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Money Supply and Inflation

24-NOV-2015 14:41

    Supplying the money in the market is the sole responsibility of the central bank of the country (Reserve Bank of India in case of India). RBI prints the currency and supplies money in the economy. Coins are minted by the Ministry of Finance but circulated by the RBI in the whole country. Supply of money decides the rate of inflation in the economy. If supply of money increases in the economy then inflation starts rising and vice versa.

    The currency issued by the central bank is in fact a liability of the central bank and the government. In general therefore this liability must be backed by an equal value of assets consisting mainly of gold and foreign exchange reserves, especially in terms of high power foreign currencies.

    In India money supply is done on the basis of Minimum Reserve System since 1956. The RBI required holding a reserve of Gold and foreign securities and it is empowered to issue currency to any extent. Since 1957, the Minimum Reserve System changed to Gold reserve of Rs. 115 cr. and rupee securities of 85 cr. Hence RBI needs to keep 200 cr. as security to print any amount of currency in the economy.

     Monetary Aggregates according to RBI

    • M0 (Reserve Money): Currency in circulation + Bankers’ deposits with the RBI + ‘Other’ deposits with the RBI = Net RBI credit to the Government + RBI credit to the commercial sector + RBI’s claims on banks + RBI’s net foreign assets + Government’s currency liabilities to the public – RBI’s net non-monetary liabilities.
    • M1 (Narrow Money): Currency with the public + Deposit money of the public (Demand deposits with the banking system + ‘Other’ deposits with the RBI).
    • M2: M1 + Savings deposits with Post office savings banks.
    • M3 (Broad Money): M1+ Time deposits with the banking system = Net bank credit to the Government + Bank credit to the commercial sector + Net foreign exchange assets of the banking sector + Government’s currency liabilities to the public – Net non-monetary liabilities of the banking sector (Other than Time Deposits).
    • M4 (Broad Money): M3 + All deposits with post office savings banks (excluding National Savings Certificates).

    Money Supply M3 in India increased to 112200.55 INR Billion in October from 110835.65 INR Billion in September of 2015. Money Supply M3 in India averaged 18279.23 INR Billion from 1972 until 2015, reaching an all time high of 112200.55 INR Billion in October of 2015 and a record low of 123.52 INR Billion in January of 1972. Money Supply M3 in India is reported by the Reserve Bank of India.

    How to Measure Inflation in India

    • Wholesale Price Index: India is one of the few countries where the WPI is considered as the headline inflation measure by the central bank. The preference over the CPI is often explained in terms of three criteria – national coverage, timeliness of release (now only limited to food products) and its availability in a disaggregate format. Of these criteria, only the last one is uncontroversial – the CPI numbers are not released to the public in the detail available for the WPI. This however does not appear to be an insurmountable problem to address, because the detailed data is collected; it is just not made public with sufficient timeliness. The set of weights in the base 2004-05=100 proposed by the Working Group has been adopted in the new WPI. It is interesting to note that the combined weight of food (primary food articles and manufactured food items) in the WPI has come down to 24% from 26.9% in the old base 1993-94=100. This appears inconsistent with both the reduction in the share of agricultural value added in gross domestic product (GDP) (by approximately 15 percentage points during this period) and that recorded by food products in the National Sample Survey (NSS) consumption expenditure basket, in rural and urban areas
    • GDP Deflator: The GDP deflator is another indicator of inflation, which is often considered to be broader than the CPI and the WPI. The GDP deflator in most countries is obtained by using a variety of primary price indices. These are used to deflate individual components of the GDP valued at current prices (either from the production or the demand side estimates) to obtain volume estimates. The GDP deflator is then defined implicitly as the ratio of the estimate at current prices to the one at constant prices. When this process is followed, the GDP deflator is legitimately recognized as a high quality measure of inflation. Nonetheless, given the delay in publication of national accounts it is seldom used as a headline indicator of inflation in a real-time setting.
    • Consumer Price Index: The overall CPI is meant to represent the cost of a representative basket of goods and services consumed by an average household. However, in India, the existing CPIs refer to specific segments of the population.

    Types of CPI 

    • Consumer Price Index for Agricultural Labourers (CPI-AW)
    • Consumer Price Index for Industrial Workers (CPI-IW)
    • Consumer Price Index for Urban Non-Manual Employees (CPI-UNME)

    Consumer Price Index for Urban Non Manual Employees was earlier computed by Central Statistical Organisation. However this index has been discontinued since April 2008.The CPI (IW) and CPI (AL& RL) compiled is occupation specific and centre specific and are compiled by Labour Bureau. This means that these index numbers measure changes in the retail price of the basket of goods and services consumed by the specific occupational groups in the specific centre. CPI (Urban) and CPI (Rural) are new indices in the group of Consumer price index and has a wider coverage of population. This index compiled by Central Statistical Organisation tries to encompass the entire population and is likely to replace all the other indices presently compiled. In addition to this, Consumer Food Price Indices (CFPI) for all India for rural, urban and combined separately are also released w.e.f May, 2014.

    Conclusion: Supply of money and inflation are positively co-related to each other. If supply of money increases in an economy and production/ supply of goods/ services do not follow it, then inflation increases inevitably.

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