Governor Nivard Cabraal has unveiled the Road Map for monetary policy for 2009 with the CB planning an annual growth rate for Reserve Money at 5% and Broad Money growth at 14%.   Reserves refer to the money that the commercial banks hold with the CB as required by the Statutory Reserve ratio. (9.5% now). It is composed of currency and deposits held by the banks with the CB. Together they constitute the monetary base. This base determines the Money Supply which can vary over time.

What should be the right size of the Money Supply?  Some would say it should not exceed what is required to fund the increase in real GDP. As the GDP (Gross Domestic Product) rises more money is required. So does it mean the Money Supply should increase only at the rate of increase in real GDP? Not quite, for the amount of money people hold willingly depends not only on income (output) but also on the rate of interest. If more money than that figure is created then people spend faster and prices rise.

What makes the nominal value of money in existence equal to the amount people willingly want to hold? As Ann Schwartz explained "A change in interest rates is one way to make that correspondence happen. A fall in interest rates increases the amount of money people wish to hold, while a rise in interest rates decreases that amount. If more money is created than what people are willing to hold, then they will spend faster and prices will rise.’’

If easy monetary policy is expected to cause inflation, lenders demand a higher interest rate to compensate for this inflation, and borrowers are willing to pay a higher rate because inflation reduces the value of the rupees they repay. Thus, an increase in expected inflation increases interest rates. Despite the CB pumping Rs 139 billion of cheap new money to the banks through the Reverse Repo window, the interest rates in the Inter-bank market for three months and more have not come down. This is perhaps because the banks neither expect inflation to come down nor the drain in foreign exchange to stop.

A change in prices is another way to make the money supply equal the amount demanded. When people have to hold more nominal rupees than they want, they spend them faster, causing prices to rise. These rising prices reduce the purchasing power of money until the amount people want to hold equals the amount available. Conversely, when people hold less money than they want, they spend more slowly, causing prices to fall. As a result, the real value of money in existence just equals the amount people are willing to hold.

What happens if the Money Supply grows faster than the nominal rate of growth? If there is no increase in output of goods & services coming to the market (excludes defence services) prices rise causing inflation which is defined as continuous increases in prices.

How the CB changes Reserve Money

The CB has the power to control the issue of both components. By adjusting the levels of banks’ reserve balances, over several quarters it can achieve a desired rate of growth of deposits and of the money supply. The Road Map sets them out in Table 1 on page 16. It provides for an increase of 5% in Reserve Money and 14% in broad money. But a current account deficit in the balance of payments calls for negative money supply growth and not an increase of 14% if we want the deficit to be corrected. Under a Currency Board that would take place automatically. But a central bank can counter such a fall and this is what the CB is doing and planning to do in 2009 on the ground that it is to relieve the liquidity shortage in the banking system. How does the CB do it?

The Reserves held by the banks consist of their normal owned reserves as well as the reserves borrowed from the CB through the Reverse Repo window. By changing the rate of interest and the volume of funds made available through it, the CB can change the borrowed reserves. The owned Reserves of the banks are affected by their lending and foreign exchange operations.  The CB can control their owned reserves through open market operations which refer to buying or selling of government securities (CB securities) to or from the banks.

The CB will enforce its targets of Reserve Money by acting on both owned and borrowed reserves. It can force non-borrowed reserves to decline when above target. Some central banks seek to control what are called free reserves or excess reserves minus bank borrowings from the CB.

The Role of Demand by the public

When there is an outflow of foreign exchange because we pay more to foreigners than receive from them, there is a reduction in bank deposits and money supply (as is happening now). There is then a reduction in the rate of economic growth. Everybody wants high growth rate which is fine if not for the fact that high growth causes a worsening of the current account of the balance of payments and could exhaust our Foreign Reserves unless we can borrow from foreigners to offset the imbalance. So the need to maintain the growth rate must be balanced by the need to preserve balance in the current account of the balance of payments. The CB gives priority to growth over correcting the deficit. 

The Road Ahead

The Road Map assumes that this year (2009) there will be a surplus in the balance of payments of $450 million. This is an overly optimistic view. The 3rd quarter of 2008 showed a deficit not only in the current account of the balance of payments but a deficit in the over-all balance as well which meant a reduction in Gross Foreign Reserves that are now said to be below $2,000 million. The current account deficit this year is likely to exceed $2,000 million and to expect foreigners to lend to us is indeed far-fetched. In any case no country can run current account deficits indefinitely (we have done so since 1977) and even if we find the foreign finance to fund the deficit we cannot forever postpone taking corrective action for the current account deficit.

What should be the correct amount of Money Supply?

As money is used in all economic transactions, it has a powerful effect on economic activity. An increase in the supply of money works both through lowering INTEREST RATES, which spurs INVESTMENT, and through putting more money in the hands of consumers, stimulating their spending. Business firms respond to increased sales by ordering more raw materials and increasing production. The spread of business activity increases the demand for labor and raises the demand for capital goods. STOCK MARKET prices rise and firms issue equity and debt. But output growth reaches capacity limits and import capacity too limits it. If the money supply continues to expand, prices begin to rise. As the public begins to expect INFLATION, lenders insist on higher interest rates to offset an expected decline in purchasing power over the life of their loans.

To correct balance of payments what is required is deflation

Since nominal wages cannot fall owing to the protective labor laws the businessmen cannot reduce their wage bill to become competitive as businesses are doing abroad to cope with the credit crunch and recession. They will have to outsource their operations at best or close down entirely at the worst. Employment is falling in some industries like construction and financial services. Instead of reducing wages in the public sector, the government is likely to raise them in order to win votes in an election year. The consequent additional expenditure will require more money printing. All in all the only conditions for gains in competitiveness is through deflation.

 If we want exports to expand, our only salvation, then nominal depreciation alone is not enough. The government will have to hold down wage demands from the trade unions in the estate sector. Similar considerations apply in the garments industry and other export oriented local industries like shoes, ceramics etc. It is the real exchange rate and not the nominal exchange rate and the real interest rate that is relevant to restore competitiveness. The Road Map doesn’t refer to the Real Effective Exchange Rate at all. Monetary growth even at 14% will only increase inflation given that the government will not be able to provide the free imports that growth requires.

Government tax revenues will be constant at best and may even fall and certainly fall in inflation adjusted terms. Government may clamp down on imports through higher taxes and cesses on imports creating queues and black markets - the same type of thing that brought down the Communists in the former Soviet Union.