Unorthodox Monetary Policy

(Quantitative Easing)
• Portfolio rebalancing channel:
The Central Bank purchases long-term government bonds from the
non-bank private sector such as pension funds, insurance companies
and hedge funds.
• This increases deposits in the sellers account and adds to
outstanding reserve balances.
• The seller is likely to use the cash to rebalance their portfolios by
purchasing assets that are better substitutes such as corporate bonds
and equities.
• This should boost the prices of these other assets and reduce the
yield on them (given that the yield moves inversely to prices).
• Higher asset prices increase wealth across the economy, whilst the
lower yields on these assets reduce the cost for corporations of
raising external financing via corporate debt and equity markets.
• It encourages investment and consumption and thereby aggregate
demand.
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 Video links
• https://www.youtube.com/watch?v
=4TihoBfdCe8
• https://www.youtube.com/watch?v
=J9wRq6C2fgo
• https://www.youtube.com/watch?v
=CvRAqR2pAgw

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Unorthodox Monetary Policy: Negative
Interest Rates Policy(NIRP)

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 How do interest rate cuts below zero
(negative interest rates) work?
• Commercial banks hold money with Central banks.
• If the interest rate (deposit rate) is cut below zero, this means that the central
banks can charge the commercial banks interest on that money.
• The commercial banks, meanwhile, can cut the interest rate that they offer
their customers (depositors) by the same amount and make their money
back.
• (i)Imagine a pension fund is holding a deposit with a commercial bank. If the
interest rate drops, the fund might seek to buy financial assets with a higher
return, such as bonds (which are like long-term loans).
• This increases demand for, and therefore the price of, these assets, which is
how the rate cut is transmitted to the broader financial market.
• (ii)Banks might also reduce the interest rates they charge on loans (lending
rate) and start lending more.
• This would increase investment as funding investment is now cheaper. This
would also encourage household to spend more as deposit rate is lower. This
would lead to an increase in AD and output.

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 Video link
• https://www.youtube.com/watch?v
=6KibetJGVA0

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Fiscal Policy

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 Types of Fiscal Policy
Fiscal policy is the policy of the government to influence economic
activity through the following instruments:
(a) Govt. Expenditure
(b) Taxes
(c) Transfer Payments

It is of two types. (a) Expansionary and (b) Contractionary.

An increase in government purchases, an increase in transfer payments,
and a reduction in taxes (e.g.income tax, corporate tax) are called
expansionary fiscal policy. It is so they expand domestic demand for
goods and services.

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Fiscal Policy and Crowding Out
• The equation for the IS curve is: Y = G ( A − bi ) (3)
– The fiscal policy variables, G, TR and t, are within this definition
• G, and TR are part of A
• t is a part of the multiplier
→ Fiscal policy actions, changes in G, TR and t, affect the IS curve
• Suppose G increases
– At unchanged interest rates, AD increases
– To meet increased demand, output must increase
– At each level of the interest rate, equilibrium income must rise
by  G G

12-8
 Government Expenditure and the IS
curve (but without Money market)
• Figure shows two different IS
curves → differ by levels of
autonomous spending, i.e. G

– Initial AD with A and i1 →

corresponding point E1 on IS
curve in Figure 11-7 (b)
– If G spending
increases to A  (say due to
increase in MGNREGA
allocation), equilibrium level
of income increases at i1 →
point E2 in panel 11-7 (b),
shifting out IS
• The change in income as a result from a
change in autonomous spending is
Y = G A

11-9
Impact of changes in GDP on equilibrium rate
of Interest and the Derivation of the LM
Curve
• If income increases to Y2, real money balances higher at every
level of i → money demand shifts to L2
– The interest rate increases to i2 to maintain equilibrium in
money market
– The new equilibrium is at point E2

11-10
Fiscal Policy and Crowding Out
• If government expenditures
increase, equilibrium moves
to from E’ to E”
• The goods market is in
equilibrium at E”, but the
money market is not:
– Because Y has increased,
the demand for money also
increases → interest rate
increases
– Firms’ planned investment
spending declines and AD
falls→ move up along the
IS curve to E’

12-11
Fiscal Policy and Crowding Out
• Comparing E to E’:
increased government
spending increases income
and the interest rate
• Comparing E ” to E’ :
adjustment of interest rates
and their impact on AD
(via decrease in I) dampen
expansionary effect of
increased G
– Income increases to Y’0
instead of Y”
– We say that the increase in
government spending
crowds out investment
spending.
• When interest rates rise, fewer
corporations offer new bonds
12-12
Fiscal Policy and Crowding Out
– Income increases to Y’0
instead of Y”
– We say that the increase in
government spending
crowds out investment
spending.
– Crowding out occurs
when expansionary fiscal
policy causes interest rate
to rise, thereby, reducing
private spending,
particularly investment.
G
 Real GDP increases
 Demand for money
increases
 Interest rate increases
 Investment Decreases
 GDP Increases but not by
full multiplier effect 12-13
Factors Determining the Crowding Out (Zero
crowding out /Strong Effects of Fiscal policy)
– If the demand for money is
very sensitive to the interest
rate (liquidity trap), an
increase govt. spending has
maximal effect on GDP (i.e.,
full multiplier effect) and no
effect on interest rate. Income
increases to Y1 to Y2.
– In other words, if an economy
is in the liquidity trap, an
increase in govt spending has
full multiplier effect on the
equilibrium level of income.
– There is no dampening effects
of increased govt spending on
GDP.
– Further, monetary policy has
no effect on output.

12-14
 The Strong Effects of
Monetary Policy
• The opposite of the horizontal LM curve (implies that monetary
policy cannot affect the level of income) is the vertical LM curve.
• The LM curve becomes vertical when the demand for money is
entirely unresponsive to the interest rate.
– Recall, the equation for the LM curve is
M
= kY − hi
P
• If h=0 and P is moved to the right-hand side, we obtain
M = k(P Y )
• This implies that NGDP depends only on the quantity of money → quantity
theory of money(QTM).
• As per the classical QTM, the demand for nominal money balances (M) is
proportional to total transactions (PY) irrespective of the interest rate.

12-15
 The Strong Effects of
Monetary Policy
• When the LM curve is vertical
1. A given change in the quantity of money (monetary policy) has a
maximal effect on the level of income
2. Shifts in the IS curve (may be fiscal policy) do not affect the level of
income
Thus, when the LM curve is vertical, monetary policy has a maximal effect
on the level of income and fiscal policy has no effect on income
• Vertical LM curve implies the comparative effectiveness of
monetary policy over fiscal policy
– “Only money matters” for the determination of output.
– This suggests that the “interest sensitivity of demand for
money” is an important issue in determining the
effectiveness of alternative policies.

12-16
Factors Determining the Crowding Out (Full
crowding out/Weak Effects of Fiscal policy)
– If the demand for money is not
related to the interest rate (Classical
case), an increase govt. spending has
no effect on GDP (i.e., zero multiplier
effect) and increase the interest rate.
Income increases remains at Y1.
– In other words, an increase in govt
spending crowds out an equivalent
amount of private spending. So
output does not change.
– There is complete dampening effects
of increased govt spending on GDP.
– Further, monetary policy has maximal
effect on output.

12-17
 Monetary accommodation
and crowding out
• There may not be any crowding out if
monetary authorities accommodate the
fiscal expansion by increasing money
supply.
• Monetary accommodation means printing
of money by the central bank to buy the govt
bonds following government’s market borrowing
to finance fiscal deficit.
• Monetary accommodation is also known
as monetization of fiscal deficits.
• When the central bank accommodates a fiscal expansion, both the IS
and LM schedules shift to the right. Output clearly increases, but
interest rates do not rise.
• Accordingly, there need not be any adverse effect on investment.

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 The Composition of Output
and the Policy Mix
• Table 12-2 summarizes effects of expansionary monetary and fiscal policy on
output and the interest rate

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 The Composition of Output
and the Policy Mix
• Monetary policy operates by stimulating interest-responsive
components of AD, i.e., and consumption.
• Fiscal policy operates through G, TR and t. It operates by
stimulating consumption component of aggregate demand. Its
impact on investment depends upon what taxes and transfers it
changes.
Interest Rate Consumption Investment GDP
Money Supply ↑ ↓ ↑ ↑ ↑
Govt. Spending ↑ ↑ ↑ ↓ ↑
Income tax ↓ ↑ ↑ ↓ ↑
Investment ↑ ↑ ↑ ↑
Subsidy ↑
Corporate income ↑ ↑ ↑ ↑
tax rate ↓

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 The Composition of Output
and the Policy Mix
• Policy problem of reaching full employment output, Y*, for an economy that
is initially at point E, with unemployment.
Choices:
1. Fiscal policy expansion ( increase in G or decrease in t), moving to
point E1, with higher income and higher interest rates.
2. Monetary policy expansion (decrease in interest rate), resulting in full
employment with lower interest rates at point E2
3. A mix of fiscal expansion and accommodating monetary policy
resulting in an intermediate position.
• All the policy choices raise output,
but differ significantly in their impact
on different sectors of the economy.
• This also suggests that a combination
fiscal and monetary policy not only stabilizes
output at potential level but also solves other
policy problems.

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 Application of IS-LM Model
• Answer the following questions using IS-LM model and data
g
• 1. What caused recession in India during 2020-21?
• (How did the COVID-19 pandemic affect real GDP in India?)
• 2. Did the RBI follow an expansionary monetary policy?
• 3. How would you predict the effects of this change on GDP
and its components (endogenous variables)?
• 4. What are the factors behind the recovery in 2021-22?
• 5. Which policy (fiscal or monetary) dominated the economy?

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 What caused recession in India during
2020-21?
Real GDP (in lakh crores of Rupees)
1,60,00,000

1,50,00,000

1,40,00,000

1,30,00,000

1,20,00,000

1,10,00,000

1,00,00,000

90,00,000

80,00,000
2011-12
2012-13
2013-14
2014-15
2015-16
2016-17
2017-18
2018-19

2020-21
2021-22
2022-23
2019-20

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• The pandemic has been a unique economic shock that has triggered
both supply and demand side shocks simultaneously across
economies around the world .
Demand shock:
• Increased uncertainty, lower confidence, loss of incomes, weaker
growth prospects, curtailment of spending options due to closure of
all contact-sensitive activities, the triggering of precautionary
savings, risk aversion among businesses led to a fall in consumption
and investment – leading to a fall in aggregate demand demand
shock.
Supply shock
• The supply chain disruptions caused by closure of economic activity
and restricted movement of labour caused an adverse supply
shocks.

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Annual Real growth in demand side of GDP
and its components (per cent)

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Did the RBI follow an expansionary
monetary policy?

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Did the RBI follow an expansionary
monetary policy?

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Growth Rate of Bank Credit declined

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Growth Rate of Broad Money declined

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 1.24
1.29
1.34
1.39
1.44
1.49
1.54
1.59
1.64
Apr-19
Jun-19
Aug-19
Oct-19
Dec-19
Feb-20
Apr-20
Jun-20
Aug-20
Oct-20
Dec-20
Feb-21
Apr-21
Jun-21
Aug-21
Oct-21
increased

Dec-21
Feb-22
Apr-22
Jun-22
Aug-22
Oct-22
Dec-22
Feb-23
Apr-23
Currency-Deposit Ratio in

Jun-23
30
 3
8
13
18
23
Apr-20
Jun-20
Aug-20
Oct-20
Dec-20
Feb-21
Apr-21
Jun-21
Aug-21
Oct-21
Dec-21
Feb-22
Apr-22
Jun-22
Aug-22
Oct-22
Dec-22
Feb-23
Apr-23
Growth Rate of Currency
held by the Public declined

Jun-23
31
Money multiplier Declined

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Operation Twist

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Shift of the Yield Curve

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What are the factors behind the
recovery in 2021-22?

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• Fiscal Policy

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 Mahatma Gandhi National Rural
Employment Guarantee Act (MGNREGA)
• Mahatma Gandhi National Rural Employment Guarantee Act
(MGNREGA) provides at least 100 days of guaranteed wage employment
every year to each rural household whose adult members volunteer to do
unskilled manual work.
• In the 2020-21 Union Budget, the scheme was allocated Rs 61,500 crore.
• In May 2020 allocation to the scheme was increased by 65% to Rs 1,01,500
crore (increased by 40,000 crore).
• Further, under the Pradhan Mantri Garib Kalyan Yojana, MGNREGA wage
has been increased by Rs 20 (i.e., from Rs 182 to Rs 202 per day).

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 Pradhan Mantri Kisan Samman
Nidhi (PM-KISAN)
• Pradhan Mantri Kisan Samman Nidhi (PM-KISAN) is a Central Sector scheme with
100% funding from Government of India.
• Under the Scheme an income support of Rs.6000/- per year is provided to all farmer
families across the country in three equal installments of Rs.2000/- each every four
months.
• All landholding farmers' families, which have cultivable landholding in their
names are eligible to get benefit under the scheme.
• In 2019-20, it had a budget estimate of Rs 75,000 and a revised estimate of Rs
54,370.
• In 2020-21, Rs 17,891 crores was disbursed to 8.94 crore beneficiaries as of June
2020.

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 Which policy (fiscal or monetary)
dominated the economy?
• Answer this? Refer to Handbook of
statics on Indian Economy.

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