Magazine 2013
International Peer-Reviewed Journal
RH, VOL. 3 JULY 2013
Inflation in India: An Empirical Study
Arvind Dhond
ABSTRACT
“
Inflation is bringing us true democracy. For the first time in history, luxuries and necessities
are selling at the same price.”
- Robert Orben
When one describes inflation, it hardly makes any difference whether one refers to it as an ‘episode’ or
a ‘disaster’. However, most of the central bankers, who are having a tenacious battle of preventing an
episode from turning into a disaster, express different views regarding inflation. Inflation is often described
by economists as the general and persistent increase in prices across an economy over a period of
time. The rise in prices affects the wages, real income, production, unemployment and so on. For
economies that are persistently fighting high rates of inflation, the rise in prices brings no smiles.
Inflation hits the dinner table of both the rich and the poor, only the degree varies. While the government
considers a rise in prices as a signal of economic growth, Central Bankers’ have often treated inflation
as their ‘first enemy’. The present paper tries to study the relationship between money supply and
inflation.
Keywords - Inflation, Monetary Policy, Interest Rate, Central Bank, M1, M2, M3.
Inflation is like a ‘syndrome’, which is always talked about, but only a few are aware of its intricacies.
The main focus of Central Banks is to control inflation, which has often been perceived as a ‘mission impossible’.
However, inflation is not a supernatural phenomenon which cannot be controlled. The existence of inflation is
man-made and potentially inflation cannot only be overcome, but also its occurrence in the first place can be
prevented. According to the finance and economic literature, the key instrument used by Central Banks to
restrict inflation is the short-term interest rate. It is presumed that an increase in interest rates leads to a fall in
inflation. However, with reference to the Indian economy, can interest rates be used for the purpose of reducing
inflation?
For more than two decades, controlling inflation has been the main goal for policymakers. Empirical
research confirms that inflation has a deleterious impact on economic growth as it creates distortions related to
savings and investments. Central banks deploy an appropriate monetary policy as the key instrument to
maintain the desired level of inflation. In order to be effective, the monetary policy must be preemptive and
proactive to contain inflation. Since the causes of inflation vary from country to country, the Central Bank must
be react speedily and intelligently and employ appropriate country-specific monetary policy instruments such
as the interest rate. The monetary policy must be flexible enough to act according to the changing scenarios.
An effective option normally used is an inflation targeting framework.
Problem area of the Study:
To find out casual link between Money supply, Interest rate and Inflation rate.
Objectives of the Study:
The main objectives of this study are:
1
2
3
4
.
.
.
.
To analyze the causal link between money supply, inflation and interest rate in India.
To analyze the effect of rate of interest on inflation in India.
To see how inflation is calculated in India.
To see the relationship between Inflation and GDP growth rate.
Research Methodology
a) Sample Data Used and Sources:
In order to determine the relationships between money supply, inflation and interest rates and in an
attempt to discover the actual instrument used to control inflation, monthly data from March 2009-2011 from
(24)
International Peer-Reviewed Journal
RH, VOL. 3 JULY 2013
the Handbook of Statistics on the Indian Economy by the Reserve Bank of India (RBI) is used. The variables
used were Wholesale Price Index, interest rates, M1 and M3.
•
The Wholesale Price Index is the ‘headline inflation index’ for the Indian economy. (Virmani, 2003)
•
M1 is a narrow measure of money supply including the total money in circulation, traveller’s cheques,
checking account balances, Negotiable Order of Withdrawal (NOW) accounts, automatic transfer service accounts
and balances in Credit Unions. It includes currency plus all the items which can be treated like currency in the
Banking System.
•
M2 is a broader measure which includes everything present in M1 plus all the items which act as perfect
substitutes for M1 such as certificates of deposit, savings deposits and money market funds held by individuals.
Stiglitz and Walsh, 2006)
M3 is the broadest measure of money which includes everything in M1 and M2, that is, large denomination
(
•
savings accounts, large time deposits, repos of maturity greater than one day at commercial banks and
institutional money market mutual funds.
b) Analytical Tools
Two separate regressions were conducted for analyzing the different relationships:
•
•
Inflation, M1 and Interest rate with inflation being the dependent variable.
Inflation, M3 and Interest rate using inflation as the regression.
Limitations of the Study
The study is based on the secondary data provided by Reserve Bank of India (RBI) and due to lack of
time, the researcher could not take a long time series data for the analysis purposes, which may give a better
result for the inter-relationship between money supply, Interest rate and inflation.
Literature Review:
•
Fama and Gibbons (1982) have attempted to explain the negative association between inflation and
real interest rates.
•
Koreisha and Partch (1985) used a vector autoregressive-moving average (VARMA) model to examine
the causal links between money supply, interest rates and inflation which was supported by Geske and Roll
(
1983). Interest rates explain a substantial fraction of the variation in inflation.
•
Mehra (1978) and Sims (1980) however, point out that the causal relations obtained from a bivariate
causal test are not robust enough when other variables are introduced in the vector autoregressive (VAR)
system. In this respect, Koreisha and Partch’s causality test based on the VARMA model which uses the first
difference in interest rates as a proxy for a change in expected inflation is more appropriate than others even
though a separate role for interest rates is not allowed for. However, the monetary base growth rate is highly
correlated with interest rates and the rate of inflation to an extent which is almost redundant. (Lee, 1992).
Data and Empirical Results
The relationships between money supply growth, inflation and interest rates is a highly debated issue
in literature. Neoclassical theory states that inflation can either be
controlled by increasing short-term interest rates or by reducing money
supply growth.
The different relationships are analyzed by conducting six separate
regressions:
•
Inflation, M1 and interest rates with inflation being the dependent
variable.
•
Inflation, M3 and interest rates using inflation as the dependent
variable.
•
•
M1, interest rates and inflation with M1 as the dependent variable.
M3, interest rates and inflation using M3 as the dependent variable.
In the following all this will be analyzed briefly.
(25)
International Peer-Reviewed Journal
I. Inflation, M1 and interest rates with inflation being the dependent variable:
Fig. 1: Inflation, Money Supply and Interest Rates
With inflation as the dependent variable and interest rates and M1 as the explanatory variables, the
following results are received:
Interpretation:
Theoretically it is known that inflation, money supply and interest rate are related but what is the
RH, VOL. 3 JULY 2013
model? How inflation is affected by interest rate and money supply? Based on the following model an attempt
is made to work on many experiments.
Inflation = f (Money Supply and Interest Rate)
Because the study didn’t want to remove timeframe limit while constructing the model, monthly inflation
growth rate was taken and for money supply also monthly growth rate was taken, Interest rate was taken as it
is.
This 1st experiment was as follows:
Inflation = f (Money Supply)
When inflation growth rate on money supply growth rate was regressed, it turned out to be a Spurious
Regression with High T stat value and low r2 to avoid this experiment the study performed to see the difference
in growth rate and in money supply growth rate difference, it was seen that there was no Relationship. Keeping
in mind, priority assumptions that inflation is lagged effect of money supply following model was posted:
Current Inflation Growth Rate = f (Last Month Money Supply Growth Rate)
The following equation was obtained:
Inflation Growth Rate = 0.26 Money Supply Growth Rate
0
.26 is statistically significant as T-stat was 14.78,
R2 = 0.87
which means inflation growth rate changes positively by 0.26 or 26% of money supply growth rate.
Here it should be note as the study has taken only growth rate and Constant as Zero.
Further interest rate was added to the equation which turned out to be:
Inflation Growth Rate = 0.21 Money Supply Growth Rate + 0.38 Interest Rate
However, in this case interest rate was not statistically significant. Therefore it can be said that interest rate
does not have any kind of effect on inflation but however money supply have effect on inflation.
II.
When inflation was replaced by M1 as the dependent variable, the resulting equation was as
follows:
Interpretation:
Theoretically it is known that inflation, money supply and interest rate are related but what is the model? How
Inflation is affected by interest rate and money supply? The study tries to work on many experiments based on
the following model:
Money Supply = f (Inflation and Interest Rate)
Because the study didn’t want to remove timeframe limit while constructing the model, hence the study took
monthly inflation growth rate and for money supply also the study took monthly growth rate, interest rate was
taken for the study as it is.
This 1st experiment was as follows:
Money Supply = f (Inflation Growth Rate)
When inflation growth rate on money supply growth rate was regressed it turned out to be a Spurious Regression
with High T stat value and low r2 to avoid this experiment the study performed to see the difference in growth
rate and in money supply growth rate difference, it was seen that there was no Relationship. Keeping in mind,
priority assumptions that inflation is lagged effect of money supply following model was posted:
Current Money Supply Growth Rate = f (Last Month Inflation Growth Rate)
(26)
International Peer-Reviewed Journal
RH, VOL. 3 JULY 2013
The following equation was obtained:
Money Supply Growth Rate = 3.22 Inflation Growth Rate
3
.22 is statistically significant as T-stat was 18.96
R2 = 0.92
which means money supply growth rate changes negatively by 0.032 of inflation growth rate. Here it should be
noted as the study has taken only growth rate and Constant as Zero. Further interest rate was added to the
equation turned out to be:
Interpretation:
Theoretically it is known that inflation, money supply and interest rate are related but what is the model, how
inflation is affected by interest rate and money supply. The study tries to work on many experiments based on
the following model:
Inflation = f (Money Supply and Interest Rate)
Because the study didn’t want to remove timeframe limit while constructing the model, hence the study took
monthly inflation growth rate and for money supply also it took monthly growth rate, interest rate was taken as
it is.
This 1st experiment was as follows:
Inflation = f (Money Supply)
When the study regressed inflation growth rate on money supply growth rate it turned out to be a Spurious
Regression with High T stat value and low r2 to avoid this experiment the study performed to see the difference
in growth rate and in money supply growth rate difference, it was seen that there was no Relationship.
Keeping in mind, priority assumptions that inflation is lagged effect of money supply following model was
posted:
Current Inflation Growth Rate = f (Last Month Money Supply Growth Rate)
The following equation was obtained:
Inflation Growth Rate = 0.24 Money Supply Growth Rate
0
.24 is statistically significant as T-stat was 17.40
R2 = 0.90
which means inflation growth rate changes positively by 0.24 or 24% of money supply growth rate.
Here it should be noted that the study has taken only growth rate and Constant as Zero.
Further interest rate was added to the equation turned out to be:
Inflation Growth Rate = 0.64 Money Supply Growth Rate - 3.68 Interest Rate
However, in this case interest rate was not statistically significant. Therefore from the results it can be said that
interest rate don’t have any kind of effect on inflation and but money supply have effect on inflation.
IV.
When Inflation was replaced with M3 as the dependent variable, the resulting equation was as
follows:
Interpretation:
Theoretically it is known that inflation, money supply and interest rate are related but what is the model, how
inflation is affected by interest rate and money supply, the study tries to work on many experiment based on the
following model:
Money Supply = f (Inflation and Interest Rate)
Because the study didn’t want to remove timeframe limit while constructing the model, the study took monthly
inflation growth rate and for money supply also it took monthly growth rate, interest rate was taken as it is.
This 1st experiment was as follows:
Money Supply = f (Inflation Growth Rate)
(27)
International Peer-Reviewed Journal
RH, VOL. 3 JULY 2013
When the study regressed inflation growth rate on money
supply growth rate it turned out to be Spurious Regression
with High T stat value and low r2 to avoid this experiment the
study performed to see the difference in growth rate and in
money supply growth rate difference, it was seen that there
was no Relationship. Keeping in mind, priority assumptions
that inflation is lagged effect of money supply following model
was posted:
Current Money Supply Growth Rate = f (Last Month
Inflation Growth Rate)
The following equation was obtained:
Money Supply Growth Rate = 8.93 Inflation Growth Rate
8
.93 is statistically significant as T-stat was 32.51
R2 = 0.97
which means money supply growth rate changes negatively by 0.089 of inflation growth rate.
Here it should be noted that the study has taken only growth rate and Constant as Zero.
Further interest rate was added to the equation turned out to be:
Money Supply Growth Rate = 5.94 Inflation Growth Rate + 1.47 Interest Rate
However, in this case interest rate statistically significant. Therefore it can be said interest rate does have
some kind of effect on money supply and also interest rate have some effect on money supply growth rate.
Fitting these regression results into the diagram the following diagram can be presented:
Fig. 2: Inflation, Money Supply (M1, M3) and Interest Rate
It was concluded that there was no statistical evidence for any connection between interest rates and inflation.
Therefore, this particular relationship could be eliminated from the analysis. Based on tests of causality and
causation, the effect of money supply (M1 and M3) on interest rates showed very high figures in terms of
causality indicating that such causal probabilities are impossible.
The present study found that interest rates and money supply share a positive causal relationship and that
interest rates changes influence money supply, while money supply variations do not lead to changes in
interest rates. Changes in interest rates are related not only to money stock but also to changes in real income,
price level and inflation. In addition, the causation links also proved to be weak. Thus, the effect of money
supply on interest rates could be eliminated. Based on the results of the regression models, and ruling out
relationships that are not statistically significant and those that are not causally possible, only three relationships
remain:
•
•
•
Interest rate on money supply.
Money supply on inflation.
Inflation on money supply.
Also, the study concludes that interest rates do not increase or decrease inflation directly. The rise or fall in
rates affect the inflation level through the impact they have on money supply. When interest rates rise, the
demand for deposits increase, thereby increasing M1 and M3. Money supply, in turn, shares a negative relationship
with inflation. Thus, based on the results found above, interest rates have an impact on money supply, which in
turn have an impact on inflation.
Money supply
Interest rate
Inflation rate
Fig. 3: Interest Rate, Money Supply and Inflation Rate
(28)
International Peer-Reviewed Journal
RH, VOL. 3 JULY 2013
The regression model has been a guiding principle in providing information on the connection between inflation,
interest rates and money supply and has been instrumental in directing the study towards its goal. The discussion
above also suggests that a theoretical statistical procedure might prove to be superior to economic theory for
explaining the relationship between inflation, interest rates and money supply. Furthermore, because theory is
less useful a guide in evaluating such relationships, it is more important to check for the significance of statistical
methods. There are various aspects of past literature which will raise questions regarding the validity of the
conclusion. This is an empirical issue which cannot be settled on theoretical grounds as the results prove
otherwise and cannot be resolved without further research. In conclusion, even if interest rates are said to cause
inflation, does this necessarily mean that they are the only useful instruments to control inflation?
Findings and Conclusion:
Neoclassical theory suggests that the key instrument used to control inflation is the short-term interest rate.
When inflation is high, Central Banks increase the interest rates to bring inflation down. In this sense, interest
rates are said to have a negative relationship with inflation. As the results of the present study shows that interest
rate has a positive relationship with inflation that means interest rate don’t affect inflation growth rate but money
st
nd
supply affects inflation rate in the 1 Regression and in the 2 regression both money supply growth rate and
interest rate both have some effect on inflation growth rate but interest rate have very low effect as compared to
money supply rate, so it can be said that interest rate have a positive relation with inflation. But when last
month’s money supply growth rate increase it’s going to affect current month inflation growth rate and it may be
also increase in inflation rate and vice versa. But by analyzing the data it can be said that in this way interest
rates can be used to control inflation, but not in the standard way we expect them to.
Suggestions
•
As the findings shows that if money supply increase then inflation rate will also increase so government can
take some precaution to have control on inflation rate.
•
If the interest rate is to be an instrument for controlling inflation, it must exert a causal influence on inflation
and that causal influence must have the form of causality rather than causation.
References
•
Blinder, Alan S. “Keynesian Economics”. The Concise Encyclopedia of Economics, 2002.Retrieved 2008
4-09. Print.
Dimand, Robert William The Origins of the Keynesian Revolution, Stanford University Press,Stanford p.
17, ISBN 0804715254.1988. Print.
0
•
1
•
•
•
Economic and Political Weekly (Various Issues). Print.
Government of India: Economic Survey of India, Planning Commission. Print.
Keynes, John Maynard. The Theory of Money and the Foreign Exchanges, A Tract on Monetary Reform.
1
924 Print.
•
•
Keynes, John Maynard. Treatise on Money, London : Macmillan, p. 90. 1930 Print.
Keynes, John Maynard . The General Theory of Employment, Interest and Money. Basingstoke, Hampshire
:
Palgrave Macmillan, ISBN 0230004768. 2007/1936.Print.
•
•
Lindahl, Erik. “On Keynes.’ Economic System, Economic Record 30: 19–32. 1954. Print
Reserve Bank of India (RBI): Handbook of Statistics on the Indian Economy. Print
Webliography
•
•
•
•
•
•
www.imf.org
www.indexmundi.com
www.moneycontrol.com
www.rbi.org.in
www.tradingeconomics.com
www.worldbank.org.in
*
****
29)
(