Money Supply and its Impact on Inflation and Interest Rate: A case study of India during 2003-04 to 2013-14

Macroeconomics
Project Report
_____________________________________________________________________________________________________
Money Supply and its Impact on Inflation and Interest Rate:
A case study of India during2003-04 to 2013-14
____________________________________________________________________________________________________
Submitted To:
Prof. Jagdish Shettigar
__________________________________________________________________________________
Made By : Group-, Section-B, PGDM 14-16 (First Year)
Gokul K Prasad(14DM086)
HariharaPrabhu(14DM088)
Humam Khaliz(14DM095)
Jitendre Badyal(14DM120)
Manjeet Poonia(14DM104)
Jerin M Joy(14DM109)

Macroeconomics for Business
Decision Making – Project Report
Contents
List of Figures.............................................................................................................................. 3
Acknowledgement ...................................................................................................................... 4
1. Indian Economy - An Introduction............................................................................................ 5
1.1 IndianEconomybefore ColonialPeriod............................................................................... 5
1.2 IndianEconomyduringColonial Period ............................................................................... 6
1.3 IndianEconomybefore Liberalization.................................................................................. 6
1.4 IndianEconomyafterLiberalization .................................................................................... 6
1.5 CurrentScenario ................................................................................................................ 7
2. MoneySupply inthe Indian Economy ...................................................................................... 8
2.1 Introduction....................................................................................................................... 8
2.2 Monetary ToolsUsedby RBI to control Moneysupply:......................................................... 9
3. Inflationin the IndianEconomy ............................................................................................. 10
3.1 Measuresof Inflation....................................................................................................... 10
3.2 Which isbetterCPIor WPI?............................................................................................... 11
3.3 Why countrylike IndiapreferWPIoverCPI ?...................................................................... 11
3.4 Typesof inflation............................................................................................................. 11
3.5 Factors AffectingInflation................................................................................................. 12
3.6 RelationshipbetweenMoneySupplyandPrice Level ......................................................... 13
3.7 Moneysupplyandinflationbetween2005-2006 and 2012-2013.......................................... 14
4. InterestRate in the Indian Economy ...................................................................................... 16
4.1 InterestRate – Definition.................................................................................................. 16
4.2 A Brief Historyof InterestRate VariationinIndia ............................................................... 16
4.3 Implicationsof Decrease inInterestRate........................................................................... 17
4.4 How are the InterestRatesDeterminedinIndianEconomy? .............................................. 18
4.5 Factors affectingthe InterestRate .................................................................................... 19
4.6 Variationof SavingsInterestRate,AverageLendingRate,BankRate,RepoRate withM3
Average MoneySupply :......................................................................................................... 20
5. Conclusion............................................................................................................................ 21
6. References............................................................................................................................ 22
7. Annexure.............................................................................................................................. 24
Page 2 of 24

List of Figures
Figure No. Particular
Figure 2.1 Yearly Average Money Supply M3 (in Billion INR) and GDP at Constant Prices
Figure 3.1 Average Money Supply (M3) & Income Velocity
Figure 3.2 Average Money Supply (M3), M3 Growth Rate, GDP Growth Rate, Inflation
Figure 4.1 Saving Rate, Lending Rate, Repo Rate & Bank Rate Variation
Figure 7.1 Year wise data of Money Supply, GDP, Inflation & Interest Rate
Figure 8.1 Interest rate repo rate table
Figure 9.1 India’s prime lending rate
Figure 10.1 India’s Interest rate
Page 3 of 24

Acknowledgement
We are in debt to our teacher and project guide Mr. Jagdish Shettigar (Prof. & Advisor –
BIMTECH) for helping us and giving his useful ideas for making this project.
We are also thankful to Prof. Pooja Misra for her useful guidance.
We also want to acknowledge that we had learned a lot while working with our batch
mates of Bimtech.
Page 4 of 24

1. Indian Economy - An Introduction
India is one of the fastest growing economies in the world. In recent times the country
has witnessed a tremendous rise in its growth rate. The history of Indian Economy can be
broadly classified into four parts
1.1 Indian Economy before Colonial Period
India had been successful to develop international trade since as early as the first century BC.
Evidences suggest that the Coromandel, the Malabar, the Saurashtra and the Bengal coasts
were usedfor trade to parts of Middle East,Southeast Asia,Europe and Africa. In the medieval
period, the Mughal Empire introduced centrally administered uniform revenue policy and
political stability in India leading to further development of trade. During this era, India was
self-sufficient, dependent on agriculture. After the downfall of the Mughal Empire, the
Maratha Empire ruled over most parts of India. Later, with the defeat of Maratha the
economy of India turned highly disturbed in most parts of the country. Later, by the end of
eighteenth century, the British East India Company became a part of the Indian political
machinery, following which there were drastic changes in the country’s economic activities
and the trade conducted from the India.
1.2 Indian Economy during Colonial Period
During the reign of the British East India Company, there was a drastic shift in the economic
activities conducted across the country. More stress was laid on commercialization of
agriculture. During this phase, there was a constant decline in the production of food grains
which resulted to the mass impoverishment and destitution of farmers. Though, after and
during this phase, there was a sharp decline in the economic structure of the country, major
developments took place including the establishment of railways, telegraphs, common law
and legal system.
1.3 Indian Economy before Liberalization
After independence, till 1991, strong emphasis was laid on increasing the domestic self-
sufficiency and reducing the reliance on imports.The economic planning process during this
phase was conducted centrally through the Five Year Planning process of the commission.
Industries like mining, steel, machine tools, insurance, telecommunications and power plants
were effectively nationalized during this era. The Government of India laid prime focus on the
development of heavy industry in country by both the public and the private sector. However,
despite all its efforts, the economy of India was unsuccessful to grow at pace with other Asian
countries for the first three decades after independence. Later, in 1965, Green Revolution in
country, triggered by the improved irrigation facilities, increased use of fertilizers and the
introduction of high-yielding varieties of seeds improved the economic conditions of the
country and enabled a better link between industry and agriculture in India.
Page 5 of 24

1.4 Indian Economy after Liberalization
In 1991, as a result of the reforms demanded by the IMF in return of allotting India a bailout
loan of US$ 1.8 billion, the government of India adopted the economic reforms of 1991.
Under these reforms, the tariffs and the interest rates were reduced which in turn ended
the public sector monopolies in certain sectors. Also, these reforms approved the foreign
direct investment in many sectors. Later, by the end of the twentieth century, the Indian
economy had progressed towards a free market economy and was marked with increased
financial liberalization. During this phase, the Indian economy also witnessed a tremendous
improvement in the literacy rates, food security and life expectancy.
1.5 Current Scenario
The last decade has been one of the most volatile times for both, the global as well as Indian
economy. Economic reforms picked up pace in 2000-04 and fiscal deficits trended down after
2002 and there was a upswing in Indian industrial output and investment from the second
half of 2002. India’s Tenth Five-Year Plan (2002-07) targeted an annual growth rate of eight
per cent. Along with this growth target, the government alsolaiddown targets for human and
social development. A reduction of the poverty rate by five percentage points by 2007,
providing gainful employment to at least those who join the labour force during 2002-07,
education for all children in schools by 2003, and an increase in the literacy rate to 75 percent
by March 2007.
Currently the economy is expected to grow at 4.9% for the current financial year despite
favourable monsoon brightening the scope for agriculture performance. The industrial and
services sector growth performance in 2013-14 is likely to be lower than 2012-13. While in
general economic growth performance in FY14 is likely to be similar to the FY13 levels, the
current account may improve considerably. This will strengthen rupee to stabilize to around
59-61 to the dollar by the end of 2013-14. Bolstered by agriculture and exports, the economic
growth is expected to improve from the third quarter of FY14. Three consecutive months of
double-digit exports growth and healthy agriculture performance due to 6% above normal
rainfall in 2013 would increase demand for industrial goods and services.
Page 7 of 24

2. Money Supply in the Indian Economy
2.1 Introduction
Up to 1967-68, the RBI adopted only the narrow measure of money supply (M). It was the
sum of currency and demand deposits, which are held by the public. A broader measure for
money supply called aggregate monetary resources is published from 1967-68 by RBI.
The RBI has adopted four alternative definitions of money supply which are labelled as M1,
M2, M3, & M4.
M1 = currency with public + demand deposits with the banking system+ other deposits with
RBI
M2 = M1 + saving deposits with post office savings
banks M3 = M2 + time deposits with the banking system
M4 = M3 + all deposits with post office savings banks excluding National Saving Certificates
Reserve money (M0) =Currency in circulation + Bankers’ deposits with the RBI + ‘Other’
deposits with the RBI.
For practical purposes, mainly M1 (narrow money) and M3 (broad money) concepts are used
in India.
Money Supply M3 in India increased to 81600 INR Billion in February 2013 from 81004 INR
Billionin January of 2013. Historically,from 1972 until 2013, India Money Supply M3 averaged
13127.16 INR Billion reaching an all-time high of 81600 INR Billion in February of 2013 and a
record low of 123.52 INR Billion in January of 1972.
Average Money Supply (M3) & GDP at Constant Prices
(Billion INR)
100000.00
80000.00
60000.00
40000.00
20000.00
0.00
2005-06 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12 2012-13
Year
M3 Average MoneySupply… GDP at Constant Prices…
Figure 2.1 : Yearly Average Money Supply M3 (in Billion INR) and GDP at Constant Prices
Data Source : RBI Annual Reports
Page 8 of 24

2.2 Monetary Tools Usedby RBI to control Money supply:
Repo Rate :
Repo is a money market instrument, which enables collateralized short term borrowing and
lending through sale/purchase operations in debt instruments. Under a repo transaction, a
holder of securities sells them to an investor with an agreement to repurchase at a
predetermined date and rate. In the case of a repo, the forward clean price of the bonds is
setin advance at a level which is different fromthe spot cleanprice by adjusting the difference
between repo interest and coupon earned on the security.
[3]
The present Repo Rate is 7.75%
Reverse Repo Rate :
A reverse repo is the mirror image of a repo. For, in a reverse repo, securities are acquired
with a simultaneous commitment to resell.Hence whether a transaction is a repo or a reverse
repo is determined only in terms of who initiated the first leg of the transaction. When the
reverse repurchase transaction matures, the counterparty returns the security to the entity
concerned and receives its cash along with a profit spread. One factor which encourages an
organization to enter into reverse repo is that it earns some extra income on its otherwise
idle cash.
[3]
The Reverse Repo Rate is 6.75%
Bank Rate :
Bank rate is the rate at which the Central bank lends money to the commercial banks for their
liquidity requirements. Bank rate is also called discount rate. In other words bank rate is the
rate at which the central bank rediscounts eligible papers held by commercial banks. Inflation
will cause bank rate to increase.
The current Bank Rate is 8.75%
Cash reserve Ratio :
Cash Reserve Ratio (CRR) is the amount of funds that all Scheduled Commercial Banks (SCB)
excluding Regional Rural Banks (RRB) are required to maintain without any floor or ceiling
rate with RBI with reference to their total net Demand and Time Liabilities (DTL) to ensure
the liquidity and solvency of Banks (Section 42 (1) of RBI Act 1934).
At present the Cash Reserve Ratio is 4%
Page 9 of 24

Statuary Liquidity Ratio (SLR):
Apart from keeping a portion of deposits with RBI as cash, banks are also required to
maintain a minimum percentage of deposits with them at the end of every business day, in
the form of gold, cash, government bonds or other approved securities. This minimum
percentage is called Statutory Liquidity Ratio. In times of high growth, an increase in SLR
requirement reduces lendable resources of the banks and pushes up interest rates.
The current SLR is 23.0%
3. Inflation in the Indian Economy
In a broad sense of the term, inflation means a considerable and persistent rise in the general
level of prices over a long period of time. It can also defined as a situation I which supply of
money increases at a rate much faster than the supply of real output. Inflation also reflects
an erosion in the purchasing power of money. Inflation’s effects on an economy can be
positive or negative. The rate of inflation is measured by the annual percentage change in the
level of prices as measured by the consumer price index.
In India, inflation rate in the month of Oct 2013 is around 7% (WPI). Historically, from 1969
until 2013, the inflation rate in India averaged 7.7% reaching an all time high of 34.7% in
September 1974 and a record low of -11.3% in May 1976. The average inflation of India in the
year 2013 (Up to Sept month) is 11.04% (CPI).
3.1 Measures ofInflation
Percentage change in Price Index Numbers (PIN), where the price index is an indicator of the
averageprice movement over time of afixed basket of goods and services.There are different
indictors used to measure inflation namely Wholesale Price Index (WPI), Consumer Price
Index (CPI) and the GDP Deflator or Implicit Price Index, which is constructed from the
National Income Data.

Wholesale Price Index (WPI) was first published in 1902, and was one of the economic
indicators available to policy makers until it was replaced by most developedcountries by
the Consumer Price Index in the 1970s. WPI is the index that is used to measure the
change in the average price level of goods traded in the wholesale market



Consumer Price Index (CPI) is a statistical time-series measure of a weighted average
of prices of a specified set of goods and services purchased by consumers. It is a
price index that tracks the prices of a specified basket of consumer goods and
services, providing a measure of inflation.

Page 10 of 24

3.2 Which is better CPI or WPI?
The Wholesale Price Index (WPI) is used extensively as a measure of inflation and
important monetary and fiscal policy changes are often linked to it. But, the WPI in its role
as a guide to policy formulation has several critical limitations like

Non-inclusion of services



Following a fixed weighting scheme while the economy is undergoing major structural
changes


Use of gross transactions data rather than data on final purchases





3.3 Why country like India prefer WPI over CPI ?
The demographic and structure of India does not allow it to use the advance method i.e CPI.
Consumer Price Index in India is difficult to adopt as 4 types of CPI indices are there in India:

CPI Industrial workers



CPI Urban Non – Manual Employees



CPI Agricultural Labourers



CPI Rural Labour

Then lag in reporting, as CPI is released on monthly basis whereas WPI is released on weekly
basis. So, these things makes countries like India to use CPI method for calculating inflation.
3.4 Types ofinflation

Moderate Inflation, where the general level of price rises at a moderate rate over a
long period of time. Such an inflation is also called creeping inflation. Inflation rate
will be in single digit & its predictable value. For example, country like India facing a
inflation of 7% (WPI) in the month of Oct 2013.



Galloping Inflation, where the inflationrate is exceptionallyhigh. Here, the inflationrate
goes in double digit number. For example, during 1970s or 1980s, countries like
Argentina, Brazil were facing triple digit inflationi.e 416.9 %, 327.6% respectively.

Page 11 of 24


Hyper Inflation, where the price rise is at more than three digit number rate. For
example, Hungarian inflation of 1945-46 is the worst case of hyperinflation ever
recorded. The rate of inflation averaged about 20,000 percent per month for a
year and in the last month prices sky rocked 42 quadrillion percent.





3.5 Factors Affecting Inflation
There are several factors which help to determine the inflationary impact in the country
and further help in making a comparative analysis of the policies. The major determinant of
the inflation in regard to the employment generation and growth is depicted by the
Phillips curve.

Demand-Pull situation, where inflation is caused by aggregate demand being more
than the available supply. Aggregate demand is made up of consumer spending,
investments, government spending, and whatever is left after subtracting imports
from exports. Factors that commonly lead to demand-pull inflation include a
sudden increase in the amount of money in an economy and decreases in taxes on
goods, which leaves consumers with more disposable income. Since people have
more money to spend, manufacturers raise the general prices of goods and
services. And this ultimately leads to inflation in the country.




Cost-push situation, where inflation occurs when manufacturers and businesses
raise prices as a result of shortages, or to balance their increase in production
costs. An example of this is rising labour costs. When workers demand more wages,
companies usually pass on these costs to their customers or increase in the taxes
imposed on goods may also lead to a cost-push situation. This also often happens
when one or several companies has a monopoly in the market, and decides to raise
their prices above demand to increase their profit.




Built-in situation, where inflationhappens as a result of previous increases in prices
caused by demand-push or cost-pull. In this type of situation, people expect prices to
continue to rise, so they push for higher wages. This raises costs for manufacturers,
which then raise the cost of goods to compensate, causing a cycle of inflation.





External factors, like the exchange rate which also an important factor which affects
countrieslike India.Asthe pricesin UnitedStatesof Americarisesit impacts India where
the commodities are now imported at a higher price impacting the price rise.

Page 12 of 24

3.6 RelationshipbetweenMoney Supply and Price Level
The relationship between money supply and the general price level, is given by the following
equation of exchange:
MV = PY
Where:
M = Money supply/Quantity of money
V = Velocity of circulation of money
P = General Price level Y
= Real national income
It reveals that total value of payments (MV) equals the money value of national output (PY).
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 in money supply always produce changes in either P and/or Y. According to
them, money does matters and whenever there appears an excessiveincreaseinP (inflation),
it is primarily because of the excessive increase in the money supply.
The relationship between money supply, real income and general price level described above
willbe observed only when the velocity of money remains stable.Thus, what lies atthe center
of this relationship is the velocity of money, that is, the ratio of national income in money
terms to the quantity of money.
Thus we can say 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 income velocity and demand
for money are inversely related. That is, if people want to save more money than spending it,
they save more and the velocity of money decreases. Thus demand for money and income
velocity are both related.
Two types of velocities are distinguished, one, transaction velocity and two, income velocity.
In this report, income velocity has been estimated by using the formulation Y/M, where Y
refers to national income for a period and M denotes average money supply in the economy
during the same period.
Page 13 of 24

3.7 Money supply and inflationbetween 2005-2006 and 2012-2013
There is an increasein money supply from 2005-2013 and the money supply (M3) growth rate
was close to 21% in 2005-2007 and decreased to around 13% by 2012-2013 (shown in figure)
The income velocity showed a decreasing trend from 2005-2009, being least in 2009-2010 at
1.25. This shows that the demand for money was high in 2009-2010, which can be attributed
to recessionary situation in 2008-2010. There is also a significant decrease in GDP in 2008-
2009 because of the recession.
Average Money Supply (M3) & Income Velocity
1.55 90000.00
1.50 80000.00
1.45 70000.00
1.40 60000.00
1.35 50000.00
1.30 40000.00
1.25 30000.00
1.20 20000.00
1.15 10000.00
1.10 0.00
2005-06 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12 2012-13
M3 Average Money Supply Income Velocity
(in Billion INR) (%)
Figure 3.1 : Average Money Supply (M3) & Income Velocity
The money supply and the inflation has a correlation of 0.605 which shows that they vary in the
same direction, but it doesn’t give any details of which one varies because of the other. The
dependence of money supply and inflationcan further be tested using regression analysis.
Page 14 of 24

Average Money Supply (M3), M3 Growth Rate, GDP Growth Rate, Inflation
25.00 90000.00
80000.00
20.00
70000.00
60000.00
15.00
50000.00
40000.00
10.00
30000.00
5.00
20000.00
10000.00
0.00 0.00
2005-06 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12 2012-13
Year
M3 Growth Rate (%) GDPGrowth Rate (%) Inflation(%) M3 Average Money Supply
(WPI) (in Billion INR)
Figure 3.2 : Average Money Supply (M3), M3 Growth Rate, GDP Growth Rate, Inflation
Page 15 of 24

4. Interest Rate in the Indian Economy
4.1 Interest Rate –Definition
When a lender (creditor) lends money to the borrower (debtor), he wants to earn a profit on
the money he has given. This extra money charged by the lender to the borrower is caller the
interest and the rate charged by the lender is called interest rate.
Interest rate is the percentage of principal paid in a certain period of time.
For example, if a company borrows some money from a bank to buy new assets for its job,
then the bank will charge a predetermined rate of interest to the borrower (i.e. the company)
as the company is deferring the payment.
4.2 A Brief History of Interest Rate VariationinIndia
Pre liberalization Era - A Regulated One
Interest rate could also be called as the opportunity cost of money. Till very late in Indian
economy, the interest rates were regulated RBI.This trend continued tillthe year 1991. Hence
banks were not allowed to fix their interest rates according to their cost of funds, RBI used to
fix the interest rates.
The PLR was fixed by the RBIand banks used to set their interest rate accordingly. The interest
rates of the banks was the determinant for the corporate borrowing and hence the money
pumped by the businessmen depended on this. Hence the RBI used to regulate the corporate
funding in the GDP and control the whole structure.
Post Liberalization Era - A Deregulated One
The Indian Economy went through a drastic change in the year 1991 which is also known for
the year of Liberalization of Indian Economy. Gradually the interest rates were being
deregulated by the RBI. Indian Economy started to move towards the market determined
interest rate from the regulated one.
The Bank Rate, Repo Rate, Reverse Repo Rate CRR, SLR were the new tools used by RBI to
give only indications to the market operations and now it only fixes the interest rate to be
paid by the banks on the saving bank deposits.
Page 16 of 24

The PLR and other interest rates based on their cost of funds are now decided by the banks.
This was also accompanied by the cuts and the increase in the CRR, SLR and bank rate. This
was all possible because of the liberalization of the economy. But RBI at every step and took
the necessary action to develop a well-functioning money market.
Primary Dealer was the new concept which came into being. Apart from the banks some financial
institutions were allowed in the money market. This increased the funds available and the
turnover was increased in the money market. Interest rates of the economy depends a lot on the
well-functioningof the money market hence RBI keeps a close check on this.
The Fall Out
It created wonderful results for the Indian Economy. The interest rates (i.e., prime lending
rates), which were as high as 16 - 17% in 1992 - 1993, came down to as low as 10.75% at
present.
This happened because of the increasing competition in the market and because the
operators were ready to operate on thin margins. Also, the RBI (Reserve bank of India), was
fixed on decreasing interest rates in the economy and kept on lowering the CRR, SLR and the
Bank Rate.
4.3 Implications of Decrease inInterest Rate
Decrease in interest rates had various implications for the Indian economy.

Firstly, it provided a much - needed boost to the industrial activity. Many Corporates,
who had their loans outstanding, replaced their costlyloans by the new loans atlower
interest rates. This increased the investment activity in the country and thus
increased the economic growth.



This decreased the advantage of a price difference betweentwo or more markets, which
were earlieravailable.It was always helpful to control volatility.It also helpthe operators
to manage their balance sheets in an efficientmanner.



The market determined interest rate increases the width & maturity in the financial
markets. In Indian economy, the deregulation was accompanied by liberalization of
financial markets. This introduced new players in the market.



Low interest rates have put pressure to take excessive risks in search for high yields, which may
result in asset price bubbles.

Page 17 of 24

4.4 How are the Interest Rates DeterminedinIndianEconomy?
Call Rates :
The call rate is the interest rate paid by the bank for lending and borrowing for daily fund
requirement. The call rates sets all the interest rates in the economy.
The call money market is an overnight market and is considered to be the most liquidmarket in
an economy, therefore the interest rates in other markets have to be more than call rates. These
rates are determined each day on the basis of demand and supply situation.
Sovereign Securities :
Next comes the market for sovereign securities, i.e., T - bills and dated securities. These
securities are sold on the basis of competitive bidding system. The dealers make their bid on
the basis of call rates. Of all the bids, a cut - off rate is decided as yield to be payable on that
particular issue.
Interest Rates Charged by Banks :
Next in line comes the interest rates charged by the banks. The banks fix their interest rates
based on their cost of funds which includes the rates they pay on the deposits they get and
their operational expenses.
Prime lending rate (PLR) is the benchmark rate for all other interest rates charged by the
banks. PLR is the rate which the banks charge from their top clients who have the best credit
rating. All the other interest rates charged by the banks includes arisk premium for advancing
money to clients who don't have as good a credit rating.
Corporate Debt:
And finally comes the interest rates paid by the Corporates on their debt. The interest to be
paid on this debt is PLR plus a risk premium because of their business and financial risk.
Page 18 of 24

4.5 Relationship Between Interest RatesAndInvestment Expenditure
There is negative relationship between interest rate and investments. It means that as interest rate falls
investment rises, and the opposite is true when interest rate rises. When the interest rates are high,
investors make less real investment, On the other hand, if the interest rate is low, more and more
investment take place in the economy.
A central bank assesses the amount of funds required to oil the economy’s wheels, commensurate with
the desirable level of economic activity. It raises rates whenever it feels the economy is over-heating
and lowers these when it wishes to spur investment and growth. The rates are an important
determinant of the level of investment in an economy. Broadly, if rates increase across the board, then,
other things remaining the same, investment will decrease (as it will no longer be as profitable as before
to invest) and so will the growth rate. If interest rates fall, investment will pick up and so will growth.
Empirical research suggests three broad possibilities on the relationship between real interest rate and
economic growth: (a) higher real interest rates leading to higher growth – the “financial repression to
reform” view of McKinnon and Shaw (1973), (b) higher real rates leading to lower growth – the standard
“monetary policy” view, and (c) higher real rates leading to higher or lower growth depending on the
level of the real rate relative to the threshold level - i.e. the non-linear relationship highlighted by Fry
(1997). Pill and Pradhan (1995) noted that the McKinnon and Shaw relationship may not hold if the
capital account of a country is open. In other words, high growth could co-exist with both modest real
rates and an open capital account.
According to one G-10 study (1995), 100 bps increase in real interest rates to about 4 per cent in G-10
countries over a 35 year period since 1960s coincided with decline in saving rate by about 5 per cent of
GDP to below 20 per cent, which was more pronounced than the moderation in investment rate. This
high real interest rate period, nevertheless, coincided with lower investment rate, slowdown in growth
of total factor productivity, and decline in measured rates of return on capital, even though the study
did not ascribe all these outcomes to higher real rate. Taylor (1999), reviewing the empirical literature
on the relationship, underscored the mixed evidence on the existence of a positive relationship
between real rate and growth.
In India, Mallick and Agarwal (2007) found that none of the three measures of real interest rate (call
rate, 91 T Bill rate, and 364 T Bill rate) seemed to exert any direct influence on growth of real output.
This unusual result they ascribed to the possibility that investment, which is an important determinant
of growth, is conditioned by several factors other than real interest rate alone. Mohanty, Chakraborty
and Gangadaran (2012), on the other hand, highlighted the presence of inverse relationship between
growth and real lending rates in India, with empirical evidence on real lending rates Granger causing
both overall GDP and non-agricultural GDP growth. In India, the incremental capital output ratio (ICOR)
has increased in recent quarters, and correspondingly the implicit marginal productivity of investment
has also declined. As a result, lower levels of real interest rate would have also contributed to the
slowdown in growth.
Page 19 of 24

4.6 Variationof Savings Interest Rate, Average Lending Rate, Bank Rate,
RepoRate withM3 Average Money Supply :
Average Money Supply (M3), Saving Rate, Lending Rate, Repo Rate &
Bank Rate
16.00 90000.00
14.00 80000.00
12.00
70000.00
10.00
60000.00
50000.00
8.00
40000.00
6.00
30000.00
4.00
20000.00
2.00 10000.00
0.00 0.00
2005-06 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12 2012-13
M3 Average MoneySupply Savings Interest Rate (%) Average Lending Rates (%)
(in Billion INR)
Bank Rate Repo Rate
(%) (%)
Figure 4.1 : Saving Rate, Lending Rate, Repo Rate & Bank Rate Variation
M3 Average Money Supply (Shown on Secondary Axis) :
The Average money supply has been increasing over the period of 2005 to 2013 but the
rate of growth has been decreasing. It came down to 13.81% from 21.10% in 2005-06.
Saving Rate (Shown on Primary Axis) :
The Saving rate is the interest rate paid by the Banks to their customers when they deposit
their cash at the bank. This remained constant over period 2005 to 2011 which was 3.5%.
From 2011 it is 4% till date.
Page 20 of 24

Bank Rate (Shown on Primary Axis) :
Bank Rate remained constant at 6% for the period 2005 to 2011 but it showed a
sharp increase from fiscial year 2011-12 and in 2012-13 it is 8.97%.
Repo Rate (Shown on Primary Axis) :
The Repo Rate show slight fluctuation over the years compared to the previous year but it
shows a large dip in 2009-10 and came to 4.77%. This action was taken by RBI in order to
increase the money circulation in the economy.
As in the recession the money flow in the market is reduced then by lowering the repo
rate encourages the banks to lower their lending rate so that both common people and
industrialist can go for loan and money circulation increases.
Average Lending Rate (Shown on Primary Axis) :
From the graph, we observe that the average lending rate is sharply decreasing in the year 2009-
10 & 2010-11 and as we also know that in the year 2008-09, India went under recession, which
resulted in inflation. In order to reduce the inflation and keep the money supply going, all the
commercial banks took steps like reducing lending rates. The value of average lending rate is
decreased from 13.38% to 8.88 % from the year 2009-10 to 2010-11 respectively.
This was there due to the decrease in the repo rate which is controlled by the RBI. This action
helps in pumping money into the economy as more people shall go for loan and hence
spending shall also increase.
Prime Lending Rate (%) Repo Rate (%) CCR (%) SLR(%)
01-01-03 11.125 19-03-03 7 14-06-03 4.5 08-11-08 24
01-10-03 11 31-03-04 6 02-10-04 5 07-11-09 25
01-10-04 10.5 26-10-05 6.25 23-12-06 5.25 18-12-10 24
01-10-05 10.5 30-10-06 7.25 10-11-07 7.5 11-08-12 23
01-10-06
11.25 30-03-07 7.75 11-10-08 7.5
14-06-
2014 22.5
01-10-07 13 20-10-08 8 17-01-09 5 9-08-2014 22.00
01-10-08 13.88 21-04-09 4.75 24-04-10 6
01-10-09 11.5 16-09-10 6 22-09-12 4.5
01-09-10 7.75 25-10-11 8.5 09-02-13 4
01-10-11 10.38 17-04-12 8
01-10-12 10.18 29-10-13 7.75
01-10-13 10.03 28-01-14 8
Fig 7.1

Fig 9.1 India’sprimelendingrate
Fig 10.1India’sInterest rate
Lower the interest rate, higher is the supply of money in the economy and greater
purchasing power of individuals. This will result in increase in the price of Goods, since
there is more demand and less supply of the goods. Manipulating interest rates thus
creates a variation in growth and inflation in the economy.
Thus Interestrate is amongstthe mostsignificant components of the cost of many
companies and uncertainty of this variable only amplifies overall uncertainty in which
investment decisions have to be made. RBI has to maintain a balance between these two
factors which runs the economy. RBI's interest rate policy can help anchor expectations
and reduce uncertainty.

5. Reserve Bank Of India And Its Monetary Policy
Monetary policy refers to the use of instruments under the control of the central bank to
regulate the availability, cost and use of money and credit.
Monetary Policy of India is formulated and executed by Reserve Bank of India. Monetary
policy primary function involves firstly supply of money, secondly cost of money or rate of
interest and thirdly availability of money to achieve specific objectives.
These functions results into control over Inflation, as Money Supply at particular time control
inflation.
The Objectives of Monetary policies are
• Maintaining price stability
• Ensuring adequate flow of credit to the productive Sectors of the economy to support
economic growth
• Rapid economic growth
• Balance of payment equilibrium
• Full employment
• Equal income distribution
The Reserve Bank's monetary policy stance will be determined by how growth and inflation
trajectories and the balance of payments situation evolve in the months ahead. Inflation has
moderated as projected however the depreciation in rupee value and imbalances in the
commodity markets pose a big challenge. Given that food price are still high, the inflation
figures will be influenced by efforts to break food inflation persistence and also the impact of
the ordinance passed for the food security bill. Historically, from 2000 until 2013, India
Interest Rate averaged 6.6 Percent reaching an all-time high of 14.5 Percent in August of
2000 and a record low of 4.3 Percent in April of 2009. Due to tight cash conditions in the
system, banks have been borrowing an average Rs.8o,000 crore daily from RBI. Due to
worsening liquidity conditions, bank borrowing shot up to Rs.1.2 trillion from the central
bank in December 2012.
Empirical estimates for India indicate that RBI’s monetary policy response to inflation has not
been aggressive, and as a result the Fisher effect –i.e. one for one response of interest rate
to inflation that could leave the real rate constant – does not hold. Thus, even when a high
nominal interest rate may often signal that monetary policy stance is tight, because of higher
inflation and absence of Fisher effect, lower real interest rate may actually be growth
supportive. In India, real lending rates in recent years have been generally lower than the

levels seen during the high growth phase before the global crisis. But lower real rates in the
post-crisis period have coincided with sluggish investment and GDP growth. This is due to
the fact that while real rates are lower, marginal productivity of capital, or expected return
on new investment has also declined, which has dampened the expected positive impact of
lower real rates on investment. In such a scenario, one policy option could be to lower real
rates even more, by raising inflation tolerance, i.e. lowering nominal policy interest rate even
when high inflation persists or inflation expectations remain high.
7. Conclusion
Interest Rates are very important tool for an economy. It determines country's growth,
its inflation, value of its currency, indirectly the level of employment and investments
prospects in the country(in the form of DII, FII, FDI). To achieve an open economy, India
should be open to investments thereby reducing prevailing interest rates taking into
consideration the inflation. Also if we see the trend, even though Central Bank reduced
its repo rate, the same has not been transferred to the consumer by banks. The lending
rates have not decreased by the same percentage as expected by RBI. Thus there has
been not much investment on the growth front. This leads to a question as to whether
further reduction in interest rate by Central Bank would provide a helping hand to
growth of the country or will merely increase the money supply(causing inflation) and
providing high profit making opportunities to banks.
The money supply in the economy by RBI has been increasing year on year although
the growth rate of money supply has been decreasing.
However inflation of Indian economy has been fluctuating over the years and is also
dependent on the world economy. After doing the regression analysis of Inflation and
Money supply we found the value of R-Square to be 0.26 or we can say that the about 26%
of variation in the inflation is explained by the money supply rest 74% is dependent on
other factors.
In case of interest rate and money supply the value or R-square is .41 hence 41% variation
in interest rate is explained by the money supply.

8. References
1) Rituparna Das (2010). “Definitions and Measures of Money Supply in India”. [ONLINE]
Available at: http://mpra.ub.uni-muenchen.de/21391/. [Last Accessed 26 November
2013].
2) RBI (01 Jun 1998). “New Monetary Aggregates: an Introduction”. [ONLINE] Available at:
http://www.rbi.org.in/scripts/PublicationReportDetails.aspx?FromDate=06/01/98&SECI
D=21&SUBSECID=0. [Last Accessed 26 November 2013].
3) RBI (1999). “Repurchase Agreements (Repos): Concept, Mechanics and Uses”.
[ONLINE] Available at:
ttp://www.rbi.org.in/scripts/PublicationReportDetails.aspx?UrlPage=&ID=34.
Last Accessed 26 November 2013].
4) IIFL (2013). “India Money Supply”. [ONLINE] Available at:
http://portal.indiainfoline.com/datamonitor/Others/Inflation-of-India/India-
Money-Supply-M3.aspx. [Last Accessed 26 November 2013].
5) RBI (2013). “Cash reserve ratio and interest rates”. [ONLINE] Available at:
http://rbi.org.in/Scripts/WSSView.aspx?Id=18684. [Last Accessed 29 November 2013].
6) Money control (2013). “Factors affecting interest rates”. [ONLINE] Available
at: http://www.moneycontrol.com/glossary/fixed-income/what-affects-
interest-rates_4090.html. [Last Accessed 29 November 2013]
7) Karvy.com (2013).” Interest rates”. [ONLINE] Available at:
http://www.karvy.com/economy/Interestrates.htm. [Last Accessed 29 November 2013].
8) RBI (2013). “Structure of Interest Rates”. [ONLINE] Available at:
http://rbi.org.in/Scripts/PublicationsView.aspx?Id=15195. [Last Accessed 29
November 2013].
9) Pratima Singh (2011). “Inflation in India: An Empirical Analysis.” [ONLINE] Available at:
http://www.isas.nus.edu.sg/Attachments/PublisherAttachment/ISAS_Working_Paper_1
28_-_Email-_Inflation_in_India_-_An_Empiral_Analysis_13052011162359.pdf [Last
Accessed 25/11/2013].
Page 22 of 24

10) D.N.Dwivedi, (2005). “Macroeconomics Theory and Policy”. 2nd ed. New Delhi: Tata
McGraw-Hill Education.
11) RBI (2008). “Annual Report 2008-2009”. [ONLINE] Available at:
http://www.rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=21266. [Last Accessed
28 November 2013].
12) Vikram K. Joshi, (2012). “Impact of monetary policy of India with special reference to
CRR, repo & reverse repo rate in curbing inflation an econometric study”. Management
Insight, SMS Varanasi. 8 (2), pp.1-12.
13) Ashima Goyal (2011). “History of Monetary Policy in India since Independence”.
[ONLINE] Available at: http://www.igidr.ac.in/pdf/publication/WP-2011-018.pdf. [Last
Accessed 29 November 2013].
Page 23 of 24

9. Annexure
M3 Average
M3
GDP at
GDP Savings Average
Money Constant Inflation Income Bank Repo
Growth Growth Interest Lending
Year Supply Prices (%) Velocity Rate Rate
Rate Rate Rate Rates
(in Billion (Billion (WPI) (%) (%) (%)
(%) (%) (%) (%)
INR) INR)
2005-06 24589.25 21.10 35432.44 9.28 4.50 1.50 3.50 11.50 6.00 6.15
2006-07 29505.57 21.72 38714.89 9.26 6.60 1.46 3.50 13.50 6.00 7.02
2007-08 36034.44 21.38 42509.47 9.80 4.70 1.38 3.50 14.00 6.00 7.75
2008-09 43436.64 19.34 44163.50 3.89 8.10 1.30 3.50 14.13 6.00 7.44
2009-10 51778.82 16.85 47908.47 8.48 3.80 1.25 3.50 13.38 6.00 4.77
2010-11 60091.48 16.09 52961.08 10.55 9.55 1.30 3.50 8.88 6.00 5.88
2011-12 69578.71 13.23 56313.79 6.33 8.79 1.29 4.00 10.38 6.45 7.99
2012-13 80305.94 13.81 58136.64 3.20 7.00 1.27 4.00 9.98 8.97 7.97
Figure 7.1 : Year wise data of Money Supply, GDP, Inflation & Interest Rate
Page 24 of 24

Money Supply and its Impact on Inflation and Interest Rate: A case study of India during 2003-04 to 2013-14

Recommandé

Recommandé

Contenu connexe

Tendances

Tendances (20)

Similaire à Money Supply and its Impact on Inflation and Interest Rate: A case study of India during 2003-04 to 2013-14

Similaire à Money Supply and its Impact on Inflation and Interest Rate: A case study of India during 2003-04 to 2013-14 (20)

Plus de Gokul K Prasad

Plus de Gokul K Prasad (10)

Dernier

Dernier (20)

Money Supply and its Impact on Inflation and Interest Rate: A case study of India during 2003-04 to 2013-14