Money, Inflation and Monetary Policy

Before money existed, people traded goods for goods. This is the barter system. A farmer with wheat who wanted shoes had to find a cobbler who wanted wheat at that very moment. This problem has a name: the double coincidence of wants. Money solves it, because you can sell what you have for money first and then buy what you need from anyone else.

Economists such as Kinley group the functions into three sets: primary (medium of exchange and measure of value), secondary (store of value, standard of deferred payment, transfer of value) and contingent (basis of credit, distribution of national income, liquidity). The two primary functions are the heart of money: if an item cannot do these two, it is not money.

Liquidity means how quickly and cheaply an asset can be turned into cash without losing value. Cash is the most liquid asset; a house is the least. Money is useful precisely because it is perfectly liquid, and every measure of the money supply (M1, M2, M3...) is arranged by liquidity.

Modern money is fiat money. Since the collapse of the Bretton Woods arrangement in the early 1970s, no major currency is backed by gold or silver. A rupee note has almost no value as paper; it works because the government declares it legal tender and everyone trusts that others will accept it. That is why the statement 'currencies are not readily convertible into gold' is correct.

Legal tender is money that the law forces creditors to accept in settlement of a debt. In India, currency notes are unlimited legal tender (Section 26 of the RBI Act, 1934, with a guarantee of the Central Government), while coins are legal tender only up to limits set by the Coinage Act, 2011. Cheques are not legal tender; a creditor may refuse them.

Minimum Reserve System (since 1957): the RBI must always keep a minimum of Rs 200 crore in assets against the notes it issues, of which Rs 115 crore is gold and Rs 85 crore foreign securities. Beyond that floor, the RBI can print as much as the economy needs. The earlier proportional reserve system was dropped because it was too rigid.

Money supply is the total stock of money held by the public in an economy at a given point of time. Two words matter here. It is a stock (measured on a date, not over a period) and it counts only money held by the public. The cash lying in the government's treasury or inside bank vaults is not part of the money supply, because the government and banks are the producers of money, not its users.

Money in a modern economy has two sources. The RBI creates the base of the system, called reserve money. The commercial banks then multiply this base by accepting deposits and giving loans, because every loan eventually comes back to the banking system as a fresh deposit. So money supply = reserve money x money multiplier.

Reserve money is the RBI's own liability: the notes it has issued plus the deposits kept with it. It is also called high-powered money, base money, monetary base or central bank money. It is 'high-powered' because one rupee of it supports several rupees of deposits. Remember: savings money is not a name for it.

Money multiplier = M3 / M0 = (1 + c) / (c + r), where c is the currency-deposit ratio (how much cash the public holds per rupee of deposit) and r is the reserve-deposit ratio (what banks keep as reserves, driven mainly by CRR). The multiplier falls when the public holds more cash (a leakage), when banks keep more reserves, or when the CRR rises. It rises when CRR is cut.

Since the late 1990s the RBI has also published new monetary aggregates (NM1, NM2, NM3), which follow the Working Group on Money Supply headed by Y. V. Reddy (1998), together with broader liquidity aggregates (L1, L2, L3). A later working group in 2020 revised the framework again. For the exam, the classical M0 to M4 hierarchy is what is asked.

Inflation is a sustained rise in the general price level of goods and services over time. The key words are sustained and general: one item becoming costly for a week is not inflation. Look at it from the side of money: when prices rise, each rupee buys less, so inflation is a fall in the purchasing power of money. The rate is found by comparing the price index of two periods: inflation rate = (P_now - P_before) / P_before x 100.

The exact percentage bands for creeping, walking and running inflation differ from book to book, so do not memorise numbers. Learn the order of seriousness and the one firm definition: hyperinflation is a very high rate of inflation in which money loses its value very quickly.

The Phillips Curve (A. W. Phillips, 1958) began as a study of UK wages and unemployment, and was later restated as a link between inflation and unemployment. In the short run the relation is negative: when unemployment is low, firms compete for workers, wages and prices rise, so inflation is high; when unemployment is high, inflation is low. This suggests a trade-off for policymakers. In the long run (Friedman and Phelps), people adjust their expectations, the curve becomes vertical at the natural rate of unemployment, and there is no lasting trade-off. The stagflation of the 1970s, with high inflation and high unemployment together, shook faith in the simple curve.

Why does money matter for inflation? Irving Fisher's quantity theory says MV = PT: money supply (M) times its velocity (V) equals the price level (P) times the volume of transactions (T). If V and T stay stable, a rise in M pushes P up in proportion. Milton Friedman's line, 'inflation is always and everywhere a monetary phenomenon', rests on this idea.

To say 'prices have risen by 5 per cent' we need a yardstick. That yardstick is a price index: a fixed basket of goods and services is priced in a base year (which is set equal to 100) and then priced again in the current year. Index = (cost of the basket now / cost in the base year) x 100. The percentage change in the index between two periods is the inflation rate. For example, if the index moves from 120 to 126, inflation is (126 - 120) / 120 x 100 = 5 per cent.

The base year is a recent, normal year used as the reference (index = 100). It is revised from time to time because people's spending habits change: a basket from decades ago would not include mobile data or online services. A new base year updates the basket and weights, so the index stays realistic.

GDP deflator = (nominal GDP / real GDP) x 100. Unlike CPI and WPI, which track a fixed basket, the deflator covers all goods and services produced inside the country, and its basket changes with production. It is therefore the broadest measure of price change across the whole economy. It does not include imported goods consumed by households, which CPI does.

Core inflation removes the volatile food and fuel components from CPI. Food prices swing with the weather, and fuel prices with the global oil market, so core inflation shows the stubborn underlying trend. The RBI watches core inflation, but its legal target is set on the headline CPI.

Monetary policy is the policy through which the central bank controls the supply of money and the cost of credit (the interest rate) to reach macroeconomic goals: price stability first, and then growth, employment and a stable currency. In India the RBI runs it. Think of the RBI as the driver of the economy's car: when the economy overheats (inflation), it presses the brake by making money costly and scarce; when the economy is sluggish, it presses the accelerator by making money cheap and plentiful.

This three-level structure is the Liquidity Adjustment Facility (LAF) corridor. The LAF (introduced in June 2000, following the Narasimham Committee on banking sector reforms) lets the RBI adjust liquidity every day through repo and reverse repo auctions. Since April 2022 the SDF has replaced the fixed-rate reverse repo as the floor. The effect: the overnight interbank rate (call money rate) stays inside this corridor, close to the repo rate. Banks then reset their deposit and lending rates, and in this way a repo change travels to the common borrower.

Open market operations (OMO) are the RBI's market-based tool. When the RBI sells government securities, banks and investors pay it money, so money leaves the system (liquidity falls). When the RBI buys securities, it pays money into the system (liquidity rises). Operation Twist means buying long-term and selling short-term securities at the same time to bring long-term yields down without changing the total money much. The Market Stabilisation Scheme (MSS, 2004) lets the RBI issue special government securities to soak up the excess rupees created when it buys dollars in the foreign exchange market. The Variable Rate Repo (VRR) and Variable Rate Reverse Repo (VRRR) are auction-based operations, mostly 14-day, in which banks quote their own rates, which lets the RBI fine-tune liquidity.

For decades the RBI used many indicators to decide its policy: money supply, credit, interest rates, exchange rate, and so on (the 'multiple indicators approach'). But targets were fuzzy, and the public could not judge whether the RBI was succeeding. Most modern central banks therefore adopted flexible inflation targeting: the law fixes a clear inflation goal, and the central bank is held accountable for meeting it. India shifted to this system in 2015-16, and the Monetary Policy Committee (MPC) became the body that decides the policy rate.

Monetary transmission is the path by which a policy-rate change reaches the real economy. The RBI changes the repo rate, then banks and financial intermediaries (banks, NBFCs) reset their deposit and lending rates, then households and firms change their borrowing, spending and investing, and finally inflation and growth respond. If banks are slow to pass on the change, the transmission is weak, which is why the RBI has linked loan rates directly to external benchmarks such as the repo (EBLR).

A liquidity trap (a Keynesian idea) arises when interest rates are already close to zero and yet people prefer to hold cash rather than invest or spend. Then even more money from the central bank does not raise demand, because the extra money is simply hoarded. Monetary policy loses power, and the government must step in with fiscal policy.