Post covid-19, money supply has constantly increased in the Indian economic system. What are the main reasons behind the increase?
It is normally believed that more money in the hands of everyone means more welfare for all. However, higher money supply has its own side-effects. As money supply increases in the system, people’s buying power goes up, resulting in higher demand, which ultimately results in higher inflation in the economy. In the long run, a higher inflation can erode assets- both financial and physical and destroy people’s savings beyond imagination. RBI is facing a similar dilemma, constricting money supply would mean eroding demand and growth in the economy but giving a free hand to money supply may erode people’s capital in the long run. In the present timeframe, RBI has focused on growth over inflation, constantly increasing money supply in the economy. The main reasons behind the increase are-
Higher spending by the government- The non-food credit growth of banks as of 25 September stood at a very slow 5.1%. This primarily reflects the reluctance of banks to lend and hesitance on part of both individuals and firms to borrow. However, the lenders seem to be happy to grant loans to the government. The government has in turn spent this money on policies such as the Mahatma Gandhi National Rural Employment Guarantee Scheme (MGNREGA). It has also put money into 20 crore female Jan Dhan accounts. These efforts by the Centre have led to an overall increase in currency with the public.
Inflow of Foreign money- Foreign money continuously keeps coming into India, leading to an increase in demand for the rupee against the dollar. To prevent the rupee from appreciating, RBI sold rupees and bought dollars, adding to an increase in M3. Also, in order to drive down interest rates, RBI has pumped money into the financial system by buying bonds from institutions.
Lower repo rate- There is too much money floating around in the financial system. Until now, this excess money has not really chased goods and services in the economy and has thus not led to higher inflation rates. A lower repo rate can lead to a further lowering of the interest rates. This can then result in some of the money chasing goods and services and thus cause higher inflation. There is also the danger of food inflation seeping into the overall inflation as has happened in the past. Note that inflation is already above MPC’s comfort zone.
The RBI needs to maintain a fine balance between Inflation and Growth. Although the world is going through a desperate time where growth seems to be the ultimate goal. However, once inflation creeps up, it would be very difficult to sustain growth and control the rising inflation.
Notes-
Measuring money supply- Money supply in the economy has increased over the months. We can look at money supply from the component side and the sources side. One of the ways of measuring money supply is M3, which is a sum of the currency with the public, the demand deposits with the banking system, which include current deposits and savings deposits, the time deposits with the banking system, such as fixed deposits, recurring deposits, and other deposits of RBI. The currency with the public has grown by more than 21% since June and so have bank deposits. This has led to M3 growing by over 12% since June.
Food inflation can get into core inflation- An IMF paper titled Food Inflation in India says: “Food inflation [feeds] quickly into… core inflation.” This happened between 2009 and 2013. RBI expects food inflation to fall in the second half of the year. Nevertheless, it has no control over food inflation. What it has control over is the amount of money floating around in the financial system. By keeping the repo rate constant, it is trying to control the currency supply.