Contents

List of Figures .......................................................................................................................................... 1 List of Tables ............................................................................................................................................ 1 Executive Summary ................................................................................................................................. 2 Introduction: ........................................................................................................................................... 3 Objectives of the Study ............................................................................................................................ 3 Money Supply in India ............................................................................................................................. 3 Measures of Money Stock. ................................................................................................................... 3 RBI s channels for monetary policy ...................................................................................................... 3 RBI s instruments of controlling money supply..................................................................................... 4 Inflation ................................................................................................................................................... 5 Measuring Inflation.............................................................................................................................. 5 Trends of Inflation ............................................................................................................................... 6 Quantity theory of money: ...................................................................................................................... 7 History of the Quantity Theory of Money: ............................................................................................ 7 Opposing Theories: .............................................................................................................................. 7 What is the Velocity of Money: ............................................................................................................ 8 Findings ................................................................................................................................................... 9 Correlation between WPI and Money Supply ..................................................................................... 10 Regression Analysis............................................................................................................................ 11 Impact of FII and FDI Inflows on Money supply and inflation.................................................................. 12 Sterilization:....................................................................................................................................... 13 Conclusion: ............................................................................................................................................ 15

List of Figures
Figure 1: Inflation Trends in India............................................................................................................. 6 Figure 2: Velocity of Money ..................................................................................................................... 9 Figure 3: Price Level Vs. Money Supply .................................................................................................. 10 Figure 4: WPI vs. FII & FDI ...................................................................................................................... 13

List of Tables
Table 1: WPI Weights............................................................................................................................... 5 Table 2: Velocity of Money ...................................................................................................................... 8 Table 3: WPI and Money Supply............................................................................................................... 9 Table 4: Correlation Between WPI and Money Supply............................................................................ 10

the Wholesale Price Index (WPI) & the Consumer Price Index (CPI). and that changing price levels can be directly attributed to the supply of money in the country. and is measured by the three parameters: Reserve Money (M0). India uses the growth rate of WPI to compute its inflation levels. CPI gives an indication of the prices prevailing at the retail level. Supply of money in the country is controlled by the Reserve Bank of India. While WPI measures prices at the wholesale level. In other words. provided velocity & quantity of real output are held constant. . RBI uses various instruments like Liquidity Adjustment Facility. The Quantity Theory of Money says that general price-level in an economy is directly proportional to the amount of money circulating in it.Executive Summary The report aims to study the effect of money supply in India with the price levels. it helped us conclude that quantity theory of money holds true in case of India. Quantitative Easing and Open Market Operations to regulate the amount of money circulating in the Indian economy. The report aims to study effect that changing money supply has had on the price levels in the Indian economy. M1 and M3) and how their changing levels are mathematically co-related with the WPI Index numbers. It includes a thorough study of the three measures of money supply (M0. It also found that velocity has been more or less constant over the same time period. It also studies the velocity of money over the last 20 years. Thus. Narrow Money (M1) & Broad Money (M3). Price levels in the Indian economy are measured with the help of two indices. a central bank s action to increase or decrease money supply in the country has direct implication of affecting the prevailing price levels. The report found a positive correlation of money supply in India with WPI Index numbers over the last 20 years. and checks if it remains constant or not.

These transactions result in increasing or decreasing the base currency M0. RBI s channels for monetary policy y y y y Quantum Channel Interest Rate Channel Exchange Rate Channel Asset Prices .Introduction: This report investigates the money-supply/price level relationship in India. The debate on the role of moneysupply in the determination of nominal income and price has remained one of the important issues in the history of economic thought. Broad money) to study the correlation between them and their impact on the price levels. Narrow money. foreign currencies. The main measures of money are as follows: Reserve money (M0) = Currency in circulation + Other Deposits with RBI + Bankers Deposits with RBI Narrow Money (M1)= {Currency in circulation Deposits Cash with banks } + Other Deposits with RBI + Demand Broad Money (M3) = Narrow Money + Time Deposits The amount of Broad money in the system depends to a significant extent on the amount of reserve Money (M0). the Monetarists firmly believe that changes in money stocks change nominal income as well as prices while the Keynesians think that moneysupply does not play any important role in the determination of nominal income and prices. Objectives of the Study In this project report we will attempt to study the dynamics of money supply in India and its effects on prices. We will attempt to analyze the relationship if any theoretically as well as using data from the real world. The Monetarists and the Keynesians have diametrically opposite views on this important issue. commodities. To study the effect of money supply on prices we will first concentrate on money supply What constitutes money supply? How it is used by the Central Bank in its monetary policies? etc. In this project an attempt has been made to study the direction of causality between money supply and prices. The RBI attempts to control the total amount of money circulating in the system in this fashion. The relationship is given by the Money Multiplier = M3 / M0 The RBI attempts to control the quantity of money in circulation by purchase and sale of different credit instruments. We have taken the data on Wholesale price inflation index and Measures of money (Reserve money. Money Supply in India Measures of Money Stock. Then we will analyze the various price levels and measures of inflation in India. We will then try to see if there is any co-relation between changes in money supply and the price levels in the country. Controlling M0 indirectly impacts the amount of broad money in the economy (M3). etc.

Various banks will use eligible securities as collateral through a repo agreement and will use the funds to alleviate their short-term requirements. 2000 in phases.000.000. Another instrument used by RBI which indirectly affects money supply is the Liquidity Adjustment Facility (LAF): It is a tool used in monetary policy that allows banks to borrow money through repurchase agreements. it soaks up the liquidity from the system. the lower the amount of money that can be released into the market. y Discount Rate: The discount rate is the interest rate charged by the central bank to banks which borrow money from its reserves. to ensure smooth transition. Hungary in mid 1940s.Repos and Reverse Repos in transferable Central Govt.000. On the other hand. This arrangement allows banks to respond to liquidity pressures and is used by governments to assure basic stability in the financial markets.000. LAF was introduced by RBI during June. keeping pace with technological up gradation. Open . Germany in 1920s.000.000. both are markedly different mechanisms.All commercial banks (except RRBs) and PDs having current account and SGL account with RBI are eligible to use the LAF to mitigate the matches in their day to day liquidity. The higher the CRR and SLR. the RBI can influence the amount of money that flows into the economy. Yugoslavia in late 1980s and Zimbabwe are examples governments taking note printing to the extremes.Hungary even printed money notes of 100 quintillion peng (100. E. or 1020). While both Liquidity Adjustment Facility and Open Market Operations are ways to induce liquidity into the monetary system. This process is known as quantitative easing. The use of quantitative easing can lead to high inflation and in many countries even hyper-inflation. LAF involves lending and borrowing of securities to the banks. thus remaining stable.Liquidity adjustment facilities are used to aid banks in resolving any short-term cash shortages during periods of economic instability or from any other form of stress caused by forces beyond their control.g. dated securities and treasury bills are the eligible securities that can be used for LAF.RBI s instruments of controlling money supply The RBI controls the quantum of money with the following instruments at its disposal: y Printing new currency The government and in turn the central bank has at its disposal the power to print more money. so that their day-to-day liquidity problem is resolved. y Controlling Credit Reserve Ratio (CRR) & Statutory Liquidity Ratio (SLR): By controlling the above ratios. This in turn reduces y Open Market Operations: The Central bank increases or decreases money supply by buying or selling Government bonds in the open market. When the Central Bank buys bonds from the market it is actually passing on huge sums of money into the economy and when it sells bonds.

the base year of WPI was changed from 1981-82 to 1993-94.The sector. Also. Power. power. wholesale and consumer price indices are based on the wholesale and retail prices prevailing in the market. the consumption basket was changed to cover 435 items. WPI is published by the Office of the Economic Adviser (OEA). through official as well as non-official sources. While the CPI UNME series is published by the Central Statistical Organization. due to different consumption patterns of its diverse population. In all 2. In April 2000. Table 1: WPI Weights y y y y Major Group I. on weekly basis.402 6. the others are published by the Department of Labor. Fuel. and its percentage-change is used as the measure of inflation in the country. these CPIs capture the price changes relevant to each segment of population at the retail level and provide an undistorted image of market rates. relative to the prices in a chosen base year. Inflation In economics. covered 447 commodities. Light & lubricants-19 (iii) manufactured products-318.485 14.138 0.wise breakup of Commodities is (i) primary articles-98 (food articles-54. Wholesale Price Index The Office of the Economic Adviser (OEA).025 15. The CPIs are: CPI UNME (Urban Non-Manual Employee) CPI AL (Agricultural Laborer) CPI RL (Rural Laborer) CPI IW (Industrial Worker) Even though change in WPI is used as the measure of inflation. Also. India uses 4 different CPIs.371 quotations of wholesale prices in respect of 447 commodities were collected. on base 1981-82. Non-food articles-25. the WPI series. inflation is defined as a rise in the general level of prices of goods and services in an economy over a period of time. Earlier. Ministry of Industry.226 . Measuring Inflation Inflation is generally measured using 2 key indices: y y Wholesale Price Index (WPI) Consumer Price Index (CPI) As their names suggest. on weekly basis. minerals-19) (ii) fuel. Ministry of Industry compiles Wholesale Price Index (WPI) numbers for all-India. Primary Articles (a) Food Articles (b) Non-food Articles (c) Minerals II. Light & Lubricants Weights 22.Market Operation involves buying and selling of securities from the government to regulate liquidity in the system.

339 9. Commodity index is computed as a simple arithmetic average of the price relatives of the quotations under that commodity. Trends of Inflation The chart below shows the inflationary trend (measured using WPI).538 1. Group index is obtained as weighted arithmetic average of the indices of subgroups included under that group. Tobacco & Tobacco Products (c) Textiles (d) Leather & Leather Products (e) Others Total 63. Index for all commodities is computed as weighted average of the indices for major groups. CPIs are computed on a monthly basis. Price relatives are calculated as percentage ratios which the current prices bear to those prevailing in the base period. Work is already underway to change the base year of WPI from 1993-94 to 2004-05.III. and are obtained by dividing the current prices by the corresponding base year prices.019 40.00 10.749 11.00 1990199119921993199419951996199719981999200020012002200320042005200620072008 -5. Manufactured Products (a) Food Products (b) Beverages. The major group index is arrived at as weighted average of the indices of the groups that are included under that major group. relevant to different segments of population. and the four CPIs in the last 20 years.053 100 Laspeyres based-weighted formula is used to compile WPI.00 WPI BASED INFLATION INFLATION BASED ON CPI RL INFLATION BASED ON CPI AL Figure 1: Inflation Trends in India INFLATION BASED ON CPI IW INFLATION BASED ON CPI UNME . For instance.00 0. It should be noted that the numerical data might be slightly distorted on account of change of base years and consumption baskets. the consumption pattern of an urban dweller is markedly different from that of a rural laborer. and multiplying by 100. Consumer Price Index India uses four different CPIs to capture the relative price levels of different commodities. Subgroup index is derived as weighted average of the indices of the commodities included in that subgroup.800 1.00 5. Inflation Trends in India 15.

The Quantity Theory of Money adds some assumptions to the Equation of Exchange. P*T represents the nominal GDP of the economy. The Quantity Theory assumes that the economy is at equilibrium and at potential employment. This implies that any increase in money supply should be accompanied by a proportionate increase in the price levels. The above equation is also known as the Equation of Exchange. The easy availability of these metals was leading to easy supply of money and a subsequent rise in inflation. Thus. This led economist Henry Thornton to put forward the theory that more money implies more inflation and that increase in the money stock does not always lead to increase in economic output. Opposing Theories: There a few theories such as the Keynesian Theory on inflation which counter the Quantity Theory of Money. taking V &T as constants. The theory assumes that the Velocity of money generally doesn t change over short periods of time. These metals were getting minted into coins. However. we can say that increasing money supply decreases the value of every unit of money. It also assumes that the real output in the economy is fairly stable in the short run as it is determined by factorsof production such as Labor & Capital and Technological Advances. European powers colonized various parts of the world and started plundering precious metals such as gold and silver back to the European mainland. The quantity Theory of Money states that there is direct relationship between the quantity of money in the economic system and the price level associated with the goods and services being offered in that particular economy. Keynesian Theory of Inflation: . then too much money chasing fewer items will lead to a general increase in price levels.A prominent macroeconomic theory which relates money supply to prices (inflation) is the Quantity Theory of Money Quantity theory of money: History of the Quantity Theory of Money: Starting from the 15th century. Looking at it from another angle. there are considerable disagreements about the validity of the theory in the short run. M = Money Supply (M0) V = Velocity of Money P = Price Level T = Quantity of Real Output Thus. Some economists believe that the velocity of money is not constant and that in the short run the prices are sticky and hence not proportional to money supply. People who support the QTM state that if there is more money in the system than the amount of goods and services. Economists generally agree that the quantity theory holds in the long run. M*V=P*T Where. we get M / P = T / V = constant.

836 .92 Velocity @ M0 6.. The more money that people demand and hence hold on to. Locke talked about a ratio which had money stock in the numerator and trade in the denominator. etc. in the short run it is affected by other factors such as increase in aggregate demand and increase in production costs. it is logical to assume that the GDP is fairlystable as it would return to the potential GDP level after deviating from it for a short while due to change in Aggregate Demand. Sir William Petty was probably one of the first economists to have written about the concept of velocity of money.050 1. on the other hand is due to increase in prices of factors of production such as raw material and wage rates.96 1417933.172 6.Keynesians believe that while money supply does impact inflation in the long run. it is how fast money circulates in an economy.92 890496.966 2.He put forward the view that the frequency of people s pay periods determined the velocity of money in the economy. The classicists assume that the economy is at potential GDP. firms will inadvertently jack up the prices of factors of production. What is the Velocity of Money: The velocity of money can be defined as the number of times that a unit of currency is spent on goods and services per year on an average. Thus.124 2.304 7. The other important assumption necessary for Quantity Theory of Money is that the velocity of money is fairly stable for a considerable period of time. Increase in velocity of money would increase the price level in the economy and vice-versa. a concept quite similar to velocity. Thus.27 1225801. forms a major portion of the cost push inflation as labor usually makes up majority of the cost in most organizations. government spending. Increase in wage rates.768 6. The former is known as Demand-Pullinflation and the latter is known as Cost-Pushinflation. Thus.94 673401. while trying to meet the added demand from consumers. To check the veracity of the implications of the Quantity Theory of Money we need to check if the assumptions made by the theory actually hold in the real world.090 6. The real bills doctrine states that increasing money supply by introducing more money in exchange of assets of equal value has no effect on inflation. the lesser is the velocity. The velocity of money depends among other things on the demand for money.37 1570710. exports.987 6.943 6.56 1801140. Alternative theories include and fiscal theory of price level&the real bills doctrine.63 1044732.110 2.The Cost Push inflation.947 Velocity @ M3 2. The DemandPull inflation is caused due to increase the components of Aggregate Demand such as investments.422 6. when the economy is at or near its full output potential.029 2. Velocity also found mention in the writings of the John Locke (1632 1704).02 774053.674 6.204 2. we can see that Velocity has a similar impact on inflation as does money supply.025 1.912 1. Table 2: Velocity of Money Year 1990-91 1991-92 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 Reserve Money 87779 99505 110779 138672 169282 194457 199985 226233 259285 Broad Money 265828 317049 366825 434407 531426 604007 700183 821332 980960 GDP at MP 585868. As MV = PT.

622 6.27 2343944.50473 1.19 3239224.935 6. Thus. M1& M3 for the past 28 years.7 120.4 M0 23110 28994 35216 M1 28535 33398 39915 M3 73184 86525 102933 YEAR 2000 2001 2002 WPI 366.717 0.439 1.00 3706473.231 1. we can say that the assumption that the Velocity of money stays stable over long periods of time is true to a large extent.358 1.163 1.564 1. Thus. M0.841 6.294 1. The standard deviation has been around 0.642 6. Now let us analyze the theory in the real world and see if it can be seen practically as well.000 0.042 5. Table 3: WPI and Money Supply YEAR 1982 1983 1984 WPI 105.647 1.9 379. Findings The following is the data on WPI.577 0.3316749 Standard Deviation Velocity (GDP/M0) 8.000 Velocity (GDP/M0) Figure 2: Velocity of Money We can see that the Velocity of money over the last 20 odd years has not deviated much from its mean of 6.5 units.00 7.4105 M0 303311 337970 369061 M1 379450 422843 473581 M3 1313220 1498355 1717960 .5 113.9 366. atleast theoretically there seems to be a direct relation between Money supply & price levels.490 6.1999-00 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 280555 303311 337970 369061 436512 489135 573055 709016 928302 987998 Average 1124174 1313220 1498355 1717960 2005676 2251449 2729545 3310068 4017883 4794812 2007705. Thus.468 6.000 6.786 1. both the assumptions started in the Quantity Theory of Money seem to hold.413 1.00 4947857.75 2524561.000 4.57.470 1.156 7.000 2.89 2833178.53 2162269.00 4283979.330 5.129 6.00 5574448.

6 186.0 100.897929 M1 0.1098 426.9 297.7 279.4 251.8366 532.5 365.896442 M3 0.0 300.7 320.0407 426.7958 475.4 38165 44808 53489 62958 77591 87779 99505 110779 138672 169283 194457 199985 226402 259286 280555 44095 51516 58555 66786 81060 92892 114406 124066 150778 192257 214835 240615 267844 309068 341796 119394 141632 164275 193493 230950 265828 317049 364016 431084 527596 599191 696012 821332 980960 1124174 2003 2004 2005 2006 2007 2008 2009 400.0 0.1 334.0 200. M1 and M3) was plotted and analyzed for last 30 years.0 154.3 133. Money Supply 600.4 355. Money Supply 6000000 5000000 4000000 3000000 2000000 1000000 0 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 M0 Figure 3: Price Level Vs.6 213.1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 125.8815 .6326 513. Following were the correlation coefficients obtained: Table 4: Correlation Between WPI and Money Supply WPI Correlation Coefficient M0 0.204 436512 489135 571958 708890 928302 987998 1155686 578716 649790 826415 967955 1155837 1259707 1494611 2005676 2245677 2719519 3310068 4017883 4794812 5599762 The following is the graph of WPI versus the various measures of money supply: Price Level Vs.0 500.0407 453.2 231.0 400.0 M1 M3 WPI Correlation between WPI and Money Supply The data for WPI and Money Supply (M0.9 166.1 146.

483 1. .058 .082 We can see from the data that the standardized coefficient of M0 (.182).As can be seen. .857 Sig.000a Standardized Unstandardized Coefficients Model 1 (Constant) M0 GDP B 242.082 for the t-statistic for GDP co- . M1 and M3 numbers) in the country.109 Std.000 .832 .000 .945 a R Square . Thus. Error 13.262 Sig.395 .832) is much higher than that of GDP (. Regression Analysis We performed regression analysis of the WPI data as dependent variable with Reserve Money (M0) & GDP as the independent Variables.267 df 2 16 18 Coefficients a Mean Square 65918.880 Std.30516 ANOVAb Model 1 Regression Residual Total Sum of Squares 131836.182 Coefficients Beta t 17.058 15680.029 980.894 Adjusted R Square . price levels in Indian economy (measured through WPI Index numbers) are positively and highly correlated to the extent of money supply (measured through M0. Error of the Estimate 31.282 .863 2.493 8.883 . it provides a very conclusive proof that money supply is more significant in explaining the dependent variable WPI as compared to GDP. Model Summary Model 1 R . Also the significance of 0.209 147516.013 F 67.

FDI inflows into India during 2009 have crossed Rs. Inflation and risk in the domestic country and return in the foreign country adversely affect the FII flowing to the domestic country.1 billion per annum in the second half of 1990s and peaked at US $ 37 billion in 2009-10. FII. This is known as Yen Carry Trade . can have bidirectional causation with the returns of other domestic financial markets such as money markets. The LAF operations were supplemented by outright open market operations. . The investors then invest this money into higher yielding assets in developing countries such as India and earn an easy arbitrage. Whereas the t-statistic for Mo is quite significant in determining WPI. if low pushes the country to invest elsewhere. India.8 billion per annum in the second half of the 1980s to US $ 9. i. to absorb liquidity on an enduring basis. the rates in Japan are expected to continue to remain at low levels and hence there is not going to be any cash crunch affecting FDI flows.All these bodies attempt to illustrate the nature of FDI with certain measuring methodologies.FDI refers to the capital flows from the abroad that invest in the production capacity of the economy and are usually preferred over other forms of external finance because they are non-debt creating and non-volatile. whereas inflation and risk in the foreign country and return in the domestic country have a favorable effect on the flow of FII. given its short-term nature. modernization and employment generation that helps in creating a competitive business environment. Trends and developments In recent years. outright sales of the government securities. has taken many measures to attract foreign investment since the beginning of reforms in 1991. 80.e. The liquidity impact of large inflows was managed mainly through the repo and reverse repo auctions under the day-to-day Liquidity Adjustment Facility (LAF). it would not be considered to be a significant factor in determining WPI. The attractiveness of India for FDI is far from receding and can surely be expected to sustain over the next decade as well. The determinants of FII are very important for any emerging economy as FII exerts a larger impact on the domestic financial markets in the short run and a real impact in the long run. Impact of FII and FDI Inflows on Money supply and inflation FDI: There is no specific definition of FDI owing to the presence of many authorities like OECD. Another possible determinant of FII is the operation of foreign factors such as returns in the source country s financial markets. Net capital flows increased from an average of US $ 5. FII: Foreign institutional investment is a short-term investment. stock markets. a lot money has also originated from the near-zero interest rates in the United States. India has experienced a significant spurt in forex inflows.000 crores and this is the highest ever flow into the country in rupee terms. While this is not going to remain low forever in the US.skill and technology. Source of money The primary source of money has been borrowings in Japanese yen where the interest rates have been extremely low over the past decade.efficient shows that at 5% level of significance.FDI also facilitates international trade and transfer of knowledge . and foreign exchange markets.IMF. being a capital scarce country.IBRD and UNCTAD. Currently. mostly in the financial markets.FDI is described as a source of economic development.

Sterilization: A form of monetary action in which a central bank or federal reserve attempts to insulate itself from the foreign exchange market to counteract the effects of a changing monetary base. Canada (26). Trinidad and Tobago. FIIs are from geographically dispersed countries: Malaysia. but in the past decade developing country investors have also become significant. they now focus in services activities. FII (Net Investments in crores) 50000 40000 30000 20000 10000 0 -10000 500. While. FII & FDI FDI(Net investment in crores) WPI The Wholesale price inflation and foreign direct investments and the Wholesale price inflation and foreign institutional investment has a strong positive correlation between them in the range of 0. with average growth of 6. 7. Sweden.0 100.8 billion to US$ 191.0 400. FDI .7 them which implies that wholesale price inflation moves in the same direction with increase in the FDI and the FII.FII have dipped sharply during the 1998. rising by US$ 46. Luxemburg (64). As of 31 March 2006. The sterilization process is used to manipulate the value of one domestic currency relative to another. Australia. Developed country firms dominated investment in the 1990s.0 FII (Net Investment in crores) Figure 4: WPI vs. Canada.9 billion as of March 2007. Ireland and the Netherlands with 23 each. etc.4% in 2005 06. Denmark.2003 and 2008 periods. Hong Kong (30).0 200.4% from 2000 01 to 2005 06.The economy has been on a high growth trajectory. initially. Although Foreign institutional investment seem to grow year on year . Mauritius (32). The number of FIIs from the United States was the highest at 342.5% in 2004 05 and 8. and is initiated in the forex market. Italy.6 ~ 0. .0 300. Saudi Arabia.0 0. The flow of funds has produced comfortable foreign currency asset positions: US$ 145. Singapore (47). followed by the United Kingdom (148). etc.there is no specific trend that follows the institutional investment in india. Australia.1 billion in March 2006. investors concentrated in manufacturing.Average annual foreign direct investment (FDI) inflows into India have grown fifteen fold since 2000. Institutions around the globe channeled funds to the Indian securities markets for investments. Belgium. Ireland. power and telecommunications. the SEBI had registered FIIs from 37 countries.

Reserve Bank may continue to resort to the existing instruments of sterilization. mostly banks. The repo operations under LAF have a direct cost to the Reserve Bank. (c) Liberalization of the CapitalAccount: Liberalization of outflows under the capital account can be considered while taking advantage of the excess forex inflows. in the case of OMO sales. the differential between the yield on government securities and return on foreign exchange assets is the cost to the Reserve Bank. it would represent a "tax . When measures that directly impact the financial system/non-government sector are resorted to. if the CRR balances are remunerated. For example. there are several other instruments available to offset the impact of capital inflows on domestic money supply. looking ahead. particularly. rapid trade liberalization can also lead to additional capital inflows which may have the effect of actually making the current account deficit unsustainable in the future when such capital inflows slow down or reverse. However. Implementation of such measures would be desirable to reduce the current account surplus or expand the relatively low level of current account deficit. Sales of government securities under OMO also involve a transfer of market risks to the financial intermediaries. leading to erosion of competitiveness of the economy. be justified in view of the benefits that accrue to this sector from sterilization. trade liberalization is generally irreversible and hence may not be suitable for dealing with temporary or reversible capital inflows. This could. Thus. and consideration needs to be given to the addition of new instruments to enhance its ability to sterilize the impact of increase in its foreign currency assets. However. However. In the absence of sterilization. with regard to the . While some of the existing instruments can be modified and strengthened within the ambit of the RBI Act. the cost could be shared between the banking sector and the Reserve Bank. (b) Investment Promotion: Absorption of capital flows for growth promoting purposes can be considered through measures designed to facilitate greater investment in the economy. the cost is borne by the banking sector if CRR balances are not remunerated. government and the financial sector. this would have an adverse impact on the economy at large and the non-government sector in particular. In the context of an increase in CRR. leading to productive absorption of capital flows. also depend upon the impact on the balance sheets of these entities.Instruments of Sterilization used by RBI The various instruments have differential impact on the balance sheets of the central bank. (a) Trade liberalization: Trade liberalization could have the effect of increasing imports leading to a higher trade and current account deficit and this would enable the economy to absorb the capital inflows. The extent of capital flows to be sterilized and the choice of instruments. Furthermore. decisions on trade liberalization have to be based on the overall view of the economy and not just on issues related to forex inflows. however. such measures would become progressively effective over a period of time. thus. While open market operations (OMO) involving sale of securities constitute the commonly used instrument of sterilization. interest and exchange rates. although inflows may provide some comfort in terms of timing the transition to a more liberal trade regime. there could be excessive volatility in the financial markets. introduction of some new instruments for sterilization would require amendment to the RBI Act.

Such pre-payment is attractive provided the cost differential between the domestic and external debt is adequate after taking into account the associated costs of prepayment like penalties and other charges. Management of Capital Flows into India: Balances of the Government of India with the Reserve Bank The surplus balances of the Government with the Reserve Bank effectively act as an instrument of sterilization. based on the Quantity Theory of Money & our findings on the relation between money supply & price levels in India. the liberalization of outflows can also have the effect of increasing inflows further if it reinforces the positive sentiment relating to the host country. .and are accorded higher priority in the hierarchy of capital flows. thus enabling the Central Government to obtain a return on such balances as per the agreement entered into with the Central Government in 1997. the surplus balances of the Central Government are invested in government securities from out of the portfolio of the Reserve Bank. FDI decisions are taken in a medium term perspective. going ahead as the amount of money supply in the country increases it will be a daunting task for the central bank to control the inflation in the country. 1934. State governments. they do get to see its direct effect in the form of increasing inflation. (e) Management of Non-Debt Flows: Non-debt flows consist of foreign direct investment (FDI) andportfolio investments. Usually. The general population usually has no idea about the amount of money stock available in the country. In case. it is an inflexible instrument of monetary policy that drains liquidity across the board for all banks without distinguishing between banks having idle cash balances from those that are deficient. Cash Reserve Requirements The use of Cash Reserve Ratio (CRR) as a direct method of monetary policy intervention has the ability of sterilizing liquidity by raising the proportion of net demand and time liabilities (NDTL) of banks to be kept impounded with the central bank. The money supply has been increasing at a significant pace over last couple of decades and the inflation has been following suit. thus. it has the distortionary impact of a tax on the banking system.timing for such action. there is verylittle reason to restrict FDI flows. As the RBI Act does not permit payments of interest on deposits or current accounts of Central government. CRR is not remunerated. Some other instruments could be (i) Interest Bearing Deposits by Scheduled Banks An option for impounding excess liquidity in the banking system is to pay interest on deposits parked by banks on a voluntary basis with the central bank. (d) Management of External Debt: Pre-payment of external debt can be used to reduce the accretion of forex inflows. However. Thus. (ii) Issuance of Central Bank Securities (iii) Issuance of Market Stabilization Bills/Bonds by the Central Government Conclusion: Thus. we can conclude that money supply has a significant impact on the price levels in the country. However. However. local authorities and banks or other persons under sections 17(1) and 19(6) of Reserve Bank of India (RBI) Act.

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