Page 120 - DMGT401Business Environment

Unit 5: Monetary Policy

3. Foreign Exchange Assets: Foreign exchange assets acquired by the banking system are also Notes
a source of money supply.

When an exporter receives a payment in foreign exchange (forex) he surrenders it to the
bank, which in turn gives him local currency. This increases supply of money in the
country. On the other hand, when an importer asks for foreign exchange to import, he
gives local currency to the bank and supply of money in the country is reduced.

4. Government Currency Liabilities to the Public: The Government of India prints/mints
one rupee notes, rupee coins and small coins (50 paisa, 25 paisa etc.) which constitute the
government's currency liabilities to the public. This leads to increase in the volume of
money supply and the government's currency liabilities to the public.

5. Non-monetary Liabilities of the Banking Sector: Non-monetary liabilities of the RBI and
other banks are deducted before we calculate the stock of money. These liabilities of bank
include their paid up capital and reserves, pension fund, provident fund and other liabilities
like bills payable over other assets of banks, errors and omission, etc. Since they are
liabilities of the banking system, they have to be deducted to arrive at the money stock
(M3).

5.4 Need to Regulate the Supply of Money

The supply of money has a direct impact on inflation, level of investment, employment
generation, interest rate, etc. It is clear that supply of money has an effect on every aspect of the
economy and has a close relationship with development. Supply of money is a sensitive issue as
even a slight imbalance can create havoc in the form of deflation or hyperinflation in the
country.

Example: In the initial stages of perestroika in the erstwhile USSR, because of imbalances
in supply of money, the value of the Russian trouble decreased to such an extent much that
people used to carry bags full of roubles to purchase bread. Every country manages supply of
money in the national interest through its central bank.

5.4.1 Money Supply and Inflation

There is a direct relationship between the supply of money and inflation. It is based on the
simple fundamental of demand and supply. The value of a currency is defined by its purchasing
power. As the supply of money increases its value decreases. Decrease in purchasing power
means an increase in inflation.

When the supply of money increases with the people it gives them more purchasing power,
which results in an increase in demand. Prices rise if demand increases without a correspondent
increment in supply. This doesn't mean that money supply is directly proportional to inflation.
Because increment in supply of money not only increases the demand, it also increases investment,
i.e., supply. Part of the increased money also goes into savings. This is the reason that with an
increase in money supply, the government promotes investment and savings so that it does not
have an inflationary impact. There is thus a close relationship between inflation and supply of
money, but not a proportional relation.

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