PROJECT OBJECTIVE:

To test that Inflation has relationship with Fiscal Deficit, Money Supply, Cash
Reserve Ratio and Repo rate in an Indian perspective.

HYPOTHESIS:
Inflation has correlation with Fiscal Deficit, Money Supply , Cash reserve ratio (CRR)
and repo rate.

METHODOLOGY:
To study whether Inflation has a positive or negative correlation with fiscal deficit
and money supply ,CRR and repo rate. For this, we collected the data from Reserve
Bank of India website (www.rbi.org.in). We have chosen Consumer Price Index (CPI)
as an indicator of inflation . We have collected data from the year 1996 to 2008 with
1999-2000 price index as base. We have considered the aggregate money supply by
taking into account Currency money, Reserve money, narrow money and broad
money and then correraled it with Inflation data. We have used Excel as our analysis
tool for conducting Correlation and Linear regression analysis to prove our
hypothesis. We have also used bar charts and graphs to show the trends of the
different economic parameters over the years.

REPORT:
We will first define each term and go through the concept of those terms and
simultaneously apply our methodology to prove our hypothesis.

INFLATION:
Inflation is a sustained upward movement in the aggregate price level that is
shared by most products. It is also said that Inflation is an increase in the
amount of money and credit in relation to the supply of goods and services.

When money enters circulation at a rate that is higher than the supply of goods
available, inflation is occurring. It is a rise in the general level of prices of goods and
services in an economy over a period of time. The term "inflation" once referred to
increases in the money supply (monetary inflation); however, economic debates about
the relationship between money supply and price levels have led to its primary use
today in describing price inflation. Inflation can also be described as a decline in the
real value of money—a loss of purchasing power in the medium of exchange which is
also the monetary unit of account. When the general price level rises, each unit of
currency buys fewer goods and services. A chief measure of price inflation is the
inflation rate, which is the percentage change in a price index over time.
KEYNESIAN VIEW:

Keynesian economic theory proposes that money is transparent to real forces in the
economy, and that visible inflation is the result of pressures in the economy
expressing themselves in prices.

There are three major types of inflation, as part of what Robert J. Gordon calls the
"triangle model":-

• Demand-pull inflation: inflation caused by increases in aggregate demand

due to increased private and government spending.
• Cost-push inflation: also called "supply shock inflation," caused by drops in
aggregate supply due to increased prices of inputs.
• Built-in inflation: induced by adaptive expectations, often linked to the
"price/wage spiral" because it involves workers trying to keep their wages up
(gross wages have to increase above the CPI rate to net to CPI after-tax) with
prices and then employers passing higher costs on to consumers as higher
prices as part of a "vicious circle." Built-in inflation reflects events in the past,
and so might be seen as hangover inflation.

RELATIONSHIP WITH MONEY & PRICE:

Monetarists assert that the empirical study of monetary history shows that inflation
has always been a monetary phenomenon. The quantity theory of money, simply
stated, says that the total amount of spending in an economy is primarily determined
by the total amount of money in existence. This theory begins with the identity:

where

P is the general price level;

V is the velocity of money in final expenditures;

Q is an index of the real value of final expenditures or Output;

M is the quantity of money.

In this formula, the general price level is affected by the level of economic activity
(Q), the quantity of money (M) and the velocity of money (V). The formula is an
identity because the velocity of money (V) is defined to be the ratio of final
expenditure ( ) to the quantity of money (M).

Velocity of money is often assumed to be constant, and the real value of output is
determined in the long run by the productive capacity of the economy. Under these
assumptions, the primary driver of the change in the general price level is changes in

2
the quantity of money. With constant velocity, the money supply determines the value
of nominal output (which equals final expenditure) in the short run.

EFFECTS OF INFLATION:

Inflation affects the economy on three sides. One, it is directly linked to interest
rates. The interest rates prevailing in an economy at any point of time are nominal
interest rates, i.e., real interest rates plus a premium for expected inflation. Due to
inflation, there is a decrease in purchasing power of every rupee earned on account of
interest in the future, therefore the interest rates must include a premium for expected
inflation. In the long run, other things being equal, interest rates rise one for one with
rise in inflation.

Two, it effects the exchange rate. The exchange rates between the currencies of two
countries depend upon the level of inflation prevailing in the two countries.
According to Purchasing Power Parity principle, the change in the value of one
currency is approximately equal to the inflation differential of the two countries. So
the inflation levels provide an indication of the movement of currencies against each
other.

Three, there is also an inverse inflation between inflation & economic growth. Other
things being equal, economic growth is equal to the difference between money supply
growth & inflation.

CONSUMER PRICE INDEX:

Inflation is usually measured by calculating the inflation rate of a price index, usually
the Consumer Price Index. The Consumer Price Index measures prices of a selection
of goods and services purchased by a "typical consumer". The inflation rate is the
percentage rate of change of a price index over time.

The price indices in the system of economic statistics that are closely watched
indicators of macro-economic performances. They are direct indicators of the
purchasing power of money in various types of transactions involving goods and
services. As such, they are also used as deflators in providing summary measures of
the volume of goods and services produced and consumed. Consequently, these
indices are important tools in the design and conduct of the monetary and fiscal policy
of the Government, and also of great utility in taking economic decisions throughout
the private sector. In India, for these varied purposes Central and State Government
agencies collect the primary data on prices. There are mainly three agencies namely,
Labour Bureau in the Ministry of Labour, Office of Economic Adviser in Ministry of
Industry and Central Statistical Organisation in the Ministry of Statistics and
Programme Implementation responsible for the compilation and release of various
indices.

At the national level, there are four Consumer Price Index (CPI) numbers. These are:

A. CPI for Industrial Workers (IW),

3
B. CPI for Agricultural Labourers (AL), CPI for Rural Labourers (RL) and

C. CPI for Urban Non-Manual Employees (UNME).

Following shows the data from RBI for the CPI in India :-

CONSUMER PRICE INDEX

Industrial Urban Non-manual Agricultural
Year Worker(IW) Employees(UNME) Laborers(AL)
1996-97 342 283 256
1997-98 366 302 264
1998-99 414 337 293
1999-00 428 352 306
2000-01 444 371 305
2001-02 463 390 309
2002-03 482 405 319
2003-04 500 420 331
2004-05 520 436 340
2005-06 542 456 353
2006-07 579 486 380
2007-08 616 515 409

The average CPI is calculated taking the geometric mean as given below :-

Average CPI
(IW*UNME*AL)^0.33
275
291
325
338
348
360
373
387
401
417
446
476

4
Bar Graph depicting India”s Consumer Price Index over the years :-

CPI

500
450
400
350
300
250 CPI
200
150
100
50
0
1996- 1997- 1998- 1999- 2000- 2001- 2002- 2003- 2004- 2005- 2006- 2007-
97 98 99 00 01 02 03 04 05 06 07 08

MONEY SUPPLY:
MONEY SUPPLY, or money stock, is the total amount of money available in an
economy at a particular point in time. There are several ways to define "money", but
each includes currency in circulation and demand deposits. The different types of
money are typically classified as Ms. The number of Ms usually range from M0
(narrowest) to M3 (broadest) .

Narrow measures include those more directly affected by monetary policy, whereas
broader measures are less closely related to monetary-policy actions. Each measure
can be classified by placing it along a spectrum between narrow and broad monetary
aggregates.

The Reserve Bank of India defines the monetary aggregates as:

• Reserve Money (M0): Currency in circulation + Bankers’ deposits with the

RBI + ‘Other’ deposits with the RBI = Net RBI credit to the Government +
RBI credit to the commercial sector + RBI’s claims on banks + RBI’s net
foreign assets + Government’s currency liabilities to the public – RBI’s net
non-monetary liabilities.
• M1: Currency with the public + Deposit money of the public (Demand
deposits with the banking system + ‘Other’ deposits with the RBI).
• M2: M1 + Savings deposits with Post office savings banks.

5
 • M3: M1+ Time deposits with the banking system. = Net bank credit to the
Government + Bank credit to the commercial sector + Net foreign exchange
assets of the banking sector + Government’s currency liabilities to the public –
Net non-monetary liabilities of the banking sector (Other than Time Deposits).

Following are the data for money supply in India in the four categories :-

Year Currency Reserve Narrow Broad Aggregate

with the Money Money Money Money Supply
(M ) (M ) (M )
Public 0 1 3 (M0+M1+M2+M3)
1996-97 126712 189524 221764 642631 1180631
1997-98 142187 208994 248465 752028 1351674
1998-99 158854 234625 279638 901294 1574411
1999-00 184702 262307 320630 1056025 1823664
2000-01 201581 282683 356592 1224092 2064948
2001-02 227164 314052 397701 1420025 2358942
2002-03 258675 343060 445535 1647976 2695246
2003-04 294797 390736 514660 1861604 3061797
2004-05 336283 444887 600230 2129442 3510842
2005-06 382773 513043 714470 2461836 4072122
2006-07 451202 617478 857573 2958427 4884680
2007-08 517380 787092 992797 3603245 5900514

Chart of Money Supply and its 4 Components :-

4 00 00 0 0

3 50 00 0 0

3 00 00 0 0

2 50 00 0 0 C u rre n c y w ith th e P u blic

R e s e rve M o ne y (M 0 )
2 00 00 0 0
N a rro w M o n e y (M 1 )
1 50 00 0 0 B roa d M o n ey (M 3 )

1 00 00 0 0

50 00 0 0

0
19 96 -1 99 7 -19 98 -1 9 99 -2 00 0-20 01 -2 0 0 2 -2 0 0 3 -20 0 4 -2 0 0 5 -2 0 0 6-2 0 07 -
97 9 8 9 9 0 0 0 1 02 0 3 04 0 5 06 0 7 0 8

6
 Aggregate Money Supply (M0+M1+M2+M3)

7000000

6000000

5000000

4000000

3000000

2000000

1000000

0
1996- 1997- 1998- 1999- 2000- 2001- 2002- 2003- 2004- 2005- 2006- 2007-
97 98 99 00 01 02 03 04 05 06 07 08

EFFECTS OF MONEY SUPPLY:

Money supply also effects the economy on three sides. One, money supply is used to
control the inflation in an economy. On the demand side, whenever money supply in
the economy increases, consumer-spending increases immediately in the economy
because of increased money in the system. But supply can’t vary in the short – term,
so there is a temporary mismatch of demand & supply in the economy which exerts
an upward pressure on inflation. This argument assumes that demand drives supply,
which is generally the case. On the supply side, due to an increase in demand, supply
can only be increased by capacity additions. This causes the cost of production to rise
& that is reflected in inflation.

Two, money supply also has a direct relationship with the growth of an economy.
Until an economy reaches full – employment level, the economy growth is the
difference between money supply growth rate & the inflation, other things being
equal. When an economy reaches full employment level, the growth in money supply
is set off by a growth in inflation, other things being equal. This happens because
output can’t rise after full employment & therefore inflation increases one for one
with the money supply.

Three, money supply also has a relationship with interest rates. One variable can be
used to control the other. Both can’t be controlled simultaneously. If the RBI wants to
peg the interest rate at a certain level, it has to supply whatever money is demanded at
that level of interest rate. If it wants to fix the money supply at a certain level, the
demand & supply of money will determine the interest rates. Usually it is easier for
RBI to control the interest rates through its open market operations (OMO). So, the
money supply is allowed to vary but RBI controls it by playing around with interest
rates through its OMO.

7
 FISCAL DEFICIT:
Fiscal deficit is an economic phenomenon, where the Government's total expenditure
surpasses the revenue generated . It is the difference between the government's total
receipts (excluding borrowing) and total expenditure. Fiscal deficit gives the signal to
the government about the total borrowing requirements from all sources. Primarily, it
has to go to RBI to get the money required. RBI can either issue new notes, which
will increase the money supply in the system or it can raise the required amount from
the market. Issuing these intruments will suck out the liquidity from the system & it
will put pressure on the interest rates. So, on both counts, the increase in fiscal deficit
causes the interest rates to rise in an economy. Also, it will crowd out the private
investment from the economy.

CENTRE’S GROSS FISCAL DEFICIT AND ITS FINANCING

(Rupees crore)
Year GFD GFD Gross Financing of GFD
Receipts+ Expenditure$ Fiscal External Internal Finance

Deficit Finance Market Other Draw Total

(3-2) down
Borrowings Borrowings@ of Cash (6+7+8)
£ Balances
#
1 2 3 4 5 6 7 8 9
1996- 126734 193468 66733 2987 19093 31469 13184 63746
97
1997- 134798 223735 88937 1091 32499 56257 -910 87846
98
1998- 155359 268707 113348 1920 68988 42650 -209 111429
99
1999- 183206 287922 104716 1180 62076 40597 864 103537
00
2000- 194730 313546 118816 7505 73431 39077 -1197 111311
01
2001- 204952 345907 140955 5601 90812 46038 -1496 135354
02
2002- 233985 379057 145072 -11934 104126 50997 1883 157006
03
2003- 280765 404038 123273 -13488 88870 51833 -3942 136761
04
2004- 310415 436209 125794 14753 50940 * 68231 -8130 111041
05
2005- 348658 495093 146435 7472 106241 * 53610 -20888 138963
06
2006- 434921 577494 142573 8472 114801 * 14782 4518 134101
07
2007- 561223 704876 143653 9970 110727 * 41140 -18184 133683
08 RE
2008- 613100 746387 133287 10989 99000 * 16073 7225 122298
09 BE

8
Chart of Gross Fiscal Deficit in India :-

Gross Fiscal deficit

160000

140000

120000

100000

80000

60000

40000

20000

0
1996- 1997- 1998- 1999- 2000- 2001- 2002- 2003- 2004- 2005- 2006- 2007-
97 98 99 00 01 02 03 04 05 06 07 08

FISCAL POLICY:
Fiscal policy is an instrument in the hands of government for reallocation of resources
according to nation’s priority, redistribution, promotion of private savings &
investments & the maintenance of stability. An expansionary fiscal policy means
more investment spending on part of government. This increases the interest rates in
the economy because government resort to borrowings to finance the expenditure.
When interest rates rise, they cause private investment to fall. This phenomenon is
called "Crowding out of private investment". A contraction fiscal policy means
less expenditure by government, which hampers the economic growth of a country.
So the government has to strike a balance between growth prospects & crowding out.

MONETARY POLICY:
It refers to a regulatory policy whereby the monetary authority of a country maintains
its control over the money supply for the realization of general economic objectives. It
involves manipulation of money supply, the level & structure of interest rates & other
conditions effecting the level of credit. The central bank signals the market about the
availability of credit & interest rates through this policy. The RBI fixes the bank rate
in this policy which forms the basis of the structure of interest rates & the CRR &
SLR, which determines the availability of credit & the level of money supply in the
economy. So it plays a very important role in the development of a economy.

9
 Cash Reserve Ratio (CRR):
CRR is the percentage of its total deposits a bank has to keep with RBI in cash or near
cash assets & SLR is the percentage of its total deposits a bank has to keep in
approved securities. The purpose of CRR is to keep a bank liquid at any point of time.
When banks have to keep low CRR, it increases the money available for credit in the
system. This eases the pressure on interest rates and interest rates move down. Also
when money is available and that too at lower interest rates, it is given on credit to the
industrial sector which pushes the economic growth.

The following are the figures of the CRR in India :-

Year CRR
1996-97 11.50
1997-98 10.00
1998-99 10.5
1999-00 9.5
2000-01 8.25
2001-02 7.50
2002-03 5.00
2003-04 4.50
2004-05 5.00
2005-06 5.25
2006-07 7.00
2007-08 8.50

Graph of CRR :-

CRR

14.00
12.00

10.00
8.00
CRR
6.00
4.00

2.00
0.00
1996- 1997- 1998- 1999- 2000- 2001- 2002- 2003- 2004- 2005- 2006- 2007-
97 98 99 00 01 02 03 04 05 06 07 08

REPO RATE:

10
It’s the key lending rate that RBI offers to all other commercial banks. Repo rate is
the rate at which our banks borrow rupees from RBI. Whenever the banks have any
shortage of funds they can borrow it from RBI. A reduction in the repo rate will help
banks to get money at a cheaper rate. When the repo rate increases borrowing from
RBI becomes more expensive.

Key lending rates of RBI to other banks in India :-

Year Repo rate

1996-97 14.75
1997-98 14
1998-99 12.5
1999-00 12.25
2000-01 11.5
2001-02 11.5
2002-03 11.25
2003-04 10.75
2004-05 10.5
2005-06 10.5
2006-07 12.25
2007-08 12.5

Graph of Repo rate :-

Repo rate

16

14
12

10

4
2

0
1996- 1997- 1998- 1999- 2000- 2001- 2002- 2003- 2004- 2005- 2006- 2007-
97 98 99 00 01 02 03 04 05 06 07 08

CORRELATION ANALYSIS RESULTS OF

INFLATION WITH DIFFERENT ECONOMIC
PARAMETERS :-

11
 1. INFLATION AND FISCAL DEFICIT :

Fiscal Deficit and Inflation Line Fit Plot

500
400
Inflation

300
200
100
0
0 50000 100000 150000 200000
Fiscal Deficit

Correlation Result :

Gross
Fiscal
CPI deficit
CPI 1

Gross Fiscal deficit 0.841618 1

Inflation and Fiscal deficit have a strong positive correlation . This is because
whenever fiscal deficit increases it results in increase in money supply in the
form of printing of currency notes by RBI or the government issueing of bonds
to raise the money. Increase in money supply results in increase in inflation or
rise in the prices of goods and services as per the quantity theory of money
( assuming V ,Velocity of money and Q ,Output is fixed ).Thus fiscal deficit leads
to inflation to a great extent holds true.

2. INFLATION AND MONEY SUPPLY :

Graph showing the 4 categories of money and their growth over the years :-

12
 4000000
1996-97
3500000
1997-98

3000000 1998-99
1999-00
2500000 2000-01
2001-02
2000000
2002-03
1500000 2003-04
2004-05
1000000 2005-06
2006-07
500000
2007-08
0
Currency with the Public Reserve Money(M0) Narrow Mone y (M1) Broad Money(M3)

Money Supply and Inflation Line Fit Plot

600
Inflation

400

200

0
0 2000000 4000000 6000000 8000000
Money Supply

Correlation Result :

Aggregate CPI
Money
Supply
Aggregate Money Supply 1
CPI
0.975518 1

Inflation and Money Supply have a very strong correlation . Increase in money
supply means increase in purchasing power and increase in spending , people are
ready to pay more, hence price of goods rises and thus inflation increases.

3. INFLATION AND REPO RATE :

13
 Repo rate and Inflation Line Fit Plot

500
400
Inflation

300
200
100
0
0 5 10 15 20
Repo rate

CPI
Repo rate
Repo rate 1
CPI
-0.57594 1

Inflation and repo rate are negatively correlated as an increase in one results in
an decrease in another. This happens because an increase in repo rate means
other banks has to borrow money from RBI at a higher interest rate which
implies that they will tend to borrow less money during that time and so money
supply will go down , resulting in an decrease in inflation and vice versa.

4. INFLATION AND CRR :

14
 CRR and Inflation Line Fit Plot
500
400
Inflation

300
200
100
0
0.00 5.00 10.00 15.00
CRR

CRR CPI

CRR 1
CPI -0.61288 1

Inflation and CRR are also negatively correlated as an increase in CRR means
that banks have to keep more money deposited with RBI and hence less money
will be available with the banks , so money supply will decrease , which in turn
decreases inflation .

ANALYSIS SUMMARY :

The co-relation proves the following points

1. Inflation calculated by CPI has a direct relation with fiscal deficit. I.e.,
increase in Fiscal deficit leads to increase in Inflation.
2. Inflation calculated by CPI has a direct relation with Aggregate Money
supply. I.e., increase in Money supply leads to increase in Inflation.
3. Inflation calculated by CPI has an indirect relation with Repo rate. I.e.,
increase in Repo rate leads to decrease in Inflation.
4. Inflation calculated by CPI has an indirect relation with CRR. I.e.,
increase in CRR leads to decrease in Inflation.

STATEMENT:

Hence it is proved that our central hypothesis “Fiscal Policy leads to Inflation” is
correct and can be accepted.
CONCLUSION:

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Higher fiscal deficit in India has been one of the major reasons for relatively higher
level of inflation in the Indian economy as compared to other developing and
developed nations. The cycle of high deficit and high inflation can be explained in
two different ways. Firstly, high fiscal deficit indicates a high level of government
borrowing that has a tendency to reduce the availability of capital. This leads to lower
liquidity and consequently higher interest rates and higher inflation.

On the other hand, assuming that the government is borrowing to invest in the
economy, this leads to increased spending that leads to greater money supply in the
economy which can further lead to inflation if output fails to keep pace with this
increased amount of spending (which has usually been the case in India). Further, to
curb a rise in the level of inflation, the central bank resorts to a hike in interest rates,
something we are likely to witness going forward. Thus, we see that high fiscal
deficits could lead to higher interest rates and it could further fuel inflation in the
economy if not checked adequately.

A sustained increase in money supply in the economy will, in the long run, lead to an
equal increase in the inflation & in the short run it will lead to a decrease in interest
rates, but in the long run, the real interest rates will come down to the same level
because of an equal increase in inflation. So there is always a trade off that the
monetary authority of a country has to make between the two things. If it allows
money supply to grow to keep interest rates down, it is called interest rate targeting
& if it keeps money supply in check to keep inflation under control, it is called
inflation targeting. The RBI, right now, is targeting inflation because if it is able to
keep inflation in check, the interest rates will be automatically come in check as the
nominal interest rate is equal to real interest plus inflation & real interest rates remain
constant in the long run.

16