13. Capital inflows constitute a major factor affecting the value of the rupee now. With the resurgence in capital inflows, the net surplus on the capital account more than doubled to about US $ 11,600 million during 1996-97 thereby exceeding the previous peak of US $ 9,695 million touched in 1993-94. Reflecting these developments, surplus conditions prevailed in the foreign exchange market throughout the year. In general, the policy response has taken the form of partial sterilised intervention through open market operations, liberalisation of capital outflows, raising of reserve requirements and deepening of the foreign exchange market by routing increased volumes of transactions through the market. To prevent appreciation of the rupee, and to protect international competitiveness, the Reserve Bank made substantial purchases of US dollars in the market. During 1997, the
NOTES
RBI intervened in the spot and forward markets, both in the outright and swap segments. Outright spot and forward purchases of US dollars during 1996- 97 amounted to $ 7.9 billion and $ 0.9 billion, respectively. Swap purchases amounted to $ 2.4 billion. While spot sale of US dollars was marginal, forward and swap sales amounted to $ 0.3 billion and $ 3.1 billion, respectively. Thus, net purchases of US dollars during 1996-97 amounted to $ 7.8 billion.
The influx of capital continues during 1997-98. The Reserve Bank has accumulated US $ 3.9 billion of foreign currency assets until August 8, during the current financial year. Total spot and forward purchases and swap sales of US dollars up to end-July 1997, totalled $ 4.3 billion, $ 1.1 billion and 0.9 billion, respectively. Thus, net purchases of US dollars by the Reserve Bank of India up to end July, during the financial year 1997-98 amounted to about $ 4.6 billion.
The optimal policy response to capital inflows is very much a function of the anticipated persistence of capital inflows. The design of policy depends upon the expectation whether the inflow of capital is temporary or is expected to continue. A temporary increase in inflow and perceived as such by the public, which may lead to a temporary real appreciation of the exchange rate, is unlikely to have major effects. Problems, however, arise if the inflow is temporary, but the public expects the inflow to continue. But, in real life, nobody knows with confidence, what is temporary, how temporary it is, and what the public perception is, and indeed how temporary the public perception is! So, let me straightaway go into the instruments.
Internationally, a number of instruments have been used to sterilise capital inflows, the chief among them being the sale of government bonds through open market operations. This policy is useful temporarily and if used for long, leads to renewed inflows. We, in the Reserve Bank, are however, well equipped with physical stock of government securities. We have been active in the repo market in recent months to manage temporary liquidity conditions. The idea is to realise a fine balance in order to achieve the objectives of sterilisation without putting pressure on yields.
Discount policy, which implies restricting the access of banks to central bank credit or raising the cost of refinance has also been used by countries to sterilise capital inflows. This instrument cannot, however, be used in the current context when there is plenty of liquidity in the money market and there is no borrowing from the central bank. However, this instrument may go against the long-term objectives of monetary and credit policy. Varying the reserve requirements is yet another policy tool. Mobilising Government deposits has served as a variation to absorption of reserves in some countries. Variable deposit requirements in the nature of interest free deposits with the central bank is another form of discouraging capital inflows. This measure, while it reduces the need for costly sterilisation through sale of bonds, may result in misallocation of resources and reduce the facility to borrowers to take advantage of lower international interest rates. We have used the CRR successfully in the past, to stem inflows. After the imposition of CRR on incremental NRI deposits, there has been some deceleration in the growth of foreign currency deposits during the current financial year.
Entering into foreign currency swaps (spot sell - forward buy) is another way of sterilising capital inflows. The foreign currency purchased by banks may be used to finance domestic activities or for investment abroad. Our experience shows that the market is fairly thin and in such a market, the use of foreign currency swaps for sterilisation only adds volatility to the forward market unless there is a constant swap window.
Central banks can employ outright forward exchange transaction, i.e., buy outright forward instead of spot. This will have the desired effect on the spot rate, only if it is not countered
by very large spot inflows from participants like FIIs and forward supplies by exporters who wish to take advantage of the increase in premium.
Taxing on capital inflows is yet another form of dissuading flows. For foreign investors, it effectively lowers the rate of return on local assets. This instrument also carries the disadvantage of raising the cost of capital. This option was considered at one time, but deferred considering its disadvantages.
Conclusion
14. I have explained the dilemmas, mainly to show that we are committed to the stated objectives, and assert that we are equipped to handle the problems - equipped with requisite will and skill. However, some believe that we are cautious - whether in allowing the rupee to appreciate or inducing adequate depreciation. Perhaps, some explanation would be in order.
First, we are going through a process of economic reform. In a democratic federal set up going through such economic reform, we require a general mandate on essential complementary policies.
Second, we are vulnerable to supply shocks, especially food stock and oil prices. Third, the East Asian Countries support each other. The G-10 countries coordinate with each other. The Latin American countries are generally supported by North America. We are not members of any blocks. We have gone through the truama of balance of payments crisis in early 1990s and we cannot ignore the threat to economic sovereignty if we take undue risks.
Fourth, and most important, price stability is critical to the economy as a whole, to both the poor and exporters. In fact, as our Governor, Reserve Bank of India, Dr. C. Rangarajan, mentioned in his address at the Annual Presentation Ceremony of the Engineering Export Promotion Council earlier this month, “ containment of domestic price increase has the same beneficial effect as the depreciation of the nominal exchange rate. If the nominal exchange rate is stabilised at a certain level by letting the foreign exchange assets of the central bank to increase, it may have an adverse effect on he exporters through price increase arising from more than the desired increase in money supply. There can therefore, be no rigid formula governing exchange rate determination. Monetary authorities need continually to perform a balancing act between ensuring an exchange rate which will be supportive of exports and the need to contain monetary expansion within reasonable limits.”
During the current financial year up to August 1, deposits have grown rapidly by 4.1 per cent (3.7 per cent in the corresponding period last year). M3 has grown by 4.4 per cent up to July 18 (3.7 per cent last year). The year-on-year growth in M3 is 16.7 per cent. The positive features during the current year are that interest rates have come down, both in the short and long end, and so has the inflation rate. The area of concern relates to money supply. Any further measures in terms of exchange rate should consider the money supply effect so that the gains already made on interest rate and inflation fronts are not eroded. This is the critical aspect of the current exchange rate management stance.
Finally, the extent, the pace and the manner of correction of the exchange rate will have to be taken in conjunction with money supply, since price stability continues to be the dominant objective of monetary policy. We, in the Reserve Bank, seek your assistance, advice, cooperation and understanding. For my part, I am happy to announce that, henceforth the Reserve Bank will make available weekly data relating to its intervention in the forex market.
Thank you.
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6.12. SUMMARY
Macroeconomics takes as given distribution of output, employment and total spending, is what microeconomics seeks to explain. Thus, macroeconomic theory has a foundation in microeconomic theory. There is interdependence between the two. In practice, analysis of economy is not done separately in two watertight compartments. When macroeconomics variables are analyzed, one must allow for changes in microeconomic variables that influence the macroeconomic variables and vice versa. Macroeconomic policy operates within a framework of goals and constraints. The most important and crucial goals of economic policy are as follows. Full employment, i.e., full utilization of human and non- human resources; High living standards; Price Stability; Reduction of economic inequality and removal of poverty; Rapid economic growth and External balance vs overall balance in economic relations with the rest of the world.
Check Your Progress
1. The demand-for-money curve illustrates the relationship between the quantity demanded of money and .
a. inverse; the interest rate b. direct; GDP. c. direct; the interest rate d. inverse; GDP
2. If the interest rate increases, the opportunity cost of holding money , and the quantity demanded of money .
a. does not change; does not change b. increases; also increases c. decreases; increases d. increases; decreases e. decreases; also decreases
3. As the interest rate __________, the opportunity cost of holding money and individuals choose to hold money.
a. increases; increases; more b. increases; decreases; more c. increases; decreases; less d. decreases; increases; more e. decreases; decreases; more
4. As the interest rate falls, the quantity
a. demanded of money falls. b. demanded of money rises. c. supplied of money rises. d. supplied of money falls. 5. If the interest rate is below the equilibrium interest rate, then the quantity
of money exceeds the quantity of money, and there is a of money.
a. supplied; demanded; shortage b. supplied; demanded; surplus c. demanded; supplied; shortage d. demanded; supplied; surplus 6. If the interest rate falls, the opportunity cost of holding money and
the quantity demanded of money .
a. rises, rises b. rises, falls c. falls, rises d. falls, falls
7. A general definition of the “transmission mechanism” is: the routes or channels that ripple effects created in the
a. market for goods and the services travel to affect the money market. b. money market travel to affect the market for goods and services. c. labor market travel to affect the market for goods and services. d. market for goods and services travel to affect the labor market. e. none of the above
8. Which best describes the Keynesian transmission mechanism when the money supply rises?
a. The interest rate rises; this in turn cuts back investment spending, which in turn raises total expenditures and shifts the AD curve rightward.
b. The interest rate falls; this in turn stimulates investment spending, which in turn raises total expenditures and shifts the AD curve leftward.
c. The interest rate falls; this in turn stimulates investment spending, which in turn raises total expenditures and shifts the AD curve rightward.
d. The interest rate falls; this in turn stimulates investment spending, which in turn lowers total expenditures and shifts the AD curve leftward.
9. According to the Keynesian transmission mechanism, a rise in the money supply will the interest rate, causing a in investment demand, which then Real GDP.
a. raise; fall; raises b. raise; rise; lowers c. raise; fall; lowers d. lower; fall; lowers e. lower; rise; raises
10. Compared to the Keynesian transmission mechanism, the monetarist transmission mechanism is Macro-economics Analysis
NOTES
a. direct. b. indirect. c. e. inverse.none of the above
d. elliptical.
11. The Keynesian transmission mechanism might get blocked if a. investment is insensitive to changes in interest rates. b. the goods market is not in equilibrium.
c. the money supply rises too quickly. d. interest rates are too high before they fall.
12. Which scenario best explains the Keynesian transmission mechanism when the money supply rises while the money market is in a liquidity trap?
a. The interest rate and investment are not affected; there is no shift in the AD curve.
b. The interest rate falls, investment rises, total expenditures rise, and the AD curve shifts rightward.
NOTES
c. The interest rate falls, investment falls instead of rising, and the AD curve ends up shifting leftward.
d. The interest rate falls, but investment does not respond; there is no change in total expenditures and no shift in the AD curve.
13. If the money market is in the liquidity trap, it is operating in the segment of the demand curve.
a. vertical; investment b. vertical; money c. horizontal; investment d. horizontal; money
14. Which scenario best explains the Keynesian transmission mechanism when the investment demand curve is vertical?
a. The interest rate falls, investment falls even more, the AD curve shifts rightward, but total expenditures do not change.
b. The interest rate falls, investment rises, total expenditures rise, and the AD curve shifts rightward.
c. The interest rate falls, investment falls instead of rising, and the AD curve ends up shifting leftward.
d. The interest rate falls, but investment does not respond; there is no change in total expenditures and no shift in the AD curve.
15. The liquidity trap refers to the
a. assumption that the money supply curve is vertical as a result of the Fed’s control.
b. problem that occurs when interest rates reach such high levels that no individuals want to hold their wealth in the form of money.
c. situation that occurs when an excess supply of money results in people holding more money than they desire.
d. possibility that interest rates drop so low that people willingly hold all the additions to the money supply, rather than use it to buy bonds.
16. Suppose the money market is in the liquidity trap and the Fed increases the supply of money. We expect that
a. people will end up willingly holding more money.
b. the excess money holdings will flow into the loanable funds market and there will be a decrease in interest rates.
c. interest rates will increase, since the demand curve for money is upward sloping in this case.
d. eventually, via the transmission mechanism, Real GDP will increase. 17. What do Keynesians mean when they say that “you can’t push on a string”?
a. An increase in the supply of goods does not really create its own demand. b. If the government reduces taxes in an attempt to increase household
c. An increase in the money supply will not always stimulate the economy. d. If the government wants to get something done, the best way is not to force
the issue, but to offer incentives.
e. If the government puts too much expansionary pressure on the economy, it will probably “overheat.”
18. If market interest rates increase, the prices of existing bonds will a. decrease. b. not change. c. increase.
d. decrease if Real GDP decreases and increase if Real GDP increases. 19. An individual buys a bond for $1,000 and sells it one year later for $1,080. What
is the interest rate return that this individual has received? a. 8.0 percent b. 80.0 percent c. 7.4 percent d. 4.0 percent
20. Suppose that one year ago you purchased a $100 bond with an interest payment of $10 per year and, at the time, the interest rate was 10 percent. One year later the interest rate has increased to 10.5 percent, and you still hold the bond. Your bond is now worth
a. more than it was before. b. less than it was before. c. the same as it was before, that is, $100.
d. More information is necessary to answer the question.
21. Suppose the money market is in the liquidity trap and the Fed increases the
supply of money. Individuals would rather hold than because they expect that bond prices can go no .
a. bonds; money; higher b. bonds; money; lower c. money; bonds; higher d. money; bonds; lower 22. If a liquidity trap exists, people are likely to be thinking that
a. bond prices are so low that they have nowhere to go but up; given this, now is a good time to be holding bonds.
b. bond prices are so high that they have nowhere to go but down; given this, it is better not to be holding bonds.
c. bond prices will soon rise so it is better to get out of bonds now. d. interest rates will soon fall.
Macro-economics Analysis
NOTES
23. If the money market is in the liquidity trap, then people
a. do not want to hold money because its value is at its lowest. b. want to hold bonds because the interest rate is quite high.
c. do not want to hold bonds because their price is likely to decrease. d. want to hold bonds because their price is high.
NOTES
24. Assuming you want to earn profits, it is best to bonds when you expect interest rates are going to .
a. buy; rise b. buy; fall c. sell; rise d. a and c e. b and c
25. Compared to the monetarist transmission mechanism, the Keynesian transmission mechanism is
a. indirect and long. b. direct and long. c. direct and short. d. indirect and short. 26. Which of the following statements is true?
a. In the monetarist transmission mechanism, changes in the money market directly affect aggregate demand.
b. In the monetarist transmission mechanism, there is no need for the money market to affect the loanable funds market or investment before aggregate demand is affected.
c. In the monetarist transmission mechanism, if individuals are faced with an excess supply of money, they spend that money on a wide variety of goods— not just bonds or other assets, as is the case in the Keynesian transmission mechanism.
d. a and b e. a, b and c
27. According to the monetarist transmission mechanism, a decrease in the supply of money will result in
a. individuals initially holding excess bonds. b. individuals initially holding excess money. c. a leftward shift in the aggregate demand curve. d. a and c
28. Monetarists believe that changes in the supply of money a. do not affect aggregate demand.
b. affect aggregate demand through the loanable funds market only. c. affect only the investment component of aggregate demand. d. affect aggregate demand directly.
29. Monetary policy refers to
a. actions taken by banks and other financial institutions regarding their approaches to lending, account management, etc.
b. changes in the money supply to achieve particular economic goals.
c. changes in government expenditures and taxation to achieve particular economic goals.
d. the change in private expenditures that occurs as a consequence of changes in the money supply.
30. Keynesians are more likely to propose
a. contractionary monetary policy to eliminate an inflationary gap than expansionary monetary policy to eliminate a recessionary gap.
b. contractionary monetary policy to eliminate a recessionary gap than contractionary monetary policy to eliminate an inflationary gap.
c. expansionary monetary policy to eliminate a recessionary gap than contractionary monetary policy to eliminate an inflationary gap.
d. none of the above; instead, Keynesians are as likely to propose expansionary monetary policy to eliminate a recessionary gap as they are to propose contractionary monetary policy to eliminate an inflationary gap.
Questions and Exercises
1. List and explain the three different approaches used to measure GDP.