Inflation and the Money Supply - Essay Example

Monetary Analysis: Inflation and the Money Supply Introduction: It is said that inflation is caused by the phenomenon of surplus inflow of money against the basic and actual requirement. In our modern economy the money supply is not the deciding factor on the prices, whereas, the surplus money supply will enhance the price level of the commodity. Earlier, silver and gold served as money. Now that this commodity money gave way to paper currency and deposits, these monies were treated as fiat money which allowed the national monetary institutions to exercise their power to use them without any legal constraints. Most of the economists indicate that one of the principal reasons of inflation is the unreasonable growth in money supply. The sources of this theory lie with Monetarist economists. Milton Friedman observed that, "Inflation is always and everywhere a monetary phenomenon," (Milton Friedman, 1987). The theory of inflation takes up the Quantity Theory of Money to propose that if the amount of money in the economy grows faster than the growth in the level of possible output, then this will affect upon the prices. In other words if the money supply grows too fast there will be inflation. The broad aim of this essay is to bring out the knowledge of the basic theory concerning the relationship between the growth of money supply and inflation in an applied context. This will demonstrate a clear understanding of both narrow and broad measures of the money supply and their linkages with relevant macroeconomic variables. Through analysis of relevant macroeconomics data which is taken from official data sources, a qualified conclusion concerning the relationship between inflation and money supply growth for a country is arrived. The main policy implications of the findings for the conduct of monetary policy are also carried out. Quantity Theory of Money: According to the 'Quantity Theory of Money' there is a close relationship between the growth of the money supply and the rate of inflation. The classical theory of monetary policy defines money as a medium of exchange. Money is utilized to carry out the dealings and it is indifferent in its affect on the economy. It cannot manipulate the real variable quantities like income, output and employment. On the other hand, the economy can determine the monetary variables like price level and monetary wages. Consequently the classical economists stated that price level is the function of money supply. This was explained with the help of the quantity theory of money. The level of prices will be double the quantity of money was the conclusion which they derived. Therefore any alterations in supply of money will affect the price proportionately. It is symbolised by the equation of exchange: MV=PY: Where M= supply of money, V= velocity or the number of times money turns over per time in the purchase of final output Y, P= price level of output Y. MV= PY is an identity element and hence can be written as MV= PY. This formula states that the amount of money multiplied by the number of times each unit of money on the average is expended to purchase final output at any given time. It is again multiplied by the price level of those goods and services that is PY. As Y constitutes GNP, P is the price level of the goods and services developed Y, and V is the number of times the money supply is used to purchase goods whose value is PY then GNP = C+I+G= MV= PY. The above theory can also be represented as: MV = PY, where V is the velocity of money. It is alleged to evaluate how often the money stock turns over in each period. It can also be written as: V = nominal GDP/nominal money supply, i.e., V = PY/M. MV = PY is treated as an identity and not an equation, since by the definition of V, it must always true. When there are alterations in M, P, or Y, then V may have to adapt. Empirically, the V in the identity above is not required to be a constant. If we assume that V is a constant, then we have the QTM, which can be tested empirically. The new version of the QTM is M/P = kY, where k = 1/V. Inflation and Money supply with reference to India: As Milton Friedman (1975) said: "The special conditions that drove up the price of oil and food required purchasers to spend more on them, leaving them less to spend on other items. Did that not force other prices to go down, or to rise less rapidly than otherwise Why should the average level of prices be affected significantly by changes in the price of some things relative to others" (Milton Friedman, 1975) But when it comes to practical approach, apparent motion in relative prices does affect the total price level due to nominal inflexibilities. Consequently jumps in the price of oil for instance helps in explaining transitory periods of sharp gains in the general price level. Still, it cannot be explained as to how they alone could make clear the steady growth of high inflation. There has to be a policy accommodation i.e., elaboration of monetary policy in response to a negative supply shock. "Policies that expanded the money supply to avoid a still deeper oil shock-driven recession succeeded in transforming what was a temporary burst of inflation into a permanent jump in the level of inflation" (Taylor, 1999 and Clarida et al., 2000). Additionally, the fundamental query is whether these shocks strike core inflation as it is this that policymakers can purely aim to control. This in turn reckons on how anticipations are shaped. These anticipations, in turn, touch the current state of the economy because they are included in wages via forward-looking labor contracts. In a noetic prospects model expectations are reliable with the predictable actions of the policymaker. When agents suppose policymakers to adapt unfavorable shocks, expected inflation is likely to rise. This characterization entails that price level shocks can transfer current inflation even without monetary accommodation, but cannot become deep-rooted in the predictable inflation rate due to the lack of policy accommodation. The effects of supply shocks on inflation in India, is studied using an increased Phillips curve framework. The traditional Phillips curve approach is supplemented by taking into account the growing body of evidence suggesting a role for supply shocks. It has been noticed that supply shocks have not contributed to a permanent increase in core inflation measure during the period 1995-2005. The possible explanation that can be given is monetary policy has not allowed for the base for a supported change in the inflation process by adapting negative supply shocks. The study has taken modeling of inflation in India along the monetarist approach. The extent of the monetary policy objectives such as control over inflation, promotion of growth rate, control over public expenditure and money supply (NM3) are fulfilled is being examined. Apart from the analysis the connection between GDP growth rate and a host of other variables such as inflation rate, money supply, public expenditure and Net bank credit to government and aggregate exports. The present study is based on the RBI data. (www.rbi.org.in, viewed on 6th Mar, 2009). The focus is mainly on variables like GDP and the rest of the variables such as monetary aggregate (NM3) public expenditure (sum of central, state and union territory development and non-development expenditures) Net bank credit (credit given to central and state governments) and total Exports. The current stress is on high growth and how far these variables influence GDP and vice-versa. The data pertains to the period of over 25 years since 1980-81. Table 1 depicts that the growth rate of inflation measured in terms of WPI, records a negative rate of 5 percent during the period of economic reclaims when equated to a positive growth during pre-reform period. Yet on the whole it records a negative growth rate of around 2 percent. The monetary aggregate, credit to government, Public expenditure in nominal terms all record a smaller growth rate during the period reform period when compared to pre-reform period as well as the overall period. The Liquidity aggregate (L2) also is similar to NM3 as major part of it is accounted by the latter. An encouraging aspect of the table is the appreciable growth rates in GDP, both nominal and real, as well as real exports. Table 1 Annual Average Growth Rates of Selected Variables (Figures in Percentage) Annual Average Growth Rates (%) Variables 1980-81 to 2005-06 1980-81 to 1993-94 1993-94 to 2005-06 Inflation (WPI) INF -2.62 1.05 -5.10 Money Supply M3 17.06 17.30 16.42 Credit CREDIT 15.37 18.25 13.31 Public Expenditure PUBEXP 14.07 15.06 13.34 GDP-Nominal GDPNOM 13.97 14.67 11.71 Export EXPORT 10.16 8.14 11.53 GDP-Real GDPR 5.75 5.43 6.11 Public Expenditure-Real PUBEXPR 5.83 5.78 7.66 Export-Real EXPORTR 2.21 -0.57 5.93 Credit-Real CREDITR 7.05 8.71 7.64 L2 L2 - - 16.33 Table 2 displays the determinants of inflation. It can be observed that when GDP, NM3 and Net Bank Credit to government, public expenditure and exports are entered separately in their log forms, they all have a negative influence and also importantly the log of inflation variable at 5 per cent level of significance. (equation 1-5). At the same time, these variables are entered in the log form of inflation, only log net bank credit and log exports turn out to be significant at 5 per cent level of significance. It can also be seen that between net bank credit and exports, the elasticity of credit is 2.9 which is greater than the elasticity of exports (1.55) in equation 7, both net bank credit and exports influence inflation positively and also significantly. There exists negative elasticity between inflation and public expenditure. The public expenditure is negatively related to inflation as long as development component of it is huge and does yield return. The elasticity coefficient in respect of public expenditure is largest to the tune of 4. Table 2 Determinants of Inflation (1980-81 to 2005-06): Estimation Results of Inflation Equation Dependent Variable: Log of Inflation Variables (1) (2) (3) (4) (5) (6) (7) Constant 4.55 (4.446) 4.011 (4.999) 4.012 (4.821) 4.326 (4.706) 4.288 (4.157) 1.1413 (0.181) 7.033 (4.002) Log GDP-nominal -0.198 (2.629) - - - - 0.387 (0.274) - Log M3 - -0.167 (2.684) - - - -2.662 (1.192) - Log Credit - - -0.179 (2.588) - - 2.909 (2.084) 2.809 (2.177) Log Public Expenditure - - - -0.200 (2.684) - -1.702 (0.689) -4.024 (2.460) Log Export - - - - -0.242 (2.354) 1.552 (2.347) 1.051 (2.032) R Square [F value] 0.218 [6.698] 0.231 [7.204] 0.218 [6.698] 0.231 [7.203] 0.188 [5.542] 0.437 [3.108] 0.392 [4.726] To examine the relation between different pair of variables, stationary test is carried out. First, the unit root properties of the variables under consideration are carried out. Then Augmented Dickey - Fuller (ADF) test. The critical values for the unit root tests presented in the following Table show that: (i) Three variables - GDP, Public Expenditure and Credit in their log forms contain two unit roots or in other words follow I (2) process at 5% level of significance. (ii) Five variables - inflation (in its original form) and log M3, log public expenditure, log GDP and log Export contains unit root (at 10% level of significance) or follow I(1) process. The test results are based on the optimal lags selection using Akaike Information criterion. (Dr. Arunachalam.R., P.5-8, http://www.shsu.edu/eco_www/ resources/documents/Monetary_Management_in_India.pdf, viewed on 6th March 2009) Table 3 Augmented Dickey-Fuller Unit Root Test Variables X X 2 X Inflation (WPI) -1.9857 -6.5405* Money Supply (M3) 3.1218 2.9089 0.7667 Public Expenditure 0.1071 1.3846 -0.8363 GDP (nominal) 2.5724 1.8039 -3.8197* Credit 0.9444 -1.9145 -2.0464 Export 6.8502 -0.5181 -6.1495* Log (Inflation) -3.4115* Log (M3) -1.8013 -3.9628** Log (public Expenditure) -2.4277 -2.6333** -2.9794* Log (Credit) -2.2324 -1.68499 -6.4085* Log (GDP nominal) -1.0004 -2.8757** -7.7944* Log (export) 1.9185 -3.1894* Conclusion: Money is used in every economic transaction, and as such it has a strong impact on all economic activities. Surplus supply of money will cause shattering of interest rates. It is true that lowering interest rates will benefit the investment side. This is because when more money is put into the hands of consumers, they feel spending it, and this in turn will increase the tendency for investments. Business concerns will prosper as there will be increased sales drawing more and more raw materials from the public to increase production. This in turn, will pave the way to a higher requirement of labor. The demand for capital goods will be in the higher level and stock market will boom, and naturally, there will be more equities and debts. In India, inflation hit the Indian economy to its maximum between 2005 to 2008. This period witnessed the inflow of a large share of foreign fund. This increased supply of money went to the asset markets pushing the real estate markets to boom. A major part of the money flowed into industries and this caused the inflation. Reserve Bank of India anticipated such a disaster, but it did nothing to check the inflow of foreign fund. The rise of prices in raw materials and fuel, along with the taxation and monetary policies of the government are found to be the causes for the current inflation rate. Now, if the money supply is allowed to continue without any restrictions, there will be economic ruptures and as a result prices of commodities will start to increase. This upset of the economic equilibrium will force the money lending institutions to demand higher rate of interest anticipating a sudden slashing of the purchasing power of the public. The situation can be avoided if the supply of money is restricted and its growth is allowed to decline. In other words it can be stated that when supply of money declines there will be a proportionate decline in the economic transaction, causing deflation. Reference: 1. Crystal K.A. [1990], (ed.) Monetarism, vol. I, II; Edward Elgar. 2. Cuthbertson K. [1989], The supply and demand for money. Basil Blackwell Inc., Cambridge. 3. Dean E. [1965], (ed.), The controversy over quantity theory of money, D.C. Health & Company, a division of Raytheon education company Lexington, Massachusetts. 4. Fisher D. [1980], Monetary theory and demand for money, Martin Robertson pub., Oxford. 5. Fisher I. [1911], The purchasing power of money, its determination and relation to credit, interest and crises; assisted by H.G. Brown, reprinted by Augustus M. Kelly bookseller, 1963, new York. 6. Milton Friedman (1987), "quantity theory of money", The New Palgrave: A Dictionary of Economics, v. 4, pp. 15-19. 7. Balakrishnan, P. (1994). "How best to model inflation in India", Journal of Policy Modeling, 16,677-83. 8. Acharya, S. (2001). "India's Macroeconomic Management in the Nineties." Indian Council for Research on International Economic Relations, New Delhi. Read More