CHAPTER I

INTRODUCTION
 CHAPTER I
INTRODUCTION

In the history of human civilization money has

played a significant role. It has removed the constraints

of the barter system and served as a convenient medium of

exchange. In the course of time, money has emerged from

being more as a medium of exchange, via the

liquidity preference, to become the most preferred asset.

As an asset its accumulation, distribution and productivity

have become important considerations in the pursuit of

economic development of the nations — both developed

and developing. Necessarily therefore, monetary policy

is a powerful instrument for change helping growth and

distribution of income, as much as the fiscal policy.

Monetary policy

Monetary policy refers to the management of money

in furtherance of the economic policy of the state. It

means defining the objectives of sound management and the

measures adopted in pursuance thereof. Monetary policy

operates through changes in the stock of money, which

changes influence the level of aggregate demand for output

in money terms, either directly or indirectly. It has

two noteworthy features, one is that it is aggregative

policy, that is, any allocational or sectoral problems

are beyond its domain; the other is that it operates on

 the demand side and not on the supply side of the commodity

market. Changes in the stock of money deserves to be

carefully watched and controlled because such changes

exert a powerful influence on changes in money income,

prices, output, employment, distribution of income and

wealth, and balance of payment. Thus given the stable

demand function for money, an autonomous change in money

supply leads either to a direct change in money income or

first to a change in the rate of interest, which then to

a change in the level of income. However, there may be

several structural difficulties for the free working of

the policy and the result may be inflation or deflation,

requiring further adjustments in money supply.

The main goals of monetary policy are : (a) Maximum

feasible output; high rate of growth; fuller employment;

price stability or the optimal rate of inflation; greater

equality in the distribution of income and wealth; and a

healthy state of balance of payments. There are some

broad tenets which need to be satisfied for proper conduct

of monetary policy1. First, changes in money supply

caused changes in aggregate nominal income. Second, the

aggregate demand function for money has to be stable. In

other words, the amount of money people wish to hold

bears a stable relationship to their money income in the

1. Deepak Mohanty, "Perspectives on Monetary Developments

and Policy in India". Reserve Bank of India occasional
papers, 18 (2 & 3): 228-229, 1997.
 aggregate. However, if the relationship becomes unstable,

the conduct of monetary policy generally veers from

targeting of quantity of money to that of rate variables,

eg. interest rates, exchange rates, etc. And third,

expectations about the future price level play a critical

role in determining the current level of inflation and

the way the expectations are formed would be central to

monetary analysis.

In India
Monetary policy is an arm of economic policy.

Broadly the three major objectives of economic policy in

India have been (a) growth, (b) Social justice implying a

more equitable distribution of income, and (c) price

stability. Faced with multiple objectives that are

equally relevant and desirable, there is always the problem

of assigning to each of the several policy instruments,

the most appropriate target or objective. Of the various

objectives, price stability is the one that can be

pursued most effectively by monetary policy2.

The broad money measure (M3) has been the target

variable for purpose of monetary control and the source

of reserve money creation (usually the Reserve Bank credit

to government) was the operating variable. However,

2. C. Rangarajan, Issues in Monetary Management,

Presidential address. 71st Annual Conference of the
Indian Economic Association, 1988.
 control was also exercised through bank credit
as an
intermediate target. Thus Cash Reserve Ratio (C.R.R),

Statutory Reserve Ratio (S.R.R) and refinance policies

were combined with selective credit control, credit target,

and administered interest rates to achieve the monetary

goals3.

The promotional facet of monetary policy is

demonstrated in this country in the measures taken to

enlarge the institutional supply of rural and industrial

credit.

The focus of monetary policy in the first decade

(1951-60) of planning was on revival of the traditional

weapons of monetary control. In the second decade, (1961-

70) the emphasis shifted to economic growth and control

of the increase in money supply; since 1970 the objective

of faster economic growth with price stability was evolved

to meet the credit needs of the growing economy and to

keep a check on inflationary prices. This policy has

come to be known as "Controlled Expansion (of money supply)

Policy".

In India, monetary policy is attracting increasing

attention in recent years. Since monetary policy acts

3. C. Rangarajan, "Developing the Money and Security

Markets in India", Central Bank of India Economic
Bulletin September, 1994.P.7.
 through influencing credit and money, its effectiveness

depends on the institutional framework available for

transmitting impulses released by the Central Bank and

this institutional framework has been modified signficantly

in the last (1980's) decade and after4.

Monetary policy is best suited to achieve the goal

of price stability in the economy. It has also been

recognised that, in the long run the objectives of price

stability and growth do not necessarily conflict with

each other. Rather in today's altered economic context,

a low and stable price environment is being increasingly

regarded as an essential condition for improving the

growth and productive potentials of the economy.

In today's world, the nature of the working of

economies has changed radically due to the pressure of

competition and globalisation. This has made firms

extremely conscious of price competition. Since firms,

workforce and countries compete at the margin, public

policies for providing a stable background to the economy

has assumed critical importance for promoting growth and

productivity. These developments have made the countries,

across the world, more conscious of the hidden costs of

inflation and their adverse implications for growth.

4. C. Rangarajan, "Monetary Policy Indicators, Target

and Objective" - Address on the occasion of the Award
of Finance Man of the Decade by the Bombay Management
Association, Mumbai, May 21, 1998.
 Perhaps the single most important contribution that

monetary policy can make under these conditions is to

maintain a low and stable rate of inflation that would

provide the necessary condition for promoting

competition, efficiency and growth in the economy5.

Significance of Money Supply

^he impportance of money in developing countries

goes beyond its conventional role as a medium of exchange

and a store of value. In developing countries, money

performs a crucial function in the process of economic

growth by providing a channel through which the resources

of surplus units are transmitted to those in greatest

need of these resources. Rather it acts as a conduit of

resources from savers to investors and contributes to

economic development.

In a monetary economy, where each single transaction

is valued in terms of the unit of national currency, it

is nothing but a truism to say that money supply has a

role in determining the price level in the economy.

Analytically viewed, in the short run, with output fixed,

the price level is essentially determined by the excess

demand condition in the economy, which depends on the

level of demand and supply of real money balances. It is

5. C. Rangarajan - "The Role of Monetary Poliy", Ninth

V.T. Krishnamachari Memorial Lecture delivered at the
Institute of Economic Growth, Delhi, 11 November,
1997.
 thus natural that once the real money balance is increased

above what is demanded by people the pressure would be

felt on the demand for goods and services or assets,

leading to an increase in their prices6.

Several developing countries have experienced

chronic and at times, accelerating inflation in recent

years. The inflation has been due to increasing deficit

financing also. There is a renewed concern regarding

fiscal - monetary policy nexus in these countries,

including India. This study is an attempt to analyse the

dynamics and inter-relationship of government deficit,

money supply, inflation and economic growth in the Indian

context.

Problem Focus

Studies on inflationary process in developing

countries have argued that causation between money and

prices may not be uni-directional as postulated by the

monetarist model but it may be viewed as running both

ways. It is found that government expenditure

adjusts more rapidly than receipt to a given change in

price level and as a result, inflation widens the fiscal

deficit, leading through the Central Bank loans to the

government deficit financing; the larger money supply

exacerbating inflation further. Thus inflationary process

6. Ibid.
 in developing countries is found to be characterised by

the self-perpetuating cycle of deficit-induced inflation

followed by inflationary -induced deficit. The situation

in India is not much different. The growth process has

been accompanied by inflationary situation due to the

uncontrolled expansion of money supply.

So the experience of Indian economy marked by growth

coupled with inflationary situation, due to the expansion

of money supply is a fertile area for research.

Money supply in India has shown a high growth rate

in the years following independence. There could be

several factors leading to the growth of money supply.

So an attempt to study the determinants of money supply

is felt appropriate as the growth of money supply

extends itself by affecting the process of economic growth

and being affected by the growth.

Then, factors that affect money supply make a

balancing between money supply, GDP and inflation a

difficult task. Hence it is necessary to study these

factors or determinants of money supply. With this focus,

the objectives of the study are formulated.

Objectives

The overall objective of this study is to

understand the dynamic changes in the key economic variable

 viz., (i) money supply, (ii) GDP, (iii) inflation and

(iv) deficit financing and inter-relationship among them,

so as to suggest ways for a non-inflationary growth

of Indian economy. Specific objectives are :

1. to assess the trend in GDP, Money supply, General

Price Level and Deficit Financing since 1970 (This

refers to the fiscal year 1970-71, i.e. April 1,

1970 to March 31, 1971);

2. ■'to study instability in the above macro variables;

3. to understand the inter-relationship between these

variables; and,

4. to evaluate the scope for a balancing between

money supply and growth rate in GDP, so that the

real growth rate is non-inflationary.

Hypotheses

Above objectives suggest the following hypotheses

for empirical verification in this study.

1. There is significant growth in each of the

variables viz., Money Supply, GDP, General Price

Level and Deficit Financing. The growth in money

supply and consequent rise in general price level,

along with rapid growth of human population have

caused a very slow growth of real GDP per capita

the measure of economic growth of the economy.

 10

2. Interaction among the key variables and

interventional policy of the government have

resulted in a wide interyear variation in the

variables. It is a sign of instability in the

growth process.

3. The relationship between money supply, GDP and

general price level are bidirectional.

4. The stability in price level is possible through

monetary policy.

.5. The stability in money supply will ensure stability

in economic growth (real income per capita).

Scope of Hie Study

There are several issues of monetary policy which

are debated continuously. These issues are related to

the effectiveness of monetary policy in maintaining price

stability and achieving faster economic growth, the method

of implementation of monetary policy, effectiveness of

the direct and indirect instruments of monetary control

and what should be the intermediate target of monetary

policy.

A noted monetary economist had once said, "The

first and the foremost lesson that history teaches about

what monetary policy can do - and it is a lesson of most

profound importance - is that monetary policy can prevent

money itself from being a major source of economic

disturbance ... to provide a stable background for the

economy... and to contribute to offsetting major

disturbances in the economic system arising from other

sources.

The study analyses the changes in the money

supply, GDP, General Price Level and Deficit Financing.

The growth level in these variables and their inter­

relationship would enable to evaluate the effectiveness

of monetary policy as an instrument of promoting

economic growth with stability. The study would identify

the major components of money supply and their effect on

inflation. The study would focus special attention on

the effect of fiscal deficit on inflation. Thus the

study attempts to evaluate the effectivness of monetary

policy in bringing stability in money supply to ensure

stability in economic growth.

limfladois

The study is based entirely on secondary data

collected from different published sources. Efforts have

been made to choose the better among the different sources

without any personal bias. The limitations inherent in

the secondary data are to be recognised.

The study is based on time series data for the

period from 1971 to 1998. Since the number of observations

is small, it has left a small degree of freedom restricting

the scope of multivariate analysis. The problem of

multicollinearity, autoregressive errors and co­

integration of variables which are common in time series

analysis have been identified and solved.

Organisation of Thesis
This thesis is organised into seven chapters as

follows :

CHAPTER MNTRODICTION
The choice of the problem, problem focus, objectives

hypothesis, scope and limitations of the study are stated

and the organisation of the thesis is described.

CHAPTER li - REVIEW OF LITERATURE

An objective review of the past studies relating to

the subject, viz., impact of money supply, is presented,

to delineate the scope of this study and to identify

important inferences useful to the analysis of data.

CHAPTER Ill-METHODOIOGY
Important concepts of money supply, monetary policy,

economic growth, and inflation and their inter­

relationships are stated. Sources of data, tools of

analysis, models used and statistical texts employed in

the study are presented.

 CHAPTER IV - MONEY SUPPLY

The results of analysis of money supply, its sources,

composition, trend and instability and fiscal deficit

are discussed, decade-wise for pre and post economic

reform periods.

CHAPTER V - ECONOMIC fiROWIH AND INFUTION

The growth in nominal and real GNP, GDP, GDP per

capita, General Price Level and the rate of inflation

decade-wise are presented and discussed. The trend,

cycle and instability are also discussed.

CHAPTER VI - INTER REUHIONSHP

The interrelationships between money supply, GDP

and General Price Level are studied, with the help of

cointegration analysis, Granger's test for uni or

bidirectional relationship is applied and inferences drawn.

CHAPTER VII - SUMMARY, CONCLUSIONS AND IMPLICATIONS

A summary of inferences drawn is presented,

conclusions are drawn with reference to the hypotheses of

the study and their policy implications are studied.