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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.

Empirical Applications of Monetary Economics in the Era of Liberalization

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 problema 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 selfinterest 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

Empirical Applications of Monetary Economics in the Era of Liberalization 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.

Empirical Applications of Monetary Economics in the Era of Liberalization

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 Year 1990-91 1991-92 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 M1 (M*/M) 14.6 23.2 8.4 21.5 27.5 11.7 12.0 11.3 15.4 10.6 11.0 11.4 12.0 22.2 11.9 21.1 16.9 19.1 NDP at factor cost (y*/y) 5.5 0.9 5.3 5.6 6.4 7.3 8.1 4.0 6.6 6.2 4.1 5.6 3.4 8.6 7.3 9.4 9.6 9.1 Avg WPI (p*/p) 10.35 13.73 10.15 8.33 12.58 8.03 4.62 4.39 5.94 3.29 7.13 3.66 3.36 5.47 6.47 4.43 5.53 4.68

(Source : www.rbi.org.in)

Empirical Applications of Monetary Economics in the Era of Liberalization 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.

Empirical Applications of Monetary Economics in the Era of Liberalization 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 longrun 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.
Coefficients 1.33726337 -0.74993259 0.733659567 Standard Error 4.869787491 0.566352196 0.253168589 t Stat 0.274604 -1.32415 2.897909 P-value 0.787631 0.206667 0.01169

Empirical Applications of Monetary Economics in the Era of Liberalization
ln p(t) = a + b1*ln y(t) + b2* ln M(t) Year 1990-91 1991-92 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04 P 2004-05 P 2005-06 P 2006-07 P 2007-08 P WPI Index 0.507 0.577 0.635 0.688 0.775 0.837 0.875 0.914 0.968 1.000 1.072 1.110 1.148 1.211 647495 1.289 826375 1.345 966089 1.418 1150953 1.486 3122862 1.486 2864310 1.418 2781182 1150953 0.396014767 14.83838658 13.95610085 2612847 1.345 2549649 966089 0.349560917 14.75146626 13.78101124 2388384 1.289 2326581 826375 0.296759809 14.65991037 13.62480394 M1 92892 114406 124066 150778 192257 214835 240615 267844 309068 341796 379450 422843 473581 578716 Y 1083572 1099072 1158025 1223816 1302076 1396974 1508378 1573263 1678410 1786525 1864300 1972606 2048287 2222758 P 0.507 0.577 0.635 0.688 0.775 0.837 0.875 0.914 0.968 1.000 1.072 1.110 1.148 1.211 2126018 647495 0.253911039 14.5697613 13.38086635 Y 983651 992932 1045428 1104168 1174710 1260376 1362248 1417045 1511035 1605103 1670448 1764137 1824635 1981389 M1 92892 114406 124066 150778 192257 214835 240615 267844 309068 341796 379450 422843 473581 578716 Avg WPI ln (p) -0.678408333 -0.549677338 -0.453842133 -0.373630385 -0.254958855 -0.178063601 -0.13303992 -0.089956334 -0.032170606 0 0.069130508 0.104465415 0.137994919 0.191115081 NDP at factor cost ln (y) 13.79902644 13.80841746 13.85993693 13.91460267 13.97653187 14.04692065 14.12464683 14.16408428 14.2283054 14.28869849 14.32860241 14.38317218 14.41689052 14.49930867 M1 ln (M) 11.43919281 11.6475088 11.72856896 11.92356384 12.1665883 12.27762557 12.39095342 12.49816 12.6413166 12.74196935 12.84647811 12.95475623 13.06807824 13.26856714

Empirical Applications of Monetary Economics in the Era of Liberalization

SUMMARY OUTPUT Regression Statistics Multiple R 0.990680603 R Square 0.981448057 Adjusted R Square 0.97879778 Standard Error 0.041021837 Observations 17 ANOVA Df Regression Residual Total 2 14 16 SS 1.246338944 0.023559076 1.26989802 Standard Error 4.869787491 0.566352196 0.253168589 MS 0.623169 0.001683 F 370.319 Significance F 7.56355E-13

Coefficients Intercept 13.79902644 11.43919281 1.33726337 -0.749932595 0.733659567

t Stat 0.274604 -1.32415 2.897909

P-value 0.787631 0.206667 0.01169

Lower 95% 9.107391981 1.964637241 0.19066695

Upper 95% 11.78191872 0.464772051 1.276652185

Lower 95.0% 9.107391981 1.964637241 0.19066695

Upper 95.0% 11.78191872 0.464772051 1.276652185

Empirical Applications of Monetary Economics in the Era of Liberalization 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

Empirical Applications of Monetary Economics in the Era of Liberalization 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.

Empirical Applications of Monetary Economics in the Era of Liberalization

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

Empirical Applications of Monetary Economics in the Era of Liberalization 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

Empirical Applications of Monetary Economics in the Era of Liberalization 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 1990-91 1991-92 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 C 53048 61098 68273 82301 100681 118258 132087 145579 168944 189082 209550 240794 271581 314971 355863 413119 482906 567476 D 39170 52423 54480 65952 88193 93233 105334 118725 136388 149681 166270 179199 198757 258626 285154 406388 475687 574408 M1 92892 114406 124066 150778 192257 214835 240615 267844 309068 341796 379450 422843 473581 578716 647495 826375 966089 1150953 TD 172936 202643 239950 280306 335339 384356 455397 553488 671892 782378 933770 1075512 1244379 1426960 1603954 1903170 2350004 2855769 M3 265828 317049 364016 431084 527596 599191 696012 821332 980960 1124174 1313220 1498355 1717960 2005676 2251449 2729545 3316093 4006722

(Source : www.rbi.org.in)

Empirical Applications of Monetary Economics in the Era of Liberalization 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.

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

(Source : www.rbi.org.in)

Empirical Applications of Monetary Economics in the Era of Liberalization THE THEORY OF MONEY SUPPLY DETERMINATION In order to highlight the essential aspects of the theory of moneysupply determination, the basic definitions of M and H are given : M=C+D H=C+R - (2.1) - (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 highpowered 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)

Empirical Applications of Monetary Economics in the Era of Liberalization 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.

Empirical Applications of Monetary Economics in the Era of Liberalization THE STOCK OF HIGH-POWERED MONEY Factors affecting High-Powered Money In order to understand the factors that affect the creation of highpowered 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.

Empirical Applications of Monetary Economics in the Era of Liberalization To identify these factors, all transactors of the RBI can be divided into four sectors : 1) 2) 3) 4) The government, Banks, The commercial sector, and 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)

Empirical Applications of Monetary Economics in the Era of Liberalization 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 (sources) Government's currency liabilities to the public Net RBC to government RBC to banks RBC to commercial sector Net foreign exchange assets of the RBI Net non-monetary liabilities of RBI Monetary base (sources) 1582 86643 7258 5512 Deposits with RBI Bank deposits Other deposits 24864 2210 Currency Held by the public Cash with banks 53360 1795 Liabilities (Uses)

7418 (26184) 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)

Empirical Applications of Monetary Economics in the Era of Liberalization 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 (sources) Government's currency liabilities to the public Net RBC to government RBC to banks RBC to commercial sector Net foreign exchange assets of the RBI Net non-monetary liabilities of RBI Monetary base (sources) 9324 (113209) 4590 1788 Deposits with RBI Bank deposits Other deposits 328447 9069 Currency Held by the public Cash with banks 567476 23425 Liabilities (Uses)

1236130 (210206)

928417

Monetary base (uses)

928417

Empirical Applications of Monetary Economics in the Era of Liberalization

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.

Empirical Applications of Monetary Economics in the Era of Liberalization 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 highpowered 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

Empirical Applications of Monetary Economics in the Era of Liberalization 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.

Empirical Applications of Monetary Economics in the Era of Liberalization 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).

Empirical Applications of Monetary Economics in the Era of Liberalization 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.

Empirical Applications of Monetary Economics in the Era of Liberalization 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 consumptionincome 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 Applications of Monetary Economics in the Era of Liberalization 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 itself is very significant.
Coefficients 0.065023833 -0.133697093 -0.325652394 Standard Error 0.003724039 0.011699688 0.004837863 t Stat 17.46057 -11.4274 -67.3133 P-value 6.72E-11 1.75E-08 5.52E-19

Empirical Applications of Monetary Economics in the Era of Liberalization
ln m(t) = a + b1 ln C/D(t) + b2 ln R/D(t)

m 1.06 1.15 1.12 1.09 1.14 1.10 1.20 1.18 1.19 1.22 1.25 1.25 1.28 1.33 1.32 1.44 1.36 1.24

C 53048.00 61098.00 68273.00 82301.00 100681.00 118258.00 132087.00 145579.00 168944.00 189082.00 209550.00 240794.00 271581.00 314971.00 355863.00 413119.00 482906.00 567476.00

D 39170.00 52423.00 54480.00 65952.00 88193.00 93233.00 105334.00 118725.00 136388.00 149681.00 166270.00 179199.00 198757.00 258626.00 285154.00 406388.00 475687.00 574408.00

R 34731.00 38407.00 42506.00 56371.00 68602.00 76199.00 67898.00 80823.00 90342.00 91473.00 93761.00 97176.00 97480.00 121541.00 133272.00 159936.00 226084.00 360941.00

C/D 1.35 1.17 1.25 1.25 1.14 1.27 1.25 1.23 1.24 1.26 1.26 1.34 1.37 1.22 1.25 1.02 1.02 0.99

R/D 0.89 0.73 0.78 0.85 0.78 0.82 0.64 0.68 0.66 0.61 0.56 0.54 0.49 0.47 0.47 0.39 0.48 0.63

Empirical Applications of Monetary Economics in the Era of Liberalization

SUMMARY OUTPUT Regression Statistics Multiple R 0.998679 R Square 0.997361 Adjusted R Square 0.996984 Standard Error 0.004306 Observations 17 ANOVA df 2 14 16 Coefficient s 0.065024 -0.1337 -0.32565 SS 0.098112 0.00026 0.098372 Standard Error 0.003724 0.0117 0.004838 MS 0.049056 1.85E-05 F 2645.185 Significanc eF 8.92E-19

Regression Residual Total

Intercept 0.303286 -0.12028

t Stat 17.46057 -11.4274 -67.3133

P-value 6.72E-11 1.75E-08 5.52E-19

Lower 95% 0.057037 -0.15879 -0.33603

Upper 95% 0.073011 -0.1086 -0.31528

Lower 95.0% 0.057037 -0.15879 -0.33603

Upper 95.0% 0.073011 -0.1086 -0.31528

Empirical Applications of Monetary Economics in the Era of Liberalization 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 y r P = money multiplier = real income (Base : 1999 – 2000) = nominal interest rate = WPI Index (Base : 1999 – 2000)

H/P = real value of reserve money

Empirical Applications of Monetary Economics in the Era of Liberalization

See Excel File (RBI Dilemma – 2007-08) And its explanation below

Empirical Applications of Monetary Economics in the Era of Liberalization

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

Empirical Applications of Monetary Economics in the Era of Liberalization

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 r (%) 8 6 4 2 0 0 5 10 15 M1 (%) 20 25 30 r Linear (r)

Empirical Applications of Monetary Economics in the Era of Liberalization 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

Empirical Applications of Monetary Economics in the Era of Liberalization 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 :

Empirical Applications of Monetary Economics in the Era of Liberalization 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 highpowered 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

Empirical Applications of Monetary Economics in the Era of Liberalization 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

Empirical Applications of Monetary Economics in the Era of Liberalization 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 itself is very significant.

Coefficients

Standard Error

t Stat

P-value

18.25543989 10.47083942 1.743455 0.103162 -3.700008436 1.20683927 -3.06587 0.008382

1.746831355 0.833410371 2.096004 0.054736

Empirical Applications of Monetary Economics in the Era of Liberalization

Year 1990-91 1991-92 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08

Reserve money 87779 99505 110779 138672 169283 194457 199985 226402 259286 280555 303311 337970 369061 436512 489135 573055 708990 928417

Gross Fiscal Deficit/GDP 9.41 7.00 6.96 8.19 7.05 6.52 6.33 7.25 8.97 9.47 9.51 9.94 9.57 8.51 7.45 6.69 5.56 5.26

Internal liability 283033 317714 359655 430623 487682 554983 621437 722962 834552 962592 1102596 1294862 1499589 1690554 1933544 2165902 2435880 2784352

GFD 44632 36325 40173 60257 57703 60243 66733 88937 113348 104716 118816 140955 145072 123273 125794 146435 142573 143653 326515

BD/Y 9.41 7.00 6.96 8.19 7.05 6.52 6.33 7.25 8.97 9.47 9.51 9.94 9.57 8.51 7.45 6.69 5.56 5.26

D*/D 18.00 12.25 13.20 19.73 13.25 13.80 11.97 16.34 15.44 15.34 14.54 17.44 15.81 12.73 14.37 12.02 12.46 14.31

H*/H 13.13 13.36 11.33 25.18 22.07 14.87 2.84 13.21 14.52 8.20 8.11 11.43 9.20 18.28 12.06 17.16 23.72 30.95

ln H 11.38258 11.50796 11.61529 11.83987 12.03933 12.17797 12.206 12.33007 12.46569 12.54453 12.62251 12.73071 12.81872 12.98657 13.10039 13.25874 13.4716 13.74124

lnBD/Y 2.241773 1.94591 1.940179 2.102914 1.953028 1.874874 1.8453 1.981001 2.193886 2.248129 2.252344 2.296567 2.258633 2.141242 2.008214 1.900614 1.715598 1.660131

lnD 12.55332 12.66891 12.7929 12.97299 13.09742 13.22669 13.33979 13.49111 13.63465 13.77738 13.91318 14.07391 14.2207 14.34057 14.47487 14.58835 14.70582 14.83953

Empirical Applications of Monetary Economics in the Era of Liberalization

SUMMARY OUTPUT Regression Statistics Multiple R 0.638588 R Square 0.407795 Adjusted R Square 0.323194 Standard Error 5.873336 Observations 17 ANOVA df Regression Residual Total 2 14 16 Coefficient s 18.25544 -3.70001 1.746831 SS 332.5579 482.9451 815.503 Standard Error 10.47084 1.206839 0.83341 MS 166.279 34.49608 F 4.820228 Significanc eF 0.025545

Intercept 9.41 18.00466

t Stat 1.743455 -3.06587 2.096004

P-value 0.103162 0.008382 0.054736

Lower 95% -4.20228 -6.28842 -0.04066

Upper 95% 40.71316 -1.1116 3.534319

Lower 95.0% -4.20228 -6.28842 -0.04066

Upper 95.0% 40.71316 -1.1116 3.534319

GFD D

Empirical Applications of Monetary Economics in the Era of Liberalization

Chart Title
Chart Title

35.00
35.00 30.00 H*/H 20.00 15.00 10.00 5.00 0.00 0 2 4 6 BD/Y 8 10 12

30.00 25.00 H*/H 20.00 15.00 10.00 5.00 0.00 0.00 5.00 10.00 15.00 20.00 25.00 H*/H Linear (H*/H)

25.00 H*/H Linear (H*/H)

D*/D

Chart Title 200000 150000 GFD

Chart Title 1400000 1200000 1000000
GFD Linear (GFD)

800000 600000 400000 200000 0 -100000 -200000 0 H

H Linear (H) Linear (H)

100000 50000 0 0 1000000 2000000 3000000 Total internal liability

100000

200000

300000

400000

BOP

Empirical Applications of Monetary Economics in the Era of Liberalization 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 (highpowered 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

Empirical Applications of Monetary Economics in the Era of Liberalization 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. .

Empirical Applications of Monetary Economics in the Era of Liberalization

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.

Empirical Applications of Monetary Economics in the Era of Liberalization

Figure – Ratio of Public debt to GDP (1990 – 2008)

0.45

Sum of Debt to GDP

Empirical Applications of Monetary Economics in the Era of Liberalization 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.

Empirical Applications of Monetary Economics in the Era of Liberalization 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) Linking equations (1.7) and (1.8) together yields, D* = (1-m) [rD + x(Py)] (1.9) - (1.8)

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.

Empirical Applications of Monetary Economics in the Era of Liberalization 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.
2007-08 2006-07 d 0.590763 0.587552 M fin to GFD -0.12658 0.031689 R 0.061785 0.062122 x -0.0034 -0.0001 G 0.09 0.096 Ω 0.0468 0.0553

d* = (1-m) (rd + x) - d (Ω + g)

-0.053650189

2006-07 to 0708

-0.03587 07-08 to 08-09 ASSUMPTION: nominal int rate - 9%, GDP - 6.0%, inflation rate - 5% for the year 2008-09

DEBT 1544975 1844110 19.36180197

GDP at current 4145810 2549649 4713148 2781182 13.68461 9.080975

Debt/ GDP 0.372659 0.391269 4.993807

Debt/NDP 0.605956 0.663067 9.424949

Empirical Applications of Monetary Economics in the Era of Liberalization 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 moneyfinancing. 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

Empirical Applications of Monetary Economics in the Era of Liberalization 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

Empirical Applications of Monetary Economics in the Era of Liberalization 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.

Empirical Applications of Monetary Economics in the Era of Liberalization

lnBD/Y(t) = a + b1lnx(t-1)

Year 1990-91 1991-92 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09

Gross Fiscal Deficit (BD/Y)(t) 7.84 5.55 5.34 6.96 5.68 5.05 4.84 5.82 6.47 5.36 5.65 6.19 5.91 4.48 3.99 4.09 3.50 3.05 6.24

Gross Primary Deficit (x)(t-1) 3.67 4.06 1.49 1.21 2.72 1.34 0.86 0.53 1.53 2.03 0.74 0.93 1.47 1.11 -0.03 -0.04 0.39 -0.19 -0.60 2.56

Empirical Applications of Monetary Economics in the Era of Liberalization
SUMMARY OUTPUT Regression Statistics Multiple R 0.740492 R Square 0.548329 Adjusted R Square 0.520099 Standard Error 1.098459 Observations 18 ANOVA df Regression Residual Total 1 16 17 Coefficient s 5.567388 0.837615 SS 23.4372 19.30578 42.74298 Standard Error 0.5075 0.190053 MS 23.4372 1.206611 F 19.42398 Significanc eF 0.000441

Intercept 4.63

t Stat 10.97022 4.407265

P-value 7.46E-09 0.000441

Lower 95% 4.491536 0.43472

Upper 95% 6.643241 1.24051

Lower 95.0% 4.491536 0.43472

Upper 95.0% 6.643241 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

Empirical Applications of Monetary Economics in the Era of Liberalization

Regression Statistics Multiple R 0.55215 R Square 0.304869 Adjusted R Square 0.258527 Standard Error 2.294652 Observations 17 ANOVA df Regression Residual Total 1 15 16 Coefficient s 3.113283 1.385468 SS 34.6395 78.98139 113.6209 Standard Error 2.84882 0.540166 MS 34.6395 5.265426 F 6.57867 Significance F 0.021552

Intercept 7.84

t Stat 1.092832 2.564892

P-value 0.291709 0.021552

Lower 95% -2.95883 0.234131

Upper 95% 9.1854 2.536805

Lower 95.0% -2.95883 0.234131

Upper 95.0% 9.1854 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.

Empirical Applications of Monetary Economics in the Era of Liberalization 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.

Empirical Applications of Monetary Economics in the Era of Liberalization 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

Empirical Applications of Monetary Economics in the Era of Liberalization 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.

Empirical Applications of Monetary Economics in the Era of Liberalization 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

Empirical Applications of Monetary Economics in the Era of Liberalization 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.

Empirical Applications of Monetary Economics in the Era of Liberalization 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.

Empirical Applications of Monetary Economics in the Era of Liberalization

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.

Empirical Applications of Monetary Economics in the Era of Liberalization