CHAPTER IV

MONEY SUPPLY & INFLATION

4.1 Introduction

4.2 The relationship between money supply and price

level in theory

4.3 Money supply and price level in India

4.4 Phase I: 1935-1949

4.5 Money Supply and price level (1949 to 2009)

4.6 Phase II: 1949-1969

4.7 Phase III: 1969 – 1991

4.8 Phase IV: 1991 – 2009

4.9 Income velocity of money in India

4.10 Money Supply and alternative indicators of inflation

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CHAPTER IV
MONEY SUPPLY & INFLATION

4.1 Introduction
Milton Friedman, the father of monetarism and Nobel laureate in
Economics, said that inflation is always and everywhere a monetary
phenomenon and argued that the changes in overall price level are only
brought about by the changes in monetary stock or money supply.
Influence of changes in money supply over price level is an area of
controversy. Despite several years of research, which has gone in to
understanding the precise nature of relationship between money supply
and prices, there seems to be no final conclusion that can be relied
upon for policy formulation.
This chapter makes an attempt to study the inter-relationship
between the rate of inflation and rate of growth in money supply in
India with a very simplistic approach, which relies on the use of simple
statistical tools like growth rate, averages, correlations, etc., instead of
taking recourse to econometrics. Several studies carried out in the
Indian context make use of econometric models for understanding the
interrelationship between money, output and prices. In this study
however no attempt is made to perform econometric analysis of
inflation, rather the analysis is mostly descriptive.
First, a brief review of monetary version of quantity theory of
money is attempted, which is followed by the presentation and analysis
of Indian data pertaining to rate of growth in money supply and rate of
inflation as measured by the WPI.
 115

4.2 The relationship between money supply and price level in

theory:
The relationship between money supply and the general price
level, as implied in the refined quantity theory of money, which is
associated with Milton Friedman, is captured in the following equation.
MV = PY
Where,
M = Money supply/Quantity of money
V = Velocity of circulation of money
P = General price level
Y = Real national income
The above equation is called the ‘equation of exchange’ and is
simply an identity. What it reveals is that the total value of payments
(quantity of money times the velocity, MV) equals the money value of
national output (output times price, PY). Though it is an identity,
which may give birth to another identity, classical economists, by
introducing some assumptions converted the identity - a tautology, in
1
to a meaningful theory - the celebrated quantity theory of money,
which explains the impact of changes in money supply on the price
level.
In the above equation, if ‘V’ is assumed to remain constant, then
every change in M will produce a similar change in either price level or
real national income. If, however, the economy is operating at full
employment or close to full employment level of output, then changes
in Y are harder and therefore, every change in M will cause only the P
to change. On the other hand, if the economy operates at less than full
employment level of output, then a change in M will get reflected more
in Y than in P. Hence, the proponents of this version state that changes
 116

in money supply always produce changes in either P and/or Y.

According to them, money does matters and whenever there appears an
excessive increase in P (i.e. inflation), it is primarily because of the
excessive increase in the money supply.2
This version of the quantity theory of money also stipulated a
proportionality hypothesis, according to which if V and Y in the
equation remain constant, the general price level would vary
proportionately with the changes in money supply – a 10% rise in
quantity of money will bring about exactly 10% rise in the general
price level.3
The above analysis holds water only when it is proved that the
velocity of money is fairly constant. In other words, the relationship
between money supply, real income and general price level described
above will be observed only when the velocity of money remains stable.
Thus, what lies at the centre of this relationship is the velocity of
money, that is, the ratio of national income in money terms to the
quantity of money.4
What follows from the above argument is that growth in money
supply will bring about growth either in price level or real national
income, depending upon the state of the economy, only if the velocity
of money does not change to neutralize the growth in money supply.
The experience of the U.S. economy during the depression of 1930’s
showed that the narrow money stock in U.S. increased by about 35%
and the consumer prices instead of following suit, registered a decline
of as much as 20%. The missing link in this riddle was the velocity of
money.5
So the effect of a given change in quantity of money on price
level and real national income hinges on the behaviour of velocity of
 117

money. A given change in stock of money will have widely differing

effects on the price level and real national income in an economy,
depending upon the movement in the velocity of money.6
Stability of the velocity of money alternatively means stability of
the demand for money, as both are inversely related. If demand for
money goes up, that is, if people wish to hold more money in terms of
cash, they will spend less and consequently the turnover rate of money
(i.e. velocity of money) will go down.7 So if demand for money
changes, velocity of money will also change in the opposite direction
and if the former is stable the later will also be stable.
Several studies have been done to capture the behaviour of both
velocity of money and demand for money. It goes beyond the scope of
this study to review all those research studies conducted to estimate
demand for money or velocity of money. Two types of velocities are
distinguished, one, transaction velocity and two, income velocity. In
this study, income velocity has been estimated by using the
formulation Y/M, where Y refers to national income at current prices
for a period and M denotes average money stock in the economy
during the same period.
What follows this brief review of the monetarist’s version of the
quantity theory of money is an attempt to establish relation between
the growth in money supply, in terms of both narrow (M2) and broad
(M3) measure, and growth in price level (i.e. inflation rate). The
analysis, as earlier, has been in terms of the four phases defined by the
historical events.
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4.3 Money supply and price level in India:

It has been well documented in economic literature pertaining to
India that excessive growth in money supply has been one of the
important and prime reason behind the inflationary price spirals
experienced in the past. Along with the supply shocks, both due to a
setback in agricultural production and upsurge in international prices of
oil, monetary expansion was the major contributory factor to higher
inflation in India.8 The monetary expansion or increase in the money
stock, in turn, had been the direct consequence of borrowings of the
central govt. from the Reserve Bank or deficit financing by the govt.9
A strong and influential school of thinking has emerged, saying that
the factor chiefly, if not exclusively, responsible for the excessive
growth in money supply and, thus inflationary price spirals
experienced by India, has been the large scale resort to deficit
financing by the govt.10 It is on this background that a strong case was
made against the deficit financing which ultimately led to its
discontinuation in 1997.
Although the link between growth in money supply and price
level is well established our attempt in this study is to see whether the
link is positive and stable or not. The analysis is divided in to four
parts corresponding to four historical phases, as is done in the previous
chapters. Further the analysis done is primarily in terms of relationship
between growth in money supply and inflation rate based on WPI.

4.4 Phase I: 1935-1949

For understanding the relationship between the growth in money
supply and inflation rate during this period relevant data has been taken
 119

from the history of the Reserve Bank of India 1935-1951 (volume I),
for the sake of comparability.
As explained in chapter 1, most of the price rise of this phase
happened during the war and post war period. The Second World War
and the pattern of financing it were mainly responsible for the highest
ever price rise recorded during this period. Rupee expenditure incurred
by the Indian govt. for the British govt. against the receipt of sterling in
U.K. was the chief cause of hyper inflation type price rise during the
war and the period following it.11
The pre-war period (1935 to 1939), the period immediately
following the establishment of RBI witnessed very modest inflation,
except the calendar year 1939, which saw the price rise of the order of
44.21%, against the money supply growth of 21.05%. The year 1939
was the only year during 1935-1939 period, which saw, to a great
extent, unidirectional movement in money supply and price level. Year
1938 witnessed movement in the opposite direction in money supply
and price level. The data for this period is furnished in the following
table.
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Table No. 4.1

MONEY SUPPLY AND PRICE LEVEL (1935-1939)
April 5, As on the last Friday of the calendar year. Aug 25,
1935 1935 1936 1937 1938 1939 1939
i.e. Eve
of
World
War II
1 2 3 4 5 6 7
1.Money
supply 259.14 285.27 307.72 308.87 316.97 383.72 319.83
(excluding (July (22.45) (1.15) (8.1) (66.75)
rupee 26) (7.86) (0.37) (2.62) (21.05)
coins)*
(Rs.
Crores)
2.Index
number of
wholesale 88 93 94 102 95 137 100
prices- (April) (1) (8) (-7) (42) (Aug.)
Calcutta (1.07) (8.51) (-6.86) (44.21)
(July
1914=100)
December
index for
columns 2
to 6
* Data of rupee coins in circulation are not available for the period prior to
October 1943
Note: figures in the brackets indicate absolute and percentage variation
Source: Simha, S.L.N. (1970): History of Reserve Bank of India, 1935-1951
(Volume 1) RBI, Bombay p. 854.
The war period, in the beginning continued to experience high
growth in money supply, with the price index moving in tandem. The
year 1940-41, however, strangely witnessed high growth in money
supply co-existing with negative inflation. Towards the end of the war
(1944-45), rise in the price level slowed down following the slow down
in money supply growth, however, the deceleration in the former was
sharper than the latter.
121
 122

During this period, money supply registered a growth of 498%

(August, 1945 over August, 1939), while the growth in price level was
relatively modest at 143.9%. Though the movement in money supply
and price level was in the same direction for a large part of this period,
lack of data on national income growth prevents us from drawing any
firm conclusion about the relationship between money supply and price
level.
During the post war period, though the movement in money
supply and price level was unidirectional, it was not proportional.
During 1945 to 1948, price level registered highest growth against a
very modest growth in money supply. The growth in the index of
wholesale prices was of the order of 22.6% in mid-August 1947 over
August 31, 1945, while for the same period growth in money supply
was meager at 5.7%. Similar trend is observed for the period from Aug.
1947 to June 1948. In the subsequent period, increase in both money
supply and price level was modest.
123
 124

During this period movement in the opposite direction was seen

for August, 1949 over June, 1948. Negative growth (-14.7) in money
supply was accompanied by very modest but positive growth in price
level.
During the entire period of Phase-I, the movement in the money
supply and price level was mostly in the same direction. Four times,
the movement was in the opposite direction. However, the movement
in the price level in the opposite direction had not preceded by the
movement in money supply in the same direction during the previous
year /period. This means other factors were also at work. The
percentage change in money supply over the period of phase I comes
close to 660%, while that in price level works out to be nearly 400%.
In conclusion, both the money supply and price level, though
moved in the same direction for a large part of this period, there
existed no proportional relationship between the two. A firm
conclusion in this regard can not be drawn for the lack of national
income data.

4.5 Money Supply and price level (1949 to 2009)

For studying the relationship between money supply and price
level, two measures of money supply, namely, narrow money (M1) and
broad money (M3) are used. The former includes currency with the
public, demand deposits with banks and other deposits with the RBI,
while the latter is arrived at by adding time deposits to M1. The figures
of money supply used are averages for the financial year. Averages for
the financial year are taken to make comparison between them and
other macroeconomic aggregates possible. To obtain the growth in real
national income, GDP at market prices of 1999-2000 series have been
 125

used. First, the relationship of changes in money supply with the

inflation rate based on WPI is studied, while the relationship with other
measures of inflation based on CPI-IW and GDP deflator is examined
in the next part.
The following table furnishes data on changes in both the
measures of money supply, inflation rate based on WPI and growth
rate of real national income.
Table No. 4.4
CHANGES IN MONEY SUPPLY, PRICES AND NATIONAL
INCOME IN INDIA (in %) 1949 TO 2009
Year M1* M3* WPI GDPmp**
99-00 series
1949-50 2.4
1950-51 6.3
1951-52 6.2 2.9
1952-53 -6.5 -4.4 -12.5 2.6
1953-54 0.7 1.8 4.6 6.1
1954-55 4.8 5.2 -6.8 4.8
1955-56 10.8 11.4 -5.2 3.2
1956-57 8.4 9 14 5.6
1957-58 5 9.6 2.9 -0.4
1958-59 2.6 9.1 4.1 7.4
1959-60 6.6 12 3.8 2.6
1960-61 6.8 6.8 6.6 5.5
1961-62 4.6 2.6 0.2 3.7
1962-63 8.9 9.7 3.8 2.9
1963-64 12 9 6.2 6
1964-65 11.2 10 11 7.5
1965-66 9.6 10.2 7.6 -2.7
1966-67 9.5 11.3 13.9 0
1967-68 7.9 9 11.6 7.8
1968-69 8.4 10.7 -1.1 3.4

1969-70 10.9 13.4 3.7 6.5

1970-71 14.6 16.8 5.5 5.2
1971-72 12.1 14.4 5.6 1.6
1972-73 13.4 16.4 10 -0.5
1973-74 18.1 19.8 20.2 3.3
1974-75 11.7 13.6 25.2 1.2
 126

1975-76 8.5 12.5 -1.1 9.1

1976-77 15.3 19.9 2.1 1.7
1977-78 13.9 19.9 5.2 7.3
1978-79 -5.9 20.4 0 5.7
1979-80 19 20.2 17.1 -5.2
1980-81 13.1 16.4 18.2 6.7
1981-82 14.6 17.3 9.3 6
1982-83 11 14.6 4.9 3.5
1983-84 14.7 17.6 7.5 7.3
1984-85 18.3 18.3 6.5 3.8
1985-86 13.3 16.6 4.4 5.2
1986-87 14.7 17.6 5.8 4.8
1987-88 14.9 17.3 8.1 4
1988-89 14.9 17.3 7.5 9.6
1989-90 20 19 7.5 6
1990-91 17.5 16.7 10.3 5.5

1991-92 19.2 17.2 13.7 1.1

1992-93 15.5 17.7 10.1 5.5
1993-94 13.6 15.9 8.4 4.8
1994-95 24.1 19.8 12.6 6.7
1995-96 17.2 15.6 8 7.6
1996-97 11.8 16.2 4.6 7.6
1997-98 12 17 4.4 4.1
1998-99 12.5 19.8 5.9 6.2
1999-00 14.7 17.2 3.3 7.4
2000-01 11.2 15.9 7.2 4
2001-02 11.5 16 3.6 5.2
2002-03 12 16.1 3.4 3.8
2003-04 15.5 13 5.5 8.4
2004-05 16.7 14 6.5 8.3
2005-06 18.9 15.4 4.4 9.3
2006-07 20.3 20.5 5.4 9.7
2007-08 15.9 22.1 4.7 9.1
2008-09 14.5 20.4 8.3 6.1

Averages
1952-1969 6.5 7.8 3.8 3.9
1969-1991 13.6 17.1 8.3 4.5
1991-2009 15.4 17.2 6.7 6.4
1952-2009 12.1 14.4 6.5 4.9
 127

Standard Deviation
1952-2009 5.8 5.2 6.1 3

Correlation
M1&WPI M3&WPI M1&GDPmp M3&GDPmp
1952-2009 0.51 0.4 0.13 0.13
Partial Corelation
M1&WPI. M3&WPI. M1&GDPmp. M3&GDPmp.
GDP GDP WPI WPI
1952-2009 0.54 0.42 0.24 0.20

* 1) Data for 2006-07 onwards are provisional.

2) Data include the impact of merger in the banking system on May 3, 2002 and conversion
of a non-banking entity into a banking entity on October 11, 2004.
**1) 2006-07 data are Provisional.
2) 2007-08 data are based on Quick Estimates.
3) 2008-09 data are based on Revised Estimates.
Source : 1. Handbook of Monetary Statistics of Indian Economy, RBI
2. Office of the Economic Adviser, Ministry of Commerce and Industry,
Government of India.
3. Handbook of statistics on Indian Economy.

Graph No. 4.1

Phasewise Average Change in Money Supply, Price Level and
National Income

18

16

14

12
Change in %

10
M1
8 M3
6 WPI

4 GDPmp

1952-1969
1969-1991
1991-2009
1952-2009

Period/Phase

Source : Based on Table No. 4.4

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Using the data furnished in the above table, an attempt can be

made to find out whether the movements in money supply and prices
were in the same direction and if so whether the changes were of the
same magnitude to draw a conclusion that changes in money supply
have had discernible impact on the prices.

4.6 Phase II: 1949-1969

For this phase, comparison of data is done over a period from
1952-53 to 1968-69, as the data on money supply are not available for
the first three years of this phase.
It can be seen from the table that both measures of money supply
registered a fall during only one year (i.e. 1952-53), while the WPI
inflation entered the negative territory four times12 during this phase.
Thus, a fall in inflation rate neither coincided nor was preceded by a
fall in money supply. The exception is that of year 1952-53, when a
fall of 6.4% in M1 and 4.4% in M3 co-existed with a large decrease of
12.5% in WPI inflation. Moreover, the real income registered a
positive growth of 2.6% in the same year. The year 1955-56 recorded a
two digit growth in both M1 and M3 (i.e. 10.8% and 11.4%
respectively). The WPI inflation however moved in the opposite
direction with 5.2% fall in it. There were two more years when the
movement in the money supply and price level was not in the same
direction.
There are very few years when not only the movement in money
supply and price level was in the same direction but the combined
change in price level and real national income also matched the
changes in money supply (M1) implying the spread of the effect of
change in money supply over prices and real national income. 1959-60,
1961-62 and 1963-64 are those years when the change in M1 appears to
 129

have reflected and got divided into change in inflation and growth in
real national income. For all other years, the combined change in price
level and real national income was either greater or lower than the
proportionate change in money supply.
It thus surfaces that no clear pattern existed between the rate of
change in money supply and the rate of change in price level13 and real
national income.
However, if the whole period (1952-1969) is considered, then it
becomes clear that there existed positive relationship between money
supply and price level. Further the combined change in price level and
real national income was also very close to the change in money supply,
which means change in money supply got divided into the change in
price level and real national income. Average growth in money supply
(M3) during this period works out to be 7.8%, while the combined
average growth in price level and real national income comes to 7.7,
very close to the former.
Based on the analysis of data for this phase, a conclusion that
can be drawn is, though the relationship between money supply, price
level and real national is unclear during a short period (i.e. one or two
years) the long term relationship is clear and similar to what quantity
theory of money has predicted.

4.7 Phase III: 1969 – 1991

This phase was very turbulent and severe in terms of the
inflation, as not only did the inflation rate fluctuate too much, it also
registered a big jump to 8.3% in annual average terms from 3.8%
during the second phase.
Only one year (1975-76) during this phase saw the inflation
entering into the negative zone, against the positive and large growth in
 130

both the measures of money supply. However, this was the year when
real GDP registered a growth of 9.1%. Negative inflation was probably
the result of sobering effect of robust growth in real national income.
The year 1978-79 witnessed an inflation rate of 0%, against the
negative growth in M1 (-5.9%) and positive and considerable growth in
M3 (20.4%). This year also witnessed a real GDP growth of close to
7%. From the examples of these two years, there appear to be close
relationship between M1 measure of money supply and price level and
real national income. There are other years also which support this
argument.
Further, during two years of this phase, viz. 1972-73 and 1979-
80, the WPI inflation appears to have borne the whole effect of
increase in money supply. Twice in this phase (1973-75 and 1979-81),
the WPI inflation was close to 20% and it coincided with a high and
same magnitude of growth in money supply. It is true, that these two
periods experienced two big oil price hikes, but they also saw
substantial increase in money supply.
For most of the years of this phase, the growth in money supply
was very large, while that in the price level was half or one third of it.
It is during this phase that deficit financing by the govt. broke all the
records during the post-independence period, leading to substantial
growth in money supply and thus in price level. Over the 22 years of
this phase, the growth in M1 and M3 averaged 13.6% and 17.1%
respectively, against the 6.5% and 7.8% growth during the previous
phase. The average growth in WPI inflation and real GDP turns out to
be 8.3% and 4.5 respectively, higher than what was recorded for the
previous phase.
 131

The combined average growth in WPI inflation and real GDP

comes to 12.8%, which is very close to 13.6% growth observed in case
of M1 measure of money supply. The average growth in M3 however
stayed much higher than the combined average growth in WPI inflation
and real GDP. In conclusion, this phase bears close association
between M1 measure of money supply and WPI inflation and real GDP
growth. The impact of growth in M1 appears to have got dispersed over
WPI inflation and growth in real GDP.

4.8 Phase IV: 1991 – 2009

No year of this phase witnessed negative growth either in money
supply or in WPI inflation or real GDP. Though the magnitude of
change differed, movement in the opposite direction between money
supply and price level was not witnessed for any year during the entire
phase.
For all the years the growth in money supply (both M1 and M3)
was above 10%, at some years it was close or above 20%. Though the
growth in money supply remained on higher side for all the years, it
was only for three years viz. 1991-92, 1992-93 and 1994-95 that WPI
inflation stayed above 10%. A careful observation of the data through
all the years reveals that the substantial growth in money supply
experienced during this phase had a limited impact, less than half for
some years, on price level and the main reason for this was the
improvement in real GDP growth, particularly during 1994-97 and
2003-2008.
There have been some years during this phase, when the
combined change in price level and real GDP has not matched the
change in money supply. For example, during 1991-92, the combined
 132

increase in WPI inflation and real GDP was 14.8% against an increase
of 19.2% in M1 and 17.2% in M3. For some years the combined change
in price level and real GDP was equal or very much close to the change
in money supply, for example, 1992-93, 1993-94, 1995-96, 2003-04
and 2004-05.
During this phase, the money supply growth carried forward the
momentum of the previous phase, with both M1 and M3 recording an
annual average growth of 15.4% and 17.2% respectively, against the
13.6% and 17.1% growth recorded for the previous phase. Though the
money supply growth momentum continued, the growth in price level
slowed down to 6.7% in annual average terms against 8.3% registered
during the previous phase. It was the improvement in real GDP growth
that dampened the impact of higher growth in money supply on price
level. The GDP growth improved, by nearly 2% in annual average
terms, from 4.5% during the previous phase to 6.4% in this phase.
The whole period of this phase of 22 years registered a combined
average growth in inflation and real GDP of the order of 13.1% against
the growth of 15.4% in M1 measure of money supply and 17.2% in M3
measure of money supply. The impact of growth in money supply
appears to have got spread over price level and real GDP, but not to the
fullest extent.
The argument that growth in money supply gets distributed in
growth in price level and growth in real national income is found true
particularly in case of M1. For M3 there appears to be some difference
between the growth in it and combined growth in price level and real
GDP. This implies that growth in M1, rather than in M3, has a strong
positive association with inflation in India.
 133

If the period of 57 years, encompassing all the three phases from

second phase onwards, is considered; then average annual growth in
M1 and M3 works out to be 12.1% and 14.4% respectively against a
combined annual average growth of 11.4% in WPI inflation and real
GDP. This shows that over a long period, there exists close to
proportional relationship between growth in money supply and growth
in nominal GDP. This is particularly true with M1, as the growth in it is
slightly higher than the growth in nominal GDP (growth in price level
plus growth in real GDP).
Looking at the standard deviation values for M1, M3 and WPI
inflation, it can be said that the variation in them have been of the same
magnitude.
As far as the correlation is concerned WPI inflation appears to be
closely related with M1 than with M3. A comparison of correlation
between money supply and inflation and between money supply and
real GDP reveals that inflation is highly responsive to change in money
supply than real GDP. This implies the price level carries more impact
of change in money supply than the real GDP.
If the depressing impact of GDP is wiped out (i.e. GDP is held
constant) by measuring partial correlation co-efficient between M1 and
WPI and M3 and WPI, the correlation quotient increases to 0.54 and
0.42 respectively.
In conclusion, it can be said that changes in money supply bring
about changes in price level as also in real national income. As made
out by the quantity theory of money, whether the impact of change in
money supply will be carried by price level or by real national income
depends upon the state of the economy. India being a poor performer in
terms of real GDP growth, most of the impact of rise in money supply
has got reflected in rise in price level. This is shown in the following
table
 134

Table No. 4.5

GROWTH IN PRICE LEVEL & REAL NATIONAL INCOME
AS % OF GROWTH IN MONEY SUPPLY

GDPmp**
WPI/ WPI/ GDPmp/ GDPmp/
Period M1* M3* WPI 99-00
M1 M3 M1 M3
series
1 2 3 4 5 6 7 8 9
Averages
1952-1969 6.5 7.8 3.8 3.9 58.5 48.7 60 50
1969-1991 13.6 17.1 8.3 4.5 61 48.5 33.1 26.3
1991-2009 15.4 17.2 6.7 6.4 43.5 39 41.6 37.2
1952-2009 12.1 14.4 6.5 4.9 53.7 45.1 40.5 34
Source: based on table no 4.4

It can be seen from the above table that the WPI inflation carried
more than 50% of the growth in money supply (M1), whereas the real
national income carried around 40%.
It has been argued in case of India that overall inflation has been
driven to a large extent by the food inflation, which in turn has been
the result of supply shock like shortage of food resulting from droughts,
floods, low agricultural productivity, heavy population pressure etc. On
the contrary, it has also been argued that no process of inflation can go
beyond a certain point unless there is a validating increase in demand
supported by growth in money supply.14 Nowhere in the world,
continuous and substantial inflation has been observed without an
accompanying increase in the stock of money.15
The analysis of relationship between money supply and price
level pertaining to India presented above supports the monetarist’s
argument. For a large part of the study period money supply growth
appears to be closely associated with growth in price level. The
association however has not been proportional. Though money supply
and price level have moved in the same direction, growth in money
 135

supply has almost all the time exceeded the growth in price level. The
gap between the two has been explained by the growth in real national
income. It can also be said that sometimes the impact of the growth in
money supply on price level is quick, while at other times it gets
delayed. For instance, if monetary growth is preceded by a period of
price stability, impact gets delayed, whereas if there is monetary
expansion following a period of price rise, then the impact is very
quick resulting in rapid rise in prices owing to the expectations of the
people.16
Some discrepancy has been observed with regard to the growth
in M3 measure of money supply and the combined growth in WPI
inflation and real GDP. This requires us to bring velocity of money in
to the picture. The decline in income velocity of money for M3 appears
to be the reason behind higher growth in M3 than the combined growth
in WPI inflation and real GDP. During the latter part of the study
period (i.e. fourth phase), lower inflation co-existed with substantial
growth in money supply. One reason, as is apparent from the data
given in the table, was the improvement in real GDP growth. The other
factor contributing to containment of inflation has been the decline in
velocity of broad money that appears to have restrained the aggregate
demand pressure leading to subdued inflation rate.17

4.9 Income velocity of money in India:

As stated in the previous part, velocity of money assumes the
central place in the theory that seeks to explain relationship between
money supply, price level and income. The impact of change in money
supply on price level and real income may get diluted or magnified, if
the velocity of money exhibits instability.
 136

As seen earlier, the full impact of growth in money supply,

particularly in the broad measure (M3), has not passed forward to the
price level and real national income. This is largely true for the latter
phases of this study. The reason for this has been the decline in the
income velocity of money for the broad measure of money supply.
The data on GDP at current market prices (1999-00 series),
narrow money (M1), broad money (M3) along with the respective
income velocity is presented in the following table. Percentage
variations for both the income velocities have also been worked out.
Table No. 4.6
INCOME VELOCITY OF MONEY IN INDIA
Income Income
GDP at Narrow Broad
Velocity Variation Velocity Variation
Year Market Money Money
for M1. (in %) for M3. (in %)
Prices** (M1)* (M3)*
2/3 2/4
1 2 3 4 5 6 7 8
1950-51 10085 . .
1951-52 10721 1874 2196 5.7 4.9
1952-53 10522 1752 2099 6 5.3 5 2
1953-54 11452 1765 2137 6.5 8.3 5.4 8
1954-55 10834 1850 2249 5.9 -9.2 4.8 -11.1
1955-56 11030 2049 2505 5.4 -8.5 4.4 -8.3
1956-57 13140 2222 2730 5.9 9.3 4.8 9.1
1957-58 13536 2334 2991 5.8 -1.7 4.5 -6.3
1958-59 15086 2394 3264 6.3 8.6 4.6 2.2
1959-60 15895 2551 3655 6.2 -1.6 4.3 -6.5
1960-61 17407 2725 3902 6.4 3.2 4.5 4.7
1961-62 18445 2849 4004 6.5 1.6 4.6 2.2
1962-63 19826 3102 4393 6.4 -1.5 4.5 -2.2
1963-64 22774 3475 4788 6.6 3.1 4.8 6.7
1964-65 26563 3865 5269 6.9 4.5 5 4.2
1965-66 28016 4237 5807 6.6 -4.3 4.8 -4
1966-67 31711 4641 6462 6.8 3 4.9 2.1
1967-68 37133 5009 7042 7.4 8.8 5.3 8.2
1968-69 39324 5428 7793 7.2 -2.7 5 -5.7
1969-70 43298 6021 8838 7.2 0 4.9 -2
1970-71 46249 6903 10326 6.7 -6.9 4.5 -8.2
1971-72 49523 7740 11814 6.4 -4.5 4.2 -6.7
 137

1972-73 54591 8778 13746 6.2 -3.1 4 -4.8

1973-74 66428 10363 16474 6.4 3.2 4 0
1974-75 78426 11578 18717 6.8 6.2 4.2 5
1975-76 84221 12562 21052 6.7 -1.5 4 -4.8
1976-77 90751 14485 25237 6.3 -6 3.6 -10
1977-78 102796 16496 30263 6.2 -1.6 3.4 -5.6
1978-79 111371 15529 36434 7.2 16.1 3.1 -8.8
1979-80 122155 18479 43792 6.6 -8.3 2.8 -9.7
1980-81 145370 20891 50966 7 6.1 2.9 3.6
1981-82 170805 23936 59793 7.1 1.4 2.9 0
1982-83 191059 26563 68515 7.2 1.4 2.8 -3.4
1983-84 222485 30476 80577 7.3 1.4 2.8 0
1984-85 249268 36056 95295 6.9 -5.5 2.6 -7.1
1985-86 281330 40847 111096 6.9 0 2.5 -3.8
1986-87 314816 46836 130653 6.7 -2.9 2.4 -4
1987-88 357861 53814 153207 6.6 -1.5 2.3 -4.2
1988-89 424531 61838 179687 6.9 4.5 2.4 4.3
1989-90 487684 74225 213856 6.6 -4.3 2.3 -4.2
1990-91 569624 87217 249493 6.5 -1.5 2.3 0
1991-92 654729 103970 292403 6.3 -3.1 2.2 -4.3
1992-93 752591 120050 344238 6.3 0 2.2 0
1993-94 865805 136353 399048 6.3 0 2.2 0
1994-95 1015764 169200 478196 6 -4.8 2.1 -4.5
1995-96 1191813 198283 552953 6 0 2.2 4.8
1996-97 1378617 221764 642631 6.2 3.3 2.1 -4.5
1997-98 1527158 248465 752028 6.1 -1.6 2 -4.8
1998-99 1751199 279638 901294 6.3 3.3 1.9 -5
1999-00 1952036 320630 1056025 6.1 -3.2 1.8 -5.3
2000-01 2102314 356592 1224092 5.9 -3.3 1.7 -5.6
2001-02 2278952 397701 1420025 5.7 -3.4 1.6 -5.9
2002-03 2454561 445535 1647976 5.5 -3.5 1.5 -6.3
2003-04 2754620 514660 1861604 5.4 -1.8 1.5 0
2004-05 3149407 600369 2121485 5.2 -3.7 1.5 0
2005-06 3586743 714060 2448791 5 -3.8 1.5 0
2006-07 4129173 858788 2950300 4.8 -4 1.4 -6.7
2007-08 4723400 995063 3603479 4.7 -2.1 1.3 -7.1
2008-09 5321753 1139051 4339363 4.7 0 1.2 -7.7
Average 6.3 -0.22 3.3 -2.32
* 1) Data for 2006-07 onwards are provisional.
2) Data include the impact of merger in the banking system on May 3, 2002 and conversion of a non-
banking entity into a banking entity on October 11, 2004.
**1) 2006-07 data are Provisional.
2) 2007-08 data are based on Quick Estimates.
3) 2008-09 data are based on Revised Estimates.
Source : 1. Handbook of Monetary Statistics of Indian Economy, RBI
2. Handbook of Statistics on Indian Economy, RBI
 Income velocity for M3 Income velocity for M1

0
1
2
3
4
5
6
0
1
2
3
4
5
6
7
8
1950-51 1950-51
1952-53 1952-53
1954-55 1954-55
1956-57 1956-57
1958-59 1958-59
1960-61 1960-61
1962-63 1962-63
1964-65 1964-65
1966-67 1966-67
1968-69 1968-69

Source: Based on Table No. 4.6

Source: Based on Table No. 4.6
1970-71 1970-71
1972-73 1972-73
1974-75 1974-75
1976-77 1976-77
1978-79 Year 1978-79

Year
1980-81 1980-81
1982-83 1982-83
1984-85

Graph No. 4.3

Graph No. 4.2

1984-85
1986-87 1986-87
1988-89 1988-89

Income Velocity for M3

Income Velocity for M1

1990-91 1990-91
1992-93 1992-93
1994-95 1994-95
1996-97 1996-97
1998-99 1998-99
2000-01 2000-01
2002-03 2002-03
2004-05 2004-05
2006-07 2006-07
2008-09
Income Velocity for M1.

2008-09

measure (M1) of money supply has been more or less stable during the
study period, with the average working out to 6.3. The variation in
It can be seen from the table that, income velocity for the narrow
138
 139

income velocity for M1 given in column 6 indicates that over the entire
period from 1952-53 to 2008-09, it has registered a very modest
decline of 0.22%. Given this fall in income velocity for M1, if the
growth in M1 is adjusted for this fall, the gap between growth in M1
and combined growth in WPI inflation and real GDP get narrowed
down from 0.7 to 0.48. Narrowing down of this gap implies close to
proportional relationship between M1 growth and combined growth in
WPI inflation and real GDP.
This is also true in case of the broad measure of money supply
M3. The income velocity of money for M3 has registered a steady
decline over the study period from 4.9 in 1951-52 to 1.2 in 2008-09. In
percentage terms, this decline comes to 2.32% over the entire period,
giving us an adjusted M3 growth of 12.08%. This adjusted growth in
M3 comes very close to combined average growth in WPI inflation and
real GDP, with the residual gap of just 0.68.
This implies that WPI inflation and real GDP taken together
have moved in tandem with both the measures of money supply.
Money supply thus appears to have had cent percent impact on price
level and real national income, with the impact getting divided between
the two, depending upon the state of the economy and the movement in
income velocity.
An important contributory factor can be recognized for the
decline in income velocity of money (M3) in India.18 It is the increase
in the degree of monetistaion entailing progressive widening of the use
of money in the economy, which exerts negative influence on the
velocity of money. This is particularly true in the post-bank
nationalization period which saw rapid growth in branch expansion and
deposit mobilization.
 140

4.10 Money Supply and alternative indicators of inflation:

Having discussed the relationship between changes in money
supply, WPI inflation and growth in real GDP and established that
most of the increase in price level and real GDP can be explained by
the growth in money supply, we now turn to review briefly the
relationship of money supply with alternative indicator of inflation, viz.
inflation based on CPI-IW and GDP deflator.

Table No. 4.7

CHANGES IN MONEY SUPPLY, PRICES AND NATIONAL
INCOME IN INDIA (in %) 1949-2009
Year M1* M3* CPI-IW GDP d GDPmp**
99-00 series
1949-50
1950-51
1951-52 4 3.3 2.9
1952-53 -6.5 -4.4 -0.9 -4.4 2.6
1953-54 0.7 1.8 2 2.5 6.1
1954-55 4.8 5.2 -6.6 -9.7 4.8
1955-56 10.8 11.4 -3 -1.4 3.2
1956-57 8.4 9 11.3 12.8 5.6
1957-58 5 9.6 4.9 3.5 -0.4
1958-59 2.6 9.1 5.2 3.8 7.4
1959-60 6.6 12 4.2 2.7 2.6
1960-61 6.8 6.8 0.9 3.8 5.5
1961-62 4.6 2.6 2.4 2.2 3.7
1962-63 8.9 9.7 3.2 4.4 2.9
1963-64 12 9 4.5 8.4 6
1964-65 11.2 10 15.2 8.5 7.5
1965-66 9.6 10.2 7.2 8.3 -2.7
1966-67 9.5 11.3 13 13.2 0
1967-68 7.9 9 11.6 8.6 7.8
1968-69 8.4 10.7 -0.5 2.4 3.4

1969-70 10.9 13.4 1.4 3.3 6.5

1970-71 14.6 16.8 5.1 1.6 5.2
1971-72 12.1 14.4 3.2 5.4 1.6
 141

1972-73 13.4 16.4 7.8 10.8 -0.5

1973-74 18.1 19.8 20.8 17.8 3.3
1974-75 11.7 13.6 26.8 16.7 1.2
1975-76 8.5 12.5 -1.3 -1.6 9.1
1976-77 15.3 19.9 -3.8 6 1.7
1977-78 13.9 19.9 7.6 5.6 7.3
1978-79 -5.9 20.4 2.2 2.5 5.7
1979-80 19 20.2 8.8 15.7 -5.2
1980-81 13.1 16.4 11.4 11.5 6.7
1981-82 14.6 17.3 12.5 10.8 6
1982-83 11 14.6 7.8 8.1 3.5
1983-84 14.7 17.6 12.6 8.5 7.3
1984-85 18.3 18.3 6.3 7.9 3.8
1985-86 13.3 16.6 6.8 7.2 5.2
1986-87 14.7 17.6 8.7 6.8 4.8
1987-88 14.9 17.3 8.8 9.3 4
1988-89 14.9 17.3 9.4 8.2 9.6
1989-90 20 19 6.1 8.4 6
1990-91 17.5 16.7 11.6 10.7 5.5

1991-92 19.2 17.2 13.5 13.7 1.1

1992-93 15.5 17.7 9.6 9 5.5
1993-94 13.6 15.9 7.5 9.8 4.8
1994-95 24.1 19.8 10.1 10 6.7
1995-96 17.2 15.6 10.2 9.1 7.6
1996-97 11.8 16.2 9.4 7.5 7.6
1997-98 12 17 6.8 6.5 4.1
1998-99 12.5 19.8 13.1 8 6.2
1999-00 14.7 17.2 3.4 3.8 7.4
2000-01 11.2 15.9 3.8 3.5 4
2001-02 11.5 16 4.3 3 5.2
2002-03 12 16.1 4.0 3.8 3.8
2003-04 15.5 13 3.9 3.6 8.4
2004-05 16.7 14 3.8 5.6 8.3
2005-06 18.9 15.4 4.4 4.2 9.3
2006-07 20.3 20.5 6.7 5 9.7
2007-08 15.9 22.1 6.2 4.9 9.1
2008-09 14.5 20.4 9.1 6.2 6.1

Averages
1952-1969 6.5 7.8 4.4 4.1 3.9
1969-1991 13.6 17.1 8.2 8.2 4.5
1991-2009 15.4 17.2 7.2 6.5 6.4
1952-2009 12.1 14.4 6.8 6.5 4.9
 142

Standard Deviation
1952-2009 5.8 5.2 5.7 4.9 3

Correlation
M1&CPI M3&CPI M1&GDPd M3&GDPd

1952-2009 0.38 0.35 0.53 0.46

* 1) Data for 2006-07 onwards are provisional.

2) Data include the impact of merger in the banking system on May 3, 2002 and conversion
of a non-banking entity into a banking entity on October 11, 2004.
**1) 2006-07 data are Provisional.
2) 2007-08 data are based on Quick Estimates.
3) 2008-09 data are based on Revised Estimates.
Source : 1. Same as Table No. 4.6
2.Office of the Economic Adviser, Ministry of Commerce and Industry, Government of India.
3. Mithani,D.M. (1993) Dynamics of Monetary-Fiscal Policy: An Indian Perspective,
Himalaya Publishing House, Bombay, p. 90.

Over the entire period of second, third and fourth phase (1952-
2009), the average annual combined growth in CPI-IW inflation and
real GDP comes to 11.7%, while that in GDP deflator inflation and real
GDP works out to be 11.4%. These figures are very close to the
combined average growth in WPI inflation and real GDP, which, as
seen earlier, is 11.4%. Thus, most of the growth in CPI-IW inflation
and GDP deflator inflation together with the growth in real GDP can be
associated with the growth in money supply.
In conclusion, in case of India it appears that growth in money
supply explains the most part of the growth in price level and real GDP.
Over a long period there appears to be proportional relationship
between the growth in money supply and combined growth in price
level and real GDP. It is however, the price level that has absorbed the
large part of the growth in money supply as growth in real GDP had
been unimpressive, particularly during the first four decades of
economic planning. To quote C. Rangarajan, the former governor of
RBI, “Money has an impact on both output and price. The process of
 143

money creation is a process of credit creation. Money comes in to

existence because credit is given either to the government or the
private sector or the foreign sector, since credit facilitates the
production process, it has favourable impact on output. But at the same
time, the increased money supply raises the demand with an upward
pressure on prices.”19 He further stated that the effect of growth in
money supply is more on price level than on output.
It thus gets established that over a long period of time, money
supply and price level are positively co-related. In the short run,
however, this relationship breaks down perhaps on account of the
transmission lags of changes in money supply, which can be both long
and variable. In the Indian context, the preliminary evidence indicates
that the full impact of a change in money supply on inflation rate can
take a long time, sometimes more than two years, to materialize.20 The
working group on Money Supply (1998) set up the RBI, which studied
this subject, found that over a long period the inflation in India is
explained reasonably well by the growth in money supply.21 Besides
the working group, several other studies have concluded that the price
effect of money supply in the short run may deviate from the long run
impact, on account of the supply shocks.22
 144

References:
1. Jadhav, Narendra (1994): “Monetary Economics for India”,
MacMillan India Ltd., Delhi, p. 14.

2. Kulkarni, Kishor G. (1999): “Modern Monetary Theory”,

Macmillan India Ltd., Delhi, p. 108.

3. Jadhav, Narendra, Op. cit., p. 14

4. Ibid, p. 86

5. Ibid, p. 86

6. Rao B.S.R. (1974): “Money and Prices in India” in ‘Inflation in

India’ edited by Simha, S.L.N., Vora and Co. Publishers Pvt.
Ltd., Mumbai, p. 143.

7. Kulkarni, Kishor G., Op. cit., p. 108.

8. Pattnaik, R.K. and Samantaraya Amaresh (January 28, 2006):

“Indian Experience of Inflation – A Review of the Evolving
Process”, Economic and Political Weekly, Vol. 41, No. 04, p.
356.

9. Bhinda, P.C. and Choudhary C.M. (February 16-29, 1984):

“Inflation – Causes and Consequences”, Yojana, Vol. 28, No. 3,
p. 18.

10. Chakravarty, Sukhamoy, (January, 2007): “Our Fight Against

Inflation’, Yojana, Vol. 51, p. 47.

11. Vakil, C.N. (1978): “War Against Inflation – The Story of the
Falling Rupee: 1943-77”, The Macmillan Company of India Ltd.,
Mumbai, p. 307.

12. Rao, B.S.R., Op. cit., p. 138.

13. Ibid, p. 139.

14. Gupta, Suraj B., Op. cit., p. 171.

 145

15. Ibid, p. 171.

16. Simha, S.L.N. (1974): “Inflation – An Overall View”, in

‘Inflation in India’, edited by Simha, S.L.N., Vora and Co.
Publishers Pvt. Ltd., Bombay, p. 43.

17. Jadhav, Narendra, Op. cit., p. 123.

18. Ibid, p. 99.

19. Rangrajan, C. (1998): “Issues in Monetary Management” in

‘Indian Economy – Essays on Money and Finance’, UBS
Publishers Distributors Ltd., New Delhi, pp. 8-9.

20. Reddy, Y.V. (1999): “Inflation in India: Status and Issues”, in

Reddy Y.V. (2000): ‘Monetary and Financial Sector Reforms in
India : A Central Bankers’ perspective’, UBS Publishers
Distributors Ltd., New Delhi, p. 57.

21. Ibid, p. 57.

22. Ibid, p. 57.