 When the central bank wants to increase the money supply in the

economy, it buys government bonds from the public and infuses money
in the economy and vice versa.
 A fractional-reserve banking system creates money, but it doesn’t create
wealth.
 Bank loans give borrowers some new money and an equal amount of
new debt.
 If the central bank adds a dollar to the economy and the dollar is held
as currency, the money supply increases by one dollar.
 But if the dollar is deposited in a bank, assuming a fractional reserve
banking system, the money supply goes up by more than one dollar.
 Total money supply = (1/rr) × $1,000 where rr = ratio of reserves to
deposits

 Monetary base, B = C + R controlled by the central bank

 Reserve-deposit ratio, rr = R/D depends on regulations and bank
policies (policy variable)
 Currency-deposit ratio, cr = C/D depends on households’ preferences
(behavioral variable)

 Money Supply(C+D) is proportional to the Monetary Base(C+R)

 Lower the reserve deposit ratio, bigger is the money multiplier
 Lower the C-D (cr) ratio, higher is the money multiplier

 Leverage: the use of borrowed money to supplement existing

funds for purposes of investment
 Leverage ratio = assets/capital
= $(200 + 500 + 300)/$50 = 20
A leverage ratio of 20 means that for every dollar of capital that bank
owners have contributed, the bank has 20 dollars of assets. Of the 20
dollars of assets, 19 dollars are financed with borrowed money, either by
accepting deposits or issuing debts.
Being highly leveraged makes banks vulnerable.Because banks
are highly leveraged, a small loss of assets could wipe out bank
equity.

 Capital requirement:
o minimum amount of capital mandated by regulators
o intended to ensure that banks will be able to pay off depositors
o higher for banks that hold more risky assets
 Demand for Money
 Transaction demand
 Precautionary demand
  Speculative demand or Asset demand

 Quantity theory of money-Transaction Demand

o Income
o Real GDP
 M x V ≡ P x T [This is basically an identity]
Factor Effect on Money Effect on
Demand Velocity
Introduction of ATMs Decreases Increases
Credit cards/mobile Decreases Increases
payments
Requirement to hold Increases Decreases
more cash

 Y is the real GDP; P is the GDP deflator; and PY is the nominal GDP.
MxV≡PxY
 SLIDE 9
A simple idea about money demand is that people hold money to carry out transactions, and the
amount of money they want to hold is roughly proportional to the number of transactions they
want to perform.
If the number of transactions is, in turn, proportional to income, then the amount of money that
people want to hold is proportional to income.
Also, we might expect that the amount of money that people want to hold will be proportional to
the price of a transaction; if the cost of the average transaction doubles, then we would expect
that the demand for money would double. This leads to a money demand function of the form
Md= kPY.
If the supply of money equals the demand for money, then we have
M/P = kY,
which is equivalent to the quantity equation with V = 1/k.

Demand for Money: Liquidity Preference

An interest-bearing asset pays an interest rate of i; money pays zero interest. The greater the
difference between the return on these two assets, the more individuals want to economize on
their holdings of cash.
Thus, the demand for money depends negatively on the nominal interest rate.

L(r) is the quantity of money demanded depending on the interest rate

We have seen that speculative demands for money vary negatively with the interest rate.
Transaction demand and precautionary demand for money varies positively with income
Putting those three sources of demand together, we can draw a demand curve for money to show
how the interest rate affects the total quantity of money people hold.
The demand curve for money shows the quantity of money demanded at each interest rate, all
other things unchanged.
Other Determinants of the Demand for Money
1. The Price Level
2. Expectations
3. Transfer Costs
4. Preferences
5. Financial Innovation

The IS curve shows the locus of (r, Y) for which the goods market is in equilibrium
 The LM curve shows the locus of (r, Y) for which the demand and supply of money are
equal.
The IS-LM model is a very useful tool for understanding the effect of economic shocks and
use of fiscal and monetary policy tools in the economy

Money supply is an exogenous variable

Banks respond to deposits and withdrawals and can change rates of interest based on
these factors
Therefore, rate of interest is an endogenous variable
 SLIDE 10
Planned expenditure is the amount households, firms and he government would like to spend
on goods and services (WHAT PEOPLE BUY-DEMAND)
Actual expenditure is the amount households, firms and the government spend on goods and
services, and it equals the economy’s GDP (WHAT FIRMS PRODUCE-SUPPLY)
The actual expenditure and the planned expenditure may vary. If the actual expenditure
is higher than the planned expenditure, then firms are accumulating inventories. In other words,
if the firms sell less than their planned sell, then their inventories rise.
If the actual expenditure is lower the planned expenditure, then firms are selling more
than they planned. So this will lead to an unplanned drawdown of their inventories

PE = C + I + G => planned expenditure

Y = real GDP = actual expenditure
Difference between actual and planned expenditure = unplanned inventory
investment
PE = C (Y -T) + I (r) + G.
Planned expenditure is thus an increasing function of income.
We will assume for the time being that the planned Investment is an exogenous variable

In equilibrium, planned expenditure equals actual expenditure, which, of course,

equals GDP:
PE = Y.
Actual expenditure exceeds planned expenditure when firms accumulate inventory.
In this circumstance, firms would cut back on their production, lessening their
inventory accumulation and so decreasing actual expenditure.
definition: the increase in income resulting from a 1 unit increase in G.
In this model, the govt purchases multiplier equals

If MPC =O.8, 1 unit increase in G cause 5 units increase in Y

An increase in Money Supply will shift the LM curve to the right(outwards)
 Liquidity trap: A situation where interests rates have fallen to zero, and
therefore, it is possible that (conventional) monetary policy is no longer
effective. At times referred to as the “zero lower bound”
Feature Forward Guidance Quantitative Easing
Type Communication strategy Balance sheet tool
Involves buying assets? ❌ No ✅ Yes (bonds, securities)
Goal Shape future Inject liquidity, lower
expectations long-term rates
Cost to central bank Minimal Significant (expands
balance sheet)
Risk Less risky Risk of inflation or asset
bubbles

Quantitative Easing
Action by Central Result on Market
Bank
Buys bonds (QE) ↑ Demand for bonds
↑ Bond Prices
 ↓ Yields (interest rates)
↓ Cost of borrowing for companies
↑ Company investment and economic growth

The sacrifice ratio in economics measures the impact of curbing inflation on an

economy’s total production and output. It quantifies the percentage cost of actual
production lost for every one percent decrease in inflation. Essentially, it reflects the
trade-off between inflation and economic growth
Here’s how it’s calculated:
Sacrifice Ratio=Percentage Change in GDP/ Percentage Change in Inflation

The IS curve shows combinations of interest rate (r) and income/output (Y) such
that:
 Goods market is in equilibrium
 Planned expenditure = actual expenditure = income
 No unplanned inventory changes
 SLIDE 1
GVA + taxes on products -subsidies on products = GDP
Relationship between GDP and GVA:
Why is there a difference?
 GVA measures value before tax/subsidy adjustments.
 GDP is the market value of output — it includes what consumers actually
pay, which includes taxes like GST, excise, etc.
 So, if the government increases taxes or cuts subsidies, GDP > GVA.
Limitations of GDP
1. GDP measures income without distribution.
2. It is not a measure of welfare. It ignores social issues like health, education,
freedom etc.
3. GDP only measures the output produced and sold in legal markets. It does not
include productive activity that does not have a market transaction.
4. Environmentalists have long lamented that GDP treats the plunder of the
planet as something that adds to income, rather than being treated as an
expense.
5. GDP is less suited to the task of measuring modern, service-led economies
that are geared towards the quality of consumer experience, rather than
consumption of greater quantities.

SLIDE 2
 The Gini coefficient (or Gini index) is a measure of income or wealth inequality
within a nation or a group. It ranges from 0 (perfect equality) to 1 (perfect
inequality).

✅ Gini Coefficient Formula (based on Lorenz Curve):

G=A/A+B
A = Area between the line of equality and the Lorenz curve
 B = Area under the Lorenz curve
inflation refers to the rate of general price increase over a specific period of time
High inflation is generally considered detrimental to an economy for several
reasons:
Decreased Purchasing Power: As prices rise, the value of money decreases,
meaning consumers can buy less with the same amount of money
Affects the poor relatively more, may affect the unorganized sector more.
Wage Lag: If wages do not increase at the same rate as inflation, consumers
face a higher risk of layoffs and a decrease in their standard of living.
Price Out: Consumers may be priced out of the market for large purchases,
such as homes or cars.
Economic Uncertainty: High inflation can lead to economic uncertainty and
reduce consumer and business confidence.
Impaired Long-Term Performance: Persistent high inflation can harm the
economy’s long-term performance by affecting investment and savings rates.
These effects can lead to a cycle of inflation that becomes difficult to control
and can significantly impact economic stability.

Helicopter money is the term used for a large sum of new money that is
printed and distributed among the public, to stimulate the economy during a
recession or when interest rates fall to zero.
P = P*(1+t)- Ad valorem tariff
P = P*+t- Specific tariff
When tariff is imposed
Domestic Consumers of X: Lose
Domestic Producers who produce X: Gain
Domestic producers of Y who use X as intermediate input : Lose

Phillips Curve

The paradox of thrift

If the society plans to save more, actual saving, national income, level of
employment, etc., will decline. Very high saving
 will imply low demand and hence it may negatively affect demand.
This is known as ‘paradox of thrift’. That is why Keynes said saving may be a
virtue to an individual but community saving
lowers down society’s welfare. This is especially true when the economy is in
recession! This paradox is based on the proposition, put forth in Keynesian
economics, that many economic downturns are demand based.

Consumption depends on
Current income (net of taxes)
Expected future income
Wealth
Interest rate
Psychological factors

It includes spending on
capital equipment (e.g., machines, tools)
structures (factories, office buildings, houses)
inventories (goods produced but not yet sold)
depreciation

The investment function is I = I (r ), where r denotes the real interest rate, the
nominal interest rate corrected for inflation.
• The real interest rate is:
the cost of borrowing
the opportunity cost of using one’s own funds to finance investment spending

This relationship between the rate of change of output and the rate of
investment is known as the accelerator principle.
1. Investment = I(rate of interest, demand growth, capacity utilization, business
sentiment)
= I (r, ΔY, Capacity utilization, business sentiment)

G excludes transfer payments (e.g., unemployment insurance payments)

because they do not represent spending on goods and services.