Money Supply And Inflation

The country’s central bank is solely responsible for supplying money to the market (Reserve Bank of India in case of India). The RBI prints money and distributes it to the economy. The Ministry of Finance mints coins, but the RBI distributes them throughout the country. The rate of inflation in the economy is determined by the supply of money. When the supply of money in the economy increases, so does inflation, and vice versa.

The central bank’s currency is a liability of both the central bank and the government. As a result, this debt must be backed up by an equal value of assets, primarily gold and foreign exchange reserves, particularly in terms of high-power foreign currencies.

Money Supply

The total amount of money (currency plus deposit money) in an economy at any given time is referred to as the money supply. Currency in circulation and demand deposits are two common measurements used to define money.

The country’s Central Bank maintains a record of the total money supply. The price level of securities, inflation, exchange rates, and company practices can all be affected by changes in the amount of money in an economy.

Monetary aggregates

• M1– M1 is referred to as “narrow money” since it only comprises 100% liquid deposits, which is a relatively limited definition of the money supply.
• M2- M2 is made up of M1 and only savings account deposits made at post offices.  M2 = M1 + Post Office deposits(savings account)
• M3- M3 is known as wide money since it comprises both liquid and time deposits, making it a broad category of money. M1 + TD = M3 (Broad Money) Time Deposits with Banks (TD) Fixed deposits, recurring deposits, and the time liabilities of savings accounts are all included. M3 is the most commonly used money supply indicator.
• M4-  M4 = M3 + Total Post Office Deposits There isn’t much of a difference between M3 and M4 because the total deposits with the post office are so little.

Control of money supply

Monetary policy is a series of actions aimed at regulating the flow of money in the economy with the overall purpose of guaranteeing economic and financial stability, as well as sufficient financial resources for development. In India, these monetary policy objectives have developed through time and may now include price stability, proper credit flow to productive sectors, encouragement of productive investments and trade, export promotion, and economic growth. For example,

1. Repo Rate: The rate of interest is the repo rate, at which the Reserve Bank of India (RBI), lends short-term money to banks.
2. Reverse Repo Rate: The (fixed) interest rate at which the Reserve Bank absorbs liquidity from commercial banks.

Inflation

Inflation is a numerical measure of the rate at which the general price level of a basket of goods and services rises over time. Inflation reduces the purchasing power of a certain quantity of money compared to previous periods. The loss of purchasing power of money owing to inflation has an impact on the overall cost of living for the general public, resulting in a slowdown in economic growth.

Ways to measure inflation

• Consumer Price Index: Consumer price indexes (CPIs) are index numbers that track changes in the costs of goods and services purchased or obtained by households, which they use directly or indirectly to meet their own needs and desires. CPIs solely track consumer inflation.
• The Wholesale Price Index: The Wholesale Price Index (WPI) tracks the price changes of items sold by wholesalers across India. The greater the impact on consumer inflation, the higher this value is.
• GDP Deflator: Because the deflator includes the complete spectrum of goods and services generated in the economy, as opposed to the narrow commodity baskets used in the wholesale and consumer price indices, it is seen as a more comprehensive indicator of inflation.

Relation between money supply and inflation: 

According to Quantity Theory:  Inflation is caused when the rate of increase in the money supply is faster for example printing more notes than the growth of real output. Because there is more money pursuing the same quantity of commodities, this is the case. As a result, as monetary demand rises, enterprises raise their prices. There is an assumption that prices will always remain constant if the growth of the money supply is the same as the rate of real output.

Money supply vs Inflation (No dependence on each other): 

Conventional interpretations of the quantity theory are rejected by Keynesians and other non-monetarist economists. Their definitions of inflation place a greater emphasis on actual price increases, whether or not the money supply is taken into account.

Inflation can be divided into two types, according to Keynesian economists: demand-pull and cost-push. Desire-pull inflation occurs when customers demand things at a higher rate than production, maybe due to a bigger money supply. Cost-push inflation occurs when input prices for items rise faster than consumer tastes change, sometimes as a result of a higher money supply.

Conclusion

Monetary policy used to control the money supply has always had limitations, and it’s past time we recognized them. The quantity theory of money is correct, but the functional link between M and P does not hold in India. As a result, when inflation occurs, it does not have to be attributed solely to the money supply.