INDIAN MACRO ECONOMETRIC MODELS ON MONETARY – FISCAL...

Indian Macro Econometric Models on Monetary - Fiscal Nexus : A Survey 1

CMDR Monograph Series No. - 15

INDIAN MACRO ECONOMETRICMODELS ON MONETARY – FISCAL

NEXUS : A SURVEY

P. Geetha Rani

CENTRE FOR MULTI-DISCIPLINARY DEVELOPMENT RESEARCHJubilee Circle, DHARWAD-580001, Karnataka, India

Ph : 091-0836-447639, Fax : 447627E-mail : [email protected]

2 CMDR Monograph Series No. - 15

PREFACE

Centre for Multi-Disciplinary Develop-ment Research is a social research institutein a moffusil area of Karnataka. It is one ofthe national level research institutes,sponsored by the Indian Council of SocialScience Research (ICSSR), New Delhi.The Centre aims at undertaking analyticalstudies of conceptual and policy significanceon the socio-economic and cultural issuesusing multi-disciplinary perspectives andmicro level information.

As a part of its publication programmethe Centre has initiated a CMDRMonograph series and also publicationsbased upon the research studies completedat the Centre.

We are happy to present the 15th

in the CMDR monograph series. This

monograph entitled “Indian MacroEconometric Models on Monetary - FiscalNexus : A Survey” authored by one of ourcollegues Mrs. Geetharani. This monographpresents a review of literature on the macroeconometric models focusing on themonetary fiscal linkages policy nor the fiscalpolicy would be effective in macroeconomic management. A judiciouscombination of the 2 policy measures hasbeen the subject matter of a number ofEconometric excersises. The Centreexpressed its appreciation and thanks toMrs. P. Geetharani for a technical review ofthe Literature on the subject. The Centrelooks forward to the comments andobservations on its monographs from thereaders.

P.R. PanchamukhiProfessor and Director

CMDR. Dharwad.

INTRODUCTION :

The twin major goals of Indianeconomy are price stability and grossdomestic product (GDP) growth rate.However, if price stability is not maintained,the achieved growth rate gets depreciated.In the Indian context, inflation rate iscontributed more by monetary expansion.Thus, controlling inflation indicatesregulating money supply. The theory ofmoney supply suggests that money stockcan be controlled through high poweredmoney provided the money supply functionis more stable than the money demandfunction.

The alternative available in thetheoretical literature is controlling themoney demand through rate of interest ifmoney demand function is more stable thanthe money supply function. The theory alsosuggests that both can not beoperationalised simultaneously. In theIndian situation, since interest rates areadministered and the empirical literature toosuggests that money supply function is morestable than the money demand function,controlling money stock is aimed atmonitoring high powered money.

High powered money itself varies as itaccommodates government deficit. Hence,the stock of money varies endogenously as

reserve money receives impulses throughdeficit from the fiscal sector. The issue ofmonetary-fiscal nexus is one of the mostimportant channels through which the majorinstruments or policy variables - budget andthe Reserve Bank of India (RBI) policyvariables - influence the economy in bothshort and long run.

Hence, the inter-linkages betweenmonetary and fiscal sectors gain the focusof the present survey. A substantial part ofgovernment deficit is financed by the RBIcredit to government which is the mainsource of reserve money which, in turn,forms the basis for money supply process.In the same way, the interaction of themonetary sector with the real sector isreflected in the demand for money functionand price formation. Like wise, the externalsector has a link with the monetary sector inthe determination of net foreign assets ofRBI. Thus, the monetary-fiscal nexus cannot be viewed in isolation as it sends andreceives impulses from other sectors aswell.

BRIEF OUTLINE OF EVOLUTIONOF INDIAN MACRO ECONO-METRIC MODELS :

The branch of macro econometricmodeling in the Indian economic literaturehas been initiated in the fifties and it has

INDIAN MACRO ECONOMETRIC MODELS ONMONETARY - FISCAL NEXUS : A SURVEY

P. GEETHA RANI


been gaining importance in the subsequentperiods. The earliest macro model waspresented by Narasimham (1956) underthe guidance of professor Tinbergen. Sincethen, model building activity has beenintensified. Several macro econometricmodels have emerged which are larger insize, diverse, complex and technicallysophisticated.

The models in the 1970s constitute thefirst phase which are pioneeringcontribution towards economy widemodels with general objectives. Theseeconomy wide models shed light on pricebehaviour and stability, endogenouspopulation growth, structure of financialmarkets and growth in dualistic economy.The second phase models incorporatespecific objectives in the economy widemodels following the convention of earliermodels to some extent, laying emphasis onpolicy analysis. They are moredisaggregated and involve more complexadjustment process by introducing laggedvalues.

The third phase models areincreasingly sharpened their focus leadingto a greater variety and diversification.Having attained analytical sophisticationduring the first and second phases, themodeling effort in the third phase attemptfor more purposeful and task orientedmodels with specific objectives, dealingwith problems of specific macro economicadjustments. They are of policy evaluation,forecasting and exploratory in nature.

The latest trend in macro econometricmodels is reflected in the growing size, scaleand complexity that they tackle. Thegrowing knowledge of econometricapproaches, significant improvement incomputer techniques and strength of database, sectoral statistics, team work havepersuaded building and use of macroeconometric models in abundance withcomplexity.

In an earlier attempt, Desai (1974) hassurveyed Indian macro econometricmodels till 1960s. In general, these modelssurveyed follow Tinbergen-Klein tradition.He views that the treatment of monetarymodeling in 1970s are either non-existentor elementary in nature. Money supply inthese models is treated as exogenous andnot clearly specified. Government sector inthese models are under specified.

Later, Krishnamurty and Pandit(1984) have taken stock of the macroeconometric models till 1980s. Theyclassify the Indian macro models into threegenerations. They view that the earliestgeneration models are small, simple andprototype model closer to text book theory.These models are fraught with difficulties inthe data and with new exploration. Most ofthese models are research effort as doctoraldissertations and are of pioneering efforts atexploring an uncharted and immenselycomplex economy.

The second generation models mainlyemphasis on policy analysis. They aredisaggregated and larger in size. These


models identify mixed and institutionalcharacteristics of the Indian economy. Theygo one step further by allowing for lagged,more varied and somewhat more complexadjustment process. Third generationmodels are more or less similar to thesecond generation models. The distinctfeature of these models are that they dealwith problems of macro economicadjustments and they attempt to exploreissues that have not been examined untilrecently.

A recent survey was undertaken byJadhav (1990) in which the models aresurveyed under the classification ofexplanatory, structural, exploratory andpolicy oriented and forecasting types ofmodels.

The present survey confines tosimultaneous, multi-sector models whichfocus specifically on the nexus betweenmonetary and fiscal variables after 1980s. Itattempts to examine is there any consensuson the factors that influence monetary-fiscalnexus, movement of major macroeconomic variables and their interactions,and their robust and sensitive naturetowards specification of economicrelations.

The present survey concentrates on thefollowing models in the Indian context :

Sarma (1982) is a simple explanatorymodel. It has five equations. It covers theperiod from 1961-62 through 1979-80.The Aghevli-Khan (1978) model fordeveloping countries is replicated by Sarma

in the Indian context. This model questionsthe monetary proposition of uni-directionalcausality from money supply to price level.He examines the relationship betweengovernment deficit, inflation and moneysupply.

Mathur, Nayak and Roy (MNR)(1982) is a short term macro economicforecasting and policy formulation model. Itcovers the period from 1951-52 through1979-80. Their main focus is on thebudgetary impact of certain key macroeconomic variables - inflation, money andcredit.

Krishnamurty(1984) is a structuraland explanatory model. It is an elaborateeconomy wide model with 77 equationscovering the period from 1961 through1980. It covers the agricultural, industrial,tertiary, fiscal, monetary and price sectors.

Pandit (1984) also follows thetradition of structural and explanatory typeof models. It is also an economy widemodel with 58 equations covering theperiod from 1950-51 to 1977-78. Thismodel describes agricultural sector, saving-investment equilibrium, external, fiscal,monetary and price sectors.

Pani (1984) also belongs to structural,explanatory and economy wide model. Ithas 79 equations. It covers the period from1969-70 through 1981-82. This modelattempts to analyse the factors determiningoutput, demand, government fiscaloperations, money supply and prices in theIndian economy.


Chakrabarty-(CB) (1987) is a policyoriented model. This model has 32equations. It covers the period from 1962-63 to 1983-84. It aims to incorporate theinstitutional features of the economy. Thismodel highlights the linkages among varioussectors namely real (domestic and foreign),fiscal and monetary sector. It also dealswith the determination of the general pricelevel.

The focus of the models in the 1990sis specific on a particular issue. Jadhav andSingh (JS) (1990) and Rangarajan and Arif(RA) (1990) belong to this tradition. JS(1990) is an exploratory type. This modelfocuses on single relationship and attemptsto explore all the possible inter-linkagesamong the macro variables - inflation,budget deficit and money supply. It tries toincorporate the missing links in Sarma(1982). It covers the period from1970-71through 1987-88 with 14 equations.

RA (1990) captures the impact ofmoney supply on output and price level with20 equations covering the period from1961-62 to 1984-85. The special featureof this model is it attempts to link credit andoutput by introducing real money or creditas an additional variable in the productionfunction.

As the links between monetary andfiscal variables inherit movements in price,output and foreign trade, the discussion isorganised as follows :

The common features of models arepresented in section 1. Section 2 deals with

the monetary sector considering demandfor money and supply of moneyspecifications in various models. The fiscalsector is disaggreagted into governmentexpenditure, government revenue andbudget deficit and analysed in section 3.Movements in prices captured in thesemodels follow either monetarist orstructuralist approach and is dealt in section4. Section 5 presents how the real sectorspecifications are carried out in thesemodels. Section 6 examines the externalsector and the concluding remarks arepresented in the last section.

The latest version of the models areonly considered in the study.The variablesspecified in the models are attempted togive a common notation for the samevariable (as it is found varying notations indifferent studies) are presented in appendix 1.The review considers only the specificationof various equations and not the estimatedempirical results. The equations explainedin the models are given in appendix 2.

1. Common Features

The models under considerationbelong to different categories such asdescriptive [Sarma(1982)], short runforecasting model [MNR(1982)], structuraland economy wide models [KN(1984),Pandit(1984) and Pani(1984)]. Thestructural economy wide models vary witha degree of heterogeneity. They follow thetradition of earlier models. But, they aredistinct from them by incorporating aspecific issue while attempting to structure


the economy wide models. Other kinds ofmodels are policy-oriented [CB(1987)]and exploratory type of models [JS(1990)and RA(1990)].

These models together cover a longperiod of Indian economy from 1951 to1988. All the models use annualobservations. They are full-fledged andconsists of multi-sector and followsimultaneous equation systems forestimation and analytical purposes. Allmodels carry out simulation exercises bothstatic and dynamic to assess theperformance of the overall model. Fewmodels follow partial adjustmentmechanism. The salient features captured inthe models are as follows :

1.1. Monetary Aspects :

The description of banking operationsappear in detail basically to determinemoney supply. However, demand formoney is examined following the QuantityTheory framework by specifying the priceformation as an inverted money demandfunction. Further, money demand isdisaggregated into demand for currencyand demand deposits by incorporating realincome, opportunity cost variables, priceexpectations, government deficit andforeign exchange assets of RBI.

Money supply determination is carriedout either through conventional moneymultiplier theory of money supply processor relating to government deficit or netforeign exchange assets of RBI (RBFA).Among the sources of high powered

money(H), the vital role of RBI credit togovernment (RBCG) is widely recognised.Other sources of H such as currencyliability of the government, RBI credit tocommercial sector and RBFA are assumedto be exogenous invariably in all models.

1.2. Fiscal Operations :

Varying treatment of fiscal operationsare observed in these studies. One set ofstudies specifies the government operationsin aggregative framework with fewequations relating the governmentoperations (government revenue andgovernment expenditure) to real incomeand their own lags. The second categorytries to identify the non-random factors thatcause the actual and estimated governmentexpenditure and government receipts.Further, government operations arehighlighted through the activities of publicsector - the volume and allocation ofinvestment in the public sector. And it isproposed to affect output through currentdemand and potential supply.

On the other hand, the disaggregativeanalysis captures government operationsthrough fiscal policy with more detailedexplanation of government revenue andexpenditure, providing an explicit accountof the effect of the price level variations.Further, government operations arecategorised into current and capital accounttransactions. They are also classified intodevelopmental and non-developmentaltransactions in the case of governmentexpenditure and tax and non-tax revenue


and borrowing (internal and external) forgovernment revenues.

1.3. Monetary-Fiscal Link :

The vital link of fiscal operations andgeneration of monetary impulses throughthe propagation of government deficit fromfiscal to monetary sector either one way orboth ways is formulated in many of themodels. The link variable is RBCG - anendogenous component of reserve money,which accounts for government deficit. Onthe other side, the fiscal aggregate isinfluenced by income, prices etc. Thus theinflation-induced budget deficits leads toraise RBCG and hence the combinedmoney supply increases further pressure onprices.

While, some models make a thoroughanalysis of the budget constraint, or sourcesand uses of funds and of budget deficit inthe creation of money and related aspects.Others postulate the links through partialadjustment framework, recognising the factthat the government expenditure andrevenue have a differential impact on prices.

1.4. Price Movements :

Price level is explained throughaggregative analysis adopting monetaryapproach by specifying inverted moneydemand function as price equation. On thecontrary, structural models followdisaggregated approach to price formation.They avoid exclusive dependence onmonetary expansion in explaining pricemovements. The structural and institutional

factors are incorporated in the priceequation either to replace the monetaryfactors or to support them as appropriate.There is no consensus on the form in whichmoney is incorporated in price equation.

However, sectoral as well asaggregative prices are affected by excessliquidity in the economy following QuantityTheory approach. The relative prices arestated to act as equilibriators of demandand supply in agricultural sectors while costmark-up relations (fixed or varying mark-up over different costs of input per unit ofoutput) are a general rule for industry andservices. The cost elements consists ofnominal wage rate, prices of imported rawmaterials and intermediaries and prices ofagricultural raw materials.

1.5. Link between Monetary, Fiscaland Price Movements :

An initial budget deficit in part or inwhole financed by credit from RBI,increases reserve money and thereforemoney supply via money multiplier, otherthings remaining the same. The increase inmoney supply forces an upward pressureon price level. The increase in price level inturn raises government revenue andexpenditure differentially, raising thegovernment deficit in the process - asexpenditures adjust at a faster rate towardsthe target level than revenues and withinexpenditures, current expenditures adjustsmore rapidly than investment expenditures.Hence, the resource gap becomes apositive function of price level. This cycle


continues until new equilibrium of moneysupply and prices are reached.

In brief, RBCG is the crucialdeterminant of high powered money, whichforms the basis of money supply throughmoney multiplier. And money supply has astrong influence on prices - either sectoralor general, move, by and large, at about thesame rate as money supply, given otherfactors.

This self-perpetuating process ofinflation was first studied by Olivera(1967).He questioned whether money supply itselfis independent of inflation. This process isexamined through partial adjustmentmechanism, wherein revenue andexpenditure are formulated to follow thepartial adjustment process, in whichrevenues take a longer time to adjust to thetarget. In this framework, divergencebetween expenditures and revenues willwiden if the partial adjustment coefficient ishigher for expenditures and ultimatelynominal deficit becomes a function ofprices.

The dynamic forces of this processwas empirically examined in many studies.For instance, following Olivera, Aghevli-Khan(1978) suggest that governmentexpenditure adjust more rapidly thangovernment revenue to a given change inthe price level and as a result, inflationwidens budget deficit through RBCG to alarger money supply provoking inflationfurther. In the Indian context, Sarma(1982)replicated Aghveli-Kahn.

Later, Heller(1980) argues that theexistence self-perpetuating process can notbe taken for granted, as the following feedbacks are ignored in the earlier studiesfollowing Olivera :

(i) Output is assumed to be exogenousindependent of fiscal policy whichoverestimates the inflationary pressureas part of government expenditurecould increase output both directlyand indirectly. In developing countries,production subsidies too influenceoutput

(ii) RBCG is not the sole componentwhich fills the resource gap. Internaland external borrowing also constitutethe resource gap and

(iii) Debt and interest payments for a givengovernment expenditure leaves lesscapital formation, impeding economicgrowth. The negative feedback effectsthrough debt accumulation is ignoredin these studies.

In sum, monetary expansion is fueledby budgetary deficits. Public expendituresnot only add to growth due to investmentexpenditure, but also raises the inflationarypressures as revenues expand faster thanexpenditures. However, the strength ofinterdependence relies on the pattern offinancing the gap. Greater proportion ofRBCG in the resource gap provides astronger interdependence between moneyand prices. In such situations, inflationbecomes self-perpetuating in character.


1.6. Output Generation :

The real sector in the models are eitheraggregative or disaggregative in nature. Thedisaggregative studies divide the realeconomic activities into primary, secondaryand tertiary sectors. Output from each ofthese sectors are determined separatelyand then the total output is given as a sum ofoutput obtained from these sectors. On thecontrary, the aggregative studies includereal money balances as additional argumentin the production function, the rationalebeing the economic efficiency is higher inthe monetary economy compared withbarter. It embodies two importantmechanism for growth - (i) real investmentas a stimulus to increase output and (ii)monetary impact on output.

1.7. Link between Monetary and RealVariables :

The interdependence between monetaryand real variables are not elaborate in thesestudies. Very few studies attempt to relatethe monetary effects transmitted to realvariables through variations in the rate ofinflation, rate of interest, absolute andrelative price levels. Further, some studiesattempt to link the two sectors bypostulating the Quantity theory with moneyaffecting price level given the output.

1.8. Interdependence between Monetary,Fiscal, Real and Price Movements :

The analysis rests on the hypothesisthat revenues are targeted at GDP innominal terms, whereas expenditures are

targeted at GDP in real terms and bothadjust gradually to target. As aconsequence, deficit becomes a function ofprice, its rate of change and also RBCG.The resource gap financed by RBCG isdetermined by government’s fiscal policymanagement under situations such as :

(i) Resource gap created by the differencebetween government expenditure andrevenue, due to inflationary pressures,can be filled by deficit financing orreduction of capital formation or acombination of both

(ii) If the price rise is a consequence ofbad harvest, then governmentexpenditures accommodate subsidiesand relief measures which againpushes up the money stock and

(iii) If the government is keen to maintaininvestment, the only alternativeappears to be restoring deficit financing.

However, government plays adominant role in promoting economicgrowth by its direct investment. The impactof budgetary deficits due to investmentexpenditure is more complex than thatrelated with increased current expenditures.The immediate impact of deficits forfinancing investment on prices may bedifferent from the ultimate effect. It dependson the nature of public investments, itscomposition, the direct and indirectimpulses of these investments on outputgeneration and on private investments, thelags involved and the pattern of the


economy. The inference is that there is aninherent dynamics of inflation and there maybe a trade-off between inflation and growthin the short run.

Some other studies examine whetherthe self-perpetuating process of deficit-induced inflation or inflation-induceddeficits is applicable to India incorporatingthe missing links in Olivera. Havingidentified the inherent dynamic process, thestudies provide a number of conflictingtendencies such as - (i) The initial budgetdeficit apart from increasing money supplytend to expand domestic debt whichincreases interest burden, thus increasingexpenditure and hence widening the budgetdeficit and (ii) Real developmentexpenditure enhances the productionpotential in the economy leading to growth.

Another feature added to this dynamicprocess is an attempt to link credit andoutput by introducing real money or creditas an additional variable in the productionfunction besides capital stock. An increasein credit is reflected by monetaryexpansion. The inflationary impact onmonetary expansion can be neutralised tothe extent of higher output that creditexpansion would have aided to generate.The transmission mechanism of monetaryand output impulses works simultaneouslyto determine price level with partialadjustment over time. The extent of inflationdepends upon various elasticitiesquantifying the relationship among money,output and prices.

1.9. External Sector :

Treatment of external sector is eithernon-existent or rudimentary in manymodels. The link between domesticeconomy and foreign sector are formulatedto comprehend the role of trade, balance ofpayments transactions, which so far, haveregistered a very small proportion of grossnational product. Very few studies attemptto analyse that exports and adverse termsof trade affect aggregate demand anddomestic prices.

Further, external sector is specified inaggregative framework, bringing the vitallinkages through prices as well as quantitiesof exports and imports.

On the other hand, import and importprices affect the economic activity, theformer in favourable terms and the latter inadverse terms. Import prices have asubstantial contribution to domestic pricesdespite monetary expansion. Further,foreign exchange reserves are related tocurrent account deficits and capital flows.

1.10.Link between Monetary andExternal Variables :

Treatment of the link betweenmonetary and external sectors are absent inthe studies except Pandit(1984). He linksthe two sectors through the net foreignassets of RBI via high powered money tomoney stock.

1.11. Interdependence between Monetary,Fiscal and External Sectors :

The inter-relationship amongmonetary, fiscal and external sectors are


weak in the models. The monetary-fiscalnexus sends impulses to the external sectorthrough net foreign assets of RBI in thesources of high powered money andexternal borrowing in the deficit financing ofthe government. Foreign borrowing as wellas RBFA are treated as exogenous to thesystem.

1.12. Link between Monetary, Fiscal,Price, Real and External Variables :

The fiscal and external sector jointlydetermines the reserves money as othercomponents of reserve money account forless proportion. Given the stock of reservemoney, cash reserve ratio, statutoryliquidity ratio, the spectrum of interest rates,development of financial institutions andbanking practices, the monetary sectordetermines the money stock, aggregatedeposits and total bank credit and also thesectoral distribution of credit. Given themoney stock, credit and their interactionwith the real sector determines (i) the rate ofinflation and (ii) rate of growth.

The real sector receives impulses fromthe fiscal sector through the reliance ongovernment revenue than expenditure (to alarger extent). These feedback effects aresent to the monetary sector through RBCGand RBFA (in order to fill the resource gap)which together determine high poweredmoney and then money supply via moneymultiplier. The entire set of interactions,their impulses and feedbacks among thesemacro economic variables are not dealt indetail in any of the models. Invariably all the

models treat that external transactions aredetermined outside the system.

1.13. Some Econometric Issues :

1.13.1. Partial Adjustment Mechanism1.13.1. Partial Adjustment Mechanism1.13.1. Partial Adjustment Mechanism1.13.1. Partial Adjustment Mechanism1.13.1. Partial Adjustment Mechanism

It is also known as stock adjustmentmodel. It is provided by Marc Nerlove. It isassumed that there is an equilibrium,optimal, desired or long run amount ofcapital stock is needed to produce a givenoutput under the given state of technology,rate of interest, etc. Further, it is given thatthe desired level of capital is a linearfunction of output. Since,the desired level ofcapital is not directly observable, it ispostulated that the actual change in capitalstock (investment) in any given time periodis some fraction known as partialadjustment coefficient of the desired changefor that period.

In other words, observed capitalstock at that time as a weighted average ofthe desired capital stock at that time and thecapital stock existing in the previous period.In sum, it is assumed to adjust partially tothe difference between desired and actualvalue of the variable in the previous period.

1.13.2. Simulation1.13.2. Simulation1.13.2. Simulation1.13.2. Simulation1.13.2. Simulation

The purpose of carrying out simulationexercise in the models is to assess theperformance of the overall model andspecific policy results to important macroeconomic variables. They are also used tostudy and compare the short run and longrun responses of one varaible or set ofvaraibles to another variable. The static


simulation provides a single period, shortrun simultaneous solution of the modelwithout any carry-over effects of errorsfrom the previous period.

Dynamic solution is a more effectivemethod of evaluation. The current year’ssolution of endogenous variables is linkedto the estimated values of the previous year,which provided the dynamic solution pathof the endogenous variables over the entireperiod of simulation. In the dynamicsimulation, errors get accumulated overtime. A large error in the estimation of anyendogenous variable in any year getstransmitted throughout the system andaffects the magnitude of errors in all thesuccessive years.

2. Monetary Sector

Monetary actions captured in themodels under consideration are discussedin two heads - demand for money andsupply of money.

2.1.Demand for Money :

The Fisherian analysis of demand formoney stresses the medium of exchangefunction as more important. This equationof exchange states that the amount ofmoney in circulation(M) times itsvelocity(V) must equal to the number oftransactions(T) carried out over a particularperiod times the average price(P). TheClassical believe that velocity do not varyrapidly in the short run even if there issome changes in credit practices andcommunications.

On the other hand, the Cambridgeeconomists are concerned with the factorsdetermining the amount of money people‘wish to hold’ rather ‘have to hold’postulated by Fisher. Later, this approachrecognises wealth, interest rate and futureexpectations as important additionalarguments in the demand for moneyfunction. However, all these factors areassumed to be constant in the short run andhence there is an equal proportionateincrease in money and prices.

The Classical economists view thatwhen money supply increases there is anequal, proportionate and instantaneousincrease in the price level. Given the onlyfunction of money being medium ofexchange, whenever money supplyexpands, the increase in the purchasingpower of the people is distributed onlyamong the consumption goods. Anyincrease in money supply without an equalincrease in price level indicates the gapbetween demand and supply ofcommodities in the real sector. They viewthat this gap is only a transitoryphenomenon. In the long run, the processbecomes automatic that any increase inmoney supply is taken care of by an equalincrease in price level.

Keynes(1950) analysed the demandfor money in three motives in whichtransactions and precautionary demand formoney has a stable and positive relation withincome level. The speculative demand formoney is inversely related to rate of interest.Keynes assumes that people keep the money


either in the form of bonds or cash balancesas the future interest rate is certain. Othersubstitutes of money are not considered byhim.

Later, Baumol(1952) reformulated thetransactions demand for money functionemphasising the role of business inventorycontrol. The inventory of money helps tofacilitate exchange. Otherwise, thisinventory of money is an costly affair for thewealth holder as (i) interest rate is foregoneand (ii) it incurs brokerage cost. And thus,the solution focuses on the determination ofchoice of inventory of money andminimising the brokerage cost as anyrational individual will try to maximise hisincome and minimise the cost.

In the Keynesian analysis ofspeculative demand for money, the futurerate of interest is certain and hence thespeculator holds money in the form of eithercash or bonds. When the future interest rateis not certain, Tobin introduces the choiceof a portfolio holder that he tries tomaximise his income or wealth by adjustinghis portfolio in ample ways (each having adifferent cost associated in shifting oneasset to another) after discounting the riskinvolved. Thus, Tobin’s theory ofspeculative demand for money by anindividual depends upon the individualwealth and the rate of interest.

Friedman(1959) considers moneyrendering a variety of services though themain service being an abode of purchasingpower temporarily. The demand for money

is specified as a function of ratio of humanto non-human wealth, price level, interestrate and expected rate of change as abudget constraint. In the empirical analysis,he has found real income and interest ratesare the only significant variables. Basicallythe money demand function is a deriveddemand function. However, theconventional money demand functionincludes real income, price level and interestrates as arguments.

Many of the models underconsideration follow the Classical QuantityTheory specification for demand for money.In general these models [Sarma(1982),JS(1990) and RA(1990)] explain the pricelevel through inverted money demandfunction. No seperate treatment fordemand for money is found in these models.

Pandit(1984) and CB(1987) followby and large similar specifications. Bothexplain the money demand function in realterms. Pandit specifies the real demand formoney as a function of real income, banklending and expected rate of inflation. CBexplains real currency demand and realdemand for demand deposits are thefunction of the real income and their ownlags. However, Pandit incorporates banklending and expected inflation rate asadditional arguments in CB’s specification.

On the other hand, Pani(1984) giveschange in currency demand as a function ofbudget deficit, change in foreign assets ofRBI and government borrowing. Demandfor aggregate deposits as a function of


external debt servicing, which is given as aresidual of bank reserves and impoundeddeposits. However, MNR(1982) andKN(1984) did not pay attention for aseparate treatment for demand for moneyrather, they focus on money supply.Statement 1 presents the specification ofdemand for money in the models underconsideration.

2.2. Supply of Money :

In Classical as well as Keynesiananalyses, money supply is treated asexogenous. The later developments in theliterature suggests balance sheet oraccounting identity, portfolio approach andmoney multiplier theory of money supplyprocess. The balance sheet approach givesthe assets and liabilities of a central bank. Itmerely exhibits the accounting relationship.The portfolio approach explains thedemand for and supply of portfolio of acentral bank. Among the differentapproaches, the money multiplier approachis widely recognised in the literature.

Conventionally, it is explained with anidentity which is of the form:

M = mB ... (1)

where M is money stock measure (eithernarrow or broad), m is the multipliercoefficient and B is the base money. Anychange in M is explained either through mor B. This approach assumes that B isexogenous - it is under the immediatepurview of the monetary authorities. Thus,changes in M can be brought out by

changing B. The money multiplier can bederived by substituting the components ofM and B. Ultimately, it can be explained asa function of currency to deposit ratio andreserve to deposit ratio. Equation (1) canbe written in the form of :

m = M/H ... (2)

in order to find out the determinants ofmoney multiplier. Substituting M = C + D(in narrow terms) and H = C + R, the finalform is expressed as:

m = (C/D + 1)/(C/D + R/D) ... (3)

where C = currency with the public, D =demand deposits with the banks, R =reserves held with RBI by the banks andcash reserves with banks.

The functional relationship betweencurrency to deposit ratio and reserve todeposit ratio can be explained followingsimple Classical macro economic theory.The currency to deposit ratio is expressedas a function of ratio of consumption toincome, the opportunity cost variable - rateof interest assuming that demand forcurrency is strongly linked withconsumption and deposits with income.This ratio depends primarily on thebehaviour of the public.

The reserve to deposit ratio is relatedto cash reserve ratio and bank reserves andto rate of interest. This ratio depends on thebehavioural choices of banks. When thereis an increase in interest rate - (i) thecurrency to deposit ratio declines. As aresult, the value of money multiplier


increases and (ii) the reserve to depositratio declines. The decline in reserve todeposit ratio has an impact of increasing thevalue of money multiplier. Thus, increase inthe rate of interest increases the value ofmoney multiplier and there exists directrelation between the two.

As already noted, in order to controlmoney supply growth rates which impliescontrolling inflation, two ways are possibleaccording to theory - (i) controlling throughinterest rate and (ii) controlling through highpowered money. The theory suggests thatboth can not be operated simultaneously.Controlling the money supply throughinterest rate is good when the moneydemand function is more stable than themoney supply function. When the moneysupply function is more stable than themoney demand function, the otherpossibility is controlling through basemoney.

In India, since interest rates areadministered, full-fledged capital andmoney markets are absent and also theempirical literature suggests that moneydemand function is less stable than themoney supply function, controlling throughbase money seems to be a better choice.However, base money is accommodativeof the government deficit and hencecontrolling the base money depends on themaneuverability of the monetary authorities.

In most of the studies money multiplieris assumed to be stable in the long run.Since money multiplier is found to be stable

[see Chitre (1986)], any variation in moneystock is due to changes in base money. Thesources of variation in high powered moneyis given from the RBI’s balance sheetidentity as :

H = RBCG + RBCC + RBFA - RBNML... (4)

where RBCG = RBI’s credit togovernment, RBCC = RBI’s credit tocommercial sector and RBNML = RBI’snet non-monetary liabilities.

Few models [MNR(1982) andRA(1990)] follow this conventionalapproach. MNR proposes to determine themoney multiplier endogenously byestimating the three asset ratios. Highpowered money is specified by the identityin usual way [see MNR(1982), KN(1984),CB(1987) and RA(1990)]. In thesemodels, RBCC, RBFA and RBNML areassumed to be exogenous. All these modelsexplain RBCG in detail and bring out its linkwith fiscal sector. Many models relateRBCG solely to budget deficit[Sarma(1982), MNR(1982) andKN(1984)]. KN(1984) treat RBCG asendogenous by relating to its own lag.

However, Pandit(1984) treat RBCGas exogenous which forms a crucial linkbetween fiscal and monetary sectors. But,he specifies net foreign assets of RBI asendogenous and captures the link betweenmonetary and external sectors. He explainsmoney supply through M3-money identity.This model determines each component ofM3-money endogenously. JS(1990)relates money supply in a different manner -


relating the budget deficit and lagged valueof money supply. The budget deficit feedsback into monetary sector from fiscalsector. Statement 2 presents the specificationof money supply in the models underconsideration.

3. Fiscal Sector :

The treatment of fiscal sector isexplained through two approaches -(i)aggregate analysis along neo-keynesianlines, and (ii) disaggregate analysis.Aggregate analysis does not exhibit much ofinflationary potential [see Rakshit (1987)].All models under consideration followdisaggregate analysis except Sarma(1982).Fiscal sector is discussed under three heads- government expenditure, governmentrevenue and budget deficit.

3.1. Government Expenditure :

Sarma(1982) adopts aggregateexpenditure approach and explains themodel by relating exogenously determinedreal income and lag of the dependentvariable to government expenditure. Mostof the models [MNR(1982), KN(1984),Pandit(1984), Pani(1984), CB(1987) andRA(1990)] disaggregate governmentexpenditure as current, revenue and capitalexpenditure. In many models [KN(1984),CB(1987) and RA(1990)] current andrevenue expenditure are specified as afunction of real income and the lag of thedependent variable.

However, MNR(1982) specifiesgovernment revenue expenditure differently

as a function of estimated governmentexpenditure and ratio of net external loansto budget deficit. Pandit(1984) attempts todivide government current and revenueexpenditure into government consumptionexpenditure and other current expenditures.Government consumption expenditure isrelated to total per capita current revenueand per capita consumption expenditure.The other current expenditure is related tochanges in debt, changes in other currentexpenditure and revenue from foodgrainoutput (prices of foodgrains are multipliedby the output of foodgrains).

JS(1990) is distinct from other modelsas it disaggregates government expenditureinto developmental, non-developmentaland interest payments. Developmentalexpenditure are treated as exogenous.Non-developmental expenditure isspecified as a function of real income, pricelevel and lag of the dependent variables.Interest rate is related to lag of debt.

In few models [Pani(1984) andCB(1987)] government expenditure isrelated to exogenous governmentinvestment expenditure as a function ofprices in the secondary sector, ratio of netexternal loans to budget deficit andestimated government capital expenditure.KN(1984) explains governmentexpenditure as an identity by summing uppublic investment and capital revenue ofpublic sector. Pandit(1984) also specifiesgovernment capital expenditure as anidentity by adding up government saving,domestic borrowing, foreign borrowing,


foreign assistance and budget deficit.RA(1990) treats government expenditureas exogenous. Statement 3 exhibits thegovernment expenditure specifications infiscal sector.

3.2. Government Revenue :

Few models [Sarma(1982), Pani(1984) and CB(1987)] adopt aggregaterevenue approach. Sarma(1982) explainsgovernment revenue by relating nominalincome and lag of the dependent variable.Pani(1984) specifies government revenueas a function of nominal income. On theother hand, few models [MNR(1982),KN(1984), Pandit(1984), CB(1987),JS(1990) and RA(1990)] attempt to followdisaggregate analysis.

Few models [MNR(1982) andJS(1990)] disaggregate governmentrevenue as tax and non-tax receipts andnon-tax receipts are treated as exogenous.MNR(1982) specifies tax receipts as thesum of individual taxes such as receiptsfrom custom duties, union excise duties,personal income tax and corporate incometax. Each of these taxes are estimatedendogenously. This model does not includethe receipts from internal and externalborrowing, deficit financing andgovernment saving in government revenue.

KN(1984) specifies governmentcurrent receipts as a function of real incomeand lag of the dependent variable.Domestic borrowing is related togovernment capital and current expenditure,government current saving and foreign

borrowing. Government saving is specifiedas a function of the difference betweengovernment revenue receipts andgovernment current expenditure. Thismodel fails to incorporate the source ofdeficit financing in government revenue.

Pandit(1984) shows governmentrevenue as the sum of direct tax receipts,indirect tax receipts and other currentreceipts. Direct and indirect receipts aregiven as a function of real income from non-agricultural sector. Government saving isgiven as the sum of direct taxes, indirecttaxes, other current receipts, capitalconsumption allowances and subtractingthe sum of government consumption andother current expenditure. This model failsto include the sources of revenue fromdomestic and foreign borrowing, deficitfinancing and government capital receipts.

CB(1987) relates governmentrevenue to nominal income andexogenously determined effective tax ratesand its own lag. It specifies governmentcapital receipts as a sum of governmentmarket borrowing and exogenouslydetermined non-market borrowing andforeign borrowing. Government marketborrowing is related to total bank depositsand its own lag.

JS(1990) specifies governmentrevenue as the sum of tax and non-taxreceipts. Both are related to real income,price and their own lag values. This modelmisses to incorporate many items in thesource of government revenue such as


government current and capital receipts,internal and external borrowing, governmentsaving and deficit financing.

RA(1990) presents governmentrevenue as the sum of current and capitalreceipts. Government capital receipts aretreated as exogenous. Current receipts aredisaggregated into government market andnon-market borrowing and governmentexternal borrowing. Government externalborrowing is treated as exogenous.Government market borrowing is given asthe sum of government investment insecurities in banks and governmentinvestment in non-bank institutions. Thechange in government investment ofsecurities in banks is related to the changesin total deposits of the banks.

Government non-bank investment ofsecurities is related to nominal income. Thismodel also misses to include the sourcefrom deficit financing. All these models treatnon-tax revenue as exogenous.Disaggregation of non-tax revenue intoborrowing, deficit financing, governmentsaving and government capital receiptswould give a clear picture. Among thesesources, deficit financing must be givengreater attention as it generates moreinflationary pressures in the economy.

3.3. Budget Deficit :

In India, budget deficit is the source ofinflation besides money supply. Majority ofthe models [Sarma(1982), MNR(1982),Pandit(1984), CB(1987), JS(1990) andRA(1990)], identify budget deficit as the

difference between government revenueand government expenditure. Pandit(1984)does not provide any explicit specificationfor budget deficit. KN(1984) specifiesbudget deficit in a different manner - as thedifference between government capitalexpenditure and the sum of governmentpublic sector saving, other domesticborrowing and foreign borrowing.

Most of the models link budget deficitfrom fiscal sector through RBI credit togovernment in monetary sector, whichserves as a link variable between the twosectors. Few models [Sarma(1982) andMNR(1982)] specifies that deficit is solelyfinanced by RBI credit to government. Theother sources of financing the budget deficitsuch as domestic and foreign borrowing,government saving are ignored in thesemodels. Few studies [Pandit(1984),Pani(1984), CB(1987), JS(1990) andRA(1990)] consider domestic borrowingbut treat foreign borrowing as exogenous.These models also ignore governmentsaving and government capital receipts asthe sources of financing budget deficit.Statement 5 reports the specification ofbudget deficit in various models.

4. Price Movements :

Broadly there are two views regardingthe mechanics of inflation - monetarist andstructuralist.

4.1. Monetarist View

The Classical Quantity Theory traditionstresses inflation is a monetary pheno-


menon. Price behviour analysed in a simpleQuantity Theory framework assumes:

(i) the rate of increase in the general pricelevel is approximately equal to the rateof increase in money supply per unit ofaggregate real output,

(ii) money supply is exogenous and can befixed by the authorities at any level andit is predictable and controllable interms of monetary policy instruments,

(iii) unidirectional causal flow from moneyto price and not the reverse can beobserved and

(iv) there is no long run effect of money onoutput. This indicates that monetaryeffects on output and employmentwould be transitory and not permanent.

However, difference of opinionpersists as to how quickly the effect istransmitted, how independent the moneysupply is from the determinants of outputand what measure of money supply to use.

4.2. Structuralist View :

Non-monetarist view that price rise isa much more complex phenomenon. It cannot be controlled by a mere regulation ofmoney supply growth rate. The structuralmodel explains behaviour of prices indeveloping countries based on thestructural disequilibrium in the growthprocess observed in Latin Americancountries. With necessary alterations, thesemodels have been applied to explaininflation in Asian and African countries.They emphasis some basic constraints inthe growth process of developing countries.

The primary sector in these countries,providing food and agricultural rawmaterials, has low income and priceelasticity of output. When income of thesecondary sector, producing manufacturinggoods rises, there exists a gap betweendemand for and supply of foodgrains. Thisexcess demand leads to rise food price -wage rate - manufacturing price nexus.Deficit in foreign exchange reserves indeveloping countries accounts for a highprice elasticity of exports mainly of primarygoods and on the other hand, importsconsisting primarily capital goods have lowprice elasticity.

The other major factors behindinflation in these countries is low savingsand high investment propensity in bothgovernment and private sectors. Thus, thefinancing of development requires creditexpansion from banks to governmentresulting excess money supply in theeconomy. In an extreme form, this viewholds that if administered prices areconstant, money supply and output movetogether and inflation is greater and outputgrowth is higher. How much the price levelresponds to increase in administered pricesor higher output growth depends on howquickly wages adjust to inflation.

Inflation in India is explained throughthese two approaches - either in anaggregate framework with single equationfollowing Quantity Theory framework or ina disaggregated manner through multiequations with structural factors. Some ofthe models [Sarma(1982), JS(1990) and


RA(1990)] are of monetarist type.However, CB explains price level byincorporating effective tax rate in thefunction. These models explain inflation in aconventional inverted demand for moneyframework as price equations.

KN(1984), Pandit(1984) andPani(1984) try to explain inflation throughstructuralist approach. They adoptdisaggregate price behaviour through multiequation model. KN explains the pricesector in detail with 12 equations. The pricesector is divided into prices of agriculturalgoods, industrial goods, energy items,infrastructure and prices in tertiary sector.

Pandit(1984) also follows disaggregateapproach. The model provides anelaborate treatment of price movementswith 17 equations. It divides the pricesector into prices of food articles, rawmaterials, manufacturing and mining,textiles, energy items and prices of minerals.Whole sale price index is given by the sumof all of these items.

Pani(1984) divides the price sectorinto prices of food articles, raw materials,manufacturing and mining. Whole sale priceindex is given as a function of nominalmoney supply, prices of food items and aspecially constructed index of administeredprices. Finally general price level isestimated by including all these items.Though these models are disaggregatedand many structural variables appear, thesemodels seem to ignore the influence ofgovernment deficit in explaining inflation.

Statement 6 shows the specification ofprice movements in the models.

5. Real Sector :

The Quantity Theory of money in itsextreme form argues that money has noimpact on output and therefore, an increasein money supply results in a proportionateincrease in the price level. Monetaristmaintain that changes in money supply havea direct effect on expenditure, andtherefore, on national income and thus achange in money supply produces change inGDP. They question the reliability of theKeyenesian model, since the IS/LM modeltypically postulates that the price level canbe assumed to be fixed.

On the other hand, Keynesian hold theview that changing the supply of moneyworks indirectly on the level of aggregateincome by altering interest rates, which inturn influences the level of investment andcredit in the economy. They maintain thatthe effectiveness of monetary policydepends on the elasticity of the supply anddemand for money with respect to the rateof interest and the responsiveness ofconsumption and investment expenditure tochanges in the rate of interest. Further,theKeynesian analysis, on the assumption ofstickiness in prices argues that an increasein money supply will lead to a fall in the rateof interest, both nominal and real,stimulating investment through which amultiplier process, would lead to anincrease in real income.


There is no unanimous view on howchanges in money supply ultimately affectthe real economy. Perhaps, the reality liessomewhere in between these two extremes.Money has an impact on both output andprices. The process of money creation isthe process of credit creation. Since creditfacilitates the production process, it hasfavourable impact on output. But, at thesame time, the increased money supplyincreases upward pressure in prices.Hence, the output effect and price effectmust be taken together to judge the overallimpact on the economy. However, whenmoney supply increases both prices andoutput level increase but not in the sameproportion.

Few models [Sarma(1982) andMNR(1982)] treat real sector asexogenous. KN(1984) disaggregates theoutput in each sector such as agricultural,industrial, infrastructure and tertiarysectors. And the final output is derived fromthe sum of all these individual sectors’output. Similarly, Pandit(1984) identifiesoutput in agricultural and non-agriculturalsectors. It links real and fiscal sectors.These two models does not relate realoutput to price movements, whereasJS(1990) made an attempt to link realsector to fiscal and price sectors. This studytries to estimate real output in a differentmanner - by measuring capacity output andcapacity utilisation. But, it does not relatereal and monetary sectors.

Pani(1984) explains the real sector indetail with 8 equations disaggregating

output into agriculture (output fromfoodgrains and non-foodgrains), mining andmanufacturing, unregistered manufacturingindustry, tertiary (transport and communi-cation) and other services.

Agricultural income is given as afunction of agricultural output. Income frommanufacturing and mining are specified as afunction of capital stock in mining andmanufacturing, the ratio of government non-consumption expenditure to price deflatorof gross domestic product, andgovernment’s non-investment expenditure.Unregistered manufacturing industrialincome is related to income frommanufacturing industries and capital stockin unregistered manufacturing industry.Income from tertiary sector is given as afunction of income from agricultural andmanufacturing and capital stock in thetertiary sector.

CB(1987) also adopts a detailed anddisaggregated specification of real sectorwith 49 equations. It relates real output togross sown area, total capital stock andimports of raw materials. Total capital stockis given as the sum of government andprivate capital stock. Government capitalstock is given by an identity as the sum oflag of government capital stock and netfixed capital formation of the government.In the same way, private capital stock isgiven as lag of the dependent variable andnet private fixed capital stock. Grossprivate fixed capital formation is related togovernment capital stock, annual averageyield on corporate sector, foreign exchangereserves and private stocks.


RA(1990) attempts to distinguishfrom the existing models. Real output isestimated by a production function withcapital stock and real money stock. Capitalstock is divided into three sectors - publicsector, private corporate sector and privatenon-corporate sector. Public sector capitalstock is estimated by relating capitalexpenditure of the government. Capitalstock of private corporate sector isdetermined by relating public capital stock,lag of the dependent variable and lag of realincome. This model relates real, monetaryand price sectors. Statement 7 portrays thespecification of real sector in the selectedmodels.

6. External Sector :

External sector explains the tradeflows and accounts for current and capitaltransactions with the rest of the world. Itbrings out the extent of dependence ofdomestic economy on external sources. Ina country like India, with much dependenceon imports, it is essential to bring out theinterrelationship among the external sectorwith other sectors in the economy. Since,Indian external sector is closed for a longtime, a systematic model for this sector isnot found in the literature.

Many models [Sarma(1982), MNR(1982), KN(1984), JS(1990), andRA(1990)] treat external sector asexogenous. Pandit(1984) links the externalsector with monetary sector throughReserve banks foreign exchange assets.The real import demand for non-food items

is related positively to government investmentand the private corporate sector, negativelyto unit value index of non-food imports anddomestic price level of the secondarysector products and positively to the stockof net foreign exchange assets of RBI.

The deflated value of exports dependon export prices relative to those of India’scompetitors and the world demand forimports. World export prices are used asdeterminant of exports for any specificcountry restricting to Asian countries only(excluding China) and assuming that thesecountries are India’s real competitors.Pani(1984) describes the exports asfunction of world gross domestic product.Exports of merchandise is specified as afunction of whole sale price index and itslag. Imports are related to net domesticproduct and deflated prices of imports.

CB(1987) presents the foreign sectorin two equations. The real imports of rawmaterials is given as a function of realincome, lag of the dependent variable andlag of the real exports. Real exports arerelated to world income and lag of thedependent variable. Statement 8 exhibitsthe specifications of external sector in themodels.

7. Concluding Remarks :

The nexus between the three macrovariables - deficit, money and prices involvecomplex operations in the economicactivities. The link can be expressed in asimple flow chart as :


government’s fiscal deficit, the otheraspects such as nature of deficit, structureof government spending, constituents ofrevenues will be more inflationary.

Further, he contends that primarycause of inflation is from non-monetaryfactors. To quote from his study, “AsProf.Sukhumoy Chakravarty hasemphasised, pure statistical evidence is notenough to judge if causation runs frommoney to prices. A more appropriateapproach should be to focus on credit andas Prof.Kaldor argued the vagaries ofmoney supply do not ensure the supply ofthe right quantum of credit for the rightsectors” (pp.246-247). Thus, a freshapproach towards the entire economicscenario and monetary/credit policy inparticular is germane.

AREAS FOR FUTURE RESEARCH :

A careful study of the modelssurveyed suggests the following areas forfurther research work :

Demand for money raises a number ofcomplicated analytical and empirical issues,central one being, identifying the stablemoney demand function. As the systemdevelops with more financial institutions andmoney having a number of substitutes aswell as performing complex number offunctions, explaining a satisfactory moneydemand function requires additionalarguments which captures those changes inthe system. In the Indian context, identifyinga stable money demand function is a difficulttask as the economy has gone through

Money > Inflation

Deficit <

In the above displayed simple chart,inflation is linked to money growth. Themoney growth itself increases due tomonetisation of deficit. Thus, controllinginflation has to be aimed at controlling thedeficit through fiscal policy rather than themonetary policy. The better choice wouldbe synchronisation of fiscal and monetarypolicies for curtailing inflation.

The other argument in the literatureviews that since monetisation of deficitexpenditure is carried out for publicinvestment, any check on that is at the costof growth and income. Moreover, India isstill in the development phase, such curb onpublic expenditure will hamper thedevelopment process. In this context,analysing the link between money, creditand income besides the link betweenmoney, price and deficit must be givenemphasis as money is essentially credit-driven and endogenously determined. Iflinkage between money, credit and incomecan be established, then it is essential toregulate the growth of credit, its sectoraldistribution and more important to the enduse of credit.

Shetty(1991) argues that the emphasison price stability as the primary goal ofmonetary policy has ignored the broaderand dynamic role of money and credit ingenerating employment and output. Hefurther views that while focusing on the


various structural imbalances, but it isgermane. Much effort is needed toincorporate the following factors forexplaining a satisfactory demand for moneyfunction :

(i) development in the financial sector

(ii) bringing the non-monetary activitiesinto the monetary stream

(iii) bringing the non-banking financialintermediaries into the organisedmonetary structure

(iv) fluctuation in the agriculturalproduction, subsidies on food andfertilizers and food procurement

(v) preference of the people to hold idlecash balances is more in India and alsohoarding money in the form of gold andsilver ornaments and

(vi) black money.

Financial deepening, role of financialinstitution and how these institutionsinfluence in the short and long runmovements in the level of economic activitycould be studied.

The impact of financial sector reformson monetary sector in particular and ongeneral economic activities in general couldbe analysed.

Reduction in government spending hastwo effects - (i) on the flow of goods andservices and money demanded andsupplied and (ii) on the stock that it willeffect the private sectors’ wealth position.The reduction in money supply consistentwith a cut in government spending can

influence real output and/or prices. This willdetermine whether the nominal value ofbudget deficit increases or decreases withthe decline in money supply. The absolutesize of the government sector depends onthe political set up. The decision to reducegovernment spending, therefore, dependsbasically on the role of government and alsothe efficiency of markets and how quicklythey clear. To the extent that governmentbureaucracies are inefficient, governmentspending can be cut if these can beidentified and eliminated which may involveprivatisation. An empirical attempt on theselines would be welcomed by the policymakers.

The link from prices to other macroeconomic variables are not dealt in detail tocapture the transmission channels fromprices to other economic activities could beexamined.

Much attention needs to be devotedto trade and balance of payments. Adetailed external sector dealing with tradeflows, current and capital transactions withthe rest of the world are necessary tocomprehend the extent to which thedomestic economy is open to externalfactors. However, foreign exchangeconstraints, regulated imports and relatedtrade restrictions have an impact oneconomic growth. The gaps in the demandand domestic supply could be taken up forfurther research.

In recent periods, with the ongoingstructural adjustment programmes, substantialamount of changes have taken place in


foreign exchange markets, internationalfinancial flows and interdependence ofeconomies. This is an area which needssome firm empirical results to enable forformulating suitable policy actions. Further,an attempt can be made to compare thepresent situation and its effects oneconomic activities with the earlierregulated and restricted trade practices.

All the models under consideration byand large have confirmed the presence ofdynamic monetary-fiscal nexus, wherein thenet RBCG formed the crucial link betweenthese two sectors. However, this frameworkdoes not provide scope for policysimulations with respect to monetary andcredit policies. Hence, an appropriateappraoch to suit for policy simulation iswarranted.

The links between basic economicactivity, credit and output generation are

rarely formulated. Though an attempt ismade, they are not based on wellestablished theoretical foundations as thetheory on demand for credit for productionpurposes or demand for funds forinvestment is neither well postulated norempirically well tested for developedcountries as well. This makes the adoptionof the existing theories with appropriatemodifications to suit Indian conditions,where a dual credit system with anunorganised market funds prevail. Inaddition to this, administered interest ratescreate hardships for a proper analysis of therole of interest rates as an allocativemechanism of credit in an optimal way. Thearea for future research on this lines couldbe to analyse the role and sectoraldistribution of credit and their interactionswith the economic activities will be usefulfor policy makers.

REFERENCES

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of India Occasional Papers1, Vol.8,pp.189-263.

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Heller P S (1980), “Impact of Inflation onFiscal Policy in Developing Countries”,International Monetary Fund StaffPapers.

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Narasimham N V A (1956), “A ShortTerm Planning Model for India”, North-Holland Publishing Company,Amsterdam.

Narendra Jadhav and Balwant Singh(1990), “Fiscal-Monetary Dynamic Nexusin India : An Econometric Model”,Economic and Political Weekly, Vol.25,pp.159-165.

------------------------------- (1990), “Macroeconometric Modeling in India : A Survey”,Reserve Bank of India OccasionalPapers, Vol.11, pp.83-152.

Olivera J H G (1967), “Money, Pricesand Fiscal Lags : A Note on the Dynamicsof Inflation”, Banca Naztional de LoveraQuarterly Review.

Pandit V (1984), “Macro econometricAdjustments in a Developing Economy: AMedium Term Model of Output and Pricesin India”, Indian Economic Review,Vol.19, pp.112-155.

Pani P K (1984), “A Macro Model of theIndian Economy with Special Reference toOutput, Demand and Prices”, ReserveBank of India Occasional Papers, Vol.5,pp.113-239.

Rakshit M (1987), “On the InflationaryImpact of Budget Deficit”, Economic andPolitical Weekly, Vol.22, pp.AN35-42.

Rangarajan C and R R Arif (1990),“Money, Output and Prices : A MacroEconometric Model”, Economic andPolitical Weekly, Vol.25, pp.837-56.

Sarma Y S R (1982), “GovernmentDeficit, Money Supply and Inflation in India1961-62 - 1979-80”, Reserve Bank ofIndia Occasional Papers, Vol.3, pp.56-67.

Shetty S L (1991), “ Need for FreshApproach to Credit and Monetary PolicyFormulation in India : A Few Suggestions”,Reserve Bank of India OccasionalPapers, Vol.12, pp,227-249.

APPENDIX - 1

NOTATIONNOTATIONNOTATIONNOTATIONNOTATION

Endogenous Variables

BD = Budget deficit.

C = Currency with the public.

CITA = Corporate income tax (estimated).

CPI = Consumer price index.

CUDA = Customs duties (estimated).

D = Total bank deposits.

DB = Domestic borrowing.

D D = Demand deposits.

DER = Government domestic expendi-ture (real).

DS = Deposits of all scheduledcommercial banks.

DTR = Direct tax receipts.

EX = Exports.

EXM = Total exports of merchandise.

EXR = Total real exports.

g = Ratio of borrowing from ReserveBank by banks.

GBBS = Government investment ofsecurities in banks.

GBNB = Government borrowing fromnon-bank financial institutions.

GCE = Government current expenditure.

GCNE = Government consumptionexpenditure.

GCR = Government current revenue.

GE = Government expenditure.

GER = Government expenditure (real).

GIE = Government investmentexpenditure.

GKE = Government capital expenditure.

GKEA = Government capital expenditure(actual).

GKEF = Gross fixed government capitalformation.

GKR = Government capital receipts.

GMB = Government market borrowing.

GR = Government revenue.

GRE = Government revenue expenditure.

GREA = Government revenue expenditure(actual).

GRR = Government revenue receipts.

GS = Government saving._H = Adjusted reserve money.

H = Reserve money.

HPD = High powered deficit.

IA = Index of agricultural production.

IDTR = Indirect tax receipts.

IM = Imports.

IMNF = Imports of non-foodgrains.

IMR = Imports of raw materials.

INTN = Nominal interest rates.


k = Ratio of currency to depositswith the public.

KR = Capital stock.

m = Money multiplier.

M = Nominal money stock.

M1 = Narrow money.

M3 = Broad money.

NINDEN = Nominal non-interest non-developmental expenditure.

NTR = Non-tax receipts.

P = General price level.

PCF = Price deflator for grossdomestic capital formation.

PE = Prices of energy items.

PF = Prices of foodgrains.

PG = Implicit gross domestic productdeflator.

PITA = Personal income tax (estimated).

P M = Prices of manufacturing andmining sector.

PR = Prices of raw materials.

PT = Prices of textiles.

r = Ratio of reserves to depositswith the banks.

RBCG = Net Reserve Bank credit togovernment.

RBFA = Net Reserve Bank’s foreignexchange assets.

TB = Trade balance.

TR = Tax receipts.

UEDA = Union excise duties (estimated).

WPI = Wholesale price index.

YND = Net domestic product.

Y R = Capacity output.

YR = Net domestic output.

YRA = Output from agriculture.

YRF = Output from infrastructure.

YRI = Output from industry.

Y R M = Output from mining andmanufacturing.

YRMF = Output from mining, fisheryand forestry.

YRNA = Output from non-agriculture.

YRNF = Output from non-foodgrains.

YRT = Output from tertiary sector.

YRU = Output from unregisteredmanufacturing industry.

Exogenous Variables

AF = Per capita availability of food-grains.

AFI = Index of area under foodgrains.

AID = Foreign assistance.

ANFI = Index of area under non-foodgrains.

B = Total borrowing.

BCC = Bank credit to government.

BL = Bazar bill rate.

BR = Bank rate.

BR = Bank reserves.

CA = Cultivated area.

CCNA = Capital consumption allowance.


CITE = Corporate income tax(Estimated).

CLG = Currency liability of theGovernment.

CRR = Cash reserve ratio.

CRT = Rate of corporation income tax.

CTP = Capital transfer of public sector.

CUDE = Customs duties (Estimated).

CURT = Rate of custom duties.

CUTL = Capacity utilisation.

DEVN = Nominal developmentalexpenditure.

DEVR = Real developmentalexpenditure.

DI = Impounded deposits.

DT = Debt.

DS = Debt. servicing(external).

ETR = Effective tax rates.

FB = Foreign borrowing.

GB = Government borrowing outsidethe RBI.

GDP = Gross domestic product.

GDPR = Gross domestic product(real).

GNMB = Government non-marketborrowing.

GOCE = Government’s other currentexpenditure.

GPS = Government public sector saving.

GSA = Gross sown area.

HSS = Household saving.

IAF = Irrigated area under foodgrains.

ICRR = Incremental cash reserve ratio.

INA = Index of non-agriculturalproduction.

INF = Index of non-foodgrains.

INFM = Index of non-foodgrains imports.

KAR = Index of gross capital stock inagriculture.

KF = Capital investment ininfrastructure.

KGR = Government capital stock inthe public sector.

KI = Capital investment in industry.

KPCR = Capital stock in the privatecorporate sector.

KPOR = Private non-corporate capitalstock.

KPR = Capital stock in the privatesector(real).

KT = Capital investment in tertiarysector.

KTR = Capital stock in tertiary sector.

KUR = Capital stock in unregisteredmanufacturing industry.

N = Population.

NB = Number of bank branches inthe country.

NEXLR = Ratio of net external loan tobudget deficit.

NRB = Number of rural bank branches.

OCR = Other current receipts.


O D = Other deposits.

OGKE = Other government capitalexpenditure.

= Expected rate of inflation.

PAD = Potential impact of changes inadministered prices.

PI = Public investment.

PITE = Personal income tax (Estimated).

PMN = Prices of minerals.

PPCY = Private per capita income.

PRT = Personal income tax rate.

PY = Productivity.

RB = Borrowing rate.

RBCC = Reserve Bank’s credit tocommercial sector.

RBNML = RBI’s net non-monetaryliabilities.

RG = Rate of return on governmentsecurities.

RL = Lending rate.

RTD = Time deposit rate.

SF = Availability of foodgrains.

UEDE = Union excise duties (Estimated).

URT = Rate of union excise duties.

W = Wage rate.

W F = Weather index of foodgrains.

W N = Weather index of non-foodgrains

WPF = Wholesale price index offoodgrains.

Y N = Nominal national income.

Statement - 1Monetary Sector - Demand for Money

Model Specification No. of Period ofEquations study

Sarma Inverted Money demand function 61-62 to(1982) 79-80

M N R _________ 51-52 to(1982) 79-80

K N _________ 61-62 to(1984) 79-80

+ + _ _Pandit M1/P = f (YR, (M1/P)

-1, BL, ) 50-51 to

(1984) + + _ _ 77-78C/P = f (YR, (C/P)

-1, BL, ) 4

+ + _ _DD/P = f (YRNA, (DD/P)

-1, BL, )

+ + _Pani C = f (BD, RBFA, GB) 69-70 to(1984) + 81-82

D = f (DS) 6 +

DS = f (BR - DI) + +

CB C/P = f (YR, (C/P)-1) 62-63 to

(1987) + + + 2 83-84D/P = f (YR, RTD, (D/P)

-1)

JS Inverted Money demand function 70-71 to(1990) 87-88

R A Inverted Money demand function 61-62 to(1990) 84-85

APPENDIX - 2It presents the statements of various specifications in different sectors in the surveyedmodels. ‘D’ indicates change of current year value from the previous period value.The variables in bold letters represent exogenous variables.


Statement - 2Monetary Sector - Supply of Money


Sarma + + + 61-62 to(1982) M = f (BD, BCC, RBFA) 2 79-80

M N R M3 = [(1+k)/(k+r+g)]H* 8 51-52 to(1982) _ _ _ 79-80

k = f (NB, (NRB/NB), RTD) + + + _ _

r = f (CRR, ICRR, RB, RL, RG) + + + _ _

g = f (CRR, ICRR, RB, RL, RG)H* = C + BR - RBCC (liability side)H* = RBCC - RBNML (asset side)

+RBCG = f (BD)

K N + + 61-62 to(1984) M = f (H, M

-1) 79-80

RBCG + CLG = (RBCG + CLG-1) + HPD 5

+RBCC = f (RBCC

-1)

HPD = f (BD - DB - FB) + +

Pandit M1 = f (H, RL) 50-51 to(1984) + + 77-78

DH = f [(RBCG+RBCG-1),(DRBFA+DRBFA

-1)] 3

+ + +BCC = f (H, H

-1, (RL-BR))

Pani M3 = C + D + OD 1 69-70 to(1984) 81-82

+CB M3 = f (H) 62-63 to

(1987) H = RBCG + RBCC + RBFA - RBNML 4 83-84RBCG = RBCG + RBCG

-1 + _

JS M = f (BD, M-1) 2 70-71 to

(1990) 87-88

R A M3 = m * H 61-62 to(1990) + 84-85

D = f (M3)H = RBCG+RBCB+RBFA+CLG-RBNML 4


Statement - 3Government Expenditure


Sarma + + 61-62 to(1982) GER = f (GDPR, GER

-1) 1 79-80

+ +M N R GREA = f (NEXLR, GRE) 51-52 to(1982) + + + 79-80

GKEA = f (PI, NEXLR, GKE) 2 + +

K N GCE = f (YR, GCE-1) 61-62 to

(1984) + + + 79-80GRE = f (YR, GRE

-1, W) 3

GKE = PI + CTP + +

Pandit GCNE = f (GCR/N, GCNE/N) 50-51 to(1984) + _ _ 77-78

GOCE = f (DT, GOCE, (PF.YRF)) 3GIE = GS + DB + FB + AID + BD

Pani GE = GCE + GKE 69-70 to(1984) + 81-82

GKE = f (GIE) 2 +

GCNE = f (GCNE-1)

CB GE = GCE + GKE 62-63 to(1987) + + 83-84

GCE = f (YN, GCE-1) 3

GKE = GKEF + OGKE

JS GE = DEVN + NINDEN + INTN 70-71 to(1990) + + + 87-88

NINDEN = f (YR, P, NINDEN-1) 3

+INTN = f (DT

-1)

R A GE = GKE + GCE 61-62 to(1990) + + 84-85

GCE = f (YR, GCE-1) 2


Statement - 4Government Revenue


Sarma + + 61-62 to(1982) GR = f (GDP, GR

-1) 1 79-80

M N R GR = TR + NTR + GKR + GRR 51-52 to(1982) TR = CUDA + UEDA + PITA + CITA 79-80

+ + + +CUDA = f (PIM, M, CURT, CUDE)

+ + + +UEDA = f (PI, YRI, URT, UEDE) 6

+ + + +PITA = f (PI, YRI, PRT, PITE)

+ + + +CITA = f (PI, YRI, CRT, CITE)

K N + + 61-62 to(1984) GCR = f (YR, GCR

-1) 79-80

+DB = f (BD + FB)

+GS = f (GCR - GCE)

Pandit GR = DTR + IDTR + OCR 50-51 to(1984) + 77-78

DTR = f (YRNA) 3 +

IDTR = f (YRNA)GS = DTR+IDTR+OCR-GCNE-GOCE+CCNA

Pani GR = f (YN, GR-1) 1 69-70 to

(1984) 81-82 + + +

CB GRR = f (YN, ETR, GRR-1) 1 62-63 to

(1987) GKR = GMB + GNMB + FB 83-84 + _

GMB = f (D, GMB-1)

JS GR = TR + NTR 70-71 to(1990) + + + 87-88

TR = f (YR, P, TR-1) 3

+ + +NTR = f (YR, P, NTR

-1)


Continued...

Statement - 4 (Concluded)Government Revenue


R A + + 61-62 to(1990) GR = f (GR

-1, YN) 84-85

GCR = GMB + GNMB + FBGMB = GBBS + GBNB 5

+GBBS = f (D) +

GBNB = f (YN) +

GNMB = f (YN)


Statement - 5Budget Deficit


Sarma BD = GE - GR 1 61-62 to(1982) 79-80

M N R BD = GE - GR 1 51-52 to(1982) 79-80

K N BD = GKE - GPS - GB - FB 1 61-62 to(1984) 79-80

Pandit ------------ 50-51 to(1984) 77-78

Pani BD = GE - GR 69-70 to(1984) + + 81-82

DB = f (HSS, D) 3B = DB + FB

CB BD = GE - GR 62-63 to(1987) 83-84

JS BD = GE - GR 70-71 to(1990) 87-88

+R A DT = f (BD) 2 61-62 to(1990) BD = GE - GR 1 84-85


Statement - 6

Price Movements


Sarma _ + + 61-62 to(1982) P = f (YR, , (M/P)

-1) 1 79-80

M N R --------- 51-52 to(1982) 79-80

_ + + +K N PF = f (AF, PPCY, M/YR, WPF) 61-62 to(1984) _ + + 79-80

PR = f (PPCY, M/YR, PIM) + + + +

PM = f (PR, W, PIM, M/YR) 12 + +

PE = f (WPI-1 + PIM)

+ + + +WPI = f (PF, PR, PM, PE)

+ +CPI = f (WPI

-1, WPI)

Pandit + _ + 50-51 to(1984) PF = f (M

-1, AF

-1, PF

-1) 77-78

_ + + +PR = f (INF, PMN, YRM

-1, M)

+ + + + +PM = f (PR, PE, BCC, (W-PY), (IDTR-YRM))

+ +PT = f (PR, PE) 17 + +

PF = f (INF, INF-1)

WPI = PF + PR + PM + PT + PE + PMNPG = (YRA/YR) IA + (YRNA/YR) INA

Pani + + _ + + 69-70 to(1984) PF = f (M3/YR, YRM, SF, YRA, YRNA) 81-82

+ +PR = f (PF, YRM) + + +

PM = f (PF, PR, PIM) 5 + + + +

WPI = f (M3/P, PF, PR, PAD)


Continued...

Statement - 6 (Concluded)Price Movements


CB + + _ + 1 62-63 to(1987) P = f (M3, P

-1, YR, ETR) 83-84

JS _ + + 1 70-71 to

(1990) P = f (YR, , (M/P)-1) 87-88

R A + _ + 1 61-62 to(1990) P = f (M3, YR, P

-1) 84-85


Statement - 7Real Sector


Sarma Exogenous 61-62 to(1982) 79-80

M N R Exogenous 51-52 to(1982) 79-80

K N YR = YRA + YRI + YRF + YRT 61-62 to(1984) YRA = (YRA/CA)CA

-179-80

YRI = (YRI/KI)KI-1

YRF = (YRF/KF)KF-1

49YRT = (YRT/KT)KT

-1

Pandit YR = YRA + YRM + YRMF + YRT 50-51 to(1984) + + 77-78

YRA = f ( YRF, YRNF) + +

YRT = f (YRA, YRM) 15 + + +

Pani IA = f ((IAF/AFI), WF, AFI) 69-70 to(1984) + + + 81-82

INF = f ((IAF/ANFI), WN, ANFI, (KAR/ANFI)) + + +

YRM = f (KAR, ((GE-GCNE)/PCF), (GDER-GIE)) 8 + +

YRU = f (YRM, KUR) + +

YRT = f ((YRA + YRM), KTR) + + +

CB YRT = f (KR, GSA, IMR) 62-63 to(1987) + + + _ 83-84

GKEF = f (KGR, VDYR, FAR, KPR) 5

+ +

JS YR = f (YR, CUTL) 70-71 to(1990)

87-88

YR = f (DEVR, Y R-1)

+ +YR = f (KR

-1, (M3/P)

-1) 5

R A KR = KGR + KPCR + KPOR 61-62 to(1990) KGR = f (GKE) 5 84-85

+ + +KPCR = f (KGR, YR

-1, KPCR

-1)


Statement - 8

External Sector


Sarma Exogenous 61-62 to(1982) 79-80

M N R Exogenous 51-52 to(1982) 79-80

K N Exogenous 61-62 to(1984) 79-80

+ _ + +Pandit IMNF = f ((GIE+KPCR), INFM, PM, RBFA

-1) 8 50-51 to

(1984) 77-78EX = f (EXA, PEXA)

TB = EX - IMRBFA = RBFA

-1 + TB + INV + FB + AID - DS

+Pani EX = f (WGDP) 3 69-70 to(1984) + _ 81-82

IM = f (YND, PM/WPI) + +

EXM = f (WPI-1, WPI)

+ + _CB IMR = f (YR, IMR

-1, EXRA

-1) 3 62-63 to

(1987) + + 83-84EXR = f (WY, EXRA

-1)

JS Exogenous 70-71 to(1990) 87-88

R A Exogenous 61-62 to(1990) 84-85

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