FORECASTING MONEY SUPPLY IN INDIA IN THE POST CRISIS PERIOD: EMERGING ISSUES
In the post crisis period the studies like Sharma, Kumar and Hatekar (2012) and Mishra, Mishra and Mishra (2012) worked with cointergration, VAR, ECM, and Granger Causality involving money, price and output in short run and long run and are improvements over others like Asra, Chattopadhyay and Choudhury (2004) and Das (2003) who worked with causality analysis over long run involving the same variables with the similar methodologies.
Bose (2011) demonstrated the inflation in the post crisis period in India that originated out of price shocks in international commodities and domestic agriculture and foods. Hence the knowledge of mainstream monetary economics and orthodox monetary policy revolving around, inter alia, the relationship between money supply and price may not work here to solve the problem.
There are following cases regarding money supply as independent and dependent variable, which are not taken into account in any of the above studies. After the start of economic liberalization, there is massive forex inflow. They add to the forex assets of the banks. Net forex assets constitute a source of money stock. So liberalization might have an impact on money stock. But availability of data on such flow of foreign exchange is meagre. RBI then published such data in annual figures under three heads since 1990-91:
• NRI deposits outstanding,
• Inflows/outflows under various NRI deposit schemes, and
• Foreign investment flows.
The volume of data is not compatible with any kind of model building process, because of scanty degrees of freedom. However this point is missing in above studies especially those which were conducted in the post liberalization period. Sarma (1982) is a study in this respect on the pre-liberalisation period. Secondly repo is a monetary policy tool for injection of liquidity in the financial system.
In a floating exchange rate regime the RBI has often to intervene in the foreign exchange market in order to prevent any untoward movement in the value of rupee vis-a-vis dollar1. Dollar is the reserve currency of India2. An increase in the RBI’s purchase of foreign currencies in exchange for rupee ceteris paribus depreciates rupee and vice versa. The RBI was not disclosing the information on its foreign exchange market operation till the early part of 2000s. An increase in money supply in the country leads, ceteris paribus, to a decrease in the equilibrium interest rate in the money market and increase in liquid money in the hand of public. The term ‘public’ includes individuals as well as corporate entities save for government. A decrease in rate of interest ceteris paribus decreases cost of capital incurred by business and hence increases profits of business. Some of the increased profits are invested further in US dollar assets among other assets. This means people want to buy more of US dollars in exchange for rupees. So price of dollar vis-a-vis rupee increases, i.e. price of rupee vis-a-vis dollar falls. Thus an increase in money supply leads to a decline in the external value of the domestic currency. Further, the theory of floating exchange rate insists the Central Bank to prevent any unwanted movement of the home currency. Here the shift from net domestic assets to net foreign assets on resources side of the monetary base mentioned in Soumya and Murty (2005) should be remembered. This is another instance of theorization of empirical evidences. Following this line of argument one can envisage in the context of India a strong possibility of presence of a link between net foreign exchange assets of the banking sector including RBI (NFEA) and the rupee value of the currencies in the reference basket of currency. Because of the importance of US Dollar in international trade tracing back to the Breton Woods System, dollar is taken as the representative of the basket.10.