Income Determination Model

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Income Determination Model

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Title: Income Determination Model

1
Income Determination Model

USAID Reform Project
Dr. Brijesh C. Purohit

2
Fiscal Policy
It comprises of deliberate use of budgets (of
central and state govts.)
To achieve macroeconomic objectives, in
particular stabilization
And growth
Fiscal Policy is a term reserved for the policy
government has in balancing Government Spending
with Tax Revenues. (Net) Taxes (T) Leakage
(Withdrawal) from the CFoI Government Spending
(G) Injection to CFoI
3

Is the Government spending more than it raises in
taxes (G gt T)? If so, then the Government is
running a budget deficit, and the effect will be
to expand or reflate the economy - increase the
circular flow of income, and increase GDP (at
least in nominal or current terms)
Or, is the Budget in surplus (T gt G)? Then the
effect of Fiscal Policy is to deflate or contract
the CFoI, and reduce national income (nominal
national income will tend to fall).

Taxes remove income from the circular flow of
income - that is,
act as a leakage from the circular flow (like
imports and savings),
and other things being equal, will reduce
incomes through
the multiplier process, and deflate the economy.
Government Expenditure, on the other hand, is an
injection
into the circular flow and will tend to reflate
the economy.
There is often a conflict between Fiscal Policy -
designed to manage economic cycles - and the
other reasons and objectives of Government
spending and taxation.

an increase in the budget deficit will increase
the money supply,
which will tend to increase current or nominal
GDP, but may also
give rise to inflation.
However, a more prudent government would borrow
the difference
between G and T
In order to persuade the public to lend this
requirement to the government
(through buying Government Bonds and Stocks), the
government must
offer some reward - the rate of interest paid on
the loans
(government bonds) - the more it wants to
borrow, the higher will
have to be the rewards offered - the higher the
interest rates will
have to be.

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So expansionary Fiscal Policy (G gt T) tends to
lead to higher interest rates, which in turn tend
to reduce private investments and private
consumption, and thus reduce the expansionary
effect of the fiscal policy, and increasing the
tendency for government spending to crowd out
private spending.
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What do increased interest rates do? - deflate
the economy
(lowering growth rates and tending to increase
unemployment) by
encouraging saving (reducing consumption) and
discouraging
investment spending
increasing borrowing costs (making businesses
more difficult to
manage), and discouraging borrowing both for
consumption
(consumer durables like cars, furniture, white
goods, etc. and
especially houses and house improvements) and for
businesses
tend to hurt borrowers (often the poorer) and
help net savers
(often the better-off)
tends to lead to exchange rate appreciation
(encouraging
capital to flow into the country and discouraging
capital exports
or outflows)

How are interest rates determined?
And what effects will Fiscal Policy (changes in G
and T) have on
interest rates?
The answer is that interest rates are determined
in the Money Market
which is how Monetary Policy (control of money
supply
or interest rates) works.

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The IS curve shows the equilibrium relationships
between the rate of interest (established in the
money market) with the level of national income,
assuming that the remaining injections and
withdrawals (G, T, X and IM) stay as before. If
these other (exogenous) injections and
withdrawals change, then the IS curve itself
will shift.
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Thus, if government spending (G) is increased
(and/or taxes (T) are reduced) - an expansionary
Fiscal Policy - and the IS curve will shift to
the right - because an expansionary fiscal policy
will increase levels of national income for each
and all levels of savings and investment, each
and all levels of the interest rate.
14
The IS Curve slopes downwards because lower
interest rates (r down) encourages investment
and consumption and thus increases national
income (Y). It thus represents the combinations
of r and Y which are consistent with equilibrium
in the goods and services markets (the circular
flow of income). Note this. The CFoI is, in
effect, a description of equilibrium in the
markets for goods and services (and factors of
production) -equilibrium in the 'real' (non
money) part of the economy.
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The relationship between income and the interest
rate through the money market is represented as
the L-M curve the Liquidity preference (demand
for money) and Money supply relationship The
LM curve shows all those combinations of Y and r
which are consistent with an equilibrium in the
Money Market (given a fixed money supply and a
constant velocity of circulation)
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The LM curve will shift to the right if the money
supply is increased, or if interest rates are
reduced, in the money market through monetary
policy. An expansionary monetary policy shifts
the LM curve to the right. A contractionary
monetary policy shifts the LM curve to the left.
Notice, too, the effect of inflation (an
increase in the price level (P)) on this
relationship. If the price level increases in the
economy, then the stock of money in the economy
cannot finance the same level of real
transactions as before. We will need more money
for any given level of Y at higher price levels
than at low price levels. With a fixed supply
of money, the greater demand for money at a
higher price level means a higher rate of
interest at a higher price level for any given
Y. So inflation shifts the LM curve to the
left.
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IS and LM interactions The IS curve captures the
essential relationship between the rate of
interest and income in the markets for goods and
services (the circular flow of income). The LM
curve captures the essential relationship
between the rate of interest and income in the
money market. For the two markets to be
consistent with each other - the same rate of
interest ruling in both the goods and services
market and in the money market - there can only
be one equilibrium level of national income (Y),
shown by the intersection of the IS curve with
the LM curve.
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Links between Monetary and Fiscal Policy
We now have the effects of
Fiscal Policy captured in the IS curve (where an
expansionary
fiscal policy shifts the IS curve to the right,
and vice versa)
Monetary Policy captured in the LM curve (where
an
expansionary Monetary policy shifts the LM curve
to the right,
and vice versa)

Expansionary Fiscal Policy - shifts IS right
will tend to
increase Y and also increase the interest rate
(r)
Contractionary Fiscal Policy - shifts IS left
will tend to
reduce both Y and r
Expansionary Monetary Policy - shifts LM right -
reduces r
and increases Y
Contractionary Monetary Policy - shifts LM left
- increases r and reduces Y

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Money defined as a generally acceptable means of
payment or of settling debt. It has three main
functions a) medium of exchange between buyers
and sellers b) unit of account ( for accounts,
debt, financial assets etc.) c) store of value or
purchasing power enabling income earners to set
aside a part of their income to yield future
consumption Medium of Exchange Currency and
demand deposits (readily drawn) with the
commercial banks Store of value Time deposits
of Commercial banks (as if to store its value)
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Four measures of money supply M1 Currency
(currency notes and coins) with the public
demand deposits with banks (commercial and
cooperatives) other deposits with
RBI M2 M1 Post office savings bank
deposits M3 M1 time deposits with banks
(commercial and cooperatives) M4 M3 total
deposits with the post office saving
organisation Degree of Liquidity and
comprehensiveness
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Over time, a large and continuous rise in money
supply Trends in M1 During 50s.50 .60stwo
times .70sthree times ..80sfour
times ..90s about three times Trends in M3
During 70s..five times ..80s.four
times 90.three times
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Factors affecting Money supply Deficit
financing bank credit Foreign exchange
reserves if FE receipts exceed payment in FE FE
is surrendered to bank in return for Rs. FE falls
short of payment in FE money is paid to banks to
get FE to meet obligation
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Monetary policy also known as Money and Credit
Policy It concerns itself with the supply of
money as also credit to economy Till 1998-99 It
was announced twice in a year Oct.for
Oct..March.to coincide with busy
season Aprilfor April to Septto coincide with
lean season of agri. With decline in agri. And
rise in industrial credit since 1999-2000 in
April RBI makes an annual policy statement and a
review in Oc t
28
Monetary policy provides a) an overview of
economy b) specifies measures that RBI intends
to take to influence such key factors likemoney
supply.interest rates.inflation c)lays down
norms for financial insts. Like banks,
fin.cos.etc. relating to CRR, capital adequacy
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Since 1951 and till 1990s. Two sets of
objectives pursued a)controlled expansion of
money b)sectoral deployment of funds Done
keeping in mind plan priorities Special
attention Core industries (coal, iron, steel and
engg.) foodgrains (rice, wheat etc.) priority
sectors ( agri., SSI) weaker sections of
population
30

In general, the interaction between monetary and
fiscal policy occurs
To control inflationary or deflationary impact of
fiscal policy
For instance, a substantial multi-year rise in
the deficit need not cause an increase in
inflation was demonstrated in USA
Between 1979-85budget deficit rose from 2.7 of
GDP to 5.1 of GDPnational debt rose from 26
of GDP to 36 of GDP

However, GDP price inflation fell from 8.2 to
3.2 This due to a tough anti-inflationary
monetary policy pursued by the Federal Reserve.
31
In India, for instance, In 90s growth of
economy remain primary aim control of inflation
urgent concern (91.double digit.17) 8th
(92-97)aimed at achieving trend rate of
inflation 5 MP of 90s favoredprocess of
stabilization and structural adjustment
initiated in 91
32

Various measures used by RBI include
Rate of interest (or price of money)
Quantity or supply of money
Access to or demand for money
One imp. Instrument is bank rate or discount
rate..
Rate at which RBI lends to the banking system
Through it short term interest
long term rates
level of economic activity
international capital inflows
Second imp. Instrument is sale or purchase of
govt. securities
(by sale of securities banks resources reduce
and vice versa

33
Third imp. Instrument Cash Reserve Ratio Banks
Cash Holding/Total Deposit Liabilities Fourth
Imp. Instrument is Statutory Liquidity
Ratio(SLR) RBI imposes an obligation on banks to
buy govt. Securirties (of Low interest rates)(25
at present) To achieve the objective of sectoral
deployment of credit.. Direct (Quantity) Reserve
ratios Quantitative controls on RBI lending to
banks and commercial sector Quantitative credit
controls Indirect Instruments administrative
setting of various interest rates
e.g. RBI lending
commercial bank lending
deposits
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In 1960s.. Emphasis was on indirect measures with
little variation in reserve ratios In1970sEmpha
sis shifted to direct approaches and persisted
since then Shift from indirect to direct
measures was prevalent more due to rising
deficit or inflation Monetary instrument in
India, both direct and indirect, operate Through
administrative controls or fiat The crisis like
droughts, oil crisis in 1966,1969, 1973 were
dealt with effectively by cutting down domestic
credit
35

One of the main problem area in the monetary
policy lie with the
Exogenous element in reserve money.
Reserve money comprise of
Increased RBI lending to govt. (relates to fiscal
deficit)
Increased RBI lending to commercial banks
Growth of net foreign exchange of RBI
RBI can control only b) by prescribing high SLR
Monetary control has been reasonably successful
inspite of rising
Fiscal deficit because of aggressive use of the
reserve ratios
In a sense reserve ratios have not been genuinely
monetary policy
Instrument but rather acted as fiscal policy
instrument

36
Major developments in 1980s Increasing
deficit to control money supply .SLR..up to
38.5 by 1990 ..CRR up to 15 gtgtgtnet RBI
credit to GOI was given as a separate estimate
since 1987 RBI attempted estimates of demand for
money relationship between reserve money and
money supply real income increases income
elasticity of demand for money acceptable
increase in price level
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In 1980.inflation7.1.aimed to 5 In second
half of 1980s steps towards expanding and
activating money market in short
term securities e.g. treasury bills of 182
days discount and finance house of India was set
up instruments like certificates of deposits,
commercial papers, participation certificates
etc. These acted as transmission channel for MP
38