Money supply and inflation in India
Milton Friedman’s most famous quote was probably, “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”
The reverse will also be true, in the sense that a fall in the rate of growth of money supply relative to output will produce deflation, or at the very least, disinflation. The question is: how does this rule apply to India in recent times?
The chart provides the answer. It juxtaposes the rate of growth of nominal gross domestic product with the rate of growth of money supply. Notice how, in six out of the last seven quarters, growth in money supply was lower than growth in nominal GDP.
Going by Friedman’s rule, this should result in deflation, or at least disinflation, a fall in inflation.
That is exactly what has happened and the chart shows it. Monetary policy operates with a lag and the contractionary effect on money supply produced by demonetisation has been reverberating across the economy for a year.
What of the future? Money supply growth has picked up compared to a year ago, but remember that last year’s base was low due to demonetisation.
But then, that applies to inflation as well. Going by the Friedman yardstick, we’re likely to see higher inflation in future. Long-term bond yields are already predicting that.