Take a closer look at the money supply

Milton Friedman said in 1970 that “inflation is always and everywhere a monetary phenomenon”. The pendulum has now moved to the other extreme. Today’s discussions on inflation make no reference to money. None of the extreme positions are valid.

The old quantitative theory of money assumed that any increase in the quantity of money will have no effect on production (transactions). This is consistent with the classic view that money is a “veil”. Real quantities are only affected by real factors. But this point of view is no longer accepted. We must understand that the process of money creation is a process of creating credit. The two go together.

In the process of money creation, credit goes either to the government or to the business sector. Depending on the situation, money creation may have a greater effect on production or a greater impact on prices.

It is true that politics nowadays focuses more on price (interest rate) than quantity (money). But the two are linked. At equilibrium, quantity and price are determined.

The monetary authority cannot in fact “order” the interest rate. They have to adjust the quantity (money or liquidity) in order to achieve the desired level of interest rate. In fact, more recently, since 2008, “quantitative easing” has become popular. There are times when quantity works best. (For a more in-depth discussion of the importance of quantity, see Rangarajan & Nachane, “Inflation, Monetary Policy and Monetary Aggregates”, Journal of Indian Public Policy Review, May 2021.)

The previous discussion brings me to the main point that recent discussions of inflation in India in monetary policy statements tend to ignore money, even though there is reference to liquidity. The two (money and liquidity) are close but not the same, depending on how you define liquidity. Discussions mainly focus on supply disruptions due to internal or external factors. They explain the behavior of individual prices, but not the general price level, which is the object of inflation.

To bring inflation under control, the authorities must have control over cash or money. The crucial question is what happens to the demand, that is, to the demand in monetary terms. Thus, the amount of liquidity or currency is relevant. Analysts need to go beyond just pointing out price movements for food or crude oil.

Increase in liquidity

The pumping of cash through various channels by RBI has been quite significant. In fact, what we need to look at is not what happens at the discount window but at the reserve money. Here, we must distinguish between “sustainable liquidity” and temporary liquidity. Any purchase of government securities by the RBI from banks adds to lasting liquidity. This is more relevant than what is loaned for a short period by RBI.

In my opinion, one factor that contributed to the moderation of inflation between 2012-13 and 2019-20 is the moderation of the money supply (Table 1). Obviously, a more complicated model is needed to explain inflation, including the output gap and expectations. But we cannot ignore the money supply. As mentioned earlier, the policy rate and the creation of reserve currency are interrelated.

When we examine recent data, two things stand out: there is a clear difference between the rate of growth of reserve money and that of the money supply (Table 2). The latter shows a much slower growth. This must be attributed to a lesser expansion of credit and a greater withdrawal of foreign currency. The money multiplier has fallen. Inflation in the second CPI has increased when there is a recovery in the money supply.

However, it should be noted that inflation has remained largely in the comfort zone. If the money supply had increased in line with the growth of the reserve currency, we would have ended up with a much higher level of inflation. Indeed, several members of the Monetary Policy Committee expressed in their minutes their satisfaction that inflation had moderated. But they seek the reason for this in the behavior of individual prices. But one of the reasons is the unintentional moderation of the money supply. We have to learn the right lesson.

In a difficult situation like that posed by the Covid-19, an expansionary fiscal policy and a supportive monetary policy are necessary. But when to moderate it is also important. Many countries, including India, made this mistake after the 2008 crisis. They pursued an expansionary policy over a prolonged period, which led to inflation.

The time has come to moderate the growth of reserve currency. As the economy moves towards a normal situation, the money multiplier will also increase with the growth of credit.

There are now enough excess reserves that will also trigger money supply growth, once activity picks up. Currently, the key rate is negative corrected for inflation. A continuation of this situation can lead to a “financial repression” with all the consequences which ensue from it.

In fact, much of the growth since April 2021 can be attributed to the easing of mobility restrictions. As long as containment continues, no policy can be effective. The crucial year will therefore be 2022-2023 when political actions can become relevant. However, my main focus is not on this aspect.

What I would like to stress is that for an understanding of inflation, the dynamics of supply relative to individual commodities do not provide the full answer. The amount of money or liquidity in general is of crucial importance.

The author is a former Chairman of the Economic Advisory Council to the Prime Minister and a former Governor of the Reserve Bank of India.

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