Monetary Economics

Empirical Applications of Monetary Economics in the Era of Liberalization
OBJECTIVE OF THE PROJECT
The objective of the project aims to study the monetary policy and
monetary policy aggregates which are timely controlled by policy
makers in order to stabilize the economy. The project deals with the
up gradation of Prof. Manohar Rao’s classic study on the transition
from the controlled economy to a market economy relying on
mandatory economic adjustments through interest rate and exchange
rate policies and of fiscal adjustments through the financing of deficits.
The three primary objectives emphasized in this project are:
Money-inflation link – This study is within the framework of the

monetarist proposition that inflation is primarily a monetary
phenomenon.
Deficits and money growth link - This portion highlights the nexus
between deficits and money growth within the framework of money
supply determination. It also deals with issues pertaining to money
market equilibrium, money stock and interest rate targeting, the policy
dilemma involved in money financing vis-à-vis debt financing and the
monetary approach to the balance of payments.
Deficits and inflation link – It focuses on the interrelationship within

the framework of the potential instability of debt financing. Besides
concentrating on issues related to unsustainable deficits, the
evolutionary process governing budget deficits and the derivation of
steady-state debt-income ratios, it discusses the concept of the
inflation tax and specifies the role played by hyperinflations in
generating such tax revenues.
INTRODUCING THEORY FOR EMPIRICS
As monetary economics is closely related to current economic

problems, it yields its greatest rewards to those whose primary
interest is both theoretical and empirical. However, the need for an
effective compromise between the comprehension of theory and the
manageability of empiricism does render monetary economics a little
ragged at the edges, especially in the Indian context, where the
emphasis in monetary economics is more on the manageability of the
theory and its applications.
The great macroeconomists have all had a keen interest in the

application of monetary theory to problems of policy making. While
Keynesian economics developed during the great depression of the
1930’s and showed the way out of such recessions, monetarism
developed during the 1960’s in an effort to solve the inflation problem-
a legacy bequeathed by the Keynesians.
Thus, there have long been two intellectual traditions in macro

economics. One school of thought believes that markets work best if
left to themselves; another believes that government intervention can
significantly improve the operation of the economy. In the 1960’s, the
debate of these questions involved monetarists, led by Milton
Friedman on one side and Keynesians, on the other side. In the
1970’s, the continuing debate on much of the same issues brought to
the fore a new group- The New Classical Macroeconomists. This later
group has remained influential in macroeconomics, particularly
monetary economics till today.
The new classical macroeconomics shares many policy view points with
monetarism. It views individuals as acting rationally in their self-
interest in markets that adjust rapidly to changing conditions. The
government, they claim, can only worsen the situation through
intervention. That model is a challenge to traditional macroeconomics
which vies the economy as adjusting sluggishly, with poor information
and rigidities preempting the rapid clearing of markets, and
consequently see a dominant role for government action to try and

rectify matters.
While there is no denying that there are conflicts of opinion and even
theory between opposing camps in macroeconomics, it is also the case
that there are significant areas of agreement and that these groups
continually evolve new areas of consensus and a sharper idea of where
and how precisely they differ.
This study therefore involves an econometric investigation, based on

Indian macroeconomic data, directed towards obtaining a theoretical
perspective of the underpinnings that link together money, deficits and
inflation so that it prompts a realization of the relevance of monetary
economics within the context of our economy which is currently
undergoing a radical metamorphosis.
A few basic results have been examined in this study. The important
amongst them is the proposition that inflation is a monetary
phenomenon, implying that inflation is primarily, if not wholly, due to
monetary growth. But typically in conditions of high inflation, there are
rising budget deficits underlying the rapid money growth as well as
increasing nominal interest rates reflecting rising inflationary
expectations. Such was the case in the hyper inflations of 1984-85 in
Argentina, Bolivia and Brazil.
The real world application and significance of these results is quite

striking, especially in the current Indian context, because it warns us
that once the results isolating the role of deficits in causing an
acceleration in money growth and the rate of inflation becomes
definite, real disturbances may well end up playing a relatively minor
role in the inflation generating process and, consequently, even
favorable supply shocks would be incapable of containing the rise in
prices.
MONEY AND INFLATION
This section initially develops an analysis of the dynamics of money,

growth and inflation.
CHARACTERISTICS OF INDIAN INFLATION
Table – Money, Growth and Inflation
M1 NDP at factor cost Avg WPI

Year (M*/M) (y*/y) (p*/p)
1990-91 14.6 5.5 10.35

1991-92 23.2 0.9 13.73
1992-93 8.4 5.3 10.15
1993-94 21.5 5.6 8.33
1994-95 27.5 6.4 12.58
1995-96 11.7 7.3 8.03
1996-97 12.0 8.1 4.62
1997-98 11.3 4.0 4.39
1998-99 15.4 6.6 5.94
1999-00 10.6 6.2 3.29
2000-01 11.0 4.1 7.13
2001-02 11.4 5.6 3.66
2002-03 12.0 3.4 3.36
2003-04 22.2 8.6 5.47
2004-05 11.9 7.3 6.47
2005-06 21.1 9.4 4.43
2006-07 16.9 9.6 5.53
2007-08 19.1 9.1 4.68
(Source : www.rbi.org.in)
The above table presents data on money supply growth rates (M*/M) -
measured by M1; real output growth rates (y*/y) - measured by NDP
at factor cost; and inflation rates (P*/P) - measured by WPI index for
the Indian economy, over the period 1990-91 to 2007-08.
When one attempts to explain the causes of inflation, one finds that
the literature contains two major competing hypothesis which explains
this phenomenon. Firstly, there is the monetarist model which sees
inflation as essentially a monetary phenomenon. The structuralistic
model, by contrast, argues that the causes of inflation must be sought
in certain structure characteristics especially the presence of
bottlenecks.
MONEY-INFLATION LINK
Inflation is indeed primarily a monetary phenomenon which cannot

continue without continued money growth. In order to do so, an
analysis has to be developed of the dynamics of inflation which
attempts to explain the monetarist claim that inflation is always and
everywhere a monetary phenomenon. To obtain a firm understanding
of this, two distinctions have to be kept in mind. The first is between
the short-run and the long-run. The second is the distinction between
monetary and structural disturbances (for example oil shocks) to the
economy.
Monetarists tend to concentrate on the long-run and on economies in

which changes in money growth are the primary disturbances. In such
cases, they tend to be invariably right when they argue that money
explains most of what is happening to inflation. But as one moves
away from the long-run and from monetary disturbances towards
short-run inflation determination and alternative shocks, it becomes
necessary to be much more eclectic. In the short run, disturbances
other than changes in the money stock affect inflation and
conversely, changes in the money stock do have real effects.
And even if the disturbances are purely monetary it will still generally
take a while before they are fully reflected only in inflation.
There is one main proposition of the adjustment process towards long-

run equilibrium monetarist model that we shall prove empirically: A
sustained increase in the growth rate of money will in the long-run
when all adjustment have taken place, lead to an equal increase in the
rate of inflation.
Empirical evidence
Now, the empirical evidence on the links between money growth and
inflation is examined.
Analysis
As can be seen from the summary output, the regression established

is of the following equation :
ln p(t) = a + b1*ln y(t) + b2* ln M(t)
Co-efficient of determination R square = 0.98, which implies that

98% of the variation in ‘p’ is explained by both ‘M’ and ‘y’.
The significance ‘F’ which is very near to zero, indicates the test
itself is very significant.
Standard
Coefficients Error t Stat P-value
1.33726337 4.869787491 0.274604 0.787631
-0.74993259 0.566352196 -1.32415 0.206667
0.733659567 0.253168589 2.897909 0.01169

ln p(t) = a + b1*ln y(t) + b2* ln M(t)

Avg WPI ln
Year WPI Index M1 Y P Y M1 (p) NDP at factor cost ln (y) M1 ln (M)
1990-91 0.507 92892 1083572 0.507 983651 92892 -0.678408333 13.79902644 11.43919281
1991-92 0.577 114406 1099072 0.577 992932 114406 -0.549677338 13.80841746 11.6475088
1992-93 0.635 124066 1158025 0.635 1045428 124066 -0.453842133 13.85993693 11.72856896
1993-94 0.688 150778 1223816 0.688 1104168 150778 -0.373630385 13.91460267 11.92356384
1994-95 0.775 192257 1302076 0.775 1174710 192257 -0.254958855 13.97653187 12.1665883
1995-96 0.837 214835 1396974 0.837 1260376 214835 -0.178063601 14.04692065 12.27762557
1996-97 0.875 240615 1508378 0.875 1362248 240615 -0.13303992 14.12464683 12.39095342
1997-98 0.914 267844 1573263 0.914 1417045 267844 -0.089956334 14.16408428 12.49816
1998-99 0.968 309068 1678410 0.968 1511035 309068 -0.032170606 14.2283054 12.6413166
1999-00 1.000 341796 1786525 1.000 1605103 341796 0 14.28869849 12.74196935
2000-01 1.072 379450 1864300 1.072 1670448 379450 0.069130508 14.32860241 12.84647811
2001-02 1.110 422843 1972606 1.110 1764137 422843 0.104465415 14.38317218 12.95475623
2002-03 1.148 473581 2048287 1.148 1824635 473581 0.137994919 14.41689052 13.06807824
2003-04 578716 2222758 1981389 578716
P 1.211 1.211 0.191115081 14.49930867 13.26856714
2004-05 647495 2388384 2126018 647495
P 1.289 1.289 0.253911039 14.5697613 13.38086635
2005-06 826375 2612847 2326581 826375
P 1.345 1.345 0.296759809 14.65991037 13.62480394
2006-07 966089 2864310 2549649 966089
P 1.418 1.418 0.349560917 14.75146626 13.78101124
2007-08 1150953 3122862 2781182 1150953
P 1.486 1.486 0.396014767 14.83838658 13.95610085
SUMMARY
OUTPUT
Regression Statistics
Multiple R 0.990680603
R Square 0.981448057
Adjusted R Square 0.97879778
Standard Error 0.041021837
Observations 17
ANOVA
Significance
Df SS MS F F
Regression 2 1.246338944 0.623169 370.319 7.56355E-13
Residual 14 0.023559076 0.001683
Total 16 1.26989802
Standard Lower Upper

Coefficients Error t Stat P-value Lower 95% Upper 95% 95.0% 95.0%
- -
Intercept 1.33726337 4.869787491 0.274604 0.787631 9.107391981 11.78191872 9.107391981 11.78191872
- -
13.79902644 -0.749932595 0.566352196 -1.32415 0.206667 1.964637241 0.464772051 1.964637241 0.464772051
11.43919281 0.733659567 0.253168589 2.897909 0.01169 0.19066695 1.276652185 0.19066695 1.276652185
So, equation works out to be:
ln p(t) = 1.33 – 0.74 ln y(t) +0.733 ln M(t)
Explanation
So, 1% increase in ‘y’, leads to 0.74% decrease in ‘p’.
And, 1% increase in ‘M’, leads to 0.733% increase in ‘p’.
From the P-value i.e., 0.011, it can be said that money growth ‘M’ is
a significant explanatory variable for ‘p’, (significant level taken to
be 95%).
Thus the monetarist contention that a sustained increase in the growth

rate of money will in the long run when all adjustment have taken
place, lead to an increase in the rate of inflation as clearly borne out in
the Indian context.
However, the above analysis is based on the assumption that velocity

changes are insignificant and can be ignored. As with many of the
assumptions in economics, the assumption of constant velocity is only
an approximation to reality. Velocity does change if the money
demand function changes. For example, when automatic teller
machines (ATMs) were introduced, people could reduce their average
money holdings, which meant a fall in the money demand parameter
and an increase in velocity i.e., an increase in V. Nonetheless,
experience shows that the assumption of constant velocity is a useful
one in many situations. So it is therefore assumed that velocity is
constant and on the basis of this assumption the effects of money
supply on the economy can be seen. Hence, the assumption of
constant velocity is closely related to the behavior of the demand for
money.
Thus the answer to the question whether inflation is a monetary

phenomenon in the long-run in India is “Yes”. No major inflation can
take place without rapid money growth. Further any policy that keeps
the growth rate of money low will lead eventually to a low rate of
inflation. However, in the short-run, the reasons for inflation could be
of a structural nature. In the 1970’s, the major other cause of inflation
in India as supply shocks, particularly the oil price increases of 1973
and 1979, that reduced output, causing a recession, and increased
prices. This phenomenon was also repeated in 2008 when inflation
peaked to 12% because of the same crude oil prices.
DEFICITS AND MONEY
In the last section, it was seen that a sustained increase in money

growth eventually translates itself into higher inflation. This section
examines the factors that determine the growth rate of money which
was so far taken to be exogenously given and fixed. This section also
throws more light on the interactions of the RBI, the financial
institutions, and the public which ultimately determine the money
supply.
DEFINITIONS
As a preliminary to the study of the theory of money supply, it is

essential to understand the distinction between two kinds of money :
1. Money supply
2. High-powered money
Money Supply
The measurement of money supply is an empirical matter. The RBI

has published various measures of money supply. A brief discussion
about the same is given below:-
Narrow Money
Till 1967-68, the RBI used to publish only a single measure of money
supply (M) defined as the sum of currency (C ) and demand deposits
(D), both held by the public, plus other deposits (OD) with the RBI.
Following convention, this is referred to as the narrow measure of
money supply.
M = C + D + OD
Aggregate Monetary Resources
From 1967-68 onwards, the RBI started publishing additionally a

broader measure of money supply, called aggregate monetary
resources (AMR). It was defined empirically as narrow money plus the
time deposits (TD) of banks held by the public.
AMR = Narrow Money + TD of banks held by the public
M1, M2, M3 and M4
In April 1977, yet another change was introduced. Since then, the RBI
has been publishing data on four alternative measures of money
supply, i.e., M1, M2, M3 and M4, instead of the earlier two, i.e., M and
AMR. The empirical definitions of these measures are :
M1 = C + D + OD
M2 = M1 + savings deposits with post office savings banks
M3 = M1 + TD
M4 = M3 + total deposits with the Post Office Savings

Organization excluding National Savings Certificates
These four measures of money supply are specified in descending

order of liquidity, with M1 being the most liquid and M4 being the least
liquid of the measures. It is generally accepted that M1 most clearly
corresponds to the definition of money as it is the amount that people
keep in order to make payments for all their purchases. Thus, it this
measure that has been used in most empirical works on monetary
economics.
However, due to several definitional changes in 1978, the RBI, which

till then had carried out most of its analysis with respect to M1, was
compelled to conduct its accounting of money supply in terms of M3,
because the data on M1 for the post 1978 period was no longer
comparable with those in the earlier years. However, in this study all
empirical analysis has been conducted in terms of M1 using
comparable data as far as possible. In the below table, the data on M1
and M3 has been provided.
Table – Components of Money Stock
Year C D M1 TD M3
1990-91 53048 39170 92892 172936 265828
1991-92 61098 52423 114406 202643 317049
1992-93 68273 54480 124066 239950 364016
1993-94 82301 65952 150778 280306 431084
1994-95 100681 88193 192257 335339 527596
1995-96 118258 93233 214835 384356 599191
1996-97 132087 105334 240615 455397 696012
1997-98 145579 118725 267844 553488 821332
1998-99 168944 136388 309068 671892 980960
1999-00 189082 149681 341796 782378 1124174
2000-01 209550 166270 379450 933770 1313220
2001-02 240794 179199 422843 1075512 1498355
2002-03 271581 198757 473581 1244379 1717960
2003-04 314971 258626 578716 1426960 2005676
2004-05 355863 285154 647495 1603954 2251449
2005-06 413119 406388 826375 1903170 2729545
2006-07 482906 475687 966089 2350004 3316093
2007-08 567476 574408 1150953 2855769 4006722
High-powered Money
High-powered money (H), also referred to as the monetary base, is

money produced by the Government of India (all coins and one-rupee
notes) and the RBI (all other currency notes) and held by the public
and banks. The RBI calls H as ‘reserve money’ which is defined as the
sum of :
1) Currency (C) held by the public,
2) Cash reserves (R) of banks, and
3) Other deposits (OD) with the RBI (which constitutes slightly

more than one percent of H)
It should be noted that this empirical definition of high-powered

money is in terms of its uses or by its holders, and not in terms of its
producers (the RBI and the Government).
The next table provides the two components of H from the holder’s
viewpoint, i.e., in terms of C and R, besides providing estimates of the
money-multiplier (m) which determines money supply (M) –
henceforth synonymous with M1 – by means of a money supply
function which shall be discussed presently.
Table – High-powered money, Money Supply and the Money

Multiplier
Year C R H M1 m
1990-91 53048 34731 87779 92892 1.05
1991-92 61098 38407 99505 114406 1.14
1992-93 68273 42506 110779 124066 1.11
1993-94 82301 56371 138672 150778 1.07
1994-95 100681 68602 169283 192257 1.12
1995-96 118258 76199 194457 214835 1.09
1996-97 132087 67898 199985 240615 1.19
1997-98 145579 80823 226402 267844 1.17
1998-99 168944 90342 259286 309068 1.18
1999-00 189082 91473 280555 341796 1.21
2000-01 209550 93761 303311 379450 1.24
2001-02 240794 97176 337970 422843 1.24
2002-03 271581 97480 369061 473581 1.27
2003-04 314971 121541 436512 578716 1.31
2004-05 355863 133272 489135 647495 1.31
2005-06 413119 159936 573055 826375 1.43
2006-07 482906 226084 708990 966089 1.35
2007-08 567476 360941 928417 1150953 1.23
THE THEORY OF MONEY SUPPLY DETERMINATION
In order to highlight the essential aspects of the theory of money-

supply determination, the basic definitions of M and H are given :
M=C+D - (2.1)
H=C+R - (2.2)
On comparing equations (2.1) and (2.2), it is found that C is common

to both M and H and that the only difference between them is due to
their second component, i.e., D and R, respectively. This difference is
of crucial importance for the theory of money supply. It arises from
the presence of banks as the producers of demand deposits, which are
counted on par with currency. But to be able to produce demand
deposits, banks have to maintain reserves, which is a part of high-
powered money, produced only by the monetary authorities and not
by banks themselves. Since in a fractional reserve system, demand
deposits are a certain multiple of reserves, this lends to R which is a
component of h, the power of serving as a base for the multiple
creation of D, which is a component of M. Hence, H is also referred to
as base money.
Thus, it is apparent that the level of money supply (M) will depend
upon the amount of high-powered money (H), which is created by the
RBI as well as the government, given the value of the money
multiplier (m). It can easily be shown that m is jointly determined by
the behavior of the public, proxied by the currency-deposit ratio (C/D),
as well as the behavior of the banking institution, proxied by the
reserve-deposit ratio (R/D).
In order to derive this relation, the definition for m is initially set out
by dividing equation (2.1) by equation (2.2) to obtain :
m = (M/H) = (C + D) / (C + R) - (2.3)
Now dividing each of the components on the right-hand side of

equation (3) by D, yields :
m= [(C/D) + 1] / [(C/D) + (R/D)]
- (2.4)
An examination of this formula for the money multiplier indicates that

m varies inversely with, both, C/D and R/D.
Example
The value of the money multiplier can be calculated as given by

equation (2.4), using actual values of C/D ratio, C/D =
(567476/574408) = 0.99, and the reserve-deposit ratio, R/D =
(360941/574408) = 0.63, that existed in 2007-08. that yields m =
(0.99 + 1) / (0.99+ 0.63) = 1.24
which can be conformed by dividing the actual value of money supply

(M1) that year, M1 = 1150953, by the actual level of high-powered
money, H = 928417, which also yields m = (M / H) = (1150953 /
928417) = 1.239.
Since the RBI and the government jointly control H, it would be able to
control M exactly if the multiplier (m) were constant or fully
predictable. However, the annual data for m, along with its principal
determinants, C/D and R/D, provided in the table, reveal that m is far
from constant. Thus, while it is possible to predict the multiplier, these
predictions are not very accurate and consequently it is quite difficult
for the monetary authorities to predict the money supply exactly
regardless of the extent of control they exert over base money.
THE STOCK OF HIGH-POWERED MONEY
Factors affecting High-Powered Money
In order to understand the factors that affect the creation of high-

powered money, it should be recalled that H is money produced by the
monetary authorities (the government and the RBI) and held by the
public and banks. Speaking correctly, it is government currency –
comprising all coins and one-rupee notes – and Reserve Bank Money
(RBM) – comprising all other currency notes and deposits of banks
with the RBI. Of this total stock of H, government currency comprises
a very small proportion of it and hence, in order to simplify the
ensuing analysis, the main concentration is only upon RBM which being
the dominant component is virtually responsible for all the observed
changes in H. In a very elementary manner, it is analyzed briefly, the
factors governing RBM as the RBI does not change it arbitrarily.
It is begun with the balance sheet of the RBI given by :
monetary liabilities + non monetary liabilities = financial assets

+ other assets - (2.5)
Now, let ‘net non-monetary liabilities’ (NNML) be defined as the excess

of non-monetary liabilities over other assets. Then :
monetary liabilities = financial assets – non monetary liabilities
- (2.6)
Monetary liabilities of the RBI are the same thing as RBM and,
therefore, the factors governing RBM are identical to those that govern
the entities on the right-hand side of equation (2.6). Financial assets
are what the RBI acquires as a result of its transactions with others in
the discharge of its functions as the central bank. Consequently, they
can be analyzed sector-wise in order to identify the proximate
determinants of H.
To identify these factors, all transactors of the RBI can be divided into
four sectors :
1) The government,
2) Banks,
3) The commercial sector, and
4) The foreign sector
The RBI provides them its credit, acquires its financial assets and
creates RBM in the process. Therefore, using this four-sector
classification of the RBI’s financial assets (or net credit), the equation
(2.2) can be rewritten in terms of Reserve Bank Credit (RBC) as
follows :
RBM = (1) net RBC to the government
+ (2) RBC to banks
+ (3) RBC to the commercial sector
+ (4) net foreign exchange assets of the RBI
- (5) net non-monetary liabilities of the RBI
- (2.7)
The table below shows the RBI’s balance sheet for the year 1990-91,
designed to illustrate the sources of the monetary base – the way in
which the RBI used to create high-powered money – and the uses of
the base.
Sources and Uses of High-Powered Money :

1990 – 91(Rs. Crores)
Assets Liabilities
(sources) (Uses)
Government's
currency Currency
Held by the
liabilities to the public 1582 public 53360
Net RBC to Cash with
government 86643 banks 1795
RBC to banks 7258 Deposits with RBI
RBC to commercial Bank
sector 5512 deposits 24864
Net foreign exchange Other
assets deposits 2210
of the
RBI 7418
Net non-monetary
liabilities
of RBI (26184)
Monetary base
(sources) 82229 Monetary base (uses) 82229
As mentioned earlier, the net RBC to various sectors is financed by the
RBI partly by creating its monetary liabilities (RBM) and partly by
creating its net non-monetary liabilities (NNML). Thus, for all practical
purposes, it can be assumed that net RBC to the government (RBCG)
is the basic source of high-powered money in the Indian economy.
Thus, an increase in net RBC to the government (RBCG*), which is a

proximate measure of the extent of deficit financing undertaken by the
government, would lead to near equivalent increases in high-powered
money (H*), i.e.,
RBCG* ≈ H* - (2.8)
This scenario prevailed until 1990’s. But, the present scenario

is in stark contrast to this. After the abolition of ad-hoc
treasury bills, government started relying on public debt for
financing its deficit. And so in the present situation it is not
advisable to say that Net RBI credit to central government i.e.,
RBCG* is approximately equal to the growth rate of reserve
money H*.
The table below shows the sources and uses of high-powered

money in 2007-08 (very contrast to that of 1990-91):
Sources and Uses of High-Powered Money :

2007 – 08(Rs. Crores)
Assets Liabilities
(sources) (Uses)
Government's
currency Currency
Held by the
liabilities to the public 9324 public 567476
Net RBC to Cash with
government (113209) banks 23425
RBC to banks 4590 Deposits with RBI
RBC to commercial Bank
sector 1788 deposits 328447
Net foreign exchange Other
assets deposits 9069
of the
RBI 1236130
Net non-monetary
liabilities
of RBI (210206)
Monetary base
(sources) 928417 Monetary base (uses) 928417
As contrast to the previous balance sheet of 1990-91, where growth

rate of RBCG was approximately equal to the growth rate of reserve
money H, it is found that RBCG* is least related to the monetary base
because as mentioned earlier government has stopped debt
monetization since the last 5- 6 years.
This balance sheet of 2007-08 shows that, major component driving

monetary base on the assets side is Net Foreign Assets of the RBI
(NFA) which reflects balance of payment condition i.e., when there is a
BOP deficit there is a decrease in H and vice versa. By this balance
sheet, it can be seen that in the year 2007-08 there was a BOP
surplus.
THE GOVERNMENT BUDGET CONSTRAINT
The central government can finance its budget deficit in three ways :
1) By selling debt to the private sector, or,
2) By borrowing from the central bank, or,
3) By selling assets.
Let D* be the value of sales of government bonds to the private

sector; let B* be the sales of bonds to the central bank; and let A* be
the value of sales of assets to the private sector. Thus, if H is the stock
of high-powered money and BD is the budget deficit, then :
BD = D* + B* + A*
BD = D* + H* + A* - (2.9)
Equation (2.9) which is called the government budget constraint states

that the budget deficit is financed either by borrowing from the central
bank (B*) or from the private sector (D*) or by selling assets (A*).
The change in the central bank’s holdings of government debts causes
a corresponding change in high-powered money (H*), implying that
the budget deficit is financed either by selling debt to the public or by
increasing the stock of high-powered money. It is in this sense that
the central bank “monetizes” the debt. Equation (2.9) also shows that
for a given value of the budget deficit, changes in the stock of high-
powered money are matched by offsetting changes in public debt. A
positive H* matched by a negative D*, with A* = 0, is an open market
purchase.
Money-financing and debt-financing are the more common ways of

financing deficits; and it is only since the 1980’s that asset sales have
become important in developed as well as in developing countries.
However, this mode of financing the deficit has not yet assumed
prominence in the Indian context and so it is dropped from the

ensuing analysis although, with the current trends towards
privatization, it might soon become a viable alternative.
Thus, within the current framework, the government has only two
sources of financing its budget deficit (BD) : either from market
borrowings leading to an increase in internal debt (D*) or from
borrowing from the central bank leading to an increase in the
monetary base (H*). Setting A* = 0 in equation (2.9) yields :
BD = D* + H* - (2.10)
stating that the extent of accommodation depends on the uncovered

budget deficit, i.e., the budget deficit inclusive of market borrowings.
Linking equations (2.8) and (2.10), we get :
H* ≈ BD – D* - (2.11)
which states that increases in net RBCG will occur – leading to near
equivalent increases in the monetary base – when there is an
uncovered budget deficit which is the excess of the actual budget over
the amount raised from market borrowings.
Thus, it is sent that the RBI and the government together do have the
option of controlling increases in the stock of high-powered money
even when the government is actually running a deficit. Therefore, it
can be assumed that H is a policy controlled variable at least in
the theoretical sense of the term.
THE MONEY SUPPLY FUNCTION
Having ascertained that H can be controlled by policy, now, it has to

be decided what determines the money multiplier (m) so that a money
supply function of the following form can be specified:
M = [{(C/D) + 1} / {(C/D) + (R/D)}] * H = m (.) * H
Where,
C/D = f(c/y, r) = Currency-deposit ratio
c/y - consumption-income ratio

r - nominal interest rate
R/D =g (CRR, BR, r) = Reserve-deposit ratio
CRR – Cash Reserve ratio

BR - Bank rate
r - nominal interest rate
so,
M = Ø [c/y, CRR, BR, r] H
Given the stock of high powered money, the supply of money

increases with the money-multiplier. The multiplier, in turn, increases
with the level of the market interest rate, and decreases with the
consumption-income ratio, cash reserve ratio and the bank rate. This
Equation is referred as a money supply function because it describes
the behavior that determines money supply, given H. thus, the
monetary authority can influence the money supply through three
routes:
1) H, controlled primarily via the uncovered budget deficit;
2) The bank rate; and
3) The cash reserve ratio (CRR).

Of these three instruments, the budget deficit is the most important –

albeit the least controllable in practice.
Even assuming that the uncovered budget deficit – and, thus, the
stock of high powered money – can be controlled, why cannot the
monetary authorities control the money stock exactly? The reasons
emerge by looking at the money multiplier formula in equation. Both,
the currency-deposit ratio as well as the reserve-deposit ratio, which
vary from month to month, are determined by behavioral
considerations and it is impossible for the monetary authorities to
know in advance what its value will be. The public does not keep a
constant ratio of currency to deposits. Similarly, the reserve ratio
varies, as deposits move amongst banks with different reserve ratios
and because banks change the amount of excess reserves they want
to hold.
Thus, the monetary authority cannot control the money stock exactly
because the money multiplier is not constant. However, it is possible
to obtain policy guidelines on the basis of which they can exercise
monetary control either over the money stock or the interest rate.
EQUILIBRIUM IN THE MONEY MARKET
Theory
By combining money supply function and money demand function, the

money market equilibrium can be studied. For that purpose, it has to
be assumed that the price level is given at the level P(0). Furthermore,
it is taken that the level of real income and inflationary expectations as
given, i.e.,y = y(0) and ∏* = ∏*(0). With the price level, the level of
income and expected inflation fixed, money demand depends only on
the interest rate. Correspondingly, it is assumed that the consumption-
income ratio, the cash reserve ratio, the bank rate and the stock of
high powered money are given at the levels c(0) / y(0), CRR(0), BR(0)
and H(0), respectively. With these four variables fixed, money supply
also depends only on the interest rate. Consequently, money market
equilibrium will determine the equilibrium interest rate (r*) and the
quantity of money (M/P)*.
The equilibrium condition in the money market is that real money

supply, M/P, equals the demand for real balances, MD/P, or :
M/P = MD/P = L(y, r, ∏*) - (2.18)
Substituting equation (2.17) for M in equation (2.18) above which is

the money market equilibrium condition and noting that P = P(0), y =
y(0), ∏* = ∏*(0), c/y = c(0) /y(0), CRR = CRR (0), BR = BR(0) and
H= H(0), by assumption, it is obtained
Ø [c/y(0), CRR(0), BR(0), r] H(0)/P(0) = L[y(0), r, ∏*(0)]
– (2.19)
So, now the money market equilibrium is in terms of the interest rate
alone which affects both, the demand for, as well as the supply of
money.
Empirical evidence
In order to actually apply the money market equilibrium condition, the

equation (2.18), should be rewritten in terms of logarithms. Doing so,
and realizing, from equation (2.3), that (M/P) = m(H/P), yields :
ln M/P(t) =ln m(t) + ln H/P(t) = ln MD/P(t)
- (2.20)
To empirically estimate such an equilibrium condition within the Indian

context, it is required to initially specify the money multiplier (m) as a
function of the currency-deposit ratio (C/D) and the reserve-deposit
ratio (R/D), i.e.,
m = m [C/D, R/D] - (2.21)
Using annual observations over the period 1990-91 to 2007-08, the

following equation was estimated :
Analysis (Equation) :
ln m(t) = a + b1 ln C/D(t) + b2 ln R/D(t)
Co-efficient of determination R square = 0.997, which implies that

99.7% of the variation in ‘m’ is explained by both ‘C/D’ and ‘R/D’.
The significance ‘F’ which is very near to zero, indicates the test
Standard
0.065023833 0.003724039 17.46057 6.72E-11
-0.133697093 0.011699688 -11.4274 1.75E-08
-0.325652394 0.004837863 -67.3133 5.52E-19

ln m(t) = a + b1 ln C/D(t) + b2 ln R/D(t)
m C D R C/D R/D
1.06 53048.00 39170.00 34731.00 1.35 0.89
1.15 61098.00 52423.00 38407.00 1.17 0.73
1.12 68273.00 54480.00 42506.00 1.25 0.78
1.09 82301.00 65952.00 56371.00 1.25 0.85
1.14 100681.00 88193.00 68602.00 1.14 0.78
1.10 118258.00 93233.00 76199.00 1.27 0.82
1.20 132087.00 105334.00 67898.00 1.25 0.64
1.18 145579.00 118725.00 80823.00 1.23 0.68
1.19 168944.00 136388.00 90342.00 1.24 0.66
1.22 189082.00 149681.00 91473.00 1.26 0.61
1.25 209550.00 166270.00 93761.00 1.26 0.56
1.25 240794.00 179199.00 97176.00 1.34 0.54
1.28 271581.00 198757.00 97480.00 1.37 0.49
1.33 314971.00 258626.00 121541.00 1.22 0.47
1.32 355863.00 285154.00 133272.00 1.25 0.47
1.44 413119.00 406388.00 159936.00 1.02 0.39
1.36 482906.00 475687.00 226084.00 1.02 0.48
1.24 567476.00 574408.00 360941.00 0.99 0.63
SUMMARY OUTPUT
Multiple R 0.998679
R Square 0.997361
Adjusted R
Square 0.996984
Observations 17
ANOVA
Significanc
df SS MS F eF
Regression 2 0.098112 0.049056 2645.185 8.92E-19
Residual 14 0.00026 1.85E-05
Total 16 0.098372
Coefficient Standard Upper Lower Upper

s Error t Stat P-value Lower 95% 95% 95.0% 95.0%
Intercept 0.065024 0.003724 17.46057 6.72E-11 0.057037 0.073011 0.057037 0.073011
0.303286 -0.1337 0.0117 -11.4274 1.75E-08 -0.15879 -0.1086 -0.15879 -0.1086
-0.12028 -0.32565 0.004838 -67.3133 5.52E-19 -0.33603 -0.31528 -0.33603 -0.31528
So, equation works out to be:
ln m(t) = 0.065 – 0.133 lnC/D (t) – 0.325 ln R/D (t)
Explanation
So, 1% increase in ‘C/D’, leads to 0.133% decrease in ‘m’.
And, 1% increase in ‘R/D’, leads to 0.325% decrease in ‘m’.
From the P-value of both the independent variables, it can be said

that both the variables C/D and R/D are both significant explanatory
variable, R/D being comparatively more significant. (significant level
taken to be 95%).
Money Market Equilibrium
Substituting equations of money multiplier (m), money demand

function, the equation of money multiplier equilibrium can be written :
Money supply (M) = Money demand (MD)
ln m (t) + ln H/P (t) = ln MD/P (t-1) + ln y (t) + ln r (t)
where,
m = money multiplier
H/P = real value of reserve money
y = real income (Base : 1999 – 2000)
r = nominal interest rate
P = WPI Index (Base : 1999 – 2000)
See Excel File (RBI Dilemma – 2007-08)

And its explanation below
See Excel File (RBI dilemma-2008-09)

And its explanation below
Relationship between money supply and Interest rates for the

year 2007-08:
It can been seen from the graph that interest rates and money
supply has inverse relationship, showing that in order to
control one of the variable RBI has to compromise on other
14
12
10
8 r
r (%)
6 Linear (r)
0
0 5 10 15 20 25 30
M1 (%)
Analysis
ASSUMPTION – A SITUATION OF CLOSED ECONOMY IS

DISCUSSED BELOW IN BOTH THE CASES TO AVOID THE
COMPLEXITIES OF EXCHANGE RATE. THE REAL OUTPUT RATE IS
TAKEN AT 6% FOR THE YEAR 2008-09 AND THE INFLATION
RATE IS ASSUMED AS 5%.
(2007 – 08)
Here, it is proved that the RBI can target only one variable at a time
either money supply (M) or the interest rate (r).
The following discussion throws a very important dilemma which is

faced by RBI. The dilemma is to select between any one of the
variables as explained below:
The actual interest rate (r) for the year 2007-08 comes out to be
8.75% (this is 1 – 3 years deposit rate) and the actual money supply
(M1) growth rate comes out to be 19.135%. But, going through the
analysis, it can be inferred that RBI must have compromised between
one of the two variables.
At actual 8.75% r (t), the money supply growth rate from money
market equilibrium comes out to be 21.99% that does not match with
the actual money supply growth rate that the RBI has achieved in the
year 2007-08. i.e., 19.135%.
Similarly at 19.135% money supply growth rate, the r (t) comes out to
be 4.1926% and this also does not match with the actual interest rate
i.e., 8.75%.
So, it can be said that RBI suffers a dilemma in the closed economy of
choosing between the interest rate and the money supply. It decides
which variable to target based on the volatility of the money multiplier
and the money demand function. Out of these two variables whichever
is the most constant, the RBI will choose that target. i.e., if money
multiplier is relatively constant then, RBI will choose to target money
supply and if the money demand is relatively constant then RBI will
choose to target interest rates.
(2008 – 09)
The target money supply for the year 2008-09 initially was 16%. At
this target of 16%, equilibrium interest rate comes out to be 13%. And
at 10% actual interest rates, money supply growth rate comes out to
be 17.17%. So, in order to satisfy its targeted money supply rate, RBI
has to keep the interest rate at 13%. This is too high an interest rate
for the economy. So RBI has recently revised its money target growth
rate at 18% which is approximately equal to 17.17%.
Money Stock or Interest Rate targets?
There are two levels on which any discussion of interest rate versus
money targets proceeds. The first is at the technical level where the
question is much narrower : Can a given target level of the money
stock be attained more accurately by holding the interest rate fixed or
by fixing the stock of high-powered money? The second level is that of
the economy as a whole : Can the RBI make the Indian economy more
stable by aiming for a particular money stock or for a particular
interest rate?
As the framework for evaluating both these questions is similar, in this

section, only the first issue has been discussed. The analysis involves
the relative stability of money demand and the money multiplier and
indicates that the RBI should adopt the following elementary guidelines
in order to ensure that it hits its money stock target more closely :
1) If the demand-for-money function is stable, then the RBI should

fix interest rates;
2) If the demand-for-money function is relatively unstable

(compared with the money multiplier), then the RBI should
target high-powered money.
Control of the money stock and control of the interest rate
Now, a simple but important distinction is made : The monetary

authority cannot simultaneously set both the interest rate and the
stock of money at any given target levels that it may choose. Thus, if
the RBI wants to achieve a given interest rate target it has to supply
the amount of money that is demanded at that interest rate. If it
wants to set the money supply at a given level it has to allow the
interest rate to adjust to equate the demand for money to that supply
of money.
The point can be stressed as follows. When the monetary authority

decides to set the interest rate at some given level and keep it fixed –
a policy known as pegging the interest rate – it looses control over the
money supply.
With increasing real income growth, it must increase the stock of high-
powered money to increase the money supply. Alternatively, if the
monetary authority decides to set the money supply at a given level, it
must allow the interest rate to adjust freely to equilibrate the demand
for money with the supply of money.
THE POLICY DILEMMA
The central bank, which is the RBI in the Indian context, is said to
monetize deficits whenever it purchases a part of the debt sold by the
government to finance its deficit. In the U.S., the monetary authority,
which is the Federal Reserve System, enjoys total independence from
the Treasury, representing the government, and can therefore choose
whether or not to monetize. In India, however, the central bank enjoys
much less independence from the government and therefore it can be

ordered to finance part or all of the deficit by creating high-powered
money implying an inability to follow an independent monetary policy.
Be that as it may, the central bank (or the government) typically faces
a dilemma in deciding whether or not to monetize a deficit.
Thus, if the central bank decides not to monetize the deficit, then the
fiscal expansion must be accompanied by an increase in public debt
which implies that, in the next period, it has to pay interest on all debt
that existed in the past, plus on the new debt that it issued to cover
last period’s deficit.
Accordingly, there is a temptation for the authorities to monetize the

debt thereby increasing the money supply and accommodating the
fiscal expansion. But such a policy runs a risk as the monetization
could fuel an inflation.
Much discussion of appropriate monetary policy has centered on this

question : Should the central bank accommodate or not? In the
specific context of an increase in budget deficits, the traditional answer
has always been that the central bank should not accommodate and
should keep the money growth rate constant.
Empirics
In terms of the Indian context, it was found that in the period from
1970-71 to 1990-91; the relationship between GFD and high powered
money (H) was significant. The equation came out to be :-
Equation
H*/H = a + b1 BD/Y + b2 D*/D
Where,
H-High powered money, BD/Y-ratio of Budget deficit to income
D-Total internal liability of the government
H*/H = 12.8044 + 1.0668 BD/Y + (-0.2201) D*/ D
From the results of this equation, it can be seen that,1% increase in

the ratio of budget deficit to nominal income (BD/Y) increases the
growth rate of monetary base (H) by about 1.1%.
So, it can be inferred that RBI during this period used to accommodate
the money i.e., debt monetization and this led to the growth of high
powered money.
But, this is in very sharp contrast to the present scenario i.e., from
1990-91 to 2007-08. The equation comes out to be :
H*/H = 18.255 + (-3.70) BD/Y + 1.74 D*/ D
R square = 0.4077
The significance ‘F’ = 0.025, which is ≤ 0.05 indicates the test

Standard
18.25543989 10.47083942 1.743455 0.103162
-3.700008436 1.20683927 -3.06587 0.008382
1.746831355 0.833410371 2.096004 0.054736

Gross
Fiscal
Reserve Deficit/GDP Internal
Year money liability GFD BD/Y D*/D H*/H ln H lnBD/Y lnD
1990-91 87779 9.41 283033 44632 9.41 18.00 13.13 11.38258 2.241773 12.55332
1991-92 99505 7.00 317714 36325 7.00 12.25 13.36 11.50796 1.94591 12.66891
1992-93 110779 6.96 359655 40173 6.96 13.20 11.33 11.61529 1.940179 12.7929
1993-94 138672 8.19 430623 60257 8.19 19.73 25.18 11.83987 2.102914 12.97299
1994-95 169283 7.05 487682 57703 7.05 13.25 22.07 12.03933 1.953028 13.09742
1995-96 194457 6.52 554983 60243 6.52 13.80 14.87 12.17797 1.874874 13.22669
1996-97 199985 6.33 621437 66733 6.33 11.97 2.84 12.206 1.8453 13.33979
1997-98 226402 7.25 722962 88937 7.25 16.34 13.21 12.33007 1.981001 13.49111
1998-99 259286 8.97 834552 113348 8.97 15.44 14.52 12.46569 2.193886 13.63465
1999-00 280555 9.47 962592 104716 9.47 15.34 8.20 12.54453 2.248129 13.77738
2000-01 303311 9.51 1102596 118816 9.51 14.54 8.11 12.62251 2.252344 13.91318
2001-02 337970 9.94 1294862 140955 9.94 17.44 11.43 12.73071 2.296567 14.07391
2002-03 369061 9.57 1499589 145072 9.57 15.81 9.20 12.81872 2.258633 14.2207
2003-04 436512 8.51 1690554 123273 8.51 12.73 18.28 12.98657 2.141242 14.34057
2004-05 489135 7.45 1933544 125794 7.45 14.37 12.06 13.10039 2.008214 14.47487
2005-06 573055 6.69 2165902 146435 6.69 12.02 17.16 13.25874 1.900614 14.58835
2006-07 708990 5.56 2435880 142573 5.56 12.46 23.72 13.4716 1.715598 14.70582
2007-08 928417 5.26 2784352 143653 5.26 14.31 30.95 13.74124 1.660131 14.83953
326515
SUMMARY OUTPUT
Multiple R 0.638588
R Square 0.407795
Adjusted R
Square 0.323194
Observations 17
ANOVA
Significanc
df SS MS F eF
Regression 2 332.5579 166.279 4.820228 0.025545
Residual 14 482.9451 34.49608
Total 16 815.503

Intercept 18.25544 10.47084 1.743455 0.103162 -4.20228 40.71316 -4.20228 40.71316
9.41 -3.70001 1.206839 -3.06587 0.008382 -6.28842 -1.1116 -6.28842 -1.1116 GFD
18.00466 1.746831 0.83341 2.096004 0.054736 -0.04066 3.534319 -0.04066 3.534319 D
Chart Title
Chart Title
35.00
35.00 30.00
30.00 25.00
25.00 20.00 H*/H
H*/H
20.00 15.00 Linear (H*/H)
H*/H
H*/H
15.00 10.00
Linear (H*/H)
10.00
5.00
5.00
0.00
0.00
0.00 5.00 10.00 15.00 20.00 25.00
0 2 4 6 8 10 12
D*/D
BD/Y
Chart Title
Chart Title
1400000
200000
1200000
150000 1000000
800000 H
GFD
GFD
100000 600000 Linear (H)
H
Linear (GFD)
400000 Linear (H)
50000
200000
0
0
0 1000000 2000000 3000000 -100000
-200000 0 100000 200000 300000 400000
Total internal liability BOP

P value = 0.0084, which is less than 0.05, and it indicates that gross
fiscal deficit to income ratio, is a significant explanatory variable
determining H and its negative coefficient indicates that it is financing
most of its deficits through the route of public debt.
P value = 0.054, which is greater than 0.05, indicates that total

internal liability is not a significant variable determining H.
From the above four charts, it can be seen that BOP and H (high-
powered money) are linearly related and have the direct relationship
between them. This states that NFA or Net Foreign Assets of RBI is a
significant contributor determining high-powered money.
Also, it can be seen that Gross Fiscal deficit and High powered money
are indirectly related (downward slope) indicating public debt mode of
financing by the government.
In 2004, RBI and Government went into an agreement under MSS

(Market Stabilization Scheme) in which RBI can issue government
securities in order to sterilize the impact of capital flows and increase
in net foreign asset. Inc in capital flows since 2004, led to an increase
in supply of dollars and so RBI bought $ and sold Rs in the market.
This led to increase in money in the market and increase in NFA to
RBI. In order to sterilize this money, RBI used to issue MSS bonds.
But MSS bonds had upper cap as there is a limit to Government

securities. Moreover Government had stopped debt monetization
limiting Govnt securities with RBI. Money available from MSS bonds
was not available to Govnt to finance its deficit but was kept with an
separate A/C with RBI. As these securities were liabilities to Govnt and
as they were kept with RBI as an asset, these MSS bonds made no
difference to Govnt capital A/C. So these MSS bonds were only
increasing Govnt interest burden. This is the one of the reason, why in
the last recent years GFD was increasing despite of primary deficit
being –ve. So in order to finance these deficits, Govnt uses public debt
mode of financing, but this also increases the interest rates in the
economy and causes deterrence to growth.
Though Govnt had stopped debt monetization, increased capital flows

creates difficulty to RBI and its monetary policy, as these large capital
flows are much more then the amount required to finance current A/C
deficit and most of this money is invested into the secondary markets
as well as real estate (hot money). Due to the continuous issue of MSS
bonds, RBI became net seller of Govnt securities and this was the
reason why in the balance sheet of RBI in 2007, Net RBCG (Reserve
Bank credit to Government) was negative. .
DEFICITS AND INFLATION
In order to establish the nexus between deficits and inflation, it is

useful to distinguish between two components of the budget deficit:
1) The primary, or non-interest deficit, and
2) Interest payments on the public debt
Thus,
Budget deficit (BD) = primary deficit + interest payments

- (1.1)
Thus, the primary deficit (or surplus) represents all government
outlays, except interest payments, less all government revenue. The
distinction between these two components highlights the role of the
public debt in the budget. Interest has to be paid when there is debt
outstanding. The overall budget will be in deficit unless the interest
payments on the total debt are more than matched by a primary
surplus.
The impossibility of running a permanent money – financed deficit

because of the inflation it would entail, raises the unpleasant
possibility of having to finance the deficit by issuing debt and thereby
incurring even larger interest payments in the future. How can the
government pay this interest? One way is to borrow some more. But
then next period the interest needed to service the debt is even larger,
and hence even more debt needs to be issued, and so on. This is
referred to as the potential instability of debt finance.
The national debt in India has typically risen year after year for the
last 20 years. Does that mean the government budget is bound to get
out of hand, with interest payments rising so high that taxes have to
keep rising in order to cover this debt-servicing, until eventually
something terrible happens. The answer is “No”, because the Indian
economy has been growing.
Figure – Ratio of Public debt to GDP (1990 – 2008)
Sum of Debt to GDP

0.45
The above figure shows the Indian public debt as a fraction of nominal
GDP over the period 1990-2008. The debt ratio is given by :
Debt ratio (d) = debt (D) / Nominal income (Py)
- (1.2)
Where nominal income (Y) is defined as the price level (P) times real
output (y). Thus, the ratio, d, falls when nominal income, Y, grows
more rapidly than debt, D. The numerator, D, grows because of
deficits. The denominator, Py, grows as a result of both inflation, P*/P,
and real income growth, y*/y.
Why is it useful to look at the debt-income ratio rather than at the

absolute value of the debt? The reason is that nominal income is a
measure of the size of the economy, and the debt-income ratio is thus
a measure of the magnitude of the debt relative to the size of the
economy.
It is the notion that every person in the country has such a large debt
burden to bear that makes the existence of the debt so serious.
THE POTENTIAL INSTABILITY OF DEBT FINANCE
Now, this discussion is formalized and a framework is developed to

assess the instability problem associated with debt finance. In the
process, the conditions under which the debt-income ratio (d) will
change over time are also explicitly determined.
The debt-income ratio, defined by equation 1.2, implies that :
d (Py) = D - (1.3)
In terms of incremental changes, equation 1.3 can be written as :
d* Py + d (P*y + y*P) = D* - (1.4)
where, second and third order interaction terms have been ignored.
Rewriting equation 1.4 in terms of how the debt-income ratio will

change over time (d*),
d* = (D*/Py) – d[ (P*/P) + (y*/y) ] - (1.5)
Considering that money growth can be increased to accommodate

budget deficits, it is assumed that a constant fraction, 0 ≤ m ≤ 1, of
budget deficits is monetized, i.e.,
H* = m(BD) - (1.6)
However, from the past equation, it can be known that: BD = H* +

D*. Thus :
D* = (1-m) BD - (1.7)
From equation 1.3, the budget deficit can be spilt into two parts :
interest payments, which equal the debt outstanding (D) times the
interest rate paid on this debt (r); and the primary budget deficit,
which is equal to the ratio of the primary budget to nominal income (x)
times nominal income (Py), i.e.,
BD = rD + x(Py) - (1.8)
Linking equations (1.7) and (1.8) together yields,
D* = (1-m) [rD + x(Py)] - (1.9)
This equation can be transformed by substituting the above expression

for D* in it and by letting P*/P = ∏ and y*/y = g.
d* = (1-m)(rd +x) – d( ∏ +g) - (1.10)
Thus, debt stabilization is due to growing monetary accommodation

and nominal income; debt destabilization due to growing nominal
interest payments and primary deficits.
Solving this equation:
d*=-5.365; but the actual debt-to-GDP ratio is rising by 4.99%.
This indicates about rising Fiscal deficits and continuous rely on

public debt.
This also explains that the above eqn. of d* is not the correct
predictor of debt to GDP ratio in the present context. This can
be because m (o<m<1) does not hold true in present context
as there is a negative relationship between BD/Y and H as
established previously.
But this financing though public debt is justifiable as long as

real interest rates R is less than real growth rate of Income Y.
d M fin to GFD R x G Ω
2007-08 0.590763 -0.12658 0.061785 -0.0034 0.09 0.0468
2006-07 0.587552 0.031689 0.062122 -0.0001 0.096 0.0553
d* = (1-m) (rd + x) - d (Ω + 2006-07 to 07-

g) -0.053650189 08
-0.03587 07-08 to 08-09

ASSUMPTION: nominal int rate - 9%, GDP - 6.0%, inflation rate - 5% for the year 2008-09
Debt/
DEBT GDP at current GDP Debt/NDP
1544975 4145810 2549649 0.372659 0.605956
1844110 4713148 2781182 0.391269 0.663067
19.36180197 13.68461 9.080975 4.993807 9.424949

PRIMARY DEFICITS
The primary deficit, also called the non-interest deficit, represents all
government expenditures, except interest payments, less all
government revenues, i.e.,
Primary deficit = Non interest outlays – total revenue
This distinction between these two components highlights the role of

the public debt in the budget because, as interest has to be paid when
there is debt outstanding, the overall budget will be in deficit unless
the interest payments on the debt are more than matched by a
primary surplus.
SOME UNPLEASANT MONETARIST ARITHMETIC
When a government finances a current deficit through debt, it incurs

an obligation to pay interest on that debt in the future. Debt-financing
of a deficit may in the long run be even more inflationary than money-
financing. This is so because if money financing is used, interest
payments will be no larger in the future. But if the government turns
to debt financing, it will have a larger deficit to finance in the future.
Imagine the following circumstances where there exists a given

national debt and that the primary deficits are assumed to remain
permanently at some constant level, say, zero. The government is
considering the strategy of financing its current deficit. If it decides on
debt-financing, it intends to stop borrowing and switch to money
financing in, say, 5 years.
Under what alternative will the inflation rate be ultimately higher? The
answer can be worked out from the following considerations. If the
government starts money financing today, it will have to create money
at a rate that finances the interest payments on the existing national
debt. But if it waits 5 years to start money financing, it will have to
create money at a rate that finances interest payments on the national
debt that will exist 5 years from now. Because interest on the debt will
have accumulated in the meantime, the debt will be larger 5 years

from now, and the money growth needed to finance this will
consequently be larger and therefore so will the inflation rate.
This shows that, because of the accumulation of interest, short run

debt financing that ends in money financing will generally ultimately
be more inflationary than immediate money financing of a given
deficit. The arithmetic is unpleasant for monetarists because it
suggests that budget deficits - or rather its mode of financing –
may have more to do with the eventual inflation rate than the
current growth rate of money.
The main question raised by this example is whether the government

is eventually forced into money financing of a given deficit or whether
it can continue debt-finance for ever. That depends on the size of the
primary deficit, extent of monetary accommodation and relationship
between the growth rate of output and the real interest rate. If the
real interest rate is above the growth rate of output, and given a zero
primary deficit, i.e., x=0, debt financing cannot continue forever
because the debt becomes a larger part of income and interest
payments keep mounting up. At some point, in that case, the case, the
government will have to turn to money financing which, by generating
unanticipated inflation, will not only provide some revenue via the
inflation tax, but also reduce the value of the outstanding debt.
It should be remembered that the national debt in most countries is

nominal, meaning that the government is obliged to repay only a
certain number of rupees to the holders of the debt. A policy that
raises the price level thus reduces the real value of the payments that
the government is obliged to make. The debt can therefore be virtually
wiped off by a large enough unanticipated inflation – so long as the
debt is a nominal debt.
If however, the real interest rate is below the growth rate of output,
with a zero primary deficit, then the government can continue debt
financing indefinitely without the debt-income ration rising. This is
because the tight link examined by them assumes future primary

deficits as given. If the government is willing to reduce expenditures or
raise taxes thereby increasing the primary surplus, then there is no
necessary link between current deficits and future money growth.
The analysis however does make clear why permanent deficits cause
concern. If the national debt is growing relative to GNP, then
ultimately the government will be forced to raise taxes or raise the
inflation rate (via money financing) to meet their debt obligations. This
is what leads people to worry about deficits.
There is one last point that merits attention. It is about primary

deficits; if the total deficit is constant as a percentage of income, then
ultimately the debt-income ratio will stabilize even if the deficit were
financed entirely through debt provided the economy is growing. This
is an important point. Suppose that the debt-income ratio is denoted
by d, that income is growing at a real rate g, and that the total deficit
as a percentage of income is denoted by k. that means in steady state,
k=d*g and, consequently, the steady state debt GNP ratio would be
equal to d=k/g. for instance, if the deficit is 5 percent of GNP forever,
and the growth rate of GNP is 4 percent forever, then the debt-GNP
ratio will be 1.25 or 125 percent in steady state and at this point
interest payments will be a constant proportion of GNP.
lnBD/Y(t) = a + b1lnx(t-1)
Gross Fiscal Gross Primary Deficit

Year Deficit (BD/Y)(t) (x)(t-1)
1990-91 7.84 3.67
1991-92 5.55 4.06
1992-93 5.34 1.49
1993-94 6.96 1.21
1994-95 5.68 2.72
1995-96 5.05 1.34
1996-97 4.84 0.86
1997-98 5.82 0.53
1998-99 6.47 1.53
1999-00 5.36 2.03
2000-01 5.65 0.74
2001-02 6.19 0.93
2002-03 5.91 1.47
2003-04 4.48 1.11
2004-05 3.99 -0.03
2005-06 4.09 -0.04
2006-07 3.50 0.39
2007-08 3.05 -0.19
2008-09 6.24 -0.60

2.56
SUMMARY OUTPUT
Multiple R 0.740492
R Square 0.548329
Adjusted R
Square 0.520099
Observations 18
ANOVA
Significanc
df SS MS F eF
Regression 1 23.4372 23.4372 19.42398 0.000441
Residual 16 19.30578 1.206611
Total 17 42.74298

Intercept 5.567388 0.5075 10.97022 7.46E-09 4.491536 6.643241 4.491536 6.643241
4.63 0.837615 0.190053 4.407265 0.000441 0.43472 1.24051 0.43472 1.24051
Lagged primary deficit determining GFD
Where, lagged primary deficit is an independent variable having co-eff of 0.837
GFD is dependent variable.
This indicates that primary deficit in the year (t-1) is a significant variable determining Gross
fiscal deficits in the year t.
SUMMARY OUTPUT
Multiple R 0.55215
R Square 0.304869
Adjusted R
Square 0.258527
Observations 17
ANOVA
Significance
df SS MS F F
Regression 1 34.6395 34.6395 6.57867 0.021552
Residual 15 78.98139 5.265426
Total 16 113.6209

Intercept 3.113283 2.84882 1.092832 0.291709 -2.95883 9.1854 -2.95883 9.1854
7.84 1.385468 0.540166 2.564892 0.021552 0.234131 2.536805 0.234131 2.536805
GFD determining Interest rates
Where, GFD is an independent variable having co-eff of 1.38
Interest rates on central govt. securities are dependent variable
This also indicates the fact that Govnt. Mode of financing through public debt leads to increase
in interest rates on central Govnt. Securities.
THE INFLATION TAX
The recent increase in inflation has elevated the question the question
of whether and how the tax system should be adjusted to cope with
rising prices from a matter of academic curiosity to a live political
issue. Many other nations, having long experienced high rates of
inflation, years ago adopted rules for altering their tax systems
automatically as prices rise. Should India do so today? If so, what
adjustments should be made automatically, and which should be left
to ad hoc remedy by periodic legislation?
The problem
Inflation affects tax liabilities in three ways. First, it may alter real
factor incomes. Second, it affects the measurement of taxable income.
Third, it changes the real value of deductions, exemptions, credit,
ceilings and floors and all other tax provisions legally fixed in nominal
terms.
Inflation affects factor incomes by altering such quantities as nominal

interest rates, desired money balances, real tax collections (due to
inflation causing issuance of money), and savings. In short, inflation
may alter the comparative static general equilibrium and necessitate
lengthy adjustments. Whether taxes are collected on nominal incomes,
real incomes, or some combination, will affect the properties of the
resulting general equilibrium and may have perceptible effects on
economic efficiency and on pretax income distribution. Unfortunately,
current understanding of these issues is primitive. Whether or not the
tax code should be written to take account of inflation may well
depend on the nature of these effects. However, one must first
understand the adjustments necessary to convert the income tax from
a tax on nominal income into a tax on real income. In general, the tax
code properly disregards the forces that generated income; it is
concerned only with measuring correctly the income actually received.
Inflation thus acts just like a tax because people are forced to spend
less than their income and pay the difference to the government in
exchange for extra money.
HYPERINFLATION
Although there is no precise definition of the rate of inflation that

deserves to be termed as hyperinflation rather than high inflation, a
working definition puts it as : Hyperinflation is often defined as
inflation that exceeds 50 percent per month, which is just over 1
percent per day. Compounded over many months, this rate of inflation
leads to a very large increases in the price level. An inflation rate of 50
percent per month implies a more than 100-fold increase in the price
level over a year, and a more than 2-million-fold increase over three
years. At these extreme range, inflation is computed in terms of
monthly rates, and not at annual rates.
The costs of hyperinflation
Although economists debate whether the costs of moderate inflation

are large or small, no one doubts that hyperinflation extracts a high
toll on society as however the costs are qualitatively the same. When
inflation reaches extreme levels, however these costs are more
apparent because they are so severe.
The shoeleather costs associated with reduced money holdings, for

instance, are under hyperinflation. Business executives devote much
time and energy to cash management when cash looses its value
quickly. By diverting this time and energy from more socially valuable
activities, such as production and investment decisions, hyperinflation
makes the economy run less efficiently.
Menu costs also become larger under hyperinflation. Firms have to

change prices so often that normal business practices, such as printing
and distributing catalogs with fixed prices, become impossible. In one
restaurant during the German hyperinflation of the 1920’s, a waiter

would stand up on a table every 30 minutes to call out the new prices.
Similarly, relative prices do not do a good job of reflecting true scarcity

during hyperinflation. When prices change frequently by large
amounts, it is hard for customers to shop around for the best price.
Highly volatile and rapidly rising prices can alter behavior in many
ways. According to one report, when patrons entered a pub during the
German hyperinflation, they would often buy two pitchers of beer.
Although the second pitcher would loose value by getting warm over
time, it would loose value less rapidly than the money left sitting in the
patron’s wallet.
Tax systems are also distorted by hyperinflation-but in ways that are

different from the distortions of moderate inflation. In most tax
systems there is a delay between the time a tax is levied and the time
the tax is paid to the government. This short delay does not matter
much under low inflation. By contrast, during hyperinflation, even a
short delay greatly reduces real tax revenue. By the time the
government gets the money it is due, the money has fallen in value.
As a result, once hyperinflation start, the real tax revenue of the
government often falls substantially.
There exists a corresponding inflation rate, ∏*, which is the steady

state rate at which the inflation tax is at its maximum. If the
government tries to force the inflation rate any further beyond this
level, ∏*,the real money base that people hold starts shrinking, as
they try to flee the inflation tax. As a result the inflation tax revenue
declines even further, and the large budget deficits that inevitably
occur are part of the extreme inflation of 50 to 100 or even 500
percent per year that took place in the mid-1980s in Latin America and
Israel. They are also part of the even more extreme cases of
hyperinflation when the real money base collapses almost to zero and
the entire tax collection system breaks down.
Finally no one should underestimate the sheer inconvenience of living

with hyperinflation. The government tries to overcome this problem by
adding more and more zeroes to the paper currency, but often it
cannot keep up with the exploding price level.
Eventually these costs of hyperinflation become intolerable. Over time,

money looses its role as a store of value, unit of account, and medium
of exchange.
The causes of hyperinflation
Why do hyperinflations start, and how do they end? This question can
be answered at different levels.
The most obvious answer is that hyperinflations are due to excessive

growth in the supply of money. When the central bank prints money,
the price level rises. When it prints money rapidly enough, the result is
hyperinflation. To stop the hyperinflation, the central bank must
reduce the rate of money growth.
But this answer is incomplete, as then the question arises as to why

central banks in hyperinflating economies choose to print so much
money. To address this deeper question, attention should be diverted
from monetary to fiscal policy. Most hyperinflations begin when the
government has inadequate tax revenue to pay for its spending.
Although the government might prefer to finance this budget deficit by
issuing debt, it may find itself unable to borrow, perhaps because
lenders view the government as a bad credit risk. To cover the deficit,
the government turns to the only mechanism at its disposal – the
printing press. The result is rapid money growth and hyperinflation.
All hyperinflationary economies suffer from large budget deficits and,

given the limited scope of debt-financing under the circumstances,
from rapid money financing of such deficits. This fuels the inflation rate
which, in turn, increases the budget deficit, not only because inflation
tax revenue drops, but also because the lags in the collection of taxes
erode the real value of tax revenues – the so called Tanzi-Olivera
effect. This feedback between budget deficits and inflation leads to

money growth rates of almost the same order as the inflation rate.
Hyperinflations have usually taken place in the aftermath of wars. The

most famous of them all – although not the most rapid – was the
German hyperinflation of 1922-23. The highest rate of inflation was in
October 1923, just before the end of the hyperinflation, when prices
rose by 29,000 percent. The most rapid hyperinflation was that in
Hungary at the end of World War II : the average rate of inflation from
August 1945 to July 1946 was 19,800 percent per month. During July
1946, the price level rose by 41.9 quadrillion percent, i.e., 41.9 x
10Λ15 percent. This means that prices were doubling roughly every
twelve hours and something that cost Rs. 1on July 1, 1946 would have
cost Rs. 41,900,000 crores on July 31, 1946.
However, all hyperinflations must come to an end. The dislocation of

the economy forces the government to find ways of reforming its
budget process. Often a new money, with a drastically reduced rate of
money growth, is introduced and the tax system is reformed.
Typically, too, the exchange rate of the new money is pegged to that
of a foreign currency in order to provide an anchor for prices. In many
cases, governments freeze wages and prices (called heterodox
programs) supplemented by orthodox programs of fiscal austerity.
One very important feature of such policies should be brought out :

Money growth following stabilization can afford to be high. Why?
Because as the inflation rate falls, the demand for real balances
increases. With a rising demand for real balances, the government can
once again create more money without generating inflation. Thus, at
the beginning of a successful stabilization, it can temporarily finance
part of the deficit through the printing of money, without re-igniting
inflation. However, its theoretical relevance notwithstanding, the
ultimate success of such stabilization programs remains to be
established.
The ends of hyperinflation almost always coincide with fiscal reforms.

Once the magnitude of the problem becomes apparent, the
government musters the political will to reduce government spending
and increase taxes. These fiscal reforms reduce the need for
seiniorage, which allows a reduction in money growth. Hence, even if
inflation is always and everywhere a monetary phenomenon, the end
of hyperinflation is often a fiscal phenomenon as well.
CONCLUSION
WHICH TARGETS FOR THE RBI?
If the RBI decides to set target ranges for certain variables and has to
choose from amongst targets such as money growth, debt growth,
interest rates, budget deficits and domestic credit. However, having so
many targets all at once could imply that it could fail to hit any of
them. The question then arises as to which are the targets that it
should aim for?
Here there is an important point to note before going on to the details.

A key distinction is between ultimate targets of policy and intermediate
targets. Ultimate targets are variables such as the output growth rate
or the inflation rate whose behavior really matters. The interest rate or
the money growth rates are intermediate targets of policy – targets
which the RBI aims at only so that it can hit the ultimate targets more
accurately. The cash reserve ratio and the bank rate are the
instruments the RBI has with which to hit the targets.
The ideal intermediate target is a variable that the RBI can control
exactly and which, at the same time, bears an exact relationship with
the ultimate targets of policy. For instance, if the ultimate target could
be expressed as some particular level of nominal GDP, and if the
money multiplier and the velocity were both constant, then the RBI
could hit its ultimate target by having the monetary base as its
intermediate target.
In practice, however, while choosing intermediate targets, the RBI will

have to trade off between those targets which it can control more
precisely but have little bearing on the ultimate targets and those
targets over which it exerts very little control but are more closely
related to the ultimate targets.

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Monetary Economics

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Empirical Applications of Monetary Economics in the Era of Liberalization

OBJECTIVE OF THE PROJECT

The three primary objectives emphasized in this project are:

Money-inflation link – This study is within the framework of the

Deficits and inflation link – It focuses on the interrelationship within

INTRODUCING THEORY FOR EMPIRICS

As monetary economics is closely related to current economic

The great macroeconomists have all had a keen interest in the

Thus, there have long been two intellectual traditions in macro

consequently see a dominant role for government action to try and

This study therefore involves an econometric investigation, based on

The real world application and significance of these results is quite

MONEY AND INFLATION

This section initially develops an analysis of the dynamics of money,

CHARACTERISTICS OF INDIAN INFLATION

Table – Money, Growth and Inflation

M1 NDP at factor cost Avg WPI

1990-91 14.6 5.5 10.35

Inflation is indeed primarily a monetary phenomenon which cannot

Monetarists tend to concentrate on the long-run and on economies in

There is one main proposition of the adjustment process towards long-

As can be seen from the summary output, the regression established

ln p(t) = a + b1*ln y(t) + b2* ln M(t)

Co-efficient of determination R square = 0.98, which implies that

-0.74993259 0.566352196 -1.32415 0.206667

0.733659567 0.253168589 2.897909 0.01169

ln p(t) = a + b1*ln y(t) + b2* ln M(t)

Standard Lower Upper

So, equation works out to be:

ln p(t) = 1.33 – 0.74 ln y(t) +0.733 ln M(t)

So, 1% increase in ‘y’, leads to 0.74% decrease in ‘p’.

And, 1% increase in ‘M’, leads to 0.733% increase in ‘p’.

Thus the monetarist contention that a sustained increase in the growth

However, the above analysis is based on the assumption that velocity

Thus the answer to the question whether inflation is a monetary

DEFICITS AND MONEY

In the last section, it was seen that a sustained increase in money

As a preliminary to the study of the theory of money supply, it is

The measurement of money supply is an empirical matter. The RBI

Aggregate Monetary Resources

From 1967-68 onwards, the RBI started publishing additionally a

AMR = Narrow Money + TD of banks held by the public

M1, M2, M3 and M4

M2 = M1 + savings deposits with post office savings banks

M4 = M3 + total deposits with the Post Office Savings

These four measures of money supply are specified in descending

However, due to several definitional changes in 1978, the RBI, which

Table – Components of Money Stock

1990-91 53048 39170 92892 172936 265828

1991-92 61098 52423 114406 202643 317049

1992-93 68273 54480 124066 239950 364016

1993-94 82301 65952 150778 280306 431084

1994-95 100681 88193 192257 335339 527596

1995-96 118258 93233 214835 384356 599191

1996-97 132087 105334 240615 455397 696012

1997-98 145579 118725 267844 553488 821332

1998-99 168944 136388 309068 671892 980960

1999-00 189082 149681 341796 782378 1124174

2000-01 209550 166270 379450 933770 1313220

2001-02 240794 179199 422843 1075512 1498355

2002-03 271581 198757 473581 1244379 1717960

2003-04 314971 258626 578716 1426960 2005676

2004-05 355863 285154 647495 1603954 2251449

ln p(t) = a + b1ln y(t) + b2 ln M(t)

ln p(t) = a + b1ln y(t) + b2 ln M(t)