 In the last class we saw the distinction between the real and nominal interest rate because of the inflation and the other macroeconomic variable in which a similar distinction can also arise is the exchange rate which means there is a nominal and a real exchange rate because of inflation and I will try to explain this using an example nominal versus real exchange rate. Now a country's exchange rate strength as I told before it is relative to other currencies and for the purpose of our example let us take two countries India and the US and try to understand the nominal and the real exchange rate between the Indian rupee and the American dollar and what happens when the currency depreciates what happens when a currency appreciates I told you before that if the currency depreciates it is good news for exporters bad news for importers and vice versa but is the same argument valid under circumstances where there is also an inflation that is prevailing now let us understand this by giving you an example now let us say at the current rate the rupee versus dollar is rupees 100 to 1 US dollar right and for the purpose of example let me just say I am going to talk about buying a TV from India or US now the cost of TV in India let us say is 900 rupees or in this exchange rate terms it is US dollar 9 and cost of TV in USA is US dollar 10 right assuming there are no transaction cost these are all landed cost suppose I am in the US what will I do the cost of getting a TV from India is $9 while getting it from the US is $10 so as an American I will import or export as an American it makes sense for me to import because it is just going to cost me $9 if I am getting a TV from India and at this stage the TV manufacturers in India there is more incentive to export it there will be more demand for exports because more Americans let us assume there will be more Americans who want to buy TVs from India let us say this is the base case scenario now what happens if the dollar depreciates dollar depreciates what will happen let us say the depreciation of the dollar has resulted in this situation where the rupee versus dollar is now rupees 80 to rupee rupees 80 to 1 US dollar this is what I meant by dollar getting depreciated or rupee is been appreciated rupee gets appreciated now let us see what happens to the TV cost the TV cost is TV cost in India is the same 900 but for an American it is going to be 11.5 US dollar because he has to shell out more dollars for the same 900 rupees and the TV cost in USA is it was dollar 10 right the dollar has depreciated the rupee has appreciated otherwise this is the change in the cost structure now what will Indians do now the Indians need to spend only rupees 800 to get a TV from US because the cost of a US dollar TV is only 10 for which because my rupee has appreciated this is only 800 so it makes more sense for me to import a TV from the US because the rupee has appreciated or from an American perspective because the American dollar has depreciated USD has depreciated exports increase so from a base case scenario we understood that if a currency depreciates then it is good news for exporters and likewise it is good news for importers because now as I said before it makes more sense for me to import a TV from the US because the cost of purchasing a TV is the outflow of purchasing a TV is 800 in the present context than rupees 900 which is the cost of making a TV domestically so I would rather be importing than buying it from here now a small twist let's say in addition to the currency getting depreciated there is also inflation in the US and let's assume that there is no inflation in India so you know that the dollar depreciation is 20% from 100 to 1 dollar it is 80 to 80 rupees to 1 dollar let's say the inflation in the US is 30% and I said there is no inflation in India so under these circumstances what will be the price of US TV will be dollars 13 because it used to cost me 10 dollars before inflation of 30% which means the price of US TV is 13 dollars which is equal to rupees 1040 at the current exchange rate of 80 to 1 price of Indian TV rupees 900 and at the current price current exchange rate US dollars 11.25 nothing has changed the Indian rupee has appreciated or the US dollar has depreciated but in addition to the depreciation there is also an inflation of 30% what will Indians and Americans do now because when there was no inflation it made more sense for Indians to import the TV because of the relative the incremental strength that the local currency has got but now in the presence of inflation of 30% will an Indian import a TV from the US because now it is going to cost me 1040 whereas an Indian TV is going to cost 900 so blatantly it is not safe to assume that always an exchange rate depreciation or appreciation is beneficial to an exporter or importer respectively we also need to understand how inflation will also cost a change in the behavior because what we are interested now is the real exchange rate and not the nominal exchange rate just as the real and nominal interest rate now the inflation has the cost the inflation has resulted in the change in behavior now because it is the real exchange rate that actually counts and not the nominal exchange rate as a result of which we see now even when there is a depreciation in the US dollar or an appreciation in the Indian rupee the incentive to import is entirely missing still I would prefer a domestic purchase than importing it because the inflation has eroded the benefit of the rupee appreciation so the money growth inflation and exchange rates let us say as I said before the increase in money supply will cost currency to depreciate so the I am talking about the nominal rate so the nominal exchange rate will depreciate increase in money supply will cost inflation to rise in this case we found that if the inflation rises the real exchange rate may appreciate the real rate may also depreciate if the nominal exchange rate depreciates actually the extent of inflation decides the balancing factor just as we saw the same type of behavior in the interest rate if the inflate inflation rate differential in this case if it is less in the nominal rate of depreciation of the exchange rate then the real exchange rate will depreciate so it so ultimately it boils down to the extent to which there is a change in inflation so the inflation rate differential the extent to which there is inflation will influence the behavior of the real exchange rate and they and it is the real exchange rate that actually counts because inflation may at times erode the benefits of a local currency appreciation so this is one thing that we need to understand just as inflation has its effect on interest rate it also has an effect on exchange rate so what we have seen so far is the understanding of money as a fuel for economic growth and how money influences the interest rate exchange rate and inflation and how interest rate and exchange rate the real and nominal rate of interest rate and exchange rate can be distinctly understood based on the inflationary trends and how when the supply of money increases the interest rate falls the exchange rate depreciates and the price level increases and vice versa so we need to understand this very key relationship between interest rates exchange rate and inflation with money so the essence of the discussion as we began was with money and how it affects three key macroeconomic variables now where does this money come from let us try to understand a little bit of money and banking in most countries it is only the governments that actually can issue the currency it is the role of government that is very important when it comes to issue of currency which is therefore which is actually the legal tender and therefore required by law that since it is a legal tender it is the government that actually has a control over the money supply and invariably it is through the central banks in India it is the reserve bank of India in the US it is the federal reserve likewise every country will have its own central bank and it is central bank that prints and issues the money and it is the central bank that actually frames the monetary policies while the fiscal policies done at the government level and both fiscal and the monetary policy are two sides of the same coin that determines the extent to which money is in circulation so we need to understand that the central banks play a very key role not only because they are the ones who are printing money they are also the ones who decide the extent to which money can be circulated in the market and is not only the central banks but also the commercial banks also play a very crucial role in ensuring that there is circulation of money because money supply is not just the currency that we have in hand which is usually called the M0 money it is also the money that is available in the checking accounts the bank deposits in various mutual funds and all other denoted as M1 M2 M3 so it is this entire M0 plus M1 M2 and so on that constitutes the supply of money so when it is not only the central bank but also other commercial banks because the role of a commercial bank is to take deposits from those who save money and lend it out as a result of which it expands the monetary base which is more than the actual currency in circulation imagine for example I have 100 rupees in my hand and I go and invest this 100 rupees in a bank now the 100 rupees that I had in my hand is now is in a bank it is just changed from one place to gone from one place to another place now the result of this transaction has not expanded the monetary base at all because what was in my hand is now with the bank now how does the bank then create an expansion in the monetary base now the role of the bank now is to lend this deposit to somebody who wants to borrow money from the bank now this cash that I have given to the bank is what the bank is going to use to lend to a borrower the extent to which a bank can lend to a borrower is again limited by the central bank I will explain about that later but let us say that there is a ruling that all banks have to have a reserve of 10% and that is the reserve requirement which means now the 100 that I have received I can lend a 90 rupees to somebody who wants to borrow money so I lend 90 rupees to somebody who wants to borrow and that person who borrows the money uses that 90 rupees and now that has left the bank in it is in circulation and he uses it to buy certain types of assets and results in some business income which again he puts it in a bank and from that deposit another bank gives out money so now the circulation of money has increased the monetary base has increased which means in effect the money has multiplied because we have given velocity to the money the money has actually grown not not just we did not print extra money it was the same 100 rupees that just multiplied across if the we need to measure to what extent this money gets multiplied and that we measure from what we call as the money multiplier which is which is 1 divided by the proportion of leakage in this case the proportion of leakage is the measure of the reserve requirement and in this case as I mentioned before it is 10% because I could I have to hold 10% of the deposits before I give it to others so if it is 10% it means the 100 rupees that I put in 1 by 10% is 10 money multiplier is 10 which means the 100 rupees would have resulted in rupees 1000 due to repeated lending and depositing so this is the money multiplier effect and based on how much money that needs to be circulated central banks usually change the reserve requirement about which I will talk later now this will happen as long as there are deposits it is loaned it is the money is used more deposits and this will function as long smoothly as long as there is no bank panic or run on the bank what is run on the bank assume one day all of those who are deposited money demand that the bank return their deposits and the bank cannot say no because it is an obligation of the bank to return the depositors money now at it is very unlikely to happen but assume that every depositor wants it wants their money back on the same day and this is what we call a run on the bank and it was very common in the olden days and then came the federal deposit insurance scheme after which you know bank runs where bank run on the banks or bank panics were limited but anyway that is a different subject matter for discussion you just need to understand that the circulation of money is not measured by the actual heart cash that you have in hand or in the checking account in your bank but also measured by way of the M1 and M2 equivalence which is because that the bank is lending out money to other borrowers who in turn use it for other productive purposes and again gets back into the banking system as deposits and the extent to which this circulation happens depends on the reserve requirement that each bank has to meet and this is the circulation of money it comes it gets printed by the reserve bank and then in the presence of commercial banks it gets circulated in various forms and this is where money comes and gets circulated now it is very important for us hence to understand the role of the central bank in my view the central bank is the spine of the economy because they are the ones who actually print the money as a result of which you have any and they are the ones who supply the money but more than that they are the ones who fix the interest rate and it is that interest rate which is the primary instrument that controls the flow of money if the interest rate is more than it is it gives me more incentive to put my money in a bank account and save it than to spend it if the interest rate is very less than I would be better off to spend my money than put it in the bank and based on what is required interest rates will be changed by the central bank. I will just give you a small example for you to understand this better imagine you are driving a car and you press the accelerator and the car increases its speed of travel and you look at the speedometer you think that the speedometer from 60 to 80 to 100 it is it is increased and it is the pressing of the accelerator that has cost the car to move faster no doubt it has cost the car to move faster but what actually happens inside is the rate at which because you press the accelerated hard there is more fuel the rate at which the fuel gets discharged into the engine assembly is the one that actually makes the car move faster. So the reserve bank of India actually determines what extent of money should be let out in the market by controlling the interest rate just as in the car the extent to which petrol or diesel reaches the engine is controlled by the accelerator pedal press it hard more diesel interest rates are less more supply of money. So this is how the reserve bank operates let us say if the GDP growth is very slow as massive unemployment. So the bank will immediately reduce the interest rates to stimulate the economy because at reduced interest rate then there is incentive to borrow and invest as a result of which there will be more business and as reduced interest rate as a consumer I would feel that I am not incentive wise enough and hence it is better for me to consume spend then put my money in the bank conversely if inflation is too high due to overheating then the central bank will increase the interest rates likewise during the currency depreciation interest rates will be increased if the currency is depreciating a lot. Now the role of the central bank is very very critical because it has to be mindful of various objectives maintain a sustainable GDP growth the growth of GDP has to be sustainable unemployment levels need to be low there should be a manageable inflation level and a stable exchange rate. But the reserve bank of India or for that matter any central bank does not have a magic wand that will make sure that all of this can happen it is very difficult to achieve all of this. But all central banks are conscious that inflation must be at controllable levels and that has been the dominant policy objective of all central banks to ensure that the inflation is at manageable levels. Now how do central banks do that these are referred to as the monetary policy tools the decisions taken by the central banks are the monetary policy making decisions and what are the different monetary policy tools that are available to have a check on the monetary base on the supply of money the first is the discount rate that is the interest rate. Now if the central bank decides to increase the discount rate or the interest rate there will be less commercial bank borrowings because interest rate as I said before is the cost of money so if I increase the cost of money it is difficult to borrow money as a result of which the monetary base is contracted from another perspective more interest rates instead of having money in my hand I put it in the bank because there is more incentive to save it is in the bank it is in the bank and also the cost of borrowing that money from the bank is also high because interest rate are high as a result of which there is contraction in the money supply. Now if the reserve bank thinks that we need to expand the monetary base I will have to let loose the availability of money what does it do it decreases the interest rate now if it decreases the interest rate as a borrower I would like to borrow more money from the commercial banks because the interest rate has reduced now there is increase in the monetary base as a consumer as I said before I find no incentive in putting my money in the bank as a result of which I start spending money what do I mean by spending money I am letting loose money into the market as a result of which the monetary base widens and there is increase in money supply. So interest rate is one monetary tool that the central bank use to either increase or decrease the supply of money the next monetary tool is the reserve requirement reserve requirement as I said before is it is a mandate from the central bank that says all commercial banks from the deposits that are available should have to maintain certain reserve deposits now if I increase the reserve requirement it means I am increasing the leakage now if I increase the reserve requirement I increase the leakage one by leakage will be the money multiplier as I explained before so it decreases the money multiplier if instead of 10% I say it is 20% then that 100 that I deposit in the bank instead of creating 1000 in circulation would have reduced it to 500 because my reserve requirement is no longer 10% it is 20% on the contrary if I reduce the reserve requirement which means there is decreased leakage if I reduce it to 5% let us say then one by 5% the money multiplier increases to 220 as a result of which the 100 that was initially in the bank results in 2000 as the quantity of money in circulation because of the increased money multiplier as a result of which the monetary base is widened so the second monetary tool is the reserve requirement which the reserve bank fixes again it either increases or decreases the reserve requirement if it wants to reduce the money supply or increase the money supply respectively. The third monetary tool that the reserve bank uses is the open market operation open market operation either by purchasing or selling usually it is called OM purchase or OM sales now let us for example take open market purchases it means the reserve bank will buy government bonds or assets from private financial institutions if the reserve bank buys government bonds it means it is injecting money into the system it is making the system more liquid it is injecting liquidity into the system so a reserve bank buys bonds so if I buy bond I buy it for a price so I pay money so it issues money and widens the monetary base as a result of which there is more money supply if the reserve bank sells the same bonds which means the bonds that the reserve bank had or the assets from other institutions that the reserve bank held it sells it so when it sells it has to get back the money it sucks out sucks in money from the system sucks out money from the system as a result of which the monetary base contracts the supply of money is reduced to summarize three things reserve requirement the interest rate and the open market transaction these are the three policy tools that the reserve bank uses to control the supply of money and money relationship is very very essential for us to understand the macroeconomic behavior as I said before please have this in your mind embedded increase in money supply will cause interest rates to fall a currency to depreciate an inflation and decrease in money supply the opposite and the price of money relative to time is interest rate relative to the currency it is exchange rate and relative to aggregate price level is the inflation because I said it is price because each of this has a cost for money now on one hand you had the monetary policy which was more the prerogative of the reserve bank or the central bank in general another macroeconomic tool that the government has at its disposal is the fiscal policy here it relies heavily on how the government wants to spend its money how it receives money through taxation so a government is the one that actually frames the fiscal policy now let us for example take a case where the economy is so bad and one of the classic examples that economists usually use to explain this is the great depression so the 30s in the United States there was a gloom in the economic environment a great depression as a result of which the government had to come forward and instill some confidence as a result of which the government decided to spend a lot of money and this is the kinesian economics named after the great economist kines so kinesian approach is making the government to spend first during times of tough economy it is the government that takes the first initiative to send the good signals to businesses and other consumers it is not by increasing tax that the government wants to increase its revenue it is by spending more and where do I get it this is called the deficit financing by spending more I will first send good signals to the consumer or the businesses because what happens when the government spends when the government starts spending let us say I am spending 100 rupees I am the government I am spending 100 rupees the confidence level of an average consumer will increase he sees some economic activity and he also starts spending as a result of which conception increases so when conception increases there is good news to businesses because they see somebody there is a demand for its goods and services and there is incentive to invest so investment increases as a result of which the national output which is the GDP because remember GDP is government spending consumer spending and investment all three put together so let us say I have the first level the government decides to spend 100 rupees so government spends 100 rupees and an average consumer would and this has resulted in the national income of 100 rupees just look at this presentation so the imagine that there is some change in consumption that the household let us say an average household has 20% savings and then consumes the remaining 80% which means he spends the remaining 80% so if the government initiated an additional 100 rupees spend then the household will spend because of the additional incremental income of 100 the household will spend another 80 rupees now with this additional 80 which gets injected into the economy creates another national another income of 80 and again the multiplier effect is I spend 80% of that 80 which is 64 again 80% of 64 this keeps on going so the multiplier effect is I began with 100 spent by the government which has created in this multiplier effect as a result of which we have added 500 to the national income the national output now this is because of two things one the multiplier effect has increased the circulation of money in the economy the velocity of money has increased and as a result of which there is an increase in GDP now this resultant increase in GDP has to be matched by either an increase in price of the commodities the goods and services or the quantity that has been produced now whether it has come from increase in price or the quantity depends on what time has this kinesian stimulus or the government spending has been initiated so let us say the economy is very tough very high unemployment so that is deficit financing so the government has to increase through increased quantity because at unemployment levels you cannot increase GDP by increase in prices we have to make the assets more productive and increase in GDP is because of increase in quantity and this is called recovery economics this is the real increase in the quantity let us say the economy is already operating at full capacity then the increase in GDP is not by increase in quantity because already it is in full capacity it has to be increased by price increase so it is more inflationary so this is an overheated economy so we need to have a balance and that is why at normal times a budget deficit increases demand by ensuring that there is an increase in quantity output and to a certain extent even inflation and that is where we need to strike a balance so what we have done in this class is we have understood the importance of money being the fundamental economic unit and how it relates itself to interest rates inflation and exchange rate and the role of central banks in controlling the supply of money by using monetary tools like interest rate reserve requirement and open market purchases and apart from the monetary policy the government also through its fiscal policy measures will try to in change the economic scene by first sending the good signal that the government volunteers first by spending on its own by creating a deficit which is financed I will explain this later and then send the good signal that since the government is spending there is recovery possible and then there is consumerism there is also investment as a result of which the GDP also grows so we have understood money we have understood the three macroeconomic variables we have understood the role of central bank and the role of the government also to bring about change in economic activity now the next class I will just try to explain what this fiscal policy is and how that the budget which is the government's statement of expenditure and income how we need to interpret the budget that the government comes out every year and a few key terminologies that you need to understand and this we will see it in next class thank you