rbi: Excess money in the system not inflationary: RBI paper

It is said that too much money chasing too few goods is inflationary. But that may be only partially true. Empirical results of study by RBI economists suggest that money growth does not pose risks to inflation in the presence of economic slack. When the economy is in an expansionary phase, however, an increase in money supply can cause higher inflation, implying that its unconventional policies of ultra monetary accommodation during COVID-19 by the central bank needs to be reversed once the economy gets back to its normal path of growth

Well known economist and Nobel Laureate Milton Friedman’s theory which guided monetary policy through the world in the second half of twentieth century said that inflation is a monetary phenomenon and it occurs when too much money chases too few goods. Excess money creation, or unrestrained expansion in the balance sheet size of a central bank, accordingly, has been vaunted as the prime driver of inflation.

But that is changing since the turn of the twentieth century across the globe and the link between money supply and inflation is weakening seems to be slowing even in India. Empirical results suggest that money growth does not pose risks to inflation during an economic slack. When the economy is in an expansionary phase, however, an increase in money supply can cause higher inflation according to a research paper by by Sitikantha Pattanaik, Binod B. Bhoi and Harendra Kumar Behera, Department of Economic and Policy Research published in the latest RBI Bulletin.

“Empirical findings for India suggest that excess liquidity that does not lead to higher broad money growth is not inflationary” the authors said. ” Only a robust pick-up in demand that can absorb the surplus liquidity in the system could be inflationary”

The research assumes significance as central banks across the globe that were in quantitative easing mode after the global financial crisis in 2008 and went on aggressively expanding their balance sheets are now going for quantitative tightening. Back home in India the RBI is being criticized for being behind the curve for being slow on rate hikes even as inflation has consistently remained above 6 per cent- the upper tolerance level of the band under its flexible inflation targeting regime.

The authors say that higher money growth may counterbalance the contractionary impact of the velocity shock rather than pose risks to inflation. Also Friedman’s theory is increasingly less likely to hold in the age of financial innovations, rising digital non-cash modes of payments for transactions and also in view of the emergence of FinTech for financial intermediation.

The conclusions of the study indicate that the ultra accommodative stance of the central bank that has resulted in huge surplus liquidity in the system post COVID may be needed to be discontinued as the economy normales, which would be necessary to attain price stability. “Findings indicate that money growth during the COVID period was not a primary source of inflation, but as the economy recovers to its trend level and velocity of money normales, curbing excess money growth timely can help secure the goal of price stability” the authors said .

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