Name - Ravi Shankar Dayal

Class - M.A. Economics

College - St. Aloysius College
Jabalpur
Subject - Macro Economics
Topic – Unit 3
Submitted To – Dr. Reeta Chauhan

----------------------------------------------------------

Q 1. Explain ‘Keynes’ Liquidity Preference

Theory of Interest Rate.
Ans. The determinants of the equilibrium interest rate in the
classical model are the ‘real’ factors of the supply of saving and the
demand for investment. On the other hand, in the Keynesian analysis,
determinants of the interest rate are the ‘monetary’ factors alone.
Keynes’ analysis concentrates on the demand for and supply of money
as the determinants of interest rate. According to Keynes, the rate of
interest is purely “a monetary phenomenon.” Interest is the price
paid for borrowed funds. People like to keep cash with them rather
than investing cash in assets. Thus, there is a preference for liquid
cash.
People, out of their income, intend to save a part. How much of their
resources will be held in the form of cash and how much will be spent
depend upon what Keynes calls liquidity preference, Cash being the
most liquid asset, people prefer cash. And interest is the reward for
parting with liquidity. However, the rate of interest in the Keynesian
theory is determined by the demand for money and supply of money.
Demand for Money:
Demand for money is not to be confused with the demand for a
commodity that people ‘consume’. But since money is not consumed,
the demand for money is a demand to hold an asset.
The desire for liquidity or demand for money arises because
of three motives:
(a) Transaction motive
(b) Precautionary motive
(c) Speculative motive
(a) Transaction Demand for Money:
Money is needed for day-to-day transactions. As there is a gap
between the receipt of income and spending, money is demanded.
Incomes are earned usually at the end of each month or fortnight or
week but individuals spend their incomes to meet day-to-day
transactions.
ADVERTISEMENTS:

Since payments or spending are made throughout a period and

receipts or incomes are received after a period of time, an individual
needs ‘active balance’ in the form of cash to finance his
transactions. This is known as transaction demand for money or need-
based money—which directly depends on the level of income of an
individual and businesses.
People with higher incomes keep more liquid money at hand to meet
their need-based transactions. In other words, transaction demand for
money is an increasing function of money income.
Symbolically,
Tdm = f (Y)
Where, Tdm stands for transaction demand for money and Y stands for
money income.
(b) Precautionary Demand for Money:
Future is uncertain. That is why people hold cash balances to meet
unforeseen contingencies, like sickness, death, accidents, danger of
unemployment, etc. The amount of money held under this motive,
called ‘Idle balance’, also depends on the level of money income of
an individual.
People with higher incomes can afford to keep more liquid money to
meet such emergencies. This means that this kind of demand for
money is also an increasing function of money income. The
relationship between precautionary demand for money (Pdm) and the
volume of income is normally a direct one.
Thus,
Pdm = f (Y)
(c) Speculative Demand for Money:
This sort of demand for money is really Keynes’ contribution. The
speculative motive refers to the desire to hold one’s assets in liquid
form to take advantages of market movements regarding the
uncertainty and expectation of future changes in the rate of interest.
The cash held under this motive is used to make speculative gains by
dealing in bonds and securities whose prices and rate of interest
fluctuate inversely. If bond prices are expected to rise (or the rate of
interest is expected to fall) people will now buy bonds and sell when
their prices rise to have a capital gain. In such a situation, bond is
more attractive than cash.
Contrarily, if bond prices are expected to fall (or the rate of interest is
expected to rise) in future, people will now sell bonds to avoid capital
loss. In such a situation, cash is more attractive than bond. Thus, at a
low rate of interest, liquidity preference is high and, at a high rate of
interest, securities are attractive. Now it is clear that the speculative
demand for money (Sdm) varies inversely with the rate of interest.
Thus,
Sdm = f (r)
Where, Y is the rate of interest.
Total Demand for Money:
The total demand for money (DM) is the sum of all three types of
demand for money. That is, Dm = Tdm + Pdm + Sdm. The demand for
money has a negative slope because of the inverse relationship
between the speculative demand for money and the rate of interest.
However, the negative sloping liquidity preference curve becomes
perfectly elastic at a low rate of interest. According to Keynes, there is
a floor interest rate below which the rate of interest cannot fall. This
minimum rate of interest indicates absolute liquidity preference of the
people.
This is what Keynes called ‘liquidity trap’. In Fig. 6.20, Dm is the
liquidity preference curve. At minimum rate of interest, r-min, the
curve is perfectly elastic. However, there is a ceiling of interest rate,
say r-r-max, above which it cannot rise. Thus, interest rate fluctuates
between r-max and r-min.

Money Supply:
The supply of money in a particular period depends upon the policy of
the central bank of a country. Money supply curve, SM, has been drawn
perfectly inelastic as it is institutionally given.
Determination of Interest Rate:
According to Keynes, the rate of interest is determined by the demand
for money and the supply of money. OM is the total amount of money
supplied by the central bank. At point E, demand for money becomes
equal to the supply of money. Thus, the equilibrium interest rate is
determined at or. Now, suppose that the rate of interest is greater than
or.
In such a situation, supply of money will exceed the demand for
money. People will purchase more securities. Consequently, its price
will rise and interest rate will fall until demand for money becomes
equal to the supply of money.
On the other hand, if the rate of interest becomes less than or, demand
for money will exceed supply of money, people will sell their securities.
Price of securities will tumble and rate of interest will rise until we
reach point E.
Thus, the rate of interest is determined by the monetary variables
only.
Limitations:
Even Keynes’ liquidity preference theory is not free from
criticisms:
Firstly, like the classical and neo-classical theories, Keynes’ theory is
an indeterminate one. Keynes charged the classical theory on the
ground that it assumed the level of employment fixed.
Same criticism applies to the Keynesian theory since it assumes a
given level of income. Keynes’ theory suggests that Dm and SM
determine the rate of interest. Without knowing the level of income we
cannot know the transaction demand for money as well as the
speculative demand for money. Obviously, as income changes,
liquidity preference schedule changes—leading to a change in the
interest rate.
Therefore, one cannot, determine the rate of interest until the level of
income is known and the level of income cannot be determined until
the rate of interest is known. Hence indeterminacy. Hicks and Hansen
solved this problem in their IS-LM analysis by determining
simultaneously the rate of interest and the level of income.
It is indeed true also that the neo-classical authors or the pro-
pounders of the loanable funds theory earlier made attempt to
integrate both the real factors and the monetary factors in the interest
rate determination but not with great successes. Such defects had been
greatly removed by the neo-Keynesian economists—J.R. Hicks and
A.H. Hansen.
Secondly, Keynes committed an error in rejecting real factors as the
determinants of interest rate determination.
Thirdly, Keynes’ theory gives a choice between holding risky bonds
and riskless cash. An individual holds either bond or cash and never
both. In the real world, it is the uncertainty or risk that induces an
individual to hold both. This gap in Keynes’ theory has been filled up
by James Tobin. In fact, today people make a choice between a variety
of assets.
Conclusion:
Despite these criticisms, Keynes’ liquidity preference theory tells a lot
on income, output and employment of a country. His basic purpose
was to demonstrate that a capitalist economy can never reach full
employment due to the existence of liquidity trap.
Though the liquidity trap has been overemphasized by Keynes yet he
demolished the classical conclusion the goal of full employment.
Further, his theory has an important policy implication. A central
bank is incapable of reviving a capitalistic economy during depression
because of liquidity trap. In other words, monetary policy is useless
during depressionary phase of an economy.

----------------------------------------------
Q2. What is Monetary Policy ? Explain it’s
Instruments.
Ans.The monetary policy refers to a regulatory policy whereby the
central bank (RBI in case of India) maintains its control over the supply
of money to achieve the general economic goals. Reserve Bank of India
(RBI) is the sole authority which prints and supplies the currency in the
whole country. Coins are minted by the ministry of Finance but
supplied by the RBI. Main instruments of the monetary policy are: Cash
Reserve Ratio, Statutory Liquidity Ratio, Bank Rate, Repo Rate, Reverse
Repo Rate, and Open Market Operations.
Monetary policy refers to the credit control measures adopted by the
central bank of a country. In case of Indian economy, RBI is the sole
monetary authority which decides the supply of money in the economy.
The Chakravarty committee has emphasized that price stability, growth,
equity, social justice, promoting and nurturing the new monetary and
financial institutions have been important objectives of the monetary
policy in India.
#Instruments of Monetary Policy
The instruments of monetary policy are of two types:
1. Quantitative, general or indirect (CRR, SLR, Open market operations,
bank rate, repo rate, reverse repo rate)
2. Qualitative, selective or direct (change in the margin money, direct
action, moral suasion)
These both methods affect the level of aggregate demand through the
supply of money, cost of money and availability of credit. Of the two
types of instruments, the first category includes bank rate variations,
open market operations and changing reserve requirements (cash
reserve ratio, statutory reserve ratio). They are meant to regulate the
overall level of credit in the economy through commercial banks. The
selective credit controls aim at controlling specific types of credit. They
include changing margin requirements and regulation of consumer
credit.
We discuss them as under:
a. Bank Rate Policy:
The bank rate is the minimum lending rate of the central bank at which
it rediscounts first class bills of exchange and government securities
held by the commercial banks. When the central bank finds that
inflation has been increasing continuously, it raises the bank rate so
borrowing from the central bank becomes costly and commercial banks
borrow less money from it (RBI).
The commercial banks, in reaction, raise their lending rates to the
business community and borrowers who further borrow less from the
commercial banks. There is contraction of credit and prices are checked
from rising further. On the contrary, when prices are depressed, the
central bank lowers the bank rate.
It is cheap to borrow from the central bank on the part of commercial
banks. The latter also lower their lending rates. Businessmen are
encouraged to borrow more. Investment is encouraged and followed by
rise in Output, employment, income and demand and the downward
movement of prices is checked.
b. Open Market Operations:
Open market operations refer to sale and purchase of securities in the
money market by the central bank of the country. When prices start
rising and there is need to control them, the central bank sells
securities. The reserves of commercial banks are reduced and they are
not in a position to lend more to the business community or general
public.
Further investment is discouraged and the rise in prices is checked.
Contrariwise, when recessionary forces start in the economy, the
central bank buys securities. The reserves of commercial banks are
raised so they lend more to business community and general public. It
further raises Investment, output, employment, income and demand in
the economy hence the fall in price is checked.
c. Changes in Reserve Ratios:
Under this method, CRR and SLR are two main deposit ratios, which
reduce or increases the idle cash balance of the commercial banks.
Every bank is required by law to keep a certain percentage of its total
deposits in the form of a reserve fund in its vaults and also a certain
percentage with the central bank.
When prices are rising, the central bank raises the reserve ratio. Banks
are required to keep more with the central bank. Their reserves are
reduced and they lend less. The volume of investment, output and
employment are adversely affected. In the opposite case, when the
reserve ratio is lowered, the reserves of commercial banks are raised.
They lend more and the economic activity is favourably affected.
2. Selective Credit Controls:
Selective credit controls are used to influence specific types of credit
for particular purposes. They usually take the form of changing margin
requirements to control speculative activities within the economy.
When there is brisk speculative activity in the economy or in particular
sectors in certain commodities and prices start rising, the central bank
raises the margin requirement on them.
a. Change in Margin Money:
The result is that the borrowers are given less money in loans against
specified securities. For instance, raising the margin requirement to
70% means that the pledger of securities of the value of Rs 10,000 will
be given 30% of their value, i.e. Rs 3,000 as loan. In case of recession in
a particular sector, the central bank encourages borrowing by lowering
margin requirements.
b. Moral Suasion: Under this method RBI urges to commercial banks to
help in controlling the supply of money in the economy.

----------------------------------------------------------

Q3. What are Objectives of Monetary

Policy ?
Ans. #Objectives of the Monetary Policy
1. Price Stability: Price Stability implies promoting economic
development with considerable emphasis on price stability. The centre
of focus is to facilitate the environment which is favourable to the
architecture that enables the developmental projects to run swiftly
while also maintaining reasonable price stability.
2. Controlled Expansion Of Bank Credit: One of the important
functions of RBI is the controlled expansion of bank credit and money
supply with special attention to seasonal requirement for credit
without affecting the output.
3. Promotion of Fixed Investment: The aim here is to increase the
productivity of investment by restraining non-essential fixed
investment.
4. Restriction of Inventories: Overfilling of stocks and products
becoming outdated due to excess of stock often results is sickness of
the unit. To avoid this problem the central monetary authority carries
out this essential function of restricting the inventories. The main
objective of this policy is to avoid over-stocking and idle money in the
organization
5. Promotion of Exports and Food Procurement Operations: Monetary
policy pays special attention in order to boost exports and facilitate the
trade. It is an independent objective of monetary policy.
6. Desired Distribution of Credit: Monetary authority has control over
the decisions regarding the allocation of credit to priority sector and
small borrowers. This policy decides over the specified percentage of
credit that is to be allocated to priority sector and small borrowers.
7. Equitable Distribution of Credit: The policy of Reserve Bank aims
equitable distribution to all sectors of the economy and all social and
economic class of people
8. To Promote Efficiency: It is another essential aspect where the
central banks pay a lot of attention. It tries to increase the efficiency in
the financial system and tries to incorporate structural changes such as
deregulating interest rates, ease operational constraints in the credit
delivery system, to introduce new money market instruments etc.
9. Reducing the Rigidity: RBI tries to bring about the flexibilities in the
operations which provide a considerable autonomy. It encourages
more competitive environment and diversification. It maintains its
control over financial system whenever and wherever necessary to
maintain the discipline and prudence in operations of the financial
system.

----------------------------------------------------------

Q4. What is Money Supply & what are the

measures of Money Supply in india ?
Ans. #Money Supply
Let us first understand the meaning of money supply or monetary
supply. Simply put, the money supply is the total stock of money that
is in circulation in an economy on any specific day.
This includes all the notes, coins and demand deposits held by the
public on such a day. Such as money demand, money supply is also a
stock variable
One important point to note is that the stock of money kept with the
government, central bank, etc. is not taken into account in money
supply. This money is not in actual circulation in the economy and
hence does not form a part of the monetary supply.
Now there are essentially three main sources of money supply in our
economy. They are the produces of the money and are responsible
for its distribution in the economy. These are
i. The government who produces all the coins and the One Rupee
notes.
ii. The Reserve Bank of India (RBI) which issues all the paper currency.
iii. And commercial banks as they create the credit as per the demand.
deposits
#Measures of Money Supply in India
Now we come to the next logical question. How can we measure the
amount of money in the economy? It certainly isn’t an easy or
straightforward task.
There is no one way to calculate the money supply in our economy.
Instead, the Reserve Bank of India has developed four alternative
measures of money supply in India.
These four alternative measures of money supply are labelled M1,
M2, M3 and M4. The RBI will collect data and calculate and publish
figures of all the four measures. Let us take a look at how they are
calculated.
M1 (Narrow Money)
M1 includes all the currency notes being held by the public on any
given day. It also includes all the demand deposits with all the banks
in the country, both savings as well as current account deposits. It
also includes all the other deposits of the banks kept with the RBI. So
M1 = CC + DD + Other Deposits.
M2
M2, also narrow money, includes all the inclusions of M1 and
additionally also includes the saving deposits of the post office banks.
So M2 = M1 + Savings Deposits of Post Office Savings.
M3 (Broad Money)
M3 consists of all currency notes held by the public, all demand
deposits with the bank, deposits of all the banks with the RBI and the
net Time Deposits of all the banks in the country. So M3 = M1 + time
deposits of banks.
M4
M4 is the widest measure of money supply that the RBI uses. It
includes all the aspects of M3 and also includes the savings of the
post office banks of the country. It is the least liquid measure of all of
them. M4 = M3 + Post office savings.

----------------------------------------------------------

Q5. What is Monetary Policy Committee

(MPC)?
Ans. The Monetary Policy Committee (MPC) is the body of the
RBI, headed by the Governor, responsible for taking the
important monetary policy decision about setting the repo rate.
Repo rate is ‘the policy instrument’ in monetary policy that helps
to realize the set inflation target by the RBI (at present 4%).
The MPC replaces the previous arrangement of Technical
Advisory Committee.
The MPC was setup after a Memorandum of Understanding
between the government and the RBI about the conduct of the
new inflation targeting monetary policy framework in February
2015. First meeting of the MPC was held on October 4, 2016 after
the Government made amendment of the RBI Act in June 27,
2016. Committee’s meeting also marked the beginning of full-
fledged implementation of the new inflation targeting monetary
policy framework.
#Structure of the MPC
The Monetary Policy Committee (MPC) is formed under the RBI
with six members. Three of the members are from the RBI while
the other three members are appointed by the government.
Members from the RBI are the Governor who is the chairman of
the MPC, a Deputy Governor and one officer of the RBI. The
government members are appointed by the Centre on the
recommendations of a search-cum-selection committee which is
to be headed by the Cabinet Secretary.
The Committee is to meet at least four times a year and make
public its decisions following each meeting. The quorum for the
meeting of the MPC is four members. There will be no
reappointment of the committee.
Under MPC, the governor has a casting vote and doesn’t enjoy
veto power (there was veto power for him under TAC). Decisions
will be taken on the basis of majority vote.
The main responsibility of the MPC is to administer the inflation
targeting monetary policy regime through determining the policy
rate or repo rate to contain inflation.
#Function of the MPC
The main responsibility of the MPC will be to keep the inflation
targets set by the RBI. The MPC decides the changes to be made
to the policy rate (repo rate) to contain inflation within the target
(based on CPI) level set under India’s inflation targeting regime.
Members of the MPC can suggest reasons for their support or
opposition for a policy rate change. This will be published in the
minutes of the MPC and the minutes should be published after 14
days of MPC meeting. The minutes should contain the reasons for
each member proposing or opposing the monetary policy decision
taken by the NPC.
In case the inflation target is failed to achieve (2% higher or lower
than the set target of 4% for continuous three quarters), the RBI
has to give an explanation to the government about the reasons,
the remedial actions and the estimated time for realizing the
target. Another responsibility for the RBI is to publish a Monetary
Policy Report every six months, elaborating inflation forecasts
and inflation sources for the next six to eighteen months.
#Present Members of the MPC
As mentioned, there are six members in the MPC. Three each
from the RBI and the government.
Members from the RBI are: Governor Shaktikanta Das, Michael
Patra (officer recommended by the Central Board) and Viral
Acharya (Deputy Governor in charge of Monetary Policy
Department).
Government representatives are Chetan Ghate, Professor at
Indian Statistical Institute, Pami Dua, Director at Delhi School of
Economics and Ravindra Dholakia, Professor of IIM Ahmedabad.
The MPC members are appointed for a period of four years.