Gen Z Economics

Medium-Term Economics: Inflation, Labor & the Phillips Curve Foundation

2026-02-15T00:00:00+05:30

Opening: Kevin Warsh on Inflation as a Choice

Context and Relevance

Professor Tantri opens Class 11 by playing a clip from an interview with Kevin Warsh, former Federal Reserve Board Governor and widely expected to be the next Federal Reserve Chair. The interview is from the Hoover Institution’s Uncommon Knowledge series.

Key Argument: Inflation Is a Choice

Warsh channels Milton Friedman’s core insight: inflation is always and everywhere a monetary phenomenon. The Federal Reserve was given sole responsibility for price stability by Congress, precisely so that no one else could be blamed.

“Inflation is a choice. The central bank can hit any inflation level that it wants. We might not like how they do it, but the idea that they should be blaming someone else strikes me as quite antithetical to good economic history.” — Kevin Warsh

The Distinction: Price Level Changes vs. Inflation

Warsh draws a crucial distinction that many commentators miss. A one-time price change in a specific good (due to supply disruptions, geopolitics, or pandemics) is not inflation. Inflation occurs when that one-time price change becomes self-fulfilling: higher prices beget higher prices, and the price level becomes unpredictable for households and businesses alike.

One-time price changes: Supply shocks like Putin’s invasion of Ukraine, pandemic-related supply chain disruptions, or crude oil spikes. These are relative price adjustments in a market economy.
True inflation: When a one-time price shock becomes embedded in expectations and spirals. This is the central bank’s responsibility to prevent.

Professor Tantri’s Commentary

Professor Tantri emphasizes that Warsh’s views are directly relevant because he is likely to shape future Federal Reserve policy. Understanding his intellectual framework helps anticipate where monetary policy is headed and its downstream effects on global markets and the Indian economy.

The Production Function

Setup: Y = AN

The medium-term model begins with a simple production function that strips away mathematical complexity to focus on core insights.

Y = A × N

Y: Total output (GDP)
A: Productivity parameter (output per worker)
N: Number of workers

For simplicity, Professor Tantri assumes A = 1, so Y = N. This means each worker produces exactly one unit of output. Two workers produce two units of GDP. This assumption is not realistic (diminishing returns, Cobb-Douglas functions, etc. could be used), but it keeps the math clean without changing the directional insights.

“I can make it A-squared and bring all kinds of stuff. But let’s keep it very simple. Y = AN. We are just trying to derive simple insights.”

The Wage Setting Equation

Derivation

The wage setting equation captures how workers negotiate wages. A worker’s wage demand depends on three factors:

W = Pᵉ × F(u, z)

W: Nominal wage
Pᵉ: Expected price level
u: Unemployment rate (negative effect on wages)
z: Catch-all institutional variable (positive effect on wages)

Understanding Each Component

Expected Price (Pᵉ): Positive Effect on Wages

Wages are always set in advance. Workers do not know the actual future price level when they negotiate, so they base their wage demands on what they expect prices to be. Higher expected prices naturally lead to higher wage demands, because workers want to maintain their purchasing power.

Unemployment Rate (u): Negative Effect on Wages

Higher unemployment depresses wage demands through two channels. First, there are many people willing to do the same job, increasing competition for positions. Second, if a worker demands too high a wage and loses their job, the high unemployment rate means it will take much longer to find another position. Both effects push wage demands down.

The z Variable: Positive Effect on Wages

This is the institutional framework within which labor markets operate. Think of it as the regulatory and structural environment: minimum wage laws, labor protections, firing restrictions, union strength, and other pro-worker regulations. Higher z pushes wage demands up.

The Expected Real Wage

Dividing both sides of the wage setting equation by expected price:

W / Pᵉ = F(u, z) = Expected Real Wage

This tells us what workers expect to receive in terms of actual purchasing power. Since each worker produces one unit of output (from Y = N with A = 1), the wage divided by expected price represents the expected real wage: how much goods and services the worker expects their wage to buy.

“So the wage I’m giving you is a real wage. Expected real wage. Absolutely correct answer.”

Important caveat: This expected real wage is what workers demand. It is not necessarily what will prevail in the market. Equilibrium is determined when both sides (workers and employers) agree. As Professor Tantri emphasizes: “The guy on the other side is hallucinating. It’s okay. Does not mean you have to give it.”

The Price Setting Equation

Derivation

The price setting equation comes from the employer’s perspective. Employers set prices based on the wages they pay plus a markup:

P = W × (1 + m)

P: Actual price level (not expected, since firms can adjust prices in near-real-time)
W: Wage paid to workers
m: Markup over costs

Why P and Not Pᵉ?

A key assumption: prices are far more flexible than wages. Wages, once fixed, take time to revise (you don’t renegotiate wages every 15 days). Product prices, however, can be revised frequently, some even on an auction basis in real time. This asymmetry is why the price setting equation uses actual P rather than expected Pᵉ.

The Markup (m)

The markup represents the firm’s profit margin over labor costs. It exists because markets are not perfectly competitive. In a theoretically perfect competitive market, m = 0. But perfect competition exists only on paper.

“Markup is a kind of a bad word. It’s possible only because the market is not competitive. In a perfectly competitive market, this m guy will be zero. But as the market becomes more and more competitive, the markup tends to zero. That’s a better way of learning about markup.”

The Actual Real Wage

Rearranging the price setting equation:

W / P = 1 / (1 + m) = Actual Real Wage

Numerical Example

Suppose a worker produces 1 kg of rice (since Y = N and A = 1). The price of rice is 40 rupees, but the worker’s wage is only 30 rupees.

Real wage (W/P): 30/40 = 0.75 kg of rice
This equals 1/(1+m): 0.75, which implies m = 33%
The employer pays the worker 75% of their output and retains 25% as markup/profit.

Natural Rate of Unemployment and Potential GDP

Definition

The natural rate of unemployment is the unemployment rate at which the expected price level equals the actual price level (Pᵉ = P). At this point, no one is surprised: workers get the real wage they expected, and employers get the markup they planned for.

Natural Rate of Unemployment (Uₙ): The unemployment rate where Pᵉ = P

Potential GDP (Yₙ): The GDP level that prevails at Uₙ

Graphical Derivation

Plot unemployment rate on the horizontal axis and real wage on the vertical axis:

Price setting line (horizontal): W/P = 1/(1+m). This is flat because the employer’s real wage offer does not depend on the unemployment rate. The employer simply says: here is what I can pay given my markup and market competition.
Wage setting curve (downward-sloping): W/Pᵉ = F(u, z). Workers demand higher real wages when unemployment is low (more bargaining power) and lower real wages when unemployment is high.

The intersection of these two lines determines the natural rate of unemployment. The market clears through unemployment: if workers demand wages above what employers will pay, some workers remain unemployed until the wage demands come down to the equilibrium level.

“The way the market will clear is some of the people who are asking this much wage will not get a job. It will keep them down. Like any other price clearing mechanism, it will settle.”

The z Variable: Institutional Framework and Real-World Applications

What z Represents

The z variable captures the entire institutional framework within which labor markets operate. It includes labor laws, minimum wage regulations, firing restrictions, union strength, and all pro-worker institutional features. Higher z shifts the wage setting curve upward: workers demand higher wages at every unemployment rate.

Critical Subtlety

Higher z pushes wage demands up, but this does not necessarily mean equilibrium wages will be higher. Because employers’ markup hasn’t changed and their technology hasn’t improved, the market’s way of clearing is through higher unemployment. The wage setting curve shifts up, but the price setting line stays flat. The new intersection occurs at a higher unemployment rate with the same real wage.

“Don’t misunderstand that France’s wage is higher than US. This is the role of z itself. Equilibrium may not necessarily lead to higher wages. z on its own pushes wages up. Does not necessarily mean equilibrium wage up.”

Case Study: Maharashtra vs. West Bengal

Professor Tantri references a well-cited paper by Amartya Lahiri (who taught at ISB) comparing Maharashtra and West Bengal. West Bengal was once far more economically advanced, but diverged sharply. The key difference: the z variable. West Bengal’s pro-labor institutional framework pushed wage demands higher, leading to higher equilibrium unemployment and slower economic development. This is one of the most robust findings in economics.

“This is one of certain results in economics which hold up as good as… very close to a natural science. You can predict reasonably well. Tomorrow, let’s say India makes wages $40 an hour. You can almost predict it will lead to higher unemployment. And eight out of ten times, it will.”

India’s Recent Labor Law Changes

Professor Tantri offers a nuanced analysis of India’s recent labor law amendments, cautioning against simplistic interpretations.

The Pro-Employer Claim

Threshold change: The threshold for retrenchment approvals moved from 100 to 300 workers. This is genuinely pro-employer, making it easier to adjust workforce size.

The Hidden Pro-Worker Element

PF base redefinition: The definition of “basic salary” for provident fund calculations has changed. Nearly the entire salary now counts as basic, dramatically increasing PF outflows for employers.
Infosys example: Infosys had to make an extra provision of ₹1,000 crores in one quarter.
IT sector impact: The IT industry alone provisioned approximately ₹45,000 crores due to this change.

Classical economists would argue that if costs increase, employers simply reduce salaries. But in the short run, you cannot reduce salaries. If PF is now a function of a bigger base, it’s a real cost increase that employers must absorb. The net effect of these reforms on the z variable is ambiguous: it could be pro-labor or pro-worker, and the political credit implications differ accordingly.

“If it turns out to be pro-worker, at least get political credit for it. If it turns out to be pro-worker, then economically, it’s gonna be bad. But you will also not get political credit because in the polity, you go to Economic Times and claim it’s a reform. It may not be a reform.”

AI and the Macroeconomy: An Open-Ended Discussion

AI’s Effect on the Model

A student raises whether AI affects both unemployment and the z variable. Professor Tantri engages in an extended discussion about AI’s macroeconomic implications, acknowledging that conventional economic frameworks may be inadequate for analyzing AI’s impact.

Possibility 1: Markup Effects

For AI creators: If AI development requires massive CapEx that not everyone has access to, the big creators of AI will see their markups increase (m rises). Less competition at the frontier means more pricing power.
For AI users (services companies): Markup decreases as AI commoditizes services. The price setting line shifts up (W/P = 1/(1+m) increases as m falls), implying higher real wages at the same unemployment rate.

Possibility 2: Demand-Side Uncertainty

Even if markups fall for users, AI-driven layoffs could shift the wage setting curve itself. If workers are replaced en masse, the demand for labor changes in unpredictable ways. Unlike conventional technology, AI threatens to replace all jobs, not just some categories.

“No technology was like this. History is a very bad comparison for AI because there was no technology which was threatening to replace all jobs of everyone.”

The Larry Summers Argument: 25% GDP Growth?

Professor Tantri references Larry Summers’ now-famous argument. Before the Industrial Revolution, GDP grew at 0.2% annually. The Industrial Revolution made it 2% (a 100x increase). If AI can compress 100 years of research into 5 years, the US could theoretically grow at 25% per year. The question is distribution: who captures this growth?

The Counter-Argument: AI Making Humans Dumber

Professor Tantri shares research he is developing with Aditi Kolekar, arguing that AI’s long-term effects may be negative for growth through an unexpected channel.

The learning problem: AI currently learns from what humans have already produced. It is not generating fundamentally new knowledge.
The deskilling effect: Evidence suggests AI is making people less inclined to learn foundational skills. Why learn calculus if you can press a button? Why learn physics or modeling?
The pipeline problem: Brilliant scientists (Newton, Einstein, Hawking) emerge from systems where millions of people attempt and fail. You cannot ex-ante identify who will make breakthroughs. If AI reduces the number of people attempting deep learning and original research, the pipeline of potential geniuses dries up.
The long-run risk: AI may boost growth for 30-40 years by accelerating existing knowledge. But over 200 years, it could leave us worse off if it cannot generate fundamentally new knowledge on its own and has simultaneously destroyed the human capacity to do so.

“If you don’t have a system where lakhs and lakhs of people try, you will not get these brilliant people. For brilliant people to come out, you need the system where millions of people make an attempt. That is for sure.”

The $1 Trillion Hole

Wearing a finance hat, Professor Tantri notes that projected AI investment (trillions of dollars of CapEx) currently exceeds projected revenue by approximately $1 trillion. If this gap becomes apparent, it could trigger significant market corrections. His best guess: a phase of negativity and bubble-bursting, followed eventually by AI delivering real value, similar to the dotcom cycle.

“If you know that you put in 5 trillion and the whole revenue is gonna be 4 trillion, then you want to get out before the rest of the world realizes.”

Current Evidence

As of the lecture date, AI has not yet appeared in aggregate productivity statistics. This echoes Robert Solow’s famous 1987 observation about computers: “You can see the computer age everywhere but in the productivity statistics.” By the late 1990s, the internet did show up as roughly a 1 percentage point productivity gain. AI may follow a similar pattern.

Looking Forward: The Phillips Curve

Professor Tantri concludes by previewing the next session’s topic: the formal derivation of the Phillips curve from the wage setting and price setting equations developed in this lecture.

“Phillips curve is one of those discoveries in economics which is as applied as gravity. Everybody uses it. We’ll formally derive the Phillips curve with the toy model. And that is where the use of toy model is.”

The Phillips curve will connect the natural rate framework to inflation dynamics, revisit real interest rates, and bring the analysis full circle back to monetary policy, completing the medium-term economics toolkit.

Key Takeaways

Inflation is a central bank choice. One-time price changes (from supply shocks, geopolitics, or pandemics) are not inflation. Inflation occurs when those changes become self-fulfilling in expectations. The Federal Reserve can hit any inflation target it wants.
The Wage Setting Equation W = Pᵉ × F(u, z) captures how workers negotiate: higher expected prices raise wage demands, higher unemployment lowers them, and stronger labor protections (z) raise them.
The Price Setting Equation P = W × (1 + m) captures employer behavior: prices reflect wages plus a markup determined by market competition.
The natural rate of unemployment is where expected and actual prices converge (Pᵉ = P). At this point, the labor market is in equilibrium and no one is surprised. GDP at this unemployment rate is potential GDP.
Increasing z (pro-labor institutions) raises unemployment, not wages. When labor laws strengthen, workers demand more, but employers don’t change their markup. The market clears through higher unemployment. Maharashtra vs. West Bengal illustrates this powerfully.
India’s labor reforms are more ambiguous than reported. The retrenchment threshold change (100→300) is pro-employer, but the PF base redefinition significantly increases employer costs. The net effect on z is unclear.
AI’s macroeconomic impact is genuinely uncertain. It could reduce markups, boost productivity, and create unprecedented growth. Or it could destroy the human learning pipeline needed for future breakthroughs, leaving us worse off in the very long run.
Simple toy models yield powerful insights. The Y = N production function, combined with wage and price setting equations, builds a complete framework for understanding inflation, unemployment, and monetary policy in the medium term.

Union Budget 2025-26: A Macro Reading

2026-02-07T00:00:00+05:30

Positive #1: Government Expenditure Coming Down

The Big Picture — India’s Fiscal Discipline

The professor opens by comparing India’s government expenditure as a percentage of GDP with other countries. The US spends about 30%, the UK around 25–28% (budget of ~1 trillion pounds against a 3.5–3.6 trillion GDP). India historically hovered around 13–14% but spiked to about 15% during COVID, which was understandable — in a crisis, the government has to step in because the private sector pulls back from investment.

But the concern is that India continued spending at 15% for three to four years after COVID. The professor sees this as problematic because sustained high government spending crowds out the private sector.

This Budget’s Breakthrough: Tax Cut + Expenditure Cut

“One of the biggest takeaways of this budget is there is tax cut and expenditure cut. That is very, very rare.”

The professor emphasizes that a tax cut without an expenditure cut is a fraud — it simply means either interest rates go up or inflation eats away your savings. He contrasts India’s approach with the US:

• US Democrats: Increase expenditure. They impose some taxes, but increase expenditure far more.

• US Republicans: Talk about smaller government but only cut taxes without cutting expenditure.

• Result: Everyone adds to debt, which is where the US is right now (120%+ debt-to-GDP).

• India’s budget this time: Genuinely cutting both. Very rare globally.

The Numbers

The revised estimate for 2025–26 expenditure is 49 lakh 60 thousand crore on a GDP of 354 lakh crore — that’s less than 14%. For 2026–27, projected GDP is 391 lakh crore with projected expenditure of 52.5 lakh crore. Given the government’s track record of underspending, the professor estimates actual expenditure will be about 52 lakh crore, bringing the ratio down to approximately 13%.

For context, India’s historical low for central government expenditure was around 12.5% — and they’re heading back there.

Why This Matters: The Savings Constraint

The professor connects government spending to India’s structural savings problem:

• Savings rate declining: From 36–37% in 2008 to below 30% now. Total savings are about 100–110 lakh crore.

• Government takes 30 lakh crore: State and Central governments together consume about 30 lakh crore of national savings.

• Depreciation eats 15–20 lakh crore: Maintaining existing capital assets requires significant resources — this is why developed countries struggle to grow, all their savings go toward maintenance.

• What’s left for private investment: Only about 50–60 lakh crore. And there’s no significant FDI coming.

Countries that grew at 10% (Korea, Taiwan, Singapore, China) had investment rates of around 50%. India is nowhere close. So the government withdrawing from the economy and freeing up resources for the private sector is crucial for long-term growth.

“You can’t have a Viksit Bharat by just government stimulus. That does not happen.”

Positive #2: Defense Budget Increase

The Numbers — Context Matters

Defense budget has gone up by about 20%, from 6 lakh 90 thousand crore to 7 lakh 80 thousand crore. There’s a 20–30% increase in defense capex specifically.

However, the professor cautions against celebration. In dollar terms, it’s about 86 billion dollars. The US is approaching a trillion dollars in defense spending. And this is where the professor launches into his famous PPP rant.

The PPP Rant

“PPP is nonsense for anyone who is here. PPP is good for some poor guy, average guy. Nobody is an average guy here. You are all 99.99th percentile of the Indian economy.”

The professor’s argument: PPP (Purchasing Power Parity) exchange rates are meaningless for defense because we import critical equipment. When your HR department uses PPP in salary negotiations, he says, get lost. Your actual purchasing power parity exchange rate as an ISB graduate is not even 100 — it’s 120 or 150, because most of what you consume is priced higher, not lower. He notes that while dosa prices may differ, dosa is a tiny proportion of your expenditure.

Defense as the Highest-Multiplier Government Spending

This is where the professor connects defense spending to his broader fiscal multiplier framework. He references a paper by Valerie R. (in the Journal of Economic Perspectives) surveying global evidence on fiscal multipliers:

• Most government expenditure: Multiplier of less than 1. You’re better off leaving money with the private sector.

• Defense spending (especially capex and research): Consistently shows multipliers significantly above 1, close to 2, across all countries.

• Why? Technology spillovers. Most fundamental technology comes out of defense R&D, and that has positive externalities for the entire economy.

He also references Victor Davis Hanson’s book Second World Wars on the decisive advantage technology gives in warfare, and the history of Spain’s technological superiority in conquering civilizations.

The professor adds a caveat: all the positives from the defense increase could get nullified if the Rupee keeps depreciating, since much of defense procurement requires imports.

Criticism #1: “Capital Expenditure-ism”

The Core Problem: Accounting Drives Decision-Making

“I call it capital expenditure-ism. Accounting drives decision making, not the usefulness.”

The professor’s central criticism is that India’s economic advisors have convinced the government that as long as something is classified as capital expenditure, it is good. This leads to building tangible things (airports, trains, studios) without applying basic capital budgeting rules.

The Multiplier Principle

When the government takes money from taxpayers, there’s a deadweight cost of taxation — the classic triangle from microeconomics showing total loss of social welfare from production lost due to taxation. When that money is then spent, it should at least create more value than what was lost. If it doesn’t, it’s a negative NPV investment.

The professor’s framework: If you are unconstrained, do all positive NPV projects. But the government IS constrained — it doesn’t have unlimited money. When constrained, you must rank by NPV and fund the highest ones first. This is completely missing from India’s budgetary allocation.

Specific Examples

Airports in Remote Areas

84–90 airports built in the last few years in places where there’s virtually nothing. The argument is always the same: “If I build an airport, Elon Musk will set up a factory.” The professor calls this nonsensical. He references the UDAN subsidy scheme — flights operate for 3 years with a 3,000 rupee subsidy, then shut down. He notes 14 airports have already shut down. People reroute through subsidized airports (like flying to Shimoga instead of Mangalore) purely because of the subsidy, not genuine demand.

Vande Bharat Trains

“It’s a great train. No justification for using taxpayer money for that. Absolutely no justification.”

The professor points to IRFC (Indian Railway Finance Corporation) as a case study. IRFC was set up to raise money for railways through the market. Now railways get so much direct budget funding that IRFC has money with no borrowers. The 50–60 employees are going around lending to infrastructure borrowers at rates lower than Government of India bonds (7.4%) with no idea of credit appraisal. He sarcastically suggests: if you need to borrow, just go to IRFC — they’re looking for borrowers.

Cuts to State Grants

The professor’s specific complaint: the government cut 1 lakh 20 thousand crore from capital grants to states. Last year’s allocation was 7.2 lakh crore (which they claimed credit for increasing from 6 lakh crore). The actual spend was much lower, and now they’ve cut further. His view: states at least know where the problems are. If capex must happen, states should spend it, not the Center.

Where the Multiplier IS High: Ayushman Bharat

The professor pivots to Ayushman Bharat as the clearest example of a scheme that should get expanded based on multiplier evidence but doesn’t, because health spending isn’t “tangible” in the same way an airport is.

He cites his own research, recently published in Management Science:

• Methodology: A triple-difference design. He compared border districts of the 4 states that did NOT adopt Ayushman Bharat (Telangana, Delhi, Odisha, West Bengal) versus border districts of states that did (Jharkhand, Assam, etc.). Within those regions, he used the Kisan Credit Card cutoff of 50,000 rupees (above = ineligible) as a regression discontinuity. Three differences: before/after, above/below 50,000, implemented vs. not implemented.

• Finding: NPA rates fell by about 4 percentage points (a ~40% reduction) in eligible populations in implementing states.

• Multiplier estimate: Based on NPA reduction alone (just the banking benefit), the multiplier is around 3. Total multiplier estimate is at least 5.

Yet Ayushman Bharat expenditure per capita is only 1,300 rupees. A family floater health insurance premium for a family of 5 with elders above 60 is around 25,000 rupees in the market. The scheme hasn’t been expanded — still stuck at 5,000–7,000 crore, and in real terms, that’s declining.

“How on earth is a district hospital less important than that stupid airport in some God-forsaken place?”

Rural Schemes & Toilet Economics

The professor makes a pointed observation about tourism: the single biggest thing India could do for tourism is clean public toilets. He notes Swachh Bharat allocations (5,000 crore) see only 2,000 crore spent. Meanwhile, the government launches tourism training institutes. His view: guides are not a market failure — if there’s demand, the private sector will supply them. Clean toilets, on the other hand, are a genuine public good.

Nal Se Jal (water scheme): allocated 60–70 thousand crore, only 10 thousand crore spent. Appears to be getting wound up.

Criticism #2: State Governments Nullifying Federal Progress

The State Borrowing Problem

All the positives of the Union Budget will be nullified by state governments. The Finance Minister has worked hard to cut central expenditure and borrowing. But state governments have actually overtaken the Center in borrowing:

• Central government gross borrowing: ~14 lakh crore (net new: 11.5 lakh crore)

• State governments: Likely to borrow 14 lakh crore as well

This massive combined borrowing means the marginal saver who funds it demands higher rates. The only way to avoid this is printing money (which causes inflation) — and RBI will eventually have to let interest rates rise.

The Cash Transfer Cycle

The professor traces the current fiscal recklessness to a cycle that started with PM Kisan in 2018 and was supercharged by Karnataka’s 2023 election:

• Karnataka: The winning party sent representatives to households with signed guarantee cards — free bus, cash transfers, etc. Politically brilliant; fiscally dangerous.

• Then everyone followed: Telangana, Maharashtra, Bihar all launched similar schemes.

• Big states still to come: West Bengal and Uttar Pradesh haven’t even entered this cycle yet.

The professor draws a parallel to the 2008–14 debt waiver cycle. Every state promised agricultural debt waivers. His published research shows it led to farmers’ access to credit going down, interest rates going up, and farmers becoming worse off. That cycle only stopped when the disaster became visible. He predicts this cash transfer cycle will run for another 3–4 years before a similar reckoning.

The Central Government’s Debt Trap

The professor walks through the budget arithmetic to show the Center is trapped:

• Total expenditure: ~50 lakh crore

• Gross borrowing (fiscal deficit): ~16 lakh crore

• Interest payments: 11.6 lakh crore

• Net fresh capital from borrowing: Effectively zero. All borrowing goes to service past debt.

• Everything else: Funded entirely from tax revenue (~34 lakh crore)

In other words: the government borrows only to pay interest. The country is run entirely on tax revenue. The remaining 4–5 lakh crore from borrowing goes to defense capex and that’s it.

Historical context: At the end of the Clinton administration, the US Congressional Budget Office projected that by 2010 there would be no government bonds because the government was running a surplus. US debt-to-GDP was about 20%. Today it’s 120% and growing by billions of dollars daily. Even after World War II, most countries weren’t at current debt levels.

Criticism #3: The Sovereign Gold Bond Debacle & Trust Erosion

Correlation vs. Causation

Before diving into the gold bond issue, the professor delivers one of his signature methodological rants about the dangers of data-driven decision making without causal theory:

“Wherever there is causation, you may not have correlation. Because you do something else to offset the damn thing.”

His boat-and-rudder analogy: If a boat is sailing and someone is using a rudder to counteract wind, collecting data will show no correlation between rudder movement and boat direction. A naive analyst would conclude the rudder has no impact. But the rudder is precisely CAUSING the boat to stay on course by offsetting the wind. He extends this to criticize the rise of quick data analysis without theoretical grounding.

How the Gold Bond Scheme Went Wrong

In 2015, the government looked at 10–20 years of gold price data showing minimal movement. They ran regressions, saw no trend, and launched the Sovereign Gold Bond scheme: give us your gold, we’ll pay you gold price appreciation + 2.5% interest. The pitch was that gold is “non-productive” and “anti-national.”

The professor’s counter: gold is a technology to preserve savings. Without a way to save the fruits of labor, nobody would work beyond subsistence. Calling gold non-productive is “government trying to fool you to get inflation and then loot your savings.”

Then gold prices surged. The government is reportedly losing 1–1.5 lakh crore on the scheme (the professor notes these are unverified numbers since the government isn’t revealing the figures). They tried to salvage the situation by cutting customs duty on gold, hoping to crash domestic gold prices before bonds came up for redemption. It didn’t work — gold prices are internationally determined.

The Tax Change: Trust Destroyed for 5,000 Crore

Having lost massively on the scheme, the government’s latest move: tax the gains. They introduced a rule that only bonds bought directly from RBI get tax-free treatment, trying to recoup perhaps 5,000–10,000 crore from secondary market buyers.

“For 5,000 crore, for God’s sake 50 lakh crore is the budget. Nothing will happen if your 0.1% deficit goes up. But what you will lose is the trust.”

The professor’s concern is bigger than gold bonds: the government simultaneously offers 25-year tax holidays for data centers. How can anyone trust a 25-year commitment when the government retroactively changes terms on a scheme running for just a few years? This “chindi” (petty) behavior destroys credibility for marginal fiscal gains.

The STT (Securities Transaction Tax) Problem

The Insurance Analogy

The government’s argument for STT: 95% of derivatives traders lose money. The professor’s devastating counter:

“Take any insurance contract. 95% of the people who take insurance lose money — they don’t die! I will put tax on it! It’s insurance for God’s sake!”

His point: derivatives function as insurance. The seller is risk-neutral; the buyer is risk-averse. On average, risk-averse buyers lose money — that’s the definition of risk aversion. But ex ante (before the fact), the insurance provided comfort and value. Saying 95% lose money is like saying 95% of health insurance buyers wasted their premium because they didn’t get cancer.

What the Evidence Actually Says

The professor references O’Hara et al.’s research on Tobin’s Tax (which STT essentially is):

• Finding: When you impose a transaction tax, BOTH informed traders AND noise traders leave the market.

• The real damage: The ones who leave first are the physics PhDs and mathematicians who supply liquidity to the market through careful calculation. Noise traders don’t calculate costs anyway.

• Consequence: Without liquidity, startup founders can’t exit, FDI won’t come. The government doesn’t understand the value of liquidity.

His recommended solution: If you want to prevent small uninformed retail traders from gambling on derivatives, increase the lot size. Don’t tax everyone. Put entry barriers on uninformed participation, don’t destroy market microstructure.

Q&A Highlights

On GIFT City, Dholera & SEZs

An audience member asks about GIFT City’s expanded tax holiday (10 to 20 years in this budget) and whether more GIFT Cities will be created. The professor’s response broadens into a critique of India’s tangible-asset obsession:

• Dholera: Announced by Modi in 2007. Despite his personal push, it took ~22 years to get even partially completed. Expected partial inauguration on February 22.

• SEZ track record: Special Economic Zones ultimately became real estate plays. As long as schemes are about land, buildings, and licenses, they become discretionary and eventually corrupt.

• What we should do instead: Invest in intangibles. The professor references China’s Thousand Talents Program — offering top scientists million-dollar salaries, schooling, facilities to relocate. Why not a city for patent holders instead of another airport?

“The value is created by people, not buildings. Unfortunately all of them will become basically a real estate play.”

On Teacher Accountability & Education Spending

When discussing where budget cuts happened, the professor reveals a contrarian view on education spending:

“If you cannot fix teacher accountability, there is no point in giving money. In education research it’s very clear. The constraint is teacher accountability. No political party has the courage to fix it.”

His argument: giving laboratories to schools where teachers don’t know how to use them is the same capex-ism problem. It’s the same logic as building useless airports. Having studied in a government school himself, he says bluntly: it’s a total waste of money without teacher accountability reform.

Key References & Recommended Reading

• Valerie R. et al., Journal of Economic Perspectives — Survey of fiscal multipliers across government expenditure types

• Victor Davis Hanson, Second World Wars — Technology’s decisive advantage in warfare

• Stephen Kotkin, Biography of Stalin (3-volume series) — Historical debt-to-GDP ratios across countries

• Niall Ferguson, Biography of Kissinger — Nixon-era economic parallels to current US policy

• O’Hara et al., Research on Tobin’s Tax effects on market microstructure

• Prof. Tantri’s own paper, Management Science — Ayushman Bharat’s multiplier effect on NPAs (triple-difference methodology)

• Prof. Tantri’s team, Published papers on debt waiver cycles and farmer credit access

• RBI Document, State Finances — State government borrowing trends

Summary: The Budget Scorecard

Positives

1. Government expenditure declining to ~13% of GDP — First time India is genuinely cutting expenditure alongside tax cuts. Creates space for private sector investment.

2. Defense budget up 20% — Highest-multiplier government spending. Technology spillovers benefit the entire economy.

Negatives

3. Capital expenditure-ism — Schemes not ranked by NPV/multiplier. Useless airports funded over district hospitals and Ayushman Bharat expansion.

4. State governments on a spending spree — Cash transfer cycle will nullify Center’s fiscal discipline. Big states (UP, West Bengal) haven’t even started yet.

5. Trust erosion — Sovereign Gold Bond tax changes and STT increases destroy credibility for marginal revenue. How can 25-year tax holidays be trusted?

The Professor’s Bottom Line

“Net net I don’t see something positive coming out of this because of state governments. The Finance Minister has worked hard. But states will nullify everything.”

Exchange Rates, Inflation & Interest Rate Parity

2026-01-11T00:00:00+05:30

The Central Paradox

Three seemingly contradictory statements that confuse many:

1. Higher inflation → Currency depreciation (intuitive: goods become more expensive)

2. Higher inflation → Higher interest rates (Fisher equation: i = r + E[π])

3. Higher interest rates → Currency appreciation (news narrative: capital inflows)

These three statements are all correct when properly understood through distinguishing anticipated versus unanticipated rate changes. We now develop a systematic 3-step framework to resolve this apparent paradox.

Step 1: Inflation and Exchange Rate Depreciation

The Goods Market Logic

When one country experiences higher inflation than another, its currency depreciates to maintain purchasing power parity. Let’s work through a concrete example:

Year 0 (Today)	Year 1 (After Inflation)
Dosa in India	100 Rs → 110 Rs (10% inflation)
Dosa in USA	$2 → $2.04 (2% inflation)
Exchange rate	50 Rs/$ → 54 Rs/$ (~8% depreciation)

Real Exchange Rate Analysis

Real exchange rate = Nominal exchange rate × (Price level abroad / Price level home)

Initially: 50 × (2/100) = 1.0 dosa equivalent

After one year with unchanged real rate: 54 × (2.04/110) = 1.0 dosa equivalent


The currency of the higher-inflation country depreciates by approximately the inflation differential (10% - 2% = 8%).

Figure 1: Initial setup showing dosa prices and exchange rate

Step 2: Interest Rates and Exchange Rates

The Financial Market Logic

The Fisher Equation

i = r + E[π]

Where:

i = nominal interest rate

r = real interest rate

E[π] = expected inflation

Assuming real rates are equal in both countries:

	India	United States
Real rate (r)	2%	2%
Expected inflation	10%	2%
Nominal rate (i)	12%	4%

Interest rate differential = 12% - 4% = 8% = inflation differential

Uncovered Interest Rate Parity

This is the crucial insight that resolves the paradox:

UNCOVERED INTEREST RATE PARITY (UIRP):

Expected exchange rate depreciation ≈ Interest rate differential

The currency with HIGHER interest rates is expected to DEPRECIATE

Example

Consider an investor choosing between Indian bonds (12%) and US bonds (4%):

4. Invest $100 in India at 12% → Get 112 units of rupees

5. But rupee depreciates 8% → When converting back to dollars, gain only ~4%

6. Result equals investing in US bonds at 4% → No arbitrage profit

This arbitrage condition ensures the relationship holds:

Higher yield is offset by currency depreciation

Figure 2: India vs US comparison with interest rate calculations

Resolving the Paradox

The resolution hinges on a critical distinction:

ANTICIPATED vs UNANTICIPATED Rate Changes

ANTICIPATED RATE INCREASES

If the RBI raises rates because inflation is expected (market already knows):

• Currency continues to depreciate as expected

• Higher rates = higher expected inflation = MORE depreciation

• No contradiction

UNANTICIPATED RATE INCREASES (Surprise)

If the RBI raises rates UNEXPECTEDLY:

• Markets re-evaluate expectations

• Capital flows in (higher returns with unexpected strength)

• Currency appreciates in the SHORT TERM

Why News Narratives Say ‘Rate Hike = Currency Appreciation’

News stories focus on the SURPRISE component of rate hikes:

• “RBI unexpectedly raises rates → rupee appreciates” (short-term reaction to news)

• But the LEVEL of rates reflects long-term inflation expectations

• These long-term expectations drive ongoing depreciation

THE RESOLUTION

All three statements are correct:

High inflation → depreciation (PPP logic: goods parity)

High inflation → high rates (Fisher equation)

Surprise rate hike → short-term appreciation (market surprise)

The key: Distinguishing the level of rates (reflects inflation) from rate changes (markets react to surprises).

Real-World Application: India vs United States

Understanding rupee depreciation through the framework we’ve developed:

Current Market Levels

Metric	India	United States
Nominal rate	~12%	~4%
Expected annual depreciation	~8% per year	—
Exchange rate progression	40 → 43.2 → 46.7 → … → 90+	(stable baseline)

Why Rupee Goes from 40 to 90: It’s NORMAL

Rather than being a problem or sign of economic weakness, this depreciation is:

• A natural consequence of India having higher inflation than the US

• Consistent with interest rate parity—investors aren’t being cheated

• Expected by the market, reflected in interest rate differentials

• Mechanism for maintaining PPP and competitive balance

Class Discussion & Student Questions

Key questions raised during the lecture:

On Expectations and FII Flows

Maneshwar’s question:

How do FII inflows affect the framework, and how are expectations formed?

The expectations of depreciation embedded in interest rate differentials already account for flows that markets anticipate. Surprises—like unexpected policy changes or capital flow reversals—create deviations from this equilibrium path.

On Inflation Expectations

Lakshit’s question:

How do we anchor inflation expectations, and what happens if inflation expectations change?

Central banks anchor expectations through credible commitment to inflation targets. If expectations shift (e.g., inflation expected to rise from 7% to 12%), the entire interest rate level adjusts upward, and the equilibrium depreciation path steepens accordingly.

On the Nature of Real Rates

Bharat’s question:

Can the RBI control real interest rates?

Answer: Not fully. Real rates depend on people’s willingness to postpone consumption (time preference). The RBI controls nominal rates; real rates adjust through inflation expectations. In the short run, policy can affect real rates, but long-term real equilibrium depends on preferences and productivity growth.

On Cross-Country Real Rate Differences

Dipesh’s question:

What if real interest rates differ between countries?

The framework extends naturally. If India’s real rate (3%) exceeds the US’s (2%), then:

• India: i = 3% + 10% = 13%

• US: i = 2% + 2% = 4%

• Interest rate differential: 9% (includes both inflation difference AND real rate difference)

• Expected depreciation: ~9% per year

On Structural Factors

Bharat’s question:

How do Trump tariffs and trade policy affect long-term growth and depreciation paths?

Trade policies affect real growth potential and real interest rates through supply effects. If tariffs reduce long-term US growth potential, that could lower the equilibrium real rate and require depreciation in other directions to maintain balance. These are structural shifts operating alongside the inflation-expectation mechanisms we’ve discussed today.

Takeaways

Three-Step Framework

Goods Market (PPP): Higher inflation → Currency depreciation by approximately the inflation differential

Financial Market (UIRP): Higher interest rates → Currency expected to depreciate; arbitrage ensures yields equalize

Resolution: Distinguish anticipated (consistent with framework) from unanticipated (surprise) changes

Insights

• Currency depreciation is often normal, not pathological—a consequence of inflation differentials

• Interest rate differentials encode expectations about depreciation

• News narratives about rate hikes causing appreciation are describing short-term market reactions to surprises, not long-term equilibrium

• The framework reconciles three apparently contradictory statements about inflation, interest rates, and exchange rates

• Real interest rates depend on fundamentals (preferences, productivity); central banks manage nominal rates and inflation expectations

This lecture completed the short-term macroeconomics portion. The next session will provide a summary of core short-term macro concepts and book recommendations for deeper study. Future classes will extend to medium-term (growth, productivity) and long-term (institutions, development) perspectives.

Real Exchange Rates & Productivity

2025-12-04T00:00:00+05:30

Medium-Term Macroeconomics Introduction

This session marks the transition from short-term to medium-term framework analysis. The fundamental shift involves understanding how inflation expectations become a critical variable in macroeconomic behavior.

The big difference in the medium term is inflation expectation.

Tradable vs Non-Tradable Sectors

The Tradable Sector

• Definition: Anything with global competition

• Examples: IT services, pharmaceuticals, consulting

• Income driver: Worker efficiency and productivity

“The only way you can earn above competitive wage is by being efficient.”

The Non-Tradable Sector

• Definition: Services with local markets, no global competition

• Examples: Haircut, dentistry, teaching, medicine, driving, yoga, entertainment

• Workforce: Two-thirds of population works here, even in developed countries

• Income driver: Customer’s wealth, NOT worker’s efficiency

Dentist Paradox

Indian dentists are younger, better trained, and equipped with superior technology. Yet they earn approximately 1/10th of what US dentists earn. Why? Because their customers are significantly poorer. In non-tradable sectors, compensation is fundamentally limited by local purchasing power, not by worker quality or productivity.

Real Exchange Rate Appreciation & India’s Crisis

The critical question at the heart of India’s situation:

The problem is not whether the rupee is 90 or 200. Problem is: Are we depreciating more than inflation differential?

Two Scenarios of Currency Depreciation

Scenario 1: Market is Wrong (Temporary)

• Currency depreciates temporarily due to market misalignment

• Will self-correct - no structural worry

Scenario 2: Declining Productivity (Structural Problem)

• Depreciation reflects actual decline in tradable sector productivity

• This is a PERMANENT problem requiring structural reform

REER Index: The Critical Metric

The Real Effective Exchange Rate (REER) is constructed using a basket of 40 currencies that India actively trades with. This provides a comprehensive measure of real exchange rate movements.

Interpretation:

• Base year 2016 = 100 (reference point)

• REER > 100: Real appreciation (currency hasn’t depreciated enough relative to inflation differential)

• REER < 100: Real depreciation (currency depreciating more than inflation differential)

• If exchange moves exactly with inflation differential, REER stays at 100

India’s REER Historical Trajectory

Period	REER Level
2016 (Base Year)	100.00
2016-2020	106-107 (Real appreciation)
March 2024	Still 106-107
October 2024	94-97 (Sharp drop begins)
Late 2024 (Est.)	90-92 (Very sharp drop)

PPP & Samuelson-Balassa Theorem

Purchasing Power Parity (PPP) exchange rates differ from real exchange rates because non-tradable sector wages are substantially lower in poorer countries. This seemingly paradoxical relationship reveals something critical about economic development.

PPP income being higher actually shows that one is incompetent in the tradable sector.

Higher PPP figures often reflect lower tradable sector productivity. Richer countries have higher real wages even in non-tradable sectors because their tradable sectors are so productive that they can support higher overall wage levels.

Nominal vs Real Depreciation

“People saying the rupee reaches all-time low - it SHOULD reach all-time low every day vs dollar.”

Why Nominal Depreciation is Expected

Historically, India’s inflation rate has been higher than the United States. it is structural. When one country has persistently higher inflation, its currency depreciates relative to low-inflation countries.

Example:

• India inflation: 6%, US inflation: 4% (inflation differential: 2%)

• Expected rupee depreciation: 2% (to maintain purchasing power parity)

• If rupee depreciates MORE than 2%: Real depreciation → exports become cheaper → competitive gain

• If rupee depreciates LESS than 2%: Real appreciation → exports become more expensive → competitive loss

Current Situation

The inflation differential between India and the US has narrowed to near zero. Yet the rupee is depreciating sharply. This means the depreciation is almost entirely REAL, not merely the expected nominal adjustment for inflation differential.

Sharp real depreciation with minimal inflation differential = something fundamental is changing in India’s competitive position.

RBI Data Deep Dive

The Reserve Bank of India publishes official data on both nominal and real effective exchange rates. This data provides empirical grounding for understanding India’s exchange rate trajectory.

RBI Official Metrics

Metric	2023-24	October 2024
NEER	90.75	~88-89
REER	103.71	~97

Interpretation

• Nominal depreciation from 90.75 to 88-89: modest, reflects gradual currency adjustment

• Real depreciation from 103.71 to ~97: significant 6+ point drop in just 6-7 months

• Currently estimated at 92-94: not yet fully captured in official data

• This rapid REAL depreciation suggests structural changes in competitiveness

“If it is a fundamental issue, RBI will end up fighting a losing battle.”

The Big Question

Beneath all the technical analysis lies a fundamental question about India’s economic trajectory and future prosperity.

There was consensus that we’ll emerge as a very big economy, the Viksit Bharat economy. But will we reach $20-30-40K per capita? Or plateau at $5-7K?

Divergence of Expectations

Domestic Investors:

• Extremely bullish - “going to the moon”

Foreign Investors:

• Systematically pulling out

“I have no idea who is right - this is very unusual.”

Performance Analysis

Interestingly, FIIs who pulled out weren’t wrong in absolute rupee terms - they actually outperformed by being elsewhere. This suggests that even if rupee has appreciated, other markets provided better returns. This is a nuanced point about opportunity cost and relative performance.

Information Advantage Framework

The best economic indicator is observation accumulation AKA Smell Test

The Case Study: Asian Paints

The professor shared a personal experience visiting a paint dealer. This dealer revealed critical information about competitive threats and market shifts that never appeared in published financial reports. Months later, Asian Paints stock underperformed - validating the ground-truth information gathered through informal observation.

The Framework for Information Advantage

• Visit factory floors

• Sit in employee canteens and observe conversations

• Talk to suppliers about their margins and strategic challenges

• Build a systematic collection process for informal information

“Half day Saturday, devote to collecting information from non-standard sources.”

• Published financial data is available to everyone - zero competitive advantage

• Ground-level observations reveal information gaps that markets haven’t yet priced

• This is particularly valuable for identifying risks and structural shifts early

Takeaways

1. The Critical Exchange Rate Question

The rupee’s absolute level (90 or 200) matters far less than whether it is depreciating more than the inflation differential. Real exchange rate movements, not nominal ones, determine trade competitiveness and economic health.

2. Sectoral Wage Divergence

Tradable sector wages are determined by global productivity and efficiency. Non-tradable sector wages are constrained by customer wealth. This explains why Indian dentists earn 1/10th of US dentists despite superior skills.

3. REER as the Key Metric

India’s REER fell from 106-107 (March 2024) to approximately 92-94 (late 2024). This sharp real depreciation, occurring when inflation differentials are minimal, suggests structural changes in India’s tradable sector competitiveness.

4. Fundamental vs Temporary Movements

If the rupee’s weakness reflects fundamental productivity declines in tradable sectors, no amount of central bank intervention can reverse it. RBI cannot fight structural economic forces indefinitely.

5. The PPP Paradox

Higher PPP-adjusted income in developing countries doesn’t reflect strength - it reveals tradable sector weakness. Developed economies support higher non-tradable sector wages because their tradable sectors are so productive.

6. The Expectation Divergence

Domestic and foreign investors have sharply divergent views on India’s future. This unusual situation - where even FIIs’ outperformance elsewhere doesn’t resolve the disagreement - suggests fundamental uncertainty about India’s growth trajectory and per capita income potential.

7. Information Advantage Through Observation

Published data provides no competitive advantage - everyone has access. Ground-level observation of factory floors, supplier conversations, and informal market dynamics reveals information gaps that markets haven’t priced. This requires systematic effort and deliberate time allocation.

8. Medium-Term Framework Fundamentals

The shift from short-term to medium-term analysis requires understanding inflation expectations and how they anchor wage and price-setting behavior. Exchange rates, competitiveness, and long-term growth trajectories all hinge on expectations about future inflation.

Fiscal Policy, Crowding Out & Transmission

2025-11-23T00:00:00+05:30

GST Tax Cut Analysis

Professor Prasanna Tantri begins by analyzing recent GST rate cuts in India and their limited macroeconomic impact:

GST collection growth only 4% one month after cut (far below 10% budget target)
When government cuts spending to offset lower tax revenue, aggregate demand may fall
Only stimulative if government keeps deficits high AND RBI accommodates through Variable Rate Repos
Scope limited: GST cuts apply to goods (45% of economy); services (55%) and agriculture (16-17%) untouched

Whoever would have benefited from government expenditure will not now spend, and their people who earn from them will also not spend.

The Three Essential Tools of Short-Term Macro

The ‘whole endgame of short-term macro’ requires bringing together three essential tools:

Keynesian Cross - demand/output equilibrium
IS curve - investment-savings relationship
LM/MP curve - money market and monetary policy

Core Framework Equation

Y = C0 + C1(Y - T) + I(Y, R) + G

Investment I is now a function of both income (Y) and real interest rate (R).

Restated Assumptions

Prices are rigid (sticky) in the short run
Inflation expectations constant
Closed economy (no international trade)

Fiscal and Monetary Policy Interaction

intricate interaction between fiscal and monetary authorities:

Fiscal and monetary policy interaction quadrants

When Central Bank Accommodates

Central bank commits to maintaining interest rates and increases money supply as needed
Fiscal expansion has maximum stimulative effect
No crowding out of private investment
Output rises at same interest rate

When Central Bank Doesn’t Accommodate

Central bank holds money supply constant
Government borrowing raises interest rates
Crowding out reduces private investment
Fiscal multiplier is smaller

Government Borrowing and Crowding Out

Traditional Crowding Out: When government borrows, money demand rises and interest rates increase, reducing private investment

Modern Reality: RBI Accommodates

RBI is committed to interest rate targets
Maintains constant rate by pumping money into the system
Result: Both higher income AND same interest rate

Five-Step Tax Cut Transmission Mechanism

Direct Consumption Effect: Tax cut increases disposable income, leading to higher consumption and aggregate demand
Multiplier Effect: Expenditure increases income, which increases further demand, shifting demand curve rightward
Money Market Response: Higher income increases money demand. RBI maintains rate at target and increases money supply.
IS Curve Shift: For same interest rate, new equilibrium is at higher income level
No Crowding Out: RBI’s commitment to interest rate target prevents traditional crowding out

This is what Keynes discovered in the short run. Fiscal policy is very powerful when the central bank accommodates and inflation expectations remain constant.

Complete demand/output diagram with IS and LM curves

Professor Tantri provides analysis of India’s recent economic trajectory:

India slipped to 4th position among emerging markets (from 2nd)
Reverse AI story: AI benefits flowing to other countries, not India
IT company valuations falling while Korea’s rising
10-20 year underperformance versus S&P 500

Root Causes

Education quality issues
Lack of innovation
Structural challenges in human capital

Growth eventually is innovation. There is nothing else.

The professor expresses cautious optimism about labor law reforms as potential structural improvements.

AI, Human Capital, and India’s Future

India’s cognitive capital advantage is eroding with AI outsourcing:

China learned to manufacture; India copied IT without scaling to frontend
AI reduces gap between good and bad workers when asked to compute the easy tasks while it INCREASES the gap when asked to perform complex tasks
Without high-level talent, India will struggle in AI economy
The political system remains focused on quarterly growth while ignoring structural issues.

Figure 4: Comprehensive diagram with complete annotations

Takeaways

• The IS-LM/MP framework is the foundational tool of short-term macroeconomics

• Investment depends on both income and real interest rates

• Modern monetary systems with central bank accommodation make fiscal policy powerful

• Government borrowing doesn’t raise rates when central bank accommodates

• GST cuts without maintaining spending are not stimulative

• India’s structural challenges matter more than quarterly GDP numbers

• AI widens gap on complex tasks: India needs world-class human capital

Supplementary Notes (From Student’s Handwritten Notes)

From Keynesian Cross to IS-LM

• The concept of AD (Aggregate Demand) — take the example of economists predicting recession

• Recession is output falling for 2 consecutive quarters

• The equilibrium condition: AD = Output, or Z = Y

• The slope of Aggregate Demand is C₁ (MPC, where C₁ < 1) — also called the fiscal multiplier

• This is where the IS curve comes into the picture — there’s an alternate way of understanding the goods market through the IS curve

• Goods Market + Financial Markets: All learnings combined with Caballero’s framework

• Investment I = I_s + Ī_g: investment has both a sensitive component (to interest rate) and an autonomous component

Figure 5: From Keynesian Cross to IS-LM Framework (Recreated from handwritten notes)

Government Deficit & Crowding Out

• S(Y) = I — the savings-investment identity

• If government maintains deficit, it’ll crowd out private investment — also raises interest rates

• Can private sector now invest more? Depends on prevailing interest rates

• What are the penalties: If people are spending among firms, firms can reinvest into growth

• If the government doesn’t maintain deficit → GDP falls

• Raising deficit → raises inflation → risk of inflation expectations spiraling

• The trickle-down assumption: lower rates → more private investment. But need to examine if this actually holds

• Reference: This happened in Sri Lanka — introduced tax cuts etc. to stimulate growth but ended in crisis

Role of Consumption & Labour in Production Scenarios

• If consumption rises, firms may increase labour supply and grow, accumulate by goods and services on that path

• The role of goods and services on economy — how it has an effect, and when it is true

• Key point: no (zero) project without labour — production requires labour input

• But if most can’t get a job with more fulfilled/easier access — implications for women in labour market

• Supply of labour, domestic labour & wealth in economy — output depends on these factors

IS-MP Framework & Modern Monetary Policy

2025-11-16T00:00:00+05:30

Review of Previous Material

The Keynesian Short-Run Model

The foundational identity from our previous session is:

Y = C₀ + C₁(Y−T) + I + G

Key assumptions underlying this model:

Prices are rigid in the short run
Supply is effectively unlimited at the prevailing price level
Investment (I) and government spending (G) are exogenous
Output adjusts to clear the goods market

Keynesian Cross from October 19 Session

The Multiplier Effect Revisited

In the short run with rigid prices, the multiplier mechanism is the central transmission channel: Demand Shock → Expenditure → Income → Further Consumption → Further Income

The multiplier formula:

Multiplier = 1 / (1 − C₁)

Where C₁ is the marginal propensity to consume. A higher MPC leads to a larger multiplier effect.

Professor Tantri emphasizes: Most Indian macroeconomic discourse incorrectly applies the multiplier model as a long-term framework. This model is fundamentally SHORT-TERM and is rendered invalid once prices become flexible.

The IS-MP Framework: Integrating Interest Rates

Investment as a Function of Interest Rates

Major Innovation: Relaxing the constant investment assumption

The previous model treated investment as exogenous (I = constant). This ignores reality: business investment decisions are highly responsive to borrowing costs. We now make investment a function of two variables:

Y = C₀ + C₁(Y−T) + I(Y, i) + G

Where:

• I(Y, i) = Investment depends on both income Y and interest rate i

• Higher Y → Higher investment (firms invest more when demand is strong)

• Lower i → Higher investment (borrowing becomes cheaper, more projects become profitable)

Policy Implications

• Monetary stimulus = RBI lowers interest rates → increases investment → multiplier effect → higher GDP

• Fiscal stimulus = Government increases G → multiplier effect → higher GDP

Liquidity Preference Theory & Money Market

Money demand is the lynchpin connecting the goods market to monetary policy.

The Money Demand Function

M^d = $Y × L(i)

This states that aggregate money demand equals nominal GDP (price level P × real output Y) multiplied by a liquidity preference function L(i) that depends on the interest rate.

Why Do People Hold Money?

Income must be allocated across three uses:

• Consumption

• Money balances (zero yield)

• Financial assets—bonds, stocks, etc. (earn interest rate r)

The opportunity cost of holding money is the forgone interest rate. When interest rates are high, money becomes expensive to hold → people economize on cash and shift to interest-bearing assets. When rates are low, holding money is cheap → money demand rises.

The Money Demand Curve

• Downward sloping: Higher i → lower money demand

• Shifts with income: Higher Y → money demand curve shifts RIGHT (more transactions → more cash needed)

Key Equations and Liquidity Preference Theory Diagram

From Quantity Targeting to Interest Rate Targeting

The evolution of central banking practice reveals a fundamental shift in thinking:

Old Approach: Quantity Targeting	New Approach: Interest Rate Targeting
Central banks fix money supply M	Central banks fix interest rate target (e.g., repo rate)
Interest rates fluctuate with money demand	Money supply adjusts to maintain target rate
Creates seasonal volatility and uncertainty	Provides stable expectations for borrowers

Modern Monetary Policy: Interest Rate Targeting

The Reserve Bank of India, like most modern central banks, targets a specific real interest rate. This represents a fundamental change in policy implementation.

The RBI’s Operating Framework

• RBI sets a target for the Weighted Call Rate (WCR), the overnight interbank lending rate

• Maintains a corridor with a ceiling (marginal standing facility rate) and floor (reverse repo rate)

• When money demand increases → RBI supplies additional liquidity → maintains target rate

• When money demand decreases → RBI drains liquidity → maintains target rate

Caveat

The system assumes inflation expectations remain stable. If expected inflation rises → money demand increases → RBI must increase supply to offset. But if inflation expectations become unanchored (as in Venezuela), the central bank loses control.

IS-LM Diagram with Interest Rate Dynamics

Real vs. Nominal Interest Rates

Real Interest Rate = Nominal Interest Rate − EXPECTED Future Inflation

(NOT current reported inflation)

Distinction Matters

• Borrowers and savers care about the REAL purchasing power they earn, not nominal returns

• Investment decisions depend on the real cost of borrowing

• Expected inflation is what matters, not historical inflation

The RBI’s Mistake

Many analysts in India calculate the real rate using current CPI inflation rather than expected future inflation. This led to a critical miscalculation: From 2022-2024, India experienced some of the highest real interest rates globally—seemingly tight policy. In reality, the RBI may have been accommodative because inflation expectations had fallen.

RBI Credibility & Inflation Expectations

The Self-Fulfilling Expectation Problem

Prices fall into two categories:

• Sticky prices: Fixed in advance through contracts (salaries, school fees, long-term service agreements)

• Flexible prices: Adjust frequently (food, fuel, daily commodities)

When people negotiate long-term contracts, they anticipate future inflation. If they believe the RBI will print money → they expect higher inflation → they demand higher wages and higher contract prices → this becomes self-fulfilling.

Real-World Evidence

In 2024, the US Federal Reserve cut rates by 100 basis points. Yet the 10-year Treasury yield remained at 4.2%. Why? Because markets don’t believe the inflation will fall as much as the Fed suggests. Central bank credibility is everything.

Money vs. Savings: A Critical Distinction

“Money is a representation of savings, not a replacement for savings.”

India’s Core Problem

Savings Rate Comparison:

• India: 27-28% of GDP

• China (during 8-10% growth era): 50-60% of GDP

Printing money does not create real savings. It merely changes prices. With inadequate savings, capital formation is constrained, limiting investment and growth. No policy manipulation can overcome a structural savings deficit.

The IS-MP Framework

The IS Curve

IS = Investment-Savings; represents the goods market equilibrium

Derived from:

Y = C₀ + C₁(Y−T) + I(Y, r) + G

• Shows all combinations of interest rate (r) and output (Y) where the goods market clears

• Downward sloping: r↑ → I↓ → Y↓ (via multiplier) → C↓

• Shifts with changes in C₀, T, and G

The MP (= Monetary Policy) Curve (Replaces LM)

Because the RBI fixes the interest rate target, monetary policy is represented as a horizontal line:

• The RBI announces a target repo rate

• The MP curve is a horizontal line at that rate

• For any level of output, the interest rate remains fixed

Equilibrium in the IS-MP Model

Short-term GDP is determined by the intersection of the IS curve and the MP curve.

So, “Who determines next quarter’s GDP? The RBI(at least in the short term)—because it controls interest rates.”

Long-run growth is determined by supply-side factors: productivity, innovation, capital accumulation, and institutional quality. The RBI can boost demand in the short term, but cannot increase long-run potential output.

Policy Applications

Tax Cuts and Stimulus Analysis

Q: Does a GST cut stimulate the economy?

A: “It depends” entirely on whether the RBI accommodates the fiscal expansion.

Case A: RBI Accommodates

• GST cut → C increases → IS curve shifts right

• RBI increases money supply to maintain target rate

• Output increases, stimulus works

• Risk: Inflation if money supply grows beyond real growth

Case B: RBI Does Not Accommodate

• GST cut → demand for money increases

• RBI does not increase money supply → interest rates rise

• Higher rates → crowding out of private investment

• No net stimulus effect

How to Determine Which Case Is Happening

Monitor the RBI’s Liquidity Adjustment Facility (LAF) operations and excess reserves in the banking system:

• If RBI is supplying excess liquidity → accommodating

• If RBI is draining liquidity → not accommodating

India’s Macroeconomic Constraints

The Fiscal Trilemma

India faces a structural constraint with government finances:

• Government debt: 84-85% of GDP

• GST revenue growth: 4% annually (below nominal GDP growth)

• Current budget structure requires 10% growth in revenue

This creates an impossible choice:

• Cut government expenditure significantly

• Increase fiscal deficits (unsustainable)

• There is no third option

Professor’s Policy Recommendations

To address India’s structural constraints:

• Strategic expenditure reduction: Cut government spending on non-productive sectors while protecting education and infrastructure

• FDI attraction: Increase foreign direct investment through policy certainty and regulatory clarity

• Innovation focus: Invest in R&D and technology to increase productivity

• Regulatory simplification: Remove barriers to business formation and operation

Takeaways

1. Investment depends on BOTH income and interest rates—this is the critical evolution from the Keynesian Cross to the IS-MP framework.

2. Modern central banks target interest rates, NOT money supply. Money supply becomes an endogenous tool to maintain the rate target.

3. Money supply is a tool, not a policy target itself. Printing money cannot solve real economic problems like low savings rates.

4. Real interest rate = Nominal rate − EXPECTED inflation. Calculating real rates using current inflation is a common analytical error.

5. Short-term GDP is effectively the RBI’s choice via interest rate targeting. Long-term growth requires supply-side improvements.

6. Money ≠ Savings. You cannot solve a savings problem by printing money. This is India’s fundamental constraint.

7. Inflation expectations are self-fulfilling. Central bank credibility is paramount to maintain stable expectations.

8. India’s declining savings rate (27-28% vs. China’s 50-60% in high-growth era) is a structural constraint that cannot be overcome through monetary policy alone.

Discussion Questions

How does the interest rate responsiveness of investment affect the effectiveness of monetary policy compared to fiscal policy?

Why might a central bank’s loss of credibility lead to an uncontrollable inflation spiral?

Given India’s savings constraint, what structural reforms could help increase capital formation?

How would you expect the IS-MP equilibrium to shift in response to a sudden increase in global interest rates?

Supplementary Notes/Revision (From My Handwritten Notes)

Concept of Aggregate Demand & Recession

1. Economists often predict recession. Recession is defined as output falling for 2 consecutive quarters. Why do economists think AD or output will fall in the near future?

2. The equilibrium condition is where AD = Output, or Z = Y (AD) = (output) GDP

3. The slope of Aggregate Demand is C₁ (where C₁ < 1) — it is also called the fiscal multiplier

4. This is where the IS curve comes into the picture, and there is an alternate way of understanding the same thing

5. Investment: I = I_s + Ī_g (private investment + government/autonomous investment)

Keynesian Cross — Transition to IS Curve

Goods Market + Financial Markets Combined

1. All learnings from the goods market and financial markets are now combined, following Caballero’s framework

2. In the goods market, investment depends on the interest rate. This links the goods market to the financial/money market

3. This is the bridge to the IS-LM or IS-MP framework

The New Monetary Policy Paradigm

1. In the new paradigm, the interest rate is fixed and money supply is varied by RBI through VRR and VRRR operations

2. When money demand fluctuates, it can be stabilized by RBI conducting OMOs

3. Interest rate does not fluctuate immediately — only when inflation requires RBI to change the nominal rate explicitly

4. Earlier, central banks controlled money supply during festivals or advance tax payments. When money supply fluctuated, it moved interest rate violently, making long-term investment decisions by firms impossible in such an environment

5. The key driver of the Keynesian Cross is demand, and supply is thought to be constant because of price rigidity

6. The Keynesian view is good in the short-term because assumptions (price rigidity, production/labour efficiency/human capital constraints) are fairly accurate within that time-frame

Money Market — The New Paradigm of Monetary Policy

Aggregate Demand & Monetary Policy

2025-11-09T00:00:00+05:30

Recap - The Keynesian Cross Model

This session begins by revisiting the fundamental aggregate demand equation that forms the foundation of Keynesian macroeconomic analysis. Understanding this model is essential for analysing how consumption, investment, and government spending interact to determine income equilibrium in the short run.

The Aggregate Demand Equation

The fundamental equation relating aggregate demand (Z) to income (Y) is:


Z = C0 + C1(Y - T) + I + G

Key Components

• Z = Aggregate Demand - total spending desired by all sectors of the economy

• C0 = Autonomous Consumption - consumption that occurs independent of income, such as from existing wealth, inheritances, or charitable contributions. This represents the baseline spending level when income is zero.

• C1 = Marginal Propensity to Consume (MPC) - the slope of the consumption function. It represents the fraction of each additional rupee of income that households consume. Range: 0 < C₁ < 1

• Y = Income (or output) - the total production of the economy

• T = Taxes - lump-sum taxes on households

• (Y - T) = Disposable Income - income remaining after tax payments, which is what households actually have available to consume or save

• I = Investment - business investment in capital. Denoted with a bar (Ī) indicating it is held constant in the initial analysis, not dependent on income

• G = Government Spending - comprises only government purchases of goods and services. Note: This does NOT include transfer payments (social security, pensions) or subsidies, as these are income transfers rather than purchases of new goods/services

Equilibrium Condition

Equilibrium in the goods market occurs when aggregate demand equals actual output:

Z = Y

Solving for equilibrium income:

Y = [C0 - C1T + I + G] / (1 - C1)

The Multiplier Effect

The denominator (1 - C¹) in the equilibrium equation gives us the reciprocal of the multiplier. An increase in autonomous spending (C⁰, I, or G) increases equilibrium income by a multiple of the initial change.

Multiplier = 1 / (1 - C¹)

Examples of Multiplier Magnitudes

• If C¹ = 50%: Multiplier = 1/(1-0.5) = 2 (a 100 rupee increase in G raises income by 200)

• If C¹ = 80%: Multiplier = 1/(1-0.8) = 5 (more consumption per rupee earned = larger multiplier)

• If C¹ = 90%: Multiplier = 1/(1-0.9) = 10 (very high savings rate leads to very large multiplier)

Real-World Application: GST Collection in India

The professor discussed a recent case with the Ministry of Finance regarding GST collection. The government expected GST revenues to grow by 11-12%, but actual growth was only 4.6%.

The Policy Question: Is it stimulative to cut taxes (T) while maintaining a balanced budget by also cutting government spending (G)?

When taxes decrease and government spending decreases equally, the net effect depends on whether the MPC of taxpayers is greater than the MPC of government spending recipients.

The Problem: There is no definitive empirical proof for which MPC is higher. The theoretical answer requires knowing the income distribution and consumption patterns of both groups.

Real Interest Rates vs Nominal Rates

A critical distinction in macroeconomics is between the nominal interest rate (what you observe) and the real interest rate (what actually matters for economic decisions). This section explains why central banks often miscalculate real rates and the consequences.

Investment as a Function of Real Interest Rate

In the more complete model, investment is no longer constant. Instead, it depends on the real interest rate R:

I = I(R)

Higher real interest rate → Lower investment

Lower real interest rate → Higher investment

The Critical Insight: Real Rates Depend on EXPECTED Inflation


Real Interest Rate = Nominal Rate - EXPECTED Inflation

This is not historical or actual inflation—it is what economic agents expect inflation to be in the future. This distinction is crucial because business investment decisions are based on expected real returns, not backward-looking inflation.

The RBI Mistake (2023-2025)

The Reserve Bank of India made a calculation error that had significant economic consequences:

What RBI Did (Incorrect):	What They Should Have Done:
Real Rate = Repo Rate - Reported Inflation 6.5% - 4.0% = 2.5%	Real Rate = Repo Rate - Expected Inflation 6.5% - 2.0-2.5% = 4.0-4.5%

Real Rate = Repo Rate - Reported Inflation

6.5% - 4.0% = 2.5%

Real Rate = Repo Rate - Expected Inflation

6.5% - 2.0-2.5% = 4.0-4.5%

Problem: RBI thought the real rate was 2.5%, when it was actually 3-4%. This is an overly restrictive real rate that no country can sustain for long periods.

Macroeconomic Consequences

• Slow Investment Growth: High real rates discourage business investment. Firms postponed capital expenditure.

• Weak Job Market: Without investment in new productive capacity, job creation slowed.

• Visible Impact on Placement: Even at ISB, placement numbers and salary offers were affected by the weak job market.

Historical Context: Normal Real Rates in India

Research on India’s history shows:

• Average Real Rate (1950s-2020s): 1.0% - 1.25%

• Neutral Real Rate: Approximately 1.75% (the rate that neither stimulates nor restricts growth)

• RBI Rate: 3-4% was deeply restrictive by historical standards

Why Real Rates Matter for Business Decisions

Businesses evaluate investment returns in real terms. Asset prices rise with inflation, so a business must earn a return above inflation to justify the investment.

Scenario A

Nominal Return: 9%

Inflation: 9%

Real Return: 0%

Verdict: No real gain

Scenario B

Nominal Return: 7%

Inflation: 4%

Real Return: 3%

Verdict: Attractive, despite lower nominal rate

Scenario B is more attractive despite the lower nominal rate because it offers a real return of 3%.

Liquidity Preference Theory - Money Demand

Money is demanded not because it generates income, but because it provides liquidity—the ability to make immediate purchases. We now develop the theory of money demand and its crucial relationship with interest rates and income.

The Money Demand Equation

M = $Y × L(i)

Money Supply = Nominal Income × Liquidity Preference Function

Components

• M = Quantity of money demanded

• $Y = Nominal income (price level × real output). Higher nominal income means more transactions, requiring more money for purchases.

• L(i) = Liquidity preference function. Shows the relationship between the interest rate and the desired ratio of money to nominal income. As interest rate rises, L(i) falls because money becomes less attractive relative to interest-bearing assets.

The Fundamental Trade-off

Holding money involves a choice between two competing forces:

Cost: Opportunity Cost

When you hold money, you forego interest income you could earn on bonds or savings accounts.

Higher interest rate → Higher opportunity cost → Hold less money

Benefit: Liquidity/Convenience

Money is immediately useful for transactions. You can buy a dosa, idli, or banana without converting assets first.

Lower interest rate → Liquidity becomes more valuable relative to foregone interest → Hold more money

Thought Experiment

Imagine an equilibrium at income = 100, interest rate = 3%, money held = 10 rupees.

Question: If income doubles to 200 but money holdings stay at 10 rupees, what must happen to interest rates?

Initial Situation:

Income = 100

Cash = 10 rupees

Cash/Income = 10/100 = 10%

After Income Doubles:

Income = 200

Cash = 10 rupees (unchanged)

Cash/Income = 10/200 = 5%

Analysis: The ratio of cash to income has fallen from 10% to 5%. This means less cash is available for transactions relative to the volume of transactions needed. People would feel inconvenience (it’s now harder to make the same purchases). This inconvenience is NOT compensated by the interest rate, which is still 3%.

Solution: Interest rates must INCREASE. The higher rate compensates for the inconvenience of holding less cash relative to income needs. Only with higher interest will people accept a lower cash-to-income ratio.

Money demand equation with relationship to income and interest rates

The Same Logic Applies to Inflation

When prices double due to inflation, people need twice as much nominal cash to buy the same goods. If the central bank doesn’t supply enough money, what happens?

• If prices double but M stays constant, then M/$Y falls

• People feel less liquid (inconvenient cash situation)

• Interest rates must rise to compensate for this reduced liquidity

The Money Demand Curve

When plotted on a graph with interest rate on the vertical axis and money quantity on the horizontal axis, the money demand curve slopes downward:

• Shape: Downward sloping, like a hyperbola

• Steeper at low money quantities: Interest rates are very high. Small increases in money supply cause sharp drops in rates.

• Flatter at high money quantities: Interest rates are already low. Additional money has little effect on rates (the liquidity trap).

Shifts in the Money Demand Curve

When income increases, the entire money demand curve shifts to the right. At any given interest rate, people now want more money because they have higher income and more transactions to conduct.

Relationship between income and money demand with graphical representation

money demand curves showing shifts with income changes

Money Supply Systems - Old (IS-LM) vs New (IS-MP)

Central banks operate under different frameworks. Understanding how money is supplied to the economy and how central banks make their decisions is crucial to understanding modern monetary policy.

The Old System: IS-LM Framework

In the traditional Keynesian model (IS-LM), the central bank targets the quantity of money in the economy:

Central Bank Action:

Supply a fixed amount of money (vertical line on a graph)

Market Result:

Interest rate fluctuates based on money demand, which varies with festivals, tax seasons, and economic cycles

Problem: When demand for money spikes (e.g., during Diwali festival when people need cash for shopping), interest rates can spike sharply. When demand falls post-festival, rates plummet. This volatility can destabilize the economy.

The New System: IS-MP Framework

Modern central banks (including the RBI) target the interest rate instead:

Central Bank Action:

Set the policy interest rate (repo rate in India) at a target level (horizontal line)

Market Result:

Money supply adjusts endogenously (automatically) to match demand at the target rate

How it works: When money demand rises (festival season), the RBI supplies more money through repo operations. When demand falls, the RBI absorbs money. The interest rate stays stable at the policy rate.

Variable Rate Repo (VRR)

The RBI uses VRR auctions to supply liquidity precisely. Banks bid for rupees at the repo rate, and the RBI supplies whatever amount is demanded at that rate. This maintains interest rate stability while allowing money supply to vary.

Vulnerability: Inflation Expectations

This system has a critical vulnerability. When the RBI accommodates persistent government borrowing (supplying money to finance fiscal deficits), inflation expectations can rise if the public believes the central bank will tolerate higher inflation.

The Spiral:

1. RBI eases (lowers rates) to accommodate fiscal borrowing

2. Public sees persistent money supply growth and expects higher inflation

3. Inflation expectations rise

4. Even though RBI keeps repo rate steady, real rates INCREASE (because expected inflation is now higher)

5. This tightens monetary conditions despite RBI easing

Historical Examples of This Vulnerability

• United Kingdom (2022): After the Liz Truss government announced massive unfunded spending plans, gilt yields spiked sharply despite the Bank of England easing. Inflation expectations jumped, raising real rates.

• Venezuela: Persistent central bank accommodation of fiscal deficits led to hyperinflation and currency collapse.

• Zimbabwe: Similar pattern of monetary accommodation and loss of currency credibility.

• Pakistan: Recent experience with inflation spike following monetary accommodation of large fiscal deficits.

• Sri Lanka: Central bank accommodation of government borrowing contributed to the 2022 crisis and currency devaluation.

A central bank targeting the interest rate must maintain credibility that it will not accommodate persistent fiscal deficits indefinitely. If that credibility erodes, inflation expectations rise, real rates increase, and the accommodative policy becomes contractionary.

Takeaways

The Keynesian Aggregate Demand Model

• Aggregate demand Z = C⁰ + C¹(Y-T) + I + G determines short-run equilibrium output

• The multiplier 1/(1-C¹) shows how initial spending shocks amplify into larger income changes

• Balanced budget tax cuts are not necessarily stimulative—the net effect depends on the relative MPC of different groups

Interest Rates Matter for Investment

• The real interest rate (not nominal) determines investment: Real Rate = Nominal Rate - Expected Inflation

• Businesses evaluate investment returns in real terms—they must exceed inflation to be worthwhile

• Central banks that miscalculate real rates can inadvertently create severe constraints on investment and job creation

Money Demand and Liquidity

• Money is demanded for transactions, not for income. M = $Y × L(i) captures the relationship

• Higher income raises money demand; higher interest rates lower it (due to opportunity cost)

• The money demand curve slopes downward and shifts right with income increases

Central Bank Operating Frameworks

• Old system (IS-LM): Central bank targets money supply → interest rates fluctuate

• New system (IS-MP): Central bank targets interest rate → money supply adjusts endogenously

• Vulnerability: If inflation expectations rise faster than the central bank’s credibility can contain them, real rates increase even as nominal rates stay fixed

Next Session

• Professor will combine the IS and MP curves to complete the short-term macro framework

• Analysis of how tax changes, government spending shifts, and demand shocks propagate through the economy

• Understanding the monetary policy transmission mechanism and its limitations

The Keynesian Cross

2025-10-19T00:00:00+05:30

Opening & Research Context

Professor Prasanna Tantri opens with research on street vendor financing in emerging markets, presenting data from 1000 treatment and 1000 control groups. This empirical work motivates the shift from long-run growth theory to short-term demand analysis. He references Joel Mokyr’s seminal idea: “ideas create the world.” This philosophical foundation underpins the session’s focus on how expectations and shocks drive output in the short run.

Critical Foundation: Long-Term vs Short-Term

Always distinguish between claims about growth and actual growth drivers.

When someone claims GDP will grow, Professor Tantri emphasizes that we must ask: Will it increase labor supply? Will investment rise? Will technology improve? If none of these fundamentals change, then there is no real growth - only nominal or demand-driven changes.

This distinction is crucial because in the short run (which this session addresses), increases in aggregate demand can raise output even without changes to productive capacity. In the long run, only supply-side improvements matter.

Aggregate Demand vs GDP

Core Distinction

GDP (Y) = What is produced or supplied in the economy

Aggregate Demand (Z) = What people actually want to buy

These two need NOT be equal in the short term. If demand exceeds supply, inventories fall and producers increase output. If supply exceeds demand, inventories build and producers cut output. This dynamic is at the heart of short-run macroeconomics.

Aggregate Demand Decomposition

Z = C + I + G

C(Consumption): Spending on goods and services whose utility is exhausted within one time period.

I(Investment): Spending on capital goods (primarily machinery, equipment, and infrastructure) that provide benefits over multiple periods.

G(Government Spending): Government purchases of goods, services, and public investment.

International Consumption Patterns

Country	Consumption % of GDP
United States	~70%
India	56-60%
China	~40%

India’s consumption share has actually GROWN over recent decades. What has fallen is investment as a percentage of GDP, contributing to slower growth despite higher consumption.

Modelling Consumption

The Consumption Function

C = C0 + C1(Y - T)

C0: Autonomous Consumption

Consumption that occurs regardless of current income. Driven by:

Borrowing against future income
Wealth effects (e.g., when gold prices rise)
Expectations about future income

C1: Marginal Propensity to Consume (MPC)

The fraction of each additional rupee of disposable income that is spent on consumption. Constraint: 0 < C1 < 1 (people consume some but not all additional income)

(Y - T): Disposable Income

Income after taxes. Y = national income, T = total taxes.

Key Assumption: Price Rigidity

The Keynesian framework assumes prices are rigid in the extreme short run. This is a foundational assumption that makes demand changes translate into output changes rather than pure price movements. As we move further out, prices become more flexible and the classical model’s predictions dominate.

5. GST Cuts & Stimulus: Real-World Application

Professor Tantri uses GST cuts as a concrete case study to illustrate the model’s implications and limitations.

5.1 The Naive View

Media reports often claim that GST cuts stimulate the economy by increasing consumption. The assumption implicit in this view: reduce T → increase (Y - T) → increase C → increase Z → increase Y.

5.2 The Critical Flaw

When taxes (T) decrease, government revenue also decreases.

Unless the government either:

• Reduces expenditure (G) correspondingly, OR

• Increases borrowing

The stimulus will be incomplete or unsustainable.

5.3 Two Scenarios

Scenario A: G Stays Constant (Deficit Increases)

If government maintains spending while cutting tax revenue:

• Larger fiscal deficit → RBI must finance it or allow inflation → Crowding out of private investment

• If inflation expectations rise, consumption is discouraged → stimulus collapses

Scenario B: G Decreases (Balanced Budget)

If government cuts spending proportionally to maintain budget balance:

• Net effect is ambiguous because both C and G change

• The multiplier effect depends on the relative sizes of these changes

5.4 Real-World Example: Sri Lanka

Sri Lanka provides a cautionary tale. The government cut taxes without corresponding expenditure reductions. The result: larger deficits, inflation expectations rose, and the stimulus collapsed into a severe debt crisis. This demonstrates why the assumption that “any assumption breaks → inflation expectations rise → stimulus collapses” is not merely theoretical but empirically relevant.

Tariff Analysis

Professor Tantri offers a brief but insightful digression on tariffs and pricing:

6.1 The Key Insight

In oligopolistic markets (few large suppliers), firms have pricing power and may absorb tariffs rather than pass them fully to consumers. In competitive markets, tariffs are passed through 1:1 to prices.

6.2 Business Intelligence Application

When tariffs are imposed and prices DON’T rise proportionally, this reveals important information: the market is NOT competitive. High-margin oligopolists are absorbing the cost. This can be valuable intelligence for business strategy and competitive analysis.

7. The Keynesian Cross Equation

This section derives the fundamental equation of the Keynesian model.

7.1 Starting Point

Z = C0 + C1(Y - T) + I-bar + G-bar

7.2 Equilibrium Condition

In equilibrium, aggregate demand equals output:

Y = Z

7.3 Solving for Equilibrium Output

Substituting the consumption function into the demand equation and setting Y = Z:

Y = C0 + C1(Y - T) + I-bar + G-bar

Expanding:

Y = C0 + C1*Y - C1*T + I-bar + G-bar

Collecting Y terms on the left:

Y - C1*Y = C0 - C1*T + I-bar + G-bar

Factoring:

Y(1 - C1) = C0 - C1*T + I-bar + G-bar

7.4 Equilibrium Output (Keynesian Cross Solution)

Y* = (C0 - C1*T + I-bar + G-bar) / (1 - C1)

Figure 2: Whiteboard showing the complete consumption function with MPC notation

7.5 The Fiscal Multiplier

The term 1/(1 - C1) is the Keynesian multiplier. It shows how much output expands for each unit increase in autonomous spending (whether from C0, I-bar, or G-bar).

Example Calculation

If C1 = 0.8:

1. Multiplier = 1 / (1 - 0.8) = 1 / 0.2 = 5

This means: when government increases spending by 1 rupee:

2. Round 1: Spend 1 rupee → income rises by 1

3. Round 2: Consume 0.80 of new income → income rises by 0.80

4. Round 3: Consume 0.80 x 0.80 = 0.64 → income rises by 0.64

5. Round 4: 0.512 → …

Total Output Increase = 1 + 0.80 + 0.64 + 0.512 + … = 5 rupees

Multiplier Interpretation

The multiplier reflects a dynamic process: initial government spending creates income, recipients spend a fraction (the MPC), creating additional income, which is partially spent again, and so on. The cumulative effect amplifies the initial stimulus.

Comparative Statics

Comparative statics examines how equilibrium output changes when parameters shift. Each change is amplified by the multiplier.

Tax Decrease (T Decreases)

Lower taxes → higher disposable income → higher consumption → higher output

Output multiplier: ΔY = C1 x Multiplier x (-ΔT)

Investment Increase (I-bar Increases)

Higher investment → directly increases aggregate demand → output rises by multiplier

Output multiplier: ΔY = Multiplier x ΔI-bar

Government Spending Increase (G-bar Increases)

Higher government spending → directly increases aggregate demand → output rises by multiplier

Output multiplier: ΔY = Multiplier x ΔG-bar

Autonomous Consumption Shift (C0 Increases)

Wealth shock (e.g., gold prices spike) → autonomous consumption rises → output expands by multiplier

Output multiplier: ΔY = Multiplier x ΔC0

In the Keynesian framework, any change in autonomous spending (whether fiscal, investment-driven, or confidence-driven) is amplified through the multiplier mechanism. The MPC is the critical parameter determining multiplier magnitude.

The Keynesian Cross Diagram

Diagram Structure

• X-axis: Income (Y)

• Y-axis: Demand (Z)

Key Lines

• The 45-degree line represents Y = Z (equilibrium locus)

• The aggregate demand curve Z = C0 + C1(Y - T) + I-bar + G-bar has slope C1 (0 < slope < 1), so it is flatter than the 45-degree line

The Equilibrium

The intersection of the aggregate demand curve and the 45-degree line determines equilibrium output Y*. At this point, aggregate demand equals output, so there is no pressure for change.

Below Equilibrium

• When Y < Y*: Z > Y (demand exceeds supply)

• Inventories fall → producers increase output → income rises

• The economy moves rightward along the demand curve toward equilibrium

Above Equilibrium

• When Y > Y*: Z < Y (supply exceeds demand)

• Inventories accumulate → producers decrease output → income falls

• The economy moves leftward along the demand curve toward equilibrium

complete equilibrium derivation and the Keynesian Cross diagram

Shifts in Aggregate Demand

Changes in autonomous components (C0, I-bar, G-bar, or taxes) shift the demand curve. The new intersection with the 45-degree line defines the new equilibrium. The change in output is determined by the multiplier and the size of the shift.

Animal Spirits

Animal Spirits: A sudden change in confidence or optimism about the future with no change in fundamentals.

When animal spirits are bullish, C0 rises (consumers borrow and spend more). This shifts the demand curve up, triggering a multiplier-amplified boom. Conversely, pessimistic animal spirits cause a sharp contraction. This mechanism explains why business confidence and consumer sentiment are crucial to macroeconomic fluctuations, independent of changes to productive capacity.

Crucial Assumption: Supply Flexibility

Critical Caveat: The Keynesian model assumes that when demand increases, producers can increase supply without running into constraints. This is valid when there is unemployment and excess capacity.

If the economy is near full capacity, an increase in demand will simply raise prices rather than output. The model’s prediction - that demand drives output - breaks down when supply is constrained.

The Paradox of Thrift

10.1 The Paradox

In the Keynesian framework, increased savings can be BAD for short-run output.

10.2 Mechanism

If households increase their savings rate, they reduce their consumption (lower C1 or increase (1 - C1)). If interest rates do not fall (e.g., the central bank holds rates constant), this reduced consumption:

• Decreases aggregate demand

• Triggers a downward multiplier effect

• Income falls, which can reduce actual savings despite the desire to save more

10.3 The Classical Resolution

The paradox is resolved in the long run if lower savings leads to lower interest rates, which stimulates investment. When investment rises enough to offset consumption’s decline, output returns to trend. However, during the transition (which is what Keynesian analysis focuses on), higher savings can be contractionary.

11. Credit & Delinquency Discussion

Timeline: [46:40 - 50:50]

A student raises a question about unsecured lending: consumers borrowing to purchase items like iPhones or concert tickets. Professor Tantri provides important context.

11.1 Short-Run Effect

When unsecured lending expands, C0 (autonomous consumption) increases because more people can borrow. This directly boosts aggregate demand and output through the multiplier. The short-run stimulus is real.

11.2 Delinquency Risk

However, if delinquencies rise on unsecured loans (borrowers unable to repay), lenders reduce credit supply. This contracts future consumption and aggregate demand.

11.3 Systemic Risk Assessment

Professor Tantri notes that unsecured lending in India currently (~4-5 lakh crores) represents only about 5% of the ~180 lakh crore banking system. Compared to the scale of the 2008 US subprime crisis, this is

• Not yet a systemic threat

• But a risk to monitor

• Potentially important for monetary policy if growth slows

Figure 4: Slide from Session 1 on Investment foundations (for structural context)

Key Takeaways

1. Aggregate Demand Framework

6. Aggregate demand (Z = C + I + G) determines short-run output when prices are rigid. GDP and demand need not be equal; the gap drives inventory and production adjustments.

2. Consumption Function

7. C = C0 + C1(Y - T) separates autonomous consumption from income-dependent consumption. The MPC (C1) is the critical parameter determining multiplier size.

3. Fiscal Multiplier

8. The multiplier = 1/(1 - C1) amplifies shocks. Higher MPC means larger multiplier. Changes in government spending, taxes, or investment are magnified through multiple rounds of spending and income.

4. GST Cuts & Policy Design

9. Tax cuts only stimulate if government spending is maintained and inflation expectations remain anchored. If either assumption breaks, stimulus fails. Sri Lanka’s experience shows real costs of unsustainable fiscal policy.

5. Keynesian Cross Dynamics

10. The intersection of aggregate demand and the 45-degree line (Y = Z) determines equilibrium. Below equilibrium, rising demand boosts output. Above, falling demand contracts output. The economy naturally converges to equilibrium through inventory mechanisms.

6. Paradox of Thrift

11. In the short run, increased savings can reduce consumption → reduce aggregate demand → reduce output. This is only resolved if lower savings rates lead to lower interest rates that stimulate investment.

7. Animal Spirits

12. Sudden shifts in confidence (unrelated to fundamentals) change autonomous consumption and trigger multiplier booms or busts. Business and consumer sentiment are real drivers of macroeconomic fluctuations.

8. Supply-Side Constraint

13. The model assumes slack in the economy (unemployment, excess capacity). If the economy is near full capacity, demand increases drive prices, not output. Policy effectiveness depends critically on the economic slack available.

Session References

Joel Mokyr’s concept that ideas create the world provides the philosophical underpinning. In the Keynesian framework, ideas (expectations, animal spirits) have real economic consequences.

Sri Lanka’s fiscal crisis demonstrates the real costs of violating model assumptions. Tax cuts without expenditure cuts, unsustained by RBI accommodation, led to inflation and debt crisis.

The observation that tariff incidence (whether prices rise proportionally) reveals market structure is a valuable tool for business analysis of competitive dynamics.

Supplementary Notes (From Student’s Handwritten Notes)

Keynesian Way of Consumption

Why would a nation not produce a complete economic approach on a country/world level? Because individuals would only spend that amount which occurs — I surely would not spend money on go or whatever in or abilities.

Savings as a means to grow the economy is why lower interest rates and giving rise — savings could involve long-time horizons.

The Keynesian view: demand drives supply, not the other way around. In the short term, prices are rigid, so when people don’t consume, firms can’t slash prices and clear inventory. Inventory stays put for next quarter and production in subsequent quarters decreases.

The Goods Market Equilibrium

We call 1/(1−C₁) the fiscal multiplier

Aggregate Demand (Z) and Aggregate Output, which we also call GDP (Y)

Z = C + Ī + Ḡ → Z = C₀ + C₁(Y−T) + Ī + Ḡ

Autonomous consumption (C₀) is the baseline consumption regardless of income

MPC (C₁): The marginal propensity to consume

Key assumption: If T (taxes) reduces, even then the government maintains its deficit

The government treats deficit with pure demand for money — raising interest rates

Now RBI will step in to maintain interest rates. They will do VRRs (Variable Rate Repos), i.e., increase money supply

Real Interest Rate = Nominal Rate − Inflation

Endogenous variables move along the graph; exogenous factors shift from outside

The multiplier cycle: Output → Increasing income → Demand creates income → Income increases demand

Equilibrium: Y = (C₀ − C₁T + Ī + Ḡ) / (1 − C₁)

Keynesian Cross — Goods Market Equilibrium (Recreated from handwritten notes)

The Fiscal Multiplier & Debate Around Tax Cuts

The debate around tax cuts leading to increased GDP: The government’s argument is based on the spending argument that MPC of an ordinary citizen is much more than that of a government employee

What happens if people save instead of consuming? Inventory piles up. In the short-term there’s also price rigidity (explore this more)

Key driver of the Keynesian Cross: demand, and supply is thought to be a constant because of price rigidity

The Keynesian view is good in the short-term because assumptions (price rigidity, etc.) are fairly accurate within that time-frame

Production/labour efficiency/human capital constraints apply in the longer run

Fiscal Multiplier & Income-Demand Cycle

Economy in the Long Run

2025-10-02T00:00:00+05:30

Course Structure

Course Overview

This macroeconomics course is organized into 15 sessions, each approximately one hour long, held on weekends. The course is structured in two main phases:

Phase 1: Closed Economy Macroeconomics

Phase 2: Open Economy and Trade

Textbooks and References

Primary: Mankiw’s Macroeconomic Principles

Supplementary: Prof will provide readings for each session

Recommended Supplementary Books

The Enlightened Economy by Joel Mokyr - Historical context on economic growth

The New Geography of Jobs by Enrico Moretti - Regional economic development

Real-World Motivations and Examples

macroeconomics grounding theory in practical economic realities.

Example 1: Micro-lending in Hyderabad

Street vendors earn 30-40% monthly marginal returns, yet capital does not flow freely to these entrepreneurs. Why doesn’t capital flow to high-return opportunities?

Example 2: Darjeeling vs. Hyderabad - Regional Wage Disparity

Highly-skilled taxi drivers in Darjeeling earn 7,700 rupees/month, while unskilled Hyderabad drivers earn 25,000-40,000 rupees/month. What causes sustained regional growth gaps?

Example 3: Bangalore vs. Hyderabad - FDI and Entry Barriers

Despite superior infrastructure, Hyderabad’s FDI advantage over Bangalore is declining. Hyderabad’s economy is controlled by few families with high entry barriers and rent-seeking.

Historical Growth Context and Modern Exceptionalism

Pre-Industrial Growth Patterns

Modern economic growth is not normal. Economic stagnation was the historical norm.

Pre-Industrial Growth Rate

Annual growth: 0.2% to 0.4%

Duration: 500+ years (1250-1750)

Living standards barely improved across centuries

Modern Growth Episodes

Post-WWII Germany and Japan: Rapid reconstruction

Asian Tigers: Double-digit sustained growth

China: 10% annual growth for 20+ years

Common Misconceptions About Growth

Misconception 1: Consumption Creates Long-Run Growth

Correct: Consumption is a consequence of income, not a driver of growth. Growth comes from increased productive capacity.

Misconception 2: Events Create Growth

Correct: Events shift spending in time but don’t create new productive capacity.

The example that we took of a person choosing to travel to Ahmedabad because of the stadium or a new airport is consumption transfer, not growth.

Misconception 3: Government Spending Creates Growth

Correct: Government transfers redistribute but don’t create productive capacity. Spending may reduce growth through crowding-out.

The Leisure-Work Trade-off: Foundation of Growth

Core Principle

Universal Economic Truth: Growth depends on INCREASED LABOR SUPPLY, not consumption.

Fundamental Framework: Agents trade leisure for work. Growth occurs when the relative value of work increases because new desirable goods/services become available.

Why Would People Work More?

The goods/services available become more desirable

Work becomes more productive

Wages rise relative to leisure preferences

Critical Corollary: Consumption Follows Income

The causal chain: Increased Work Supply → Higher Income → Increased Consumption

The Island Economy Model

Model Setup

Island Economy Setup

Island Economy Parameters

Workforce: 5 workers (A, B, C, D) + 1 supervisor (L)

Production: 10 kg of rice per day

Wage: 2 kg rice per worker

Profit: Supervisor retains 2 kg as profit

GDP: 10 kg rice

Scenario 1: Government Expenditure and Deadweight Loss

Setup and Effects

The government imposes a 2 kg rice tax and hires 1 worker as a police officer.

Initial Changes

Private Workers: 4 (from 5)

Private Output: 8 kg (from 10 kg)

Government Service: 2 kg

GDP (accounting): 8 + 2 = 10 kg (unchanged)

The Problem: Incentive Distortion

Workers reduce labor supply because purchasing power falls through taxation. Output falls further to 7.5 kg private + 2 kg government = 9.5 kg total GDP.

Deadweight Loss

Loss: 0.5 kg (economic waste from the policy)

Government is justified only when services increase productivity enough to offset deadweight loss.

Scenario 2: Investment and Capital Formation

Setup: Building a Productive Asset

The economy builds a pond that increases future rice productivity. This requires diverting resources from current consumption.

Investment Requirements

2 workers + 50% supervisor time

Current output: Only 5 kg rice

Wage bill: 10 kg

The Financing Problem: Origin of Finance

Workers must be paid 10 kg, but only 5 kg is available. Solution: Workers accept IOUs (bonds). This is the origin of finance - enabling investment through promises of future returns.

The Savings Decision

Workers sacrifice 1 kg current rice for 1 kg of future rice. Investment is viable only if the pond increases future production enough to justify the sacrifice.

Real Interest Rate: The Return to Capital

The real interest rate is the expected percentage return on investment. If the pond increases future rice by 20%, the real interest rate is 20%. Workers demand this rate as compensation for sacrificing current consumption.

Economy in the Long Run

Key Takeaways and Conclusions

Growth Requires Increased Labor or Capital Productivity, Not Spending

GDP = C + I + G is an Accounting Identity, Not Causal

Government Spending Has Deadweight Costs

Investment Requires Savings

Real Interest Rates Reflect Capital Productivity

Modern Growth Is Exceptional

Looking Forward

These foundational principles will guide all subsequent analysis of macroeconomic phenomena. The next sessions will explore how these principles manifest in closed-economy macroeconomics (Phase 1) and eventually open-economy settings with international trade (Phase 2).