One simple measure of excess liquidity is to take the growth in money supply and compare it with the growth in nominal gross domestic product or GDP, that is, GDP at current prices. The gap between the growth of money supply and the growth in nominal GDP is taken as “excess liquidity".

The accompanying chart shows how this measure of liquidity has fared over the last three years. Notice how the gap between money supply growth and nominal GDP growth widened steadily between the March 2007 quarter and the December 2007 quarter. Excess liquidity is liquidity that is not used by the real economy and, therefore, spills over into the stock markets and into real estate, bidding up asset prices, or leads to inflation. Both these things happened in 2007.

Graphics: Naveen Kumar Saini / Mint

Thereafter, as foreign inflows fell, notice the reduction in excess liquidity until, in the September 2008 quarter, it became negative, with money supply growth lower than nominal GDP growth. That resulted in the credit crunch. The inescapable conclusion is the Reserve Bank of India (RBI) had kept its tightening stance for too long. After RBI loosened its purse strings, excess liquidity increased sharply in the March quarter, reached a peak in the June quarter and fell a bit during the September quarter. But, as the chart shows, it’s still very high, supporting asset prices.

As the economy improves, excess liquidity will start to wind down, provided we do not have another huge rush of foreign inflows.

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