Contents

List of Figures...............................................................................................................................................1
List of Tables................................................................................................................................................1
Executive Summary.....................................................................................................................................2
Introduction:...............................................................................................................................................3
Objectives of the Study...............................................................................................................................3
Money Supply in India.................................................................................................................................3
Measures of Money Stock.......................................................................................................................3
RBI’s channels for monetary policy.........................................................................................................3
RBI’s instruments of controlling money supply.......................................................................................4
Inflation.......................................................................................................................................................5
Measuring Inflation.................................................................................................................................5
Trends of Inflation...................................................................................................................................6
Quantity theory of money:..........................................................................................................................7
History of the Quantity Theory of Money:...............................................................................................7
Opposing Theories:..................................................................................................................................7
What is the Velocity of Money:...............................................................................................................8
Findings.......................................................................................................................................................9
Correlation between WPI and Money Supply........................................................................................10
Regression Analysis...............................................................................................................................11
Impact of FII and FDI Inflows on Money supply and inflation....................................................................12
Sterilization:...........................................................................................................................................13
Conclusion:................................................................................................................................................15

List of Figures
Figure 1: Inflation Trends in India................................................................................................................6
Figure 2: Velocity of Money.........................................................................................................................9
Figure 3: Price Level Vs. Money Supply.....................................................................................................10
Figure 4: WPI vs. FII & FDI..........................................................................................................................13

List of Tables
Table 1: WPI Weights..................................................................................................................................6
Table 2: Velocity of Money..........................................................................................................................9
Table 3: WPI and Money Supply................................................................................................................10
Table 4: Correlation Between WPI and Money Supply..............................................................................11
Executive Summary
The report aims to study the effect of money supply in India with the price levels. Supply of money in
the country is controlled by the Reserve Bank of India, and is measured by the three parameters:
Reserve Money (M0), Narrow Money (M1) & Broad Money (M3). RBI uses various instruments like
Liquidity Adjustment Facility, Quantitative Easing and Open Market Operations to regulate the amount
of money circulating in the Indian economy.

Price levels in the Indian economy are measured with the help of two indices, the Wholesale Price Index
(WPI) & the Consumer Price Index (CPI). While WPI measures prices at the wholesale level, CPI gives an
indication of the prices prevailing at the retail level. India uses the growth rate of WPI to compute its
inflation levels.

The Quantity Theory of Money says that general price-level in an economy is directly proportional to the
amount of money circulating in it, provided velocity & quantity of real output are held constant. In other
words, a central bank’s action to increase or decrease money supply in the country has direct
implication of affecting the prevailing price levels.

The report aims to study effect that changing money supply has had on the price levels in the Indian
economy. It includes a thorough study of the three measures of money supply (M0, M1 and M3) and
how their changing levels are mathematically co-related with the WPI Index numbers. It also studies the
velocity of money over the last 20 years, and checks if it remains constant or not.

The report found a positive correlation of money supply in India with WPI Index numbers over the last
20 years. It also found that velocity has been more or less constant over the same time period. Thus, it
helped us conclude that quantity theory of money holds true in case of India, and that changing price
levels can be directly attributed to the supply of money in the country.
Introduction:
This report investigates the money-supply/price level relationship in India. The debate on the role of
money supply in the determination of nominal income and price has remained one of the important
issues in the history of economic thought. The Monetarists and the Keynesians have diametrically
opposite views on this important issue; the Monetarists firmly believe that changes in money stocks
change nominal income as well as prices while the Keynesians think that money supply does not play
any important role in the determination of nominal income and prices. In this project an attempt has
been made to study the direction of causality between money supply and prices. We have taken the
data on Wholesale price inflation index and Measures of money (Reserve money, Narrow money, Broad
money) to study the correlation between them and their impact on the price levels.

Objectives of the Study

In this project report we will attempt to study the dynamics of money supply in India and its effects on
prices. To study the effect of money supply on prices we will first concentrate on money supply – What
constitutes money supply? How it is used by the Central Bank in its monetary policies? etc. Then we will
analyze the various price levels and measures of inflation in India. We will then try to see if there is any
co-relation between changes in money supply and the price levels in the country. We will attempt to
analyze the relationship if any theoretically as well as using data from the real world.

Money Supply in India

Measures of Money Stock.

The main measures of money are as follows:
Reserve money (M0) = Currency in circulation + Other Deposits with RBI + Bankers’ Deposits with RBI

Narrow Money (M1) = {Currency in circulation – Cash with banks } + Other Deposits with RBI + Demand
Deposits

Broad Money (M3) = Narrow Money + Time Deposits

The amount of Broad money in the system depends to a significant extent on the amount of reserve
Money (M0). The relationship is given by the Money Multiplier = M3 / M0

The RBI attempts to control the quantity of money in circulation by purchase and sale of different credit
instruments, commodities, foreign currencies, etc. These transactions result in increasing or decreasing
the base currency M0. Controlling M0 indirectly impacts the amount of broad money in the economy
(M3). The RBI attempts to control the total amount of money circulating in the system in this fashion.

RBI’s channels for monetary policy

 Quantum Channel
 Interest Rate Channel
 Exchange Rate Channel
 Asset Prices
RBI’s instruments of controlling money supply
The RBI controls the quantum of money with the following instruments at its disposal:

 Printing new currency

The government and in turn the central bank has at its disposal the power to print more money. This
process is known as quantitative easing. The use of quantitative easing can lead to high inflation and in
many countries even hyper-inflation. E.g. Germany in 1920s, Hungary in mid 1940s, Yugoslavia in late
1980s and Zimbabwe are examples governments taking note printing to the extremes. Hungary even
printed money notes of 100 quintillion pengő (100,000,000,000,000,000,000, or 1020).

 Controlling Credit Reserve Ratio (CRR) & Statutory Liquidity Ratio (SLR):
By controlling the above ratios, the RBI can influence the amount of money that flows into the
economy. The higher the CRR and SLR, the lower the amount of money that can be released into the
market. This in turn reduces

 Open Market Operations:

The Central bank increases or decreases money supply by buying or selling Government bonds in the
open market. When the Central Bank buys bonds from the market it is actually passing on huge sums
of money into the economy and when it sells bonds, it soaks up the liquidity from the system.

 Discount Rate:
The discount rate is the interest rate charged by the central bank to banks which borrow money from
its reserves.

Another instrument used by RBI which indirectly affects money supply is the Liquidity Adjustment
Facility (LAF):

It is a tool used in monetary policy that allows banks to borrow money through repurchase agreements.
This arrangement allows banks to respond to liquidity pressures and is used by governments to assure
basic stability in the financial markets. Liquidity adjustment facilities are used to aid banks in resolving
any short-term cash shortages during periods of economic instability or from any other form of stress
caused by forces beyond their control. Various banks will use eligible securities as collateral through a
repo agreement and will use the funds to alleviate their short-term requirements, thus remaining stable.

LAF was introduced by RBI during June, 2000 in phases, to ensure smooth transition, keeping pace with
technological up gradation. All commercial banks (except RRBs) and PDs having current account and SGL
account with RBI are eligible to use the LAF to mitigate the matches in their day to day liquidity. Repos
and Reverse Repos in transferable Central Govt. dated securities and treasury bills are the eligible
securities that can be used for LAF.

While both Liquidity Adjustment Facility and Open Market Operations are ways to induce liquidity into
the monetary system, both are markedly different mechanisms. LAF involves lending and borrowing of
securities to the banks, so that their day-to-day liquidity problem is resolved. On the other hand, Open
Market Operation involves buying and selling of securities from the government to regulate liquidity in
the system.

Inflation
In economics, inflation is defined as a rise in the general level of prices of goods and services in an
economy over a period of time.

Measuring Inflation
Inflation is generally measured using 2 key indices:

 Wholesale Price Index (WPI)

 Consumer Price Index (CPI)
As their names suggest, wholesale and consumer price indices are based on the wholesale and retail
prices prevailing in the market, relative to the prices in a chosen base year. WPI is published by the
Office of the Economic Adviser (OEA), Ministry of Industry, and its percentage-change is used as the
measure of inflation in the country. Also, India uses 4 different CPIs, due to different consumption
patterns of its diverse population. The CPIs are:

 CPI UNME (Urban Non-Manual Employee)

 CPI AL (Agricultural Laborer)
 CPI RL (Rural Laborer)
 CPI IW (Industrial Worker)

Even though change in WPI is used as the measure of inflation, these CPIs capture the price changes
relevant to each segment of population at the retail level and provide an undistorted image of market
rates. While the CPI UNME series is published by the Central Statistical Organization, the others are
published by the Department of Labor.

Wholesale Price Index

The Office of the Economic Adviser (OEA), Ministry of Industry compiles Wholesale Price Index (WPI)
numbers for all-India, on weekly basis. Earlier, the WPI series, on base 1981-82, covered 447
commodities. In all 2,371 quotations of wholesale prices in respect of 447 commodities were collected,
on weekly basis, through official as well as non-official sources. In April 2000, the base year of WPI was
changed from 1981-82 to 1993-94. Also, the consumption basket was changed to cover 435 items.The
sector- wise breakup of Commodities is (i) primary articles-98 (food articles-54, Non-food articles-25,
minerals-19) (ii) fuel, power, Light & lubricants-19 (iii) manufactured products-318.

Table 1: WPI Weights

Major Group Weights

I. Primary Articles 22.025

(a) Food Articles 15.402
(b) Non-food Articles 6.138
(c) Minerals 0.485
II. Fuel, Power, Light & Lubricants 14.226
III. Manufactured Products 63.749
(a) Food Products 11.538
(b) Beverages, Tobacco & Tobacco Products 1.339
(c) Textiles 9.800
(d) Leather & Leather Products 1.019
(e) Others 40.053

Total 100

Laspeyres based-weighted formula is used to compile WPI. Price relatives are calculated as percentage
ratios which the current prices bear to those prevailing in the base period; and are obtained by dividing
the current prices by the corresponding base year prices, and multiplying by 100. Commodity index is
computed as a simple arithmetic average of the price relatives of the quotations under that commodity.
Subgroup index is derived as weighted average of the indices of the commodities included in that
subgroup. Group index is obtained as weighted arithmetic average of the indices of subgroups included
under that group. The major group index is arrived at as weighted average of the indices of the groups
that are included under that major group. Index for all commodities is computed as weighted average of
the indices for major groups.
Work is already underway to change the base year of WPI from 1993-94 to 2004-05.

Consumer Price Index

India uses four different CPIs to capture the relative price levels of different commodities, relevant to
different segments of population. For instance, the consumption pattern of an urban dweller is markedly
different from that of a rural laborer. CPIs are computed on a monthly basis.

Trends of Inflation
The chart below shows the inflationary trend (measured using WPI), and the four CPIs in the last 20
years. It should be noted that the numerical data might be slightly distorted on account of change of
base years and consumption baskets.
 Inflation Trends in India
16.00
14.00
12.00
10.00
8.00
6.00
4.00
2.00 WPI based Inflation Inflation Based on CPI IW Inflation Based on CPI RL
0.00
Inflation
1990 1991 1992 Based on CPI
1993 1994 UNME
1995 1996 1997Inflation
1998 1999Based
2000on2001
CPI AL
2002 2003 2004 2005 2006 2007 2008
-2.00

Figure 1: Inflation Trends in India

A prominent macroeconomic theory which relates money supply to prices (inflation) is the ‘Quantity
Theory of Money’

Quantity theory of money:

History of the Quantity Theory of Money:
Starting from the 15th century, European powers colonized various parts of the world and started
plundering precious metals such as gold and silver back to the European mainland. These metals were
getting minted into coins. The easy availability of these metals was leading to easy supply of money and
a subsequent rise in inflation. This led economist Henry Thornton to put forward the theory that more
money implies more inflation and that increase in the money stock does not always lead to increase in
economic output.

The quantity Theory of Money states that there is direct relationship between the quantity of money in
the economic system and the price level associated with the goods and services being offered in that
particular economy.
M*V=P*T
Where,
M = Money Supply (M0)
V = Velocity of Money
P = Price Level
T = Quantity of Real Output

Thus, P * T represents the nominal GDP of the economy. The above equation is also known as the
Equation of Exchange. The Quantity Theory of Money adds some assumptions to the Equation of
Exchange. The theory assumes that the Velocity of money generally doesn’t change over short periods
of time. It also assumes that the real output in the economy is fairly stable in the short run as it is
determined by factors of production such as Labor & Capital and Technological Advances. The Quantity
Theory assumes that the economy is at equilibrium and at potential employment. Thus, taking V & T as
constants, we get M / P = T / V = constant. This implies that any increase in money supply should be
accompanied by a proportionate increase in the price levels. Looking at it from another angle, we can
say that increasing money supply decreases the value of every unit of money. People who support the
QTM state that if there is more money in the system than the amount of goods and services, then too
much money chasing fewer items will lead to a general increase in price levels.

Economists generally agree that the quantity theory holds in the long run. However, there are
considerable disagreements about the validity of the theory in the short run. Some economists believe
that the velocity of money is not constant and that in the short run the prices are sticky and hence not
proportional to money supply.

Opposing Theories:
There a few theories such as the Keynesian Theory on inflation which counter the Quantity Theory of
Money.

Keynesian Theory of Inflation:

Keynesians believe that while money supply does impact inflation in the long run, in the short run it is
affected by other factors such as increase in aggregate demand and increase in production costs. The
former is known as Demand-Pull inflation and the latter is known as Cost-Push inflation. The Demand-
Pull inflation is caused due to increase the components of Aggregate Demand such as investments,
government spending, exports, etc., when the economy is at or near its full output potential. Thus, while
trying to meet the added demand from consumers, firms will inadvertently jack up the prices of factors
of production. The Cost Push inflation, on the other hand is due to increase in prices of factors of
production such as raw material and wage rates. Increase in wage rates, forms a major portion of the
cost push inflation as labor usually makes up majority of the cost in most organizations.
Alternative theories include and fiscal theory of price level & the real bills doctrine. The real bills
doctrine states that increasing money supply by introducing more money in exchange of assets of equal
value has no effect on inflation.
To check the veracity of the implications of the Quantity Theory of Money we need to check if the
assumptions made by the theory actually hold in the real world.
The classicists assume that the economy is at potential GDP. Thus, it is logical to assume that the GDP is
fairly stable as it would return to the potential GDP level after deviating from it for a short while due to
change in Aggregate Demand. The other important assumption necessary for Quantity Theory of Money
is that the velocity of money is fairly stable for a considerable period of time.

What is the Velocity of Money:

The velocity of money can be defined as the number of times that a unit of currency is spent on goods
and services per year on an average. Thus, it is how fast money circulates in an economy. As MV = PT,
we can see that Velocity has a similar impact on inflation as does money supply. Increase in velocity of
money would increase the price level in the economy and vice-versa. The velocity of money depends
among other things on the demand for money. The more money that people demand and hence hold on
to, the lesser is the velocity.
Sir William Petty was probably one of the first economists to have written about the concept of velocity
of money. He put forward the view that the frequency of people’s pay periods determined the velocity
of money in the economy. Velocity also found mention in the writings of the John Locke (1632–1704).
Locke talked about a ratio which had money stock in the numerator and trade in the denominator, a
concept quite similar to velocity.

Table 2: Velocity of Money

Reserve Broad Velocity @ Velocity @

Year GDP at MP
Money Money M0 M3

1990-91 87779 265828 585868.94 6.674 2.204

1991-92 99505 317049 673401.02 6.768 2.124

1992-93 110779 366825 774053.92 6.987 2.110

1993-94 138672 434407 890496.63 6.422 2.050

1994-95 169282 531426 1044732.27 6.172 1.966

1995-96 194457 604007 1225801.96 6.304 2.029

1996-97 199985 700183 1417933.37 7.090 2.025

1997-98 226233 821332 1570710.56 6.943 1.912

1998-99 259285 980960 1801140.92 6.947 1.836

1999-00 280555 1124174 2007705.53 7.156 1.786

2000-01 303311 1313220 2162269.27 7.129 1.647

2001-02 337970 1498355 2343944.75 6.935 1.564

2002-03 369061 1717960 2524561.89 6.841 1.470

2003-04 436512 2005676 2833178.19 6.490 1.413

2004-05 489135 2251449 3239224.00 6.622 1.439

2005-06 573055 2729545 3706473.00 6.468 1.358

2006-07 709016 3310068 4283979.00 6.042 1.294

2007-08 928302 4017883 4947857.00 5.330 1.231

2008-09 987998 4794812 5574448.00 5.642 1.163

Average 6.577 1.717

Standard Deviation 0.50473 0.3316749

 Velocity (GDP/M0)
8.000
6.000
4.000
2.000
0.000
1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 7 8 9
0 -9 1 -9 2 -9 3 -9 4 -9 5 -9 6 -9 7 -9 8 -9 9 -0 0 -0 1 -0 2 -0 3 -0 4 -0 5 -0 6 -0 7 -0 8 -0
9 9 9 9 9 9 9 9 9 9 0 0 0 0 0 0 0 0 0
19 19 19 19 19 19 19 19 19 19 20 20 20 20 20 20 20 20 20

Velocity (GDP/M0)
Figure 2: Velocity of Money

We can see that the Velocity of money over the last 20 odd years has not deviated much from its mean
of 6.57. The standard deviation has been around 0.5 units. Thus, we can say that the assumption that
the Velocity of money stays stable over long periods of time is true to a large extent. Thus, both the
assumptions started in the Quantity Theory of Money seem to hold.

Thus, atleast theoretically there seems to be a direct relation between Money supply & price levels.
Now let us analyze the theory in the real world and see if it can be seen practically as well.

Findings
The following is the data on WPI, M0, M1 & M3 for the past 28 years.

Table 3: WPI and Money Supply

YEAR  WPI M0 M1 M3 YEAR  WPI M0 M1 M3

1982 105.5 23110 28535 73184 2000 366.9 303311 379450 1313220
1983 113.7 28994 33398 86525 2001 366.9 337970 422843 1498355
1984 120.4 35216 39915 102933 2002 379.4105 369061 473581 1717960
1985 125.3 38165 44095 119394 2003 400.1098 436512 578716 2005676
1986 133.1 44808 51516 141632 2004 426.0407 489135 649790 2245677
1987 146.0 53489 58555 164275 2005 426.0407 571958 826415 2719519
1988 154.9 62958 66786 193493 2006 453.7958 708890 967955 3310068
1989 166.6 77591 81060 230950 2007 475.6326 928302 1155837 4017883
1990 186.6 87779 92892 265828 2008 513.8366 987998 1259707 4794812
1991 213.2 99505 114406 317049 2009 532.204 1155686 1494611 5599762
1992 231.4 110779 124066 364016
1993 251.7 138672 150778 431084
1994 279.9 169283 192257 527596
1995 297.7 194457 214835 599191
1996 320.1 199985 240615 696012
1997 334.4 226402 267844 821332
 1998 355.5 259286 309068 980960
1999 365.4 280555 341796 1124174

The following is the graph of WPI versus the various measures of money supply:

Price Level Vs. Money Supply

6000000 600.0
5000000 500.0
4000000 400.0
3000000 300.0
2000000 200.0
1000000 100.0
0 0.0
82 84 86 88 90 92 94 96 98 00 02 04 06 08
19 19 19 19 19 19 19 19 19 20 20 20 20 20

M0 M1 M3 WPI
Figure 3: Price Level Vs. Money Supply

Correlation between WPI and Money Supply

The data for WPI and Money Supply (M0, M1 and M3) was plotted and analyzed for last 30 years.
Following were the correlation coefficients obtained:

Table 4: Correlation Between WPI and Money Supply

WPI M0 M1 M3
Correlation Coefficient 0.897929 0.896442 0.8815

As can be seen, price levels in Indian economy (measured through WPI Index numbers) are positively
and highly correlated to the extent of money supply (measured through M0, M1 and M3 numbers) in
the country.

Regression Analysis
We performed regression analysis of the WPI data as dependent variable with Reserve Money (M0) &
GDP as the independent Variables.

Model Summary

Model R R Square Adjusted R Square Std. Error of the Estimate

 1 .945a .894 .880 31.30516

ANOVAb

Model Sum of Squares df Mean Square F Sig.

1 Regression 131836.058 2 65918.029 67.262 .000a

Residual 15680.209 16 980.013

Total 147516.267 18

Coefficientsa

Standardized
Unstandardized Coefficients Coefficients

Model B Std. Error Beta t Sig.

1 (Constant) 242.863 13.883 17.493 .000

M0 2.395 .282 .832 8.483 .000

GDP .109 .058 .182 1.857 .082

We can see from the data that the standardized coefficient of M0 (.832) is much higher than that of GDP
(.182). Thus, it provides a very conclusive proof that money supply is more significant in explaining the
dependent variable WPI as compared to GDP. Also the significance of 0.082 for the t-statistic for GDP co-
efficient shows that at 5% level of significance, it would not be considered to be a significant factor in
determining WPI. Whereas the t-statistic for Mo is quite significant in determining WPI.

Impact of FII and FDI Inflows on Money supply and inflation

FDI:
There is no specific definition of FDI owing to the presence of many authorities like
OECD,IMF,IBRD and UNCTAD.All these bodies attempt to illustrate the nature of FDI with certain
measuring methodologies.FDI refers to the capital flows from the abroad that invest in the production
capacity of the economy and are usually preferred over other forms of external finance because they
are non-debt creating and non-volatile.FDI also facilitates international trade and transfer of
knowledge ,skill and technology.FDI is described as a source of economic development, modernization
and employment generation that helps in creating a competitive business environment.
FII:

Foreign institutional investment is a short-term investment, mostly in the financial markets. FII, given its
short-term nature, can have bidirectional causation with the returns of other domestic financial markets
such as money markets, stock markets, and foreign exchange markets. The determinants of FII are very
important for any emerging economy as FII exerts a larger impact on the domestic financial markets in
the short run and a real impact in the long run. India, being a capital scarce country, has taken many
measures to attract foreign investment since the beginning of reforms in 1991. Inflation and risk in the
domestic country and return in the foreign country adversely affect the FII flowing to the domestic
country, whereas inflation and risk in the foreign country and return in the domestic country have a
favorable effect on the flow of FII. Another possible determinant of FII is the operation of foreign factors
such as returns in the source country’s financial markets, if low pushes the country to invest elsewhere.
Source of money
The primary source of money has been borrowings in Japanese yen where the interest rates have been
extremely low over the past decade. The investors then invest this money into higher yielding assets in
developing countries such as India and earn an easy arbitrage. This is known as ‘Yen Carry Trade’.
Currently, a lot money has also originated from the near-zero interest rates in the United States. While
this is not going to remain low forever in the US, the rates in Japan are expected to continue to remain
at low levels and hence there is not going to be any cash crunch affecting FDI flows.

FDI inflows into India during 2009 have crossed Rs. 80,000 crores and this is the highest ever flow into
the country in rupee terms. The attractiveness of India for FDI is far from receding and can surely be
expected to sustain over the next decade as well.

Trends and developments

In recent years, India has experienced a significant spurt in forex inflows. Net capital flows increased
from an average of US $ 5.8 billion per annum in the second half of the 1980s to US $ 9.1 billion per
annum in the second half of 1990s and peaked at US $ 37 billion in 2009-10. The liquidity impact of large
inflows was managed mainly through the repo and reverse repo auctions under the day-to-day Liquidity
Adjustment Facility (LAF). The LAF operations were supplemented by outright open market operations,
i.e. outright sales of the government securities, to absorb liquidity on an enduring basis.

Average annual foreign direct investment (FDI) inflows into India have grown fifteen fold since 2000.
While, initially, investors concentrated in manufacturing, power and telecommunications, they now
focus in services activities. Developed country firms dominated investment in the 1990s, but in the past
decade developing country investors have also become significant.
Although Foreign institutional investment seem to grow year on year ,there is no specific trend that
follows the institutional investment in india.FII have dipped sharply during the 1998,2003 and 2008
periods. FIIs are from geographically dispersed countries: Malaysia, Australia, Saudi Arabia, Trinidad and
Tobago, Denmark, Italy, Belgium, Canada, Sweden, Ireland, etc. Institutions around the globe channeled
funds to the Indian securities markets for investments. As of 31 March 2006, the SEBI had registered FIIs
from 37 countries. The number of FIIs from the United States was the highest at 342, followed by the
United Kingdom (148), Luxemburg (64), Singapore (47), Hong Kong (30), Canada (26), Australia, Ireland
and the Netherlands with 23 each, Mauritius (32), etc. The economy has been on a high growth
trajectory, with average growth of 6.4% from 2000–01 to 2005–06, 7.5% in 2004–05 and 8.4% in 2005–
06. The flow of funds has produced comfortable foreign currency asset positions: US$ 145.1 billion in
March 2006, rising by US$ 46.8 billion to US$ 191.9 billion as of March 2007.
 FDI , FII (Net Investments in crores)
50000 500.0
450.0
40000 400.0
30000 350.0
300.0
20000 250.0
200.0
10000 150.0
0 100.0
50.0
-10000 0.0
1 2 3 4 5 6 7 8 9 10 11 12 13 14

FII (Net Investment in crores) FDI(Net investment in crores)

WPI

Figure 4: WPI vs. FII & FDI

The Wholesale price inflation and foreign direct investments and the Wholesale price inflation and
foreign institutional investment has a strong positive correlation between them in the range of 0.6 ~ 0.7
them which implies that wholesale price inflation moves in the same direction with increase in the FDI
and the FII.

Sterilization:
A form of monetary action in which a central bank or federal reserve attempts to insulate itself from
the foreign exchange market to counteract the effects of a changing monetary base. The sterilization
process is used to manipulate the value of one domestic currency relative to another, and is initiated in
the forex market.

Instruments of Sterilization used by RBI

The various instruments have differential impact on the balance sheets of the central bank, government
and the financial sector. For example, in the case of OMO sales, the differential between the yield on
government securities and return on foreign exchange assets is the cost to the Reserve Bank. Sales of
government securities under OMO also involve a transfer of market risks to the financial intermediaries,
mostly banks. The repo operations under LAF have a direct cost to the Reserve Bank. In the context of an
increase in CRR, the cost is borne by the banking sector if CRR balances are not remunerated. However,
if the CRR balances are remunerated, the cost could be shared between the banking sector and the
Reserve Bank. The extent of capital flows to be sterilized and the choice of instruments, thus, also
depend upon the impact on the balance sheets of these entities.

When measures that directly impact the financial system/non-government sector are resorted to, it
would represent a "tax”. This could, however, be justified in view of the benefits that accrue to this
sector from sterilization. In the absence of sterilization, there could be excessive volatility in the financial
markets, interest and exchange rates, leading to erosion of competitiveness of the economy; this would
have an adverse impact on the economy at large and the non-government sector in particular.Reserve
Bank may continue to resort to the existing instruments of sterilization, looking ahead, and
consideration needs to be given to the addition of new instruments to enhance its ability to sterilize the
impact of increase in its foreign currency assets.
While some of the existing instruments can be modified and strengthened within the ambit of the RBI
Act, introduction of some new instruments for sterilization would require amendment to the RBI Act.

While open market operations (OMO) involving sale of securities constitute the commonly used
instrument of sterilization, there are several other instruments available to offset the impact of capital
inflows on domestic money supply.

(a) Trade liberalization: Trade liberalization could have the effect of increasing imports leading to a
higher trade and current account deficit and this would enable the economy to absorb the
capital inflows. However, trade liberalization is generally irreversible and hence may not be
suitable for dealing with temporary or reversible capital inflows. Furthermore, rapid trade
liberalization can also lead to additional capital inflows which may have the effect of actually
making the current account deficit unsustainable in the future when such capital inflows slow
down or reverse. Thus, decisions on trade liberalization have to be based on the overall view of
the economy and not just on issues related to forex inflows, although inflows may provide some
comfort in terms of timing the transition to a more liberal trade regime.

(b) Investment Promotion: Absorption of capital flows for growth promoting purposes can be
considered through measures designed to facilitate greater investment in the economy.
Implementation of such measures would be desirable to reduce the current account surplus or
expand the relatively low level of current account deficit, leading to productive absorption of
capital flows. However, such measures would become progressively effective over a period of
time.

(c) Liberalization of the Capital Account: Liberalization of outflows under the capital account
can be considered while taking advantage of the excess forex inflows, particularly, with regard
to the timing for such action. However, the liberalization of outflows can also have the effect of
increasing inflows further if it reinforces the positive sentiment relating to the host country.
(d) Management of External Debt: Pre-payment of external debt can be used to reduce the
accretion of forex inflows. Such pre-payment is attractive provided the cost differential between
the domestic and external debt is adequate after taking into account the associated costs of pre-
payment like penalties and other charges.
(e) Management of Non-Debt Flows: Non-debt flows consist of foreign direct investment (FDI)
and portfolio investments. Usually, FDI decisions are taken in a medium term perspective, and
are accorded higher priority in the hierarchy of capital flows; thus, there is very little reason to
restrict FDI flows.

Management of Capital Flows into India:

Balances of the Government of India with the Reserve Bank

The surplus balances of the Government with the Reserve Bank effectively act as an instrument of
sterilization. As the RBI Act does not permit payments of interest on deposits or current accounts of
Central government, State governments, local authorities and banks or other persons under sections
17(1) and 19(6) of Reserve Bank of India (RBI) Act, 1934, the surplus balances of the Central Government
are invested in government securities from out of the portfolio of the Reserve Bank, thus enabling the
Central Government to obtain a return on such balances as per the agreement entered into with the
Central Government in 1997.

Cash Reserve Requirements

The use of Cash Reserve Ratio (CRR) as a direct method of monetary policy intervention has the ability of
sterilizing liquidity by raising the proportion of net demand and time liabilities (NDTL) of banks to be
kept impounded with the central bank. However, it is an inflexible instrument of monetary policy that
drains liquidity across the board for all banks without distinguishing between banks having idle cash
balances from those that are deficient. In case, CRR is not remunerated, it has the distortionary impact
of a “tax” on the banking system.

Some other instruments could be

(i) Interest Bearing Deposits by Scheduled Banks
An option for impounding excess liquidity in the banking system is to pay interest on deposits
parked by banks on a voluntary basis with the central bank.
(ii) Issuance of Central Bank Securities
(iii) Issuance of Market Stabilization Bills/Bonds by the Central Government

Conclusion:
Thus, based on the Quantity Theory of Money & our findings on the relation between money supply &
price levels in India, we can conclude that money supply has a significant impact on the price levels in
the country. The money supply has been increasing at a significant pace over last couple of decades and
the inflation has been following suit. Thus, going ahead as the amount of money supply in the country
increases it will be a daunting task for the central bank to control the inflation in the country. The
general population usually has no idea about the amount of money stock available in the country.
However, they do get to see its direct effect in the form of increasing inflation.

Bibliography
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Retrieved 12 3, 2010, from Reserve Bank of India: http://dbie.rbi.org.in/InfoViewApp/listing/main.do?

appKind=InfoView&service=/InfoViewApp/common/appService.do

Dornbusch, R., Fischer, S., & Startz, R. (2008). Macroeconomics. McGraw Hill.