The Hindu Business Line : Money supply versus prices

To answer the second question first, Milton Friedman, the Nobel Prize winning economist, said: “Inflation is always and everywhere a monetary phenomenon.” What he meant was that inflation always increases when the money supply growth exceeds the growth of the economy for a period of time. To Friedman, this was clear.

Inflation has also been defined as “too much money chasing too few goods”. That is what one set of economists known as “monetarists” think. However, there are other economists who think that there are more factors that influence the inflation rate and that a straight relationship between an increased money supply and prices (inflation) isn’t the full story. This is because inflation in an economy could be as a result of demand-pull (increased demand for goods) or cost-push/supply-shock (sudden fall in the production of a goods) factors.

For instance, a fall in the production of oil and vegetables could lead to prices going up. Cost-push occurs when producers pass on the higher costs to consumers. However, there is a caveat in the case of “demand-pull” inflation. The monetarist theory can be interpreted in two ways. That is, the central bank printing money willy-nilly and causing inflation to go up and the central bank printing money to satisfy the increased demand for money to buy goods. While the two actions in essence are the same, the former will cause inflation to go up right-away while the latter, since it is backed by demand, does not cause inflation to go up immediately.

Inflation will only go up if and when this money is used to buy goods, thereby, causing a shortage of those goods and thus prices to rise (demand-pull).

To answer the first question, it’s a simple demand-supply issue. However, it needs to be clarified that the interest rate mentioned is the “call-money” rate and not the “repo” rate and the money supply here is the liquidity in the system and not the regular money supply as defined by M3.

If there is more liquidity in the system, it means there is a higher supply than demand and therefore its price, the call-money rate, will fall and vice-versa.

These days, because of high liquidity, call money rates are less than half of 1 per cent while a couple of months back it was more than 50 per cent because of the above reasons.

SUNIL RONGALA

(The author is Economist, Murugappa Group. The views are personal. Send in your queries on economics to Whackonomics@gmail.com)

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Money supply versus prices

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