The monetarist conviction is that excess money creation causes persistent inflation. In other words, money increases are exogenous; the Central Bank can create excess money or decrease it by using instruments like Cash Reserve Ratio (CRR) and or interest rate.

Monetarists are of the opinion that money supply is determined without regard to the value of other variables. This means, there is a statistical relationship between changes in money stock and changes in inflation. At present, the central bank largely uses open market operations to increase or decrease money supply.

Monetary economist Philip D Cagan, for example, assumes that money creation is determined exogenously by monetary authorities, and money supply has a unique relationship with price behaviour. To quote Canadian economist Basil J. Moore: “Credit money is not supplied according to some production function with a resource cost; rather, it is supplied on demand by the Central Bank as the residual provider of system liquidity at a supply price determined exogenously…by the Central Bank itself”.


The above phenomenon, however, is not true in the case of India, where money supply largely increases due to government deficit. Yet, the Reserve Bank is held accountable for liquidity expansion in the economy, which results in higher growth of nominal income rather than real income. If we examine the trend during the past few years, the fact is that government failed to augment supply of goods to match increased demand.

Besides, there cannot be a one-to-one correspondence between money supply and inflation, when the increase in money lies outside the RBI’s control, or when money becomes an endogenous rather than exogenous variable.

In other words, when producers and distributors use their price-fixing power to create a cost-push inflation spiral on the pretext of increases in input cost, industry and business demand more credit for working capital, thus leading to an increase in the quantity of money. This increase in money supply in the current period exceeds the quantity of available goods produced in the preceding period. This endogenously excess supply of money generates inflation (as against the above observation by Basil J Moore). This is what happened in India during 2009-10 to 2011-12.

In our case, money growth was also further aggravated by the stimulus policy of government during 2008-09 and 2009-10. The stimulus policy was also responsible for inflation, as it increased the primary deficit of the Government.

Besides, the RBI also had to accommodate demand for credit to meet the cost-push requirement of money in the economy, though it resulted in inflationary pressure. Cost-push inflation has been self-generating --- credit which went on increasing without corresponding rise in real output. This inflation is not due to the RBI exogenously pumping money.

Therefore, inflation in India is a result of both endogenous and exogenous factors.


Now, RBI is under great pressure from industry, business and banks to cut interest rate, or decrease CRR. Since these variables are exogenous, the RBI uses them in keeping with the situation in the economy. Inflation due to increased RBI credit to government and private sector, and to cover cost-push inflation, is still threatening the economy. The Central Bank (RBI) had raised the interest rate repeatedly (repo and reverse repo) to reduce domestic aggregate demand, and hence inflation.

However, the Central Bank has failed to curb the animal spirits of hoarders of foodgrains, real estate owners and manufacturers of white goods by curtailing their liquidity.

The main objective of RBI has been to mitigate inflation, because inflation in our case has not been caused by excess supply of money. It has been caused by a deliberately reduced supply of several consumer goods.

As a matter of fact, interest rate has not been a successful instrument in reducing monetary liquidity and inflation, as demand for consumer goods is interest-inelastic. So inflation has also been inelastic to interest rate. As a matter of fact, it is inflation which is playing an important role in moving up the interest rate. As in Irving Fisher’s view, nominal interest rates respond endogenously to the expected inflation rate. Thus, when prices show instability, interest rates are assumed to reflect all anticipated changes in the price level.


We have to realise that inflation is a baby of multiple factors such as: GDP growth, excess money supply, short supply of goods in the market, manipulation in the market, misconceived expectations, exchange rate movement, depreciation of the Indian currency due to large current account deficit, cost-push factor, rise in per capita income and increase in demand due to shifting of population to higher income bracket, and decline in poverty ratio.

The Reserve Bank does not have multiple instruments to control all these variables. It is the government which has to grapple with the complexities of inflation, rather than hold the Reserve Bank responsible for the rise in inflation rate.

(The author is a former Economic Advisor to SEBI.)

(This article was published on July 20, 2012)
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