand side because of excess demand, people were starving for food. From markets perspective since there is excess supply, prices should come down and hence starving people should be able to afford to buy, thus economy should reach its potential, but it didn’t happen.

Here we are talking about downward trend of prices which is difficult attain by the markets. This is discussed in our last article.

Keynes

At this point a famous economist keynes (http://en.wikipedia.org/wiki/Keynesian_economics) said, that we have given too much of importance to the markets, because markets take lot of time to adjust, particularly in downward direction (B to A in above graph), i.e. prices can shoot up (upward direction) easily (see the last article) but in downward direction it takes time because nobody wants to cut down the wages.

Because of lot of uncertainties everybody wants to save a lot, especially private sectors, so when everybody starts saving and nobody is consuming but the market always has certain potential which is produced by the producers then realizes (because of everyone is saving and nobody is buying their products) their inventory will rise, which will force them to cut down production, which leads to the cut down of employees (underutilized resources) which in turn reduces the purchasing power and hence nobody can buy anything anymore which again leads to less production.

He suggested that we cannot expect private sector to spend at this point of time because of fear and uncertainty which is when the government should interfere and take the role of spending so that it make up this slack in demand (B to C in above graph) that is coming from the private sector. This concept of government spending is called stimulus OR monitory stabilization.

Keynes also said not to worry too much about the prices because they are constant (and safely assume it is going to be constant because of lot of underutilized resources) because there are many underutilized resources and economy is significantly below its capacity.

Now if money is injected into the system by govt, AD curve shifts to the right, which increases the output (growth), so by spending more we can employ underutilized resources and hence we can reach to new equilibrium point C.

Through this Keynes introduced a term called ‘Multiplier’ which says,
if government spends 1L Rs, the actual output in the economy will go up by much more than 1L Rs:
The process is something like; govt spends 1L Rs, the party on which this 1L is spent will spend fraction of their returns on somebody else, they will spend fraction of returns on somebody else and hence overall economy will go up.
Note: This will work only when you have underutilized resources.

Short Term and Long Term effects of demand and supply on the equilibrium point

Short Term and Long Term effects of demand and supply on equilibrium point

Equilibrium Point: point where demand and supply meet in price-quantity graph.

In short run equilibrium, if Then over time P will
Y > Ybar rise
Y < Ybar fall
Y = Ybar Stabilize/remain constant

Y>Ybar:
First, suppose aggregate demand is higher than the full-employment level of output in the economy’s initial short-run equilibrium. Then, there is upward pressure on prices(Y>Ybar): In order for firms to produce this above-average level of output, they must pay their workers overtime and make their capital work at a high intensity, which causes more maintenance, repairs, and depreciation. For all these reasons, firms would like to raise their prices. In the short run, they cannot. But over time, prices gradually become “unstuck,” and firms can increase prices in response to these cost pressures.

Y<Ybar:
Instead, suppose that output is below its natural rate. Then, there is downward pressure on prices(Y<Ybar): Firms can’t sell as much output as they’d like at their current prices, so they would like to reduce prices. With lower than normal output, firms won’t need as many workers as normal, so they cut back on labor, and the unemployment rate rises above the “natural rate of unemployment.” The high unemployment rate puts downward pressure on wages. Wages and prices are “stuck” in the short run, but over time, they fall in response to these pressures.

Y=Ybar:
Finally: if output equals its normal (or “natural”) level, then there is no pressure for prices to rise or fall. Over time, as prices become “unstuck,” they will simply remain constant.

Note: Markets take lot of time to adjust particularly in downward direction, i.e. prices can shoot up (upward direction) easily but in downward direction it takes time because nobody wants to cut down the wages. Hence in below figure shift in equilibrium point because of upward pressure in prices is shown.

Shift in Equilibrium Point because of Upward Pressure in Prices
AD-AS
Here we see the short-run and long-run effects, as well as the adjustment of prices over time that causes the economy to move from the short-run equilibrium at point B to the long-run equilibrium at C.

The economy starts at point A; output and unemployment are at their “natural” rates. The RBI increases the money supply, shifting AD to the right. In the short run, prices are sticky, so output rises.

The new short-run equilibrium is at point B in the graph.

In order for firms to increase output, they hire more workers, so unemployment falls below the natural rate of unemployment, putting upward pressure on wages. The high level of demand for goods & services at point B puts upward pressure on prices.

Over time, as prices become “unstuck,” they begin to rise in response to these pressures. The price level rises and the economy moves up its (new) AD curve, from point B toward point C.

This process stops when the economy gets to point C: output again equals the “natural rate of output,” and unemployment again equals the natural rate of unemployment, so there is no further pressure on prices to change.

Aggregate Demand and Aggregate Supply in an economy

AGGREGATE DEMAND

One way of looking at aggregate demand is from the quantity equation (MV = PY); for given value of ‘M’ , price ‘P’ is inversely proportional to output ‘Y’

If the money supply increases, the aggregate demand curve will shift towards the right.

So when we print more money, AD curve will shift towards right. Hence Monitory policy stimulates aggregate demand.

AGGREGATE SUPPLY

There are two forms
· Short Run Aggregate Supply (SRAS)
· Long Run Aggregate Supply (LRAS)

Short Run Aggregate Supply (SRAS)
In short run, the price level is fixed at a predetermined level, and firms sell as much as buyers demand.

In short run, if aggregate demand increases, aggregate supply can be increased even above the economy’s potential, but over a long period of time if the output is continually increased above the potential, prices will eventually begin to rise (LRAS shown in the last diagram of this post).

Long Run Aggregate Supply (LRAS)
Aggregate Supply depends on amount of resources in the economy at given point of time. At a given level of labor and capital, there is a always a certain amount of capacity in the economy. This is called as economy’s potential output.

AGGREGATE DEMAND AND SUPPLY

From economists point of view, if output really matters a lot then we should not worry about the increase in money supply(which can only shift demand curve to the right) but worry about shifting the vertical line towards the right by proper investments (like infrastructure, innovation, etc) and thereby increasing the productivity.

The supply side view of the world: if money supply is increased, then it is going to increase aggregate demand; because of increase in liquidity, hence purchasing power will be increased and therefore it is going to lead to higher prices(see in below figure from P1 to P2).

Inflation Tax or Seigniorage

Inflation Tax or Seigniorage
Making the currency weak by printing a lot of money which devalues the currency and inflates the economy and hence results in financial loss of value for the cash holders is known as Inflation Tax or Seigniorage.
Note: Inflation Tax is not related to any kind of direct tax.

Inflation is all about redistribution of resources. Inflation tax can happen either through excessive government spending within the country or through quantitative easing from US.

Inflation Tax through ‘Quantitative Easing’
Printing more money into the system is called as Quantitative Easing. Today many countries are worried of quantitative easing in US.

Just because there is no inflation is US, it does not mean that there are no consequences in the federal reserve bank’s actions. If money is excessively printed in US, it will lead to growth of stock market in other countries where US is investing which leads to inflation in other countries.

Inflation Tax through govt Spending
Let’s say, govt has borrowed money of 1000 Rs and bought 2 tables in the year 2011 and it returned back the money in 2012 but by that time it will inflated the economy in such a way that the borrower can buy only 1 table. In this way it has transferred resources (1 table) from the borrower side to the government side.

Sometimes little bit of inflation (around 2%) is good and govt officially does it as it gives incentives to people who own firms to expand their production. In real terms entrepreneurs share is becoming high. Again if this is done regularly, then RBI will lose the credibility and as a result inflation rises.

GDP and Price Index in an economy

Nominal GDP and Real GDP

Nominal GDP is the GDP measured at current price.
Real GDP is the GDP measured at constant price. This constant price is also called base year price.
Look at GDP definition here

For Example:
In 2011, let’s say Indian economy has produced 10 books @ 10 Rs each, at current price of 10 Rs,
Nominal GDP = 10*10 = 100.
In 2012, let’s say Indian economy has produced same 10 books @ 12 Rs each, at current price of 12 Rs,
Nominal GDP = 10*12 = 120.
But if we want to fix our base price level at the prices of 2011, then we need to calc. the GDP with this year’s quantity (10) multiplied by base year’s price(10), i.e.
Real GDP = 10*10 = 100
In this case even though ‘Nominal GDP’ increased by 20%, ‘Real GDP’ increased by 0%. So one has to pay attention towards Real GDP instead of Nominal GDP.

Note: Role of base year’s price? this is very important because the base price can give us different outcome. If the base year prices are  very less, than even a small change in prices seems like GDP has gone up significantly. India is growing at 13% doesn’t mean that its growth rate is very good but because it started at very low base year price. Again, US is growing at 1% does not mean its growth rate is less but because the base prices are very high.
Note: Inflation always depends on base year’s prices.

Price Index (PIs)

Price Index is a measure of relative price changes of total goods and services in an economy over a period of time.

How do we measure Price Index? we take commonly consumed basket of goods and measure the change of cost of same basket over time. Important point to note here is that the goods should be in the same basket over a period of time. Macro economics is all about aggregates (total G&S in economy), hence PIs are also calculated on the aggregate basis.
Some of the most commonly used price indices in India are

  • WPI (Wholesale Price Index) and
  • CPI (Consumer Price Index). Within CPI there are 4 different types of CPIs.

CPI measures retail changes in the prices, i.e. it will attach larger weight to goods which consumer consumes like food, services like medical, education, etc…

WPI measures wholesale prices, i.e. it will attach larger weight to goods which producers are interested in, like oil, etc..

Note: If we notice, Price Index is exactly opposite of real GDP because in Price Indexes we keep quantity constant and measure change in price and whereas in real GDP we keep price constant and measure change in quantity.

Note: Whenever we see Inflation news that is WPI but not CPI and hence we do not see decrease in cost of food.
Why is WPI measured instead to CPI?
In India we do not have sophisticated data collection processes. Since WPI is on producer’s side it is easy to collect the data whereas CPI is consumer side and hence it is difficult. India woke up as an economy only in 1991, till then there was no need to collect any data because we were not growing (at very low rate of 2%)/ or growing at very minimal rate.

Money and Inflation

Money and Inflation

Money is anything that allows us to carry out transaction. Inflation is rate of change of price.

Relation between Money and Inflation can be represented by QUANTITY equation.


#Quantity Equation
M*V = P*Y
  where
  #M - Total money supply in the economy
  #V - Velocity of the money - Number of times each unit of
                 money circulates in an economy
  #P - Price Level
  #Y - Real GDP (Output or Growth)

#At constant 'V'
 D(M)/M = D(P)/P + D(Y)/Y
# where D(M) is the change in M or delta(M)

#Inflation (Rate of change of price) is
[D(P)/P] = D(M)/M - D(Y)/Y

This implies that if the money is pumped[D(M)/M] into the market without growth rate[D(Y)/Y] in the economy, then it will lead to more inflation [D(P)/P].

Role of government subsidies in Indian economy

Role of government subsidies in Indian economy

In India, we are already running fiscal deficit every year and hence government borrowing money from the public savings and then giving it back to the public as SUBSIDIES. Today India runs a fiscal deficit of 5.9% of GDP, which means it is borrowing huge amount of money from public savings to perform its day to day activities and giving it back to the public.

So on the whole, the government’s savings are going out unproductive (in form subsidies and other consumptions) instead of actual investments and hence on the long run the govt’s economic growth will slow down which will throw many Indians jobless.

Most important thing to understand is that ‘PRICE’ is just a MESSENGER between demands and supplies. Suppressing the prices is FOOLISHNESS just because we don’t like high prices. By suppressing the price in form of subsidies we cannot address the underlying problems of the price hikes.

On the other hand, as subsidies are a form of redistributing money, it holds good only when the country is running surplus.

Note: Currently India has to grow economically at 8.5% (keeping in mind the current number of graduates passing out each year) to stay where it is in the market otherwise more number of people will become jobless.

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