Monday, September 12, 2016

Deficits = Increase in Money Supply = Inflation Rate (India’s macroeconomics)

Though I studied Economics as a subject in my MBA and have read several books on the subject of Macro-economics, it took a while for me to figure out the equation, well suited for India’s macroeconomics. 
Deficits = Increase in Money Supply = Inflation. 
This is an approximate estimate and not a perfect match in numbers. Objective is to show that they influence each other. Deficit is the cause, increase in money supply is the means and rising inflation is the result.
It is the twin deficits (fiscal deficit and current account deficit) at the root which will demand an increase in money supply which will result in inflation. If you look at text book definitions, they would explain things academically but I would like to provide a different perspective on how these are interrelated.
Responsibility of managing fiscal deficit lies with Govt. And no Govt. borrows the money directly from their central banks. But this is what happens:
Fiscal Deficit Cash Flow:
o   Govt. needs excess money (deficit) to spend than its income (taxes, other incomes). It borrows from banks and public issuing bonds.
o   When bonds reach maturity phase, central bank (RBI) buys it from banks with the newly printed money. It expands its balance sheet (increases M3 Money Supply). Banks get cash for swapping the bonds.
o   Govt. borrows again from banks and newly printed money is used to fund deficit spending.
Current Account Deficit Cash Flow:
o   Trade Deficit: Difference in trade account balance resulting in international trade (India’s imports are higher than exports so there is a trade deficit)
o   Capital Flows: India sees inward cash flows through remittances, FDI etc. There is outflow too. Though this is positive, it is not big enough to pay for trade deficit.
o   Resulting deficit (negative trade balance and lesser positive cash flow) has to be funded. Businesses borrow from banks which in turn borrows from RBI. There is expansion of balance sheet in the central bank again.
These twin deficits put together will ask for new money creation and the inflation catches up with it. To check if my hypothesis holds true, let us look at data.

Year
Fiscal
Deficit
% of GDP
Current
Account
Deficit %
Both
Deficits %
Inflation
rate %
2009
7.8%
2.8%
10.6%
10.9%
2010
6.9%
2.8%
9.7%
12.0%
2011
5.1%
4.3%
9.4%
8.9%
2012
5.8%
4.8%
10.6%
9.3%
2013
4.9%
1.7%
6.6%
10.9%
2014
4.5%
1.3%
5.8%
6.4%
2015
3.9%
1.3%
5.2%
5.9%

Yes, though numbers do not match closely, they are comparable. Since this is an approximation and not a direct measure, they would not match. Moreover, inflation has two causes, monetary causes (which is covered in this blog post) and supply side reasons (which is not scope of this post). As the objective is to establish the relationship, it would serve the purpose and it would help us in getting an idea of how different components of macro economy influence each other.


Here is another check. During 2009-2015, the total twin deficits were approximately summed up to $1 trillion. If you look at increase in M3 money supply, it is around the same. (Below chart is in INR).


After synthesizing the data and the relationships, you will wonder how the deficit funded economic growth does not change the purchasing power of consumers as inflation robs away the benefits and the currency too deflates in the process. If deficits are low or trade is surplus, there would not be much rise in inflation while economy expands and it would result in currency appreciation too, resulting in positive benefits. Present Govt. is doing a better job at it than its predecessor. But when the larger economies are having an inflation of less than 1-2%, India recording 5-6% numbers seems high. Now you know why inflation is high and who is using that newly created money. If that money had created an equivalent asset, it would not have resulted in Inflation.