Impact of money supply

OnInflation and gdp

METHODOLOGY ADOPTED:

• Understanding the type and causes of inflation in India.• Understanding monetary policy tools which are being used

by RBI.• Taking the data of money supply (M3), consumer price

indices and wholesale price indices.• Through regression calculating that how much change in

inflation in CPI & WPI is explained by the changes in money supply.

• Study the past scenario and trend through various articles and earlier selected data.

• Studying latest developments in monetary policy by RBI taking inflation into consideration.

INFLATION AND MONEY SUPPLY

Inflation in India:

Inflation is at an acceptable level and remains much lower than in many other developing countries.

Demand pull inflation:• aggregate demand > aggregate supply.

Cost push inflation:• when there is a supply shock• E.g. oil shock in 1970s

RBI and its role in Inflation ControlObjective of monetary and credit policy: • maintain price stability • ensure adequate flow of credit to the productive sectors of the economy. • Stability for the national currency and growth in employment and income

are also considered.

Control Measures• Open Market Operations (OMO)• Reserve Requirements

• CRR is the portion of deposits (as cash) which banks have to keep/maintain with the RBI.

SLR is the portion of their deposits banks are required to invest in government securities.

• Between December 2006 and July 2007, RBI has raised CRR by 2 percentage points to 7% which sucked out Rs. 56000 crore rupees from money in supply from financial system

• Bank Rate or Discount rate(rate at which the RBI makes very short term loans to banks)

Indian bank rate is at 6 per cent down from 10 per cent in 1981 and 12 per cent in 1991

• Repo rate (rate at which the RBI borrows short term money from the market)

YearGrowth Rates

IW food UNME AL WPI M3 CPI1991-92

13.47% 15.58% 13.66% 19.66% 13.74% 19.27% 15.50%1992-93

9.59% 10.43% 10.38% 12.32% 10.06% 14.81% 10.70%1993-94

7.50% 7.09% 6.93% 3.53% 8.35% 18.42% 6.22%1994-95

10.08% 11.76% 9.72% 11.94% 12.60% 22.39% 10.10%1995-96

10.21% 10.86% 9.28% 10.75% 7.99% 13.57% 9.20%1996-97

9.27% 9.50% 9.27% -81.46% 4.61% 16.16% 7.20%1997-98

7.02% 5.15% 6.71% 3.12% 4.40% 18.01% 13.10%1998-99

13.11% 14.69% 11.59% 10.98% 5.95% 19.44% 4.70%1999-00

3.38% 0.22% 4.45% 4.44% 3.27% 14.60% 4.00%2000-01

3.74% 1.57% 5.40% -0.33% 7.16% 16.82% 3.80%2001-02

4.28% 2.87% 5.12% 1.31% 3.60% 14.10% 4.30%2002-03

4.10% 2.36% 3.85% 3.24% 3.41% 15.66% 4.10%2003-04

3.73% 3.77% 3.70% 3.76% 5.46% 16.75% 3.70%2004-05

4.00% 2.22% 3.81% 2.72% 6.48% 12.25% 3.33%2005-06

4.23% 4.15% 4.59% 3.82% 4.38% 21.24% 4.30%2006-07

6.83% 9.11% 6.58% 7.65% 5.42% 21.28% 6.70%

R2 taking Money Supply as independent factor:

R square96%99%97%99%47%

IWFood

UNMEAL

WPIdependent variable

• Wholesale Price Index (WPI) to below 3 per cent recently• Inflation based on wholesale prices during the period January 1998 -

January 1999 was 4.6 percent, one of the lowest in the world. Does it show that that tight monetary policies have been effective in

bringing down inflation to within RBI's comfort zone?

A closer look:• Consumer prices continue to show a rising trend. • Large purchases of foreign exchange by the RBI have raised money supply

growth. Further, there is empirical evidence of a link between money supply and

consumer prices. Bringing consumer inflation under control will require shifting away from the policy of preventing an appreciation of the rupee/dollar rate.

1991-92

1992-93

1993-94

1994-95

1995-96

1996-97

1997-98

1998-99

1999-00

2000-01

2001-02

2002-03

2003-04

2004-05

2005-06

2006-070.00%

5.00%

10.00%

15.00%

20.00%

25.00%

M3C3

•Sharp spike in 1998 when for a brief period consumer prices rose at near 20 percent•The rate has moved down from above 5 per cent in the 1990s to below 5 per cent after 2000 and is seen to be rising again•In recent months, the trend values show money supply growth of above 20 per cent and CPI based inflation of above 7 per cent. •Declining trend till 2002•Rupee appreciation in mid 2002•Increase in money supply against rupee appreciation. In 2007, trend money supply growth has accelerated and CPI inflation has accelerated. This negates claims that are now being made about monetary policy being tightened and keeping inflation under control.

Why are the CPI and WPI telling two different stories about inflation?

• Both the appreciation of the rupee and the failure of the government to raise oil prices has resulted in the WPI growing very slowly

• The WPI consists of a large component of tradables like chemicals, intermediate goods, commodities and various manufactured goods, whose prices have come down after the rupee appreciated.

• The prices of these goods are essentially determined by local demand and supply conditions. The prices of these goods are likely to be highly correlated with changes in money supply growth.

• Consumer Price Indices are the best inflation measure in a country, as they measure prices of a basket of goods consumed by a certain sample of households.

• The prices of these goods are essentially determined by local demand and supply conditions.

• The prices of these goods are likely to be highly correlated with changes in money supply growth.

Causes for increase in money supply:• In preceding decades, India had an inflation problem

because monetary policy used to support large fiscal deficits by printing money.

• That problem was solved by politicians who realized that higher inflation reduces political support more than what is gained by higher fiscal spending.

• Now inflation is caused by large purchases of dollars by the RBI in the foreign exchange market in an attempt to prevent the rupee getting stronger.

Recent developments in monetary policies: The approach of cautious optimism. It revised its GDP growth projection to

8.5% 9% from 8% earlier. RBI has focused on rising inflation and inflationary expectations in its review.

Though RBI finds the 5% - 5.5% inflation tolerable, it has decided to moderate the growth at 5% in the medium term.

To curtail both monetary and credit growth, the central bank has taken following steps:

• Made money available at its repo window costlier by 25 bps to 7.5%. • Increased in the provisioning requirement for standard assets for the real estate

sector (excluding residential housing loans), outstanding credit card receivables, loans and advances qualifying as the capital market exposure and personal loans to 2% from 1%.

• It has increased the provisioning requirement for the banks` exposures to the non-deposit non-banking financial companies (NBFCs) to 2% from 0.4%

• Reduction in the interest rate ceiling on NRE deposits from 100 bps to 50 bps above LIBOR/SWAP rates for US Dollar of corresponding maturity. This move will result in a contraction of money supply in the economy, which would further help in checking inflation.

GDP and MONEY SUPPLY

• What is GDP?• Its relevance.• Real and nominal GDP.

• What is money?• Its uses.

– Medium of exchange.– Store of value.– Standard of deferred payments.

– Speculatory purposes.

GDP and MONEY SUPPLY

• Components of money supply– Currency in circulation– Cash with banks– Currency with public– ‘Other’ deposit with RBI– Bankers deposit with RBI

• Three major components of GDP– Trade, hotels, transport & communication – Financing, insurance, real estate & business services – Community, social& personal services

IMPACT OF MONEY SUPPLY ON GDP

• At constant price

1950-51

1954-55

1958-59

1962-63

1966-67

1970-71

1974-75

1978-79

1982-83

1986-87

1990-91

1994-95

1998-99

2002-03

2006-07 P0

100000

200000

300000

400000

500000

600000

700000

800000

900000

1000000

communityfinancetrade

IMPACT OF MONEY SUPPLY ON GDP

•At current price

1950-51

1954-55

1958-59

1962-63

1966-67

1970-71

1974-75

1978-79

1982-83

1986-87

1990-91

1994-95

1998-99

2002-030

200000

400000

600000

800000

1000000

1200000

1400000

fincommtrade

RBI-reserves

Banks-mone

y supply

Money

marketsAggregate

demand rises

GDP inreases

The process of money creation in an economy-India(1990-91)Position of banks New deposits

=narrow +broad+reserve money

New loans and investments-broad money+narrow money

New reserves-reserve money CRR=

19.66%

Original bank 4,46,499 2,65,828 87,779

1st-gen.Bank 2,65,828 2,13,566.21 52,261.78

2nd gen.Bank 213566.21 171579.09 41987.11

3rd gen.bank 171579.09 137846.64 33732.44

4th gen.bank 137846.64 110745.99 27100.64

Sum of 1st -4 gen. of banks

1235318.9 899565.93 242860.19

Sum of rem. Gen .of banks

1035784.864 452560.21 203638.81

Total for banking system as a whole

2271103.764 1352126.144 4,46,499

Summary of logic of how Banks create money

CRR=( reserve money/new deposits)*100 deposits State of Final system equilibrium- desired state- state of economic boom &

prosperity deposits at the original bank= reserve money Money supply multiplier= amount of new money created / change in reservesIn 1990-91, 1824604.76/358720 = 5.086 = 1/CRR =1/.1966 = 5.086

Scenario-56 years

0

500000

1000000

1500000

2000000

2500000

3000000

Prop*Broad moneyProp*Narrow moneyProp*reserve money

data- considered Sum of each component in all years founded proportion of each in that year w.r.t to all 56

yrs. Sum of that comp. For each yr. value of total money supply =

sum of all components taken in that yr. all three rise slowly from 1950-51 to 1980-81 From 1981-82, 3 rise with high acceleration value of (broad money component> narrow

money component> reserve money component)

Rising speed broad money>>> narrow money > reserve comp. comp. Money

comp. Corr(R,N)=0.997143, corr(R,B)=0.994253 corr(B,N)=0.9984

Inference

In India, RBI monetary policies- directed towards high amount of

time deposits and savings Much lesser amount of money available for Exchange.During 1983-84, it tries to increase CRR thus increasing

the reserves Sill, we observe –reserves is much farther away from

reaching the sum of broad and narrow moneyThus there is still a long way for India to achieve a state of

economic boom. Correlation- positive- all 3 increase or decrease in the

same direction- together

Growth of Money supply and Real GDP- 1950-51 to 2006-07

1950-51

1952-53

1954-55

1956-57

1958-59

1960-61

1962-63

1964-65

1966-67

1968-69

1970-71

1972-73

1974-75

1976-77

1978-79

1980-81

1982-83

1984-85

1986-87

1988-89

1990-91

1992-93

1994-95

1996-97

1998-99

2000-01

2002-03

2004-05 P

2006-07 P0

500000

1000000

1500000

2000000

2500000

3000000

3500000

4000000

Money Sumsum of Gdp of each yr. Constant price

•

Growth of money supply &nominal GDP-1950-51 to 2006-07

1950-51

1952-53

1954-55

1956-57

1958-59

1960-61

1962-63

1964-65

1966-67

1968-69

1970-71

1972-73

1974-75

1976-77

1978-79

1980-81

1982-83

1984-85

1986-87

1988-89

1990-91

1992-93

1994-95

1996-97

1998-99

2000-01

2002-03

2004-05 P

2006-07 P0

500000

1000000

1500000

2000000

2500000

3000000

3500000

4000000

Money Sumsum of gdp of each yr Current price

Data -analysis

real GDP analysis Initial yrs.- uptill 1980-81,Money

supply and real GDP both rise at the same rate

From 1982 onwards till date– money supply rises &real GDP both

rise rapidly rate of rise MS >> rate of rise of real GDP Corr(MS,RGDP)=0.9691

Nominal GDP analysis Initial yrs.- uptill 1976-77, both rise

at same rate From 1978 onwards- till date both rise rapidly Rate of rise >> rate of rise of of MS real GDP Nominal GDP rises much faster than

real GDP Hence , inflation considered affects

the GDP. As a result , India’s GDP increased.-

we can say that virtual GDP is much more than real GDP due to inflation.

Corr(MS,NGDP)=0.9969

Inference-

We clearly observe-in India Rising money supply in the market is due to rising reserves Rising CRR-rising multiplied money- Hence rising created

money- rising money supply Result- high liquidity –due to Light credit conditions-lower

interest rate High borrowing- high investment- high production-real

GDP rises high employment-high income High Agg. Demand- price rises- inflation- nominal GDP

rises.

• Though India has more money- it has to develop potential to convert that money into produce.

Reasons are –• Lack of infrastructure- bulidings,roads,electric

supply,clean water & others• High population high illetracyhigh

unemploymentpovertylack of economic prosperity

Regression & t –test-on money supply & GDPs

Considering real GDP1. Independent variable-Money

supply2. Dependent variable- Real GDP3. R2 =0.939- is proportion of

variance in real GDP predicted by variable MS.

4. Hence, 93.9% of variance in real GDP can be predicted.

5. The regression Equation can be written as-

Real GDP =1087177.0+ 0.398 *money supply

6. For a unit increase in MS, real GDP will increase by 0.398

Considering nominal GDP1. Independent variable –Money supply2. Dependent variable- Nominal GDP3. R2 =0.9944. henceforth, 99.4% of variance in

nominal GDP can be predicted. 5. The regression Equation can be

written as- Nominal GDP= 12250.449+0.524 *

money supply6. For a unit increase in MS, nominal

GDP will increase by 0.524

Do the money supply really predict GDP

t-test1. P- value is found-compared to alpha-level of significance=0.052. P value=0 in both cases 3. Since , 0 < 0.054. money supply will significantly predict both real and nominal GDP.5. We say ,variable MS is statistically significant.Test of level of significance-6. Also – 95% confidence interval considered,between upper bound and

lower bound limits-7. Real GDP- lies between 0.370 and 0.4758. Nominal GDP lies between 0.513 and 05359. Since ,each of the interval does not include 0, hence- it is statistically

significant.

ConclusionBy taking the example of Indian Economy,We have successfully proved that money

supply strongly affects growth of real and nominal GDP

By correlation ,we proved the direction of change in the two.

By regression, we proved the strength of association and the direct relation between the two.

Today’s Scenario

• Today large amount of money in form of stocks-due to foreign & domestic investment- through shares,debentures,bonds

• Risk-Indian companies owned by foreign share holders- who can acquire control in longer term –if larger in number

• This may bring about political uncertainty in the Nation-leading to economic break down

• Need to produce high multiplied money in India itself with less foreign investment and more domestic money.

Effect of excessive money supply

• The Indian rupee has been witnessing a continuous rise in its value against the US dollar. An increase of approximately 13.5 % has been witnessed in the last one year.

The Ripple Effect

• With rupee appreciation against dollar unrelenting, India’s first quarter

export growth in the current fiscal decelerated to 7 per cent in rupee terms

• Import growth on the other hand has been continuing its increasing trend

as imports for April-June 2007 was $54.9 billion as against $40.88 billion for

the same period last year.

• As a result, trade deficit during the first quarter of the current fiscal surged

to $20.6 billion, which was substantially higher than the deficit of $11.8

billion during April-June 2006.

Measures by Government

• On Aug 7, the finance ministry capped external commercial borrowings (ECB) at USD20mn per corporate per year for funds not spent overseas (on imports, outward foreign direct investment, etc.).

• Government increased subsidies to exporters by increase in DEPB rates.

• Regulations as to repayment of foreign debt were changed so as to attract repayment of debts.

Recommendations• Need to produce high multiplied money in India itself with less foreign investment

and more domestic money.• Not only MS, other factors also affect GDP growth- monetary and fiscal policies, foreign exchange reserves, political factors, natural factors- like famine may lead to recession, a sudden broke out of a war- may lead to increase in GDP• Hence , RBI along with the government of India should take measures to expand the

GDP growth potential of India to achieve the 3 ultimate objectives of any economy-1. Stable prices2. Low unemployment3. Rapid growth in real GDPThis will eradicate all poverty and will lead to economic upturn and prosperity of the

country.