PROJECT REPORT

on
“IMPACT OF M3 MONEY SUPPLY ON THE INFLATION RATE POST CPI
CHANGE 2012”

Submitted in partial fulfilment of the requirements for the award of the

Degree of Bachelor of Commerce (Hons) of Christ University

By

AAKASH ATHAWASYA
Register No
1411001

Under the guidance of

Mr. Yathiraju K

DEPARTMENT OF COMMERCE
Christ University, Bengaluru
2016-2017

i
 DECLARATION

I, Aakash Athawasya, do hereby declare that the Project entitled Impact of M3 Money Supply
on the Inflation rate post CPI change 2012 has been undertaken by me as part of my studies
in the degree of Bachelor of Commerce (Hons). I have completed this study under the guidance
of Mr Yathiraju K, Assistant Professor, Department of Commerce, Christ University,
Bangalore.
I also declare that this work has not been submitted for the award of any degree, diploma,
associateship or fellowship or any other title in this University or any other University.

Place: Bangalore Aakash Athawasya

Date: 1411001

ii
 CERTIFICATE

This is to certify that the project submitted by Aakash Athawasya on the title Impact M3
Money Supply on the Inflation post the CPI 2012 Changes is a record of project work done
by him during the academic year 2016-17 under my guidance and supervision in partial
fulfilment of Bachelor of Commerce (Hons). This Project has not been submitted for the award
of any degree, diploma, associateship or fellowship or any other title in this University or any
other University.

Place: Bengaluru Mr. Yathiraju K

Date:

iii
 ACKNOWLEDGEMENTS

I am indebted to many people who helped me accomplish this research project successfully.
First, I thank the Vice Chancellor Dr. Fr. Thomas C Matthew of Christ University for giving
me the opportunity to do my project.
I thank Dr. Tomy K Kallarakal, Associate Dean, Dr. Nithila Vincent, Head of the Department,
Prof. Girish S., Coordinator- Honours Programme, Department of Commerce for their kind
support.
I thank Mr. Yathiraju K for his support and guidance during the course of my research. I
remember him with much gratitude for his patience and motivation, but for which I could not
have submitted this work.
I thank my parents for their blessings and constant support, without which this research project
would not have seen the light of day.

Aakash Athawasya
Register No: 1411001

iv
 TABLE OF CONTENTS

Sl.no Title Pages

1 Declaration (ii)
2 Certificate (iii)
3 Acknowledgement (iv)
4 Table of Contents (v)
5 List of Tables (vi)
6 List of Charts (vii)
7 Abstract (viii)
8 Chapter 1: Introduction
 Introduction to Macroeconomics: Monetary 1
Policy and Inflation
 Monetary Policy 4
 Expansionary Monetary Policy 5
 Contractionary Monetary Policy 6
 Operational Definition: Monetary Policy 8
and Inflation
9
 Tools of Monetary Policy
12
 Monetary Inflation
13
 Trend in Money Supply (M3)
14
 Trend in the Consumer Price Index
 Monetary Policy and Inflation 15

9 Chapter 2: Literature Review 17

10 Chapter 3: Research Methodology
 Title 26
 Statement of Problem 26
 Theoretical Framework 26
 Research Type 26
 Objectives 27
27
 Hypothesis
27
 Research Gap
28
 Timeline
28
 Data sources
v
  Tests Used 28
 Limitations 30
11 Chapter 4: Analysis and Findings
 ADF Test 32
 Regression Analysis 34
 Interpretation 35
12 Chapter 5: Findings Conclusions and
Suggestions
 Findings & Suggestions 40
 Suggestions 42
13 Bibliography References 45

vi
 LIST OF TABLES:

Table Title Page No.

No.
1.1 Forecast of M3 (2016 to 2020) 13
4.1 ADF Test: Monthly Average of M3 32
4.2 ADF Test: Inflation Rate (Based on 2012 CPI) 33
4.3 Regression Statistics 34
4.3 Anova Table 34
4.3 Observations Residuals 34

LIST OF CHARTS:

Chart Title Page No.

No.
1.1 Effect of Expansionary Monetary Policy 5
1.2 Effect of Contractionary Monetary Policy 7
1.3 Repo and Reserve Repo rate (November 2008- 9
January 2017)
1.4 Statutory Liquidity Ratio and Cash Credit 10
Ratio (April 2008 to January 2017)
1.5 Monetary Policy Rates (March 2002-March 11
2016)
1.6 Money Supply (January 2000 to December 13
2016)
1.7 Consumer Price Index (Based on 2012 CPI, 14
January 2012 to December 2016)
3.1 Theoretical Framework 26
4.1 ADF Test: Month Average of Money Supply 32
4.2 ADF Test: Inflation Rate 33
4.3 Regression Test: Residual Value 35

vii
 ABSTRACT

This paper aims to explain the relationship between the Money Supply represented by the M3
supply on the inflation rate of the country calculated by the Consumer Price Index post 2012.
The main concepts that need to be understood is the relationship between the inflation rate and
the flow of money into the economy. This relationship is used by central banks all over the
world to control unemployment, aggregate demand and the overall level of prices.

The money supply represents the credit control policy of the Reserve Bank of India, this is one
among many tools the Monetary authority of India has to control money and credit but the
money supply will have the maximum effect on the inflation rate as determined by the research
analysis. The trend in the inflation rate is also empirically observed to move in accordance with
the trends in the money supply i.e. M3. Thus the null hypothesise (H0) will be disproved using
the Augmented Dickey-Fuller Test which proves that the variables have a unit root and are
non-stationary and thus the null hypothesis is disproved and we move on to the alternate
hypothesis. The next test that was conducted is the Regression analysis , which pointed out that
there existed a positive relationship between the two variables and that inflation rate was indeed
related to the supply of money in the economy.

Inflation rate and money supply over he years have had a slight similar trend. In the specific
period studied i.e. January 2012 to December 2016 the inflation rate and the money supply
were related and that the latter (Inflation rate measured by post 2012 CPI changes) were
affected by the changes in the money supply of the country.

viii
 CHAPTER I

INTRODUCTION

1
1.1 AN INTRODUCTION INTO MACROECONOMICS: MONETARY
POLICY AND INFLATION
The period of 1965 to 1982 was characterized by a severe form of depression and inflationary
period in the American finance and economic system. Over the nearly two decades it lasted,
the global monetary system established during the second World War was completely
abandoned, there were four economic recessions, two severe energy shortages and the
unprecedented peacetime implementation of wage and price controls. Most economists call it
the “biggest failure” of the American Macroeconomic policy. But what it did bring about was
a change in macroeconomic theory, which today governs the monetary policies of Central
Banks around the world.
The basic principle to be understood is the factors that churn the working of an economy, the
factors of production as they may be called: Land, Labour, Company and Capital, these are
further categorized into the private sector, the financial sector and the government sector. The
interactions between these sectors make the economy of any country work in a particular way
(depending on policy changes). There are several factors that will have an effect on a country’s
economy, some factors the country can control through the policies it formulates to regulate
the financial and private sector. The central bank of the country has a pivotal role to play in
this regard, as it maintains two very distinctive policies that regulate the economy of the
country and in turn control inflation: the monetary and the fiscal policy. The former deals with
how the central bank of the country aims to control the supply the supply of money into the
economy, particularly the inflation rate and the interest rate aiming to ensure that price remains
stable and the citizens of the country maintain trust in their currency.
Inflation has been particularly impactful in the last few decades and poses as one of the main
problems of the world economy. Inflation in its most basic sense leads to increase in the price
level of the country, massive changes in the economic, monetary policy and in turn social
environment. Capital migration and decrease in investment are all because of the increase of
the country’s inflation. Crediting the many influences the mainly negative on the economic
development, inflation is one of the most researched economic phenomenon (Draskovic, 2009)
The notion that the monetary policy should effect the inflation dynamics dates back the
Friedman’s dictum that inflation is always a monetary phenomenon (1968). Old Economists
proved how the changes in monetary policy could, effect inflation dynamics but the policy they
were referring to was a very stylized monetary policy, the present monetary policy effect
considers more realistic changes in policy on inflation dynamics. In modern terms inflation is

1
used as a tool by central banks around the world to regulate the supply of money or money
stock in the economy so that interest rate is kept stable and the amount of money flowing in
the economy is also regulated.
India is considered on of the fastest developing Economies in the modern era, having a GDP
per capita of $1,718 (nominal; 2016), the sixth largest economy in the world and the third
largest in terms of purchasing parity. With associations in many trade pacts and global deals
like the G-20 countries and the BRICS nation the growth is looking to continue. The long term
growth perspective of the Indian economy is only propelled by the young population,
corresponding low dependency ratio, healthy savings and investment rates and increasing
integration into the global economy. The production aside, the internal policies of various
government bodies also influence the overall economy of the country, particularly the
aforementioned monetary policy and its relationship with the overall price level of the country.
The annualised inflation rate in India was 3.78% as of August 2015 and fell to 3.41% as of
December 2016, as per the Indian Ministry of Statistics Programme Implementation. This
represent a fairly modest reduction from the previous annual figure of 9.6% for June, 2011.
The inflation rates of India were calculated based on the Wholesale Price Index (WPI) but now
the RBI has based calculations on the CPI (using 2012) as the base year, the CPI has been
divided into three distinct segments i.e. urban rural and a combination of the two. For this study
the last CPI calculation is taken. CPI numbers are measures monthly and with a significant lag,
for this study the monthly figures from Jan 2011 to December 2016 are taken and are measured
along with the Money supply of the country. The provisional annual inflation rate based on all
India general CPI (Combined) for November 2013 on point to point basis is 11.24% as
compared to 10.7% (final) for the previous month of October 2013. Inflation rates (final) for
rural and urban areas for October (2013) are 10.19% and 10.20% respectively.
The money supply any country is broadly defined under three measures of money as laid down
by the respective Central Bank. The four measures laid down by the RBI is mentioned in the
“Operational Definitions”. Of the four inter-related measures of money supply for which the
RBI publishes data, it is M3 which is of special significance. It is M3 which is taken into
account in formulating macroeconomic objectives of the economy every year. Since M1 is
narrow money and includes only demand deposits of banks along with currency held by the
public, the min factor bringing it down is that it overlooks the importance of time deposits in
policy making. That is why the reserve bank prefers M3 which includes total deposits of banks
and currency with the public in credit budgeting for the credit policy. It is on the basis of the
M3 that the effect on inflation is ascertained. The trend of M3 for 16 years i.e. from 2000 to

2
2016 is mentioned, also the effect on the year on year inflation (calculated on the basis of CPI)
from 2012 to 2016.
The Reserve Bank if India is the major pillar of the financial markets in the country and thus
the economy as a whole. It is responsible for framing the monetary policy which has a ultimate
impact on liquidity and interest rates in the financial system. The RBI being the credit controller
of the country is essential in accelerating the economic growth of the country through proper
formulation of monetary and fiscal policy Banks must keep a part of its money as reserve
money with the RBI, out of which it can control the flow of money. When commercial banks
fall short of funds, they can borrow from the RBI at a rate called the Bank or the Repo rate. As
per they monetary policy where the bank rate is high, this will discourage commercial banks
from borrowing funds from the RBI. As a result these banks will naturally charge higher
interest rates from their lenders. People will be not like to borrow money as this will lead to
high interest payments, hence money supply will reduce. However, a monetary policy where
the bank/repo rate is low and money supply is more, will be called a Cheap Monetary Policy.
Thus bank rate can be an effective instrument of the RBI to regulate the money supply and
effect various segments of the economy which can prove to be detrimental to the country.
The measures of the central bank in regulating the supply of money has a direct relationship
with the inflationary targets. When the current rate of inflation is low, the supply of money will
be high which translates to the tightening of liquidity and an increased interest rate for a
moderate aggregate demand and the avoidance of any foreseeable problems. If the output of
the country is low (GDP falls) a tightened monetary policy would affect the production in a
much more severe manner. The two incident that pay testament to the above observations are
the bumper harvest in 1998-1999 and the increase in import competition in 1991 with trade
liberalization. The variables that will be taken into account when monetary policy is gauged is
the money supply of the country and the prevailing interest rates that the respective Central
Bank is levying to the Commercial banks, since the money supply is varied depending on
country to country, India’s money supply will be gauged on the basis of M3 and not M2 or M4.
One the other end, inflation will be measured based on specific indexes that the countries
follow, since the countries follow either Consumers Price Index, Producer’s Price Index,
Wholesale Price Index, Cost of Living Index or a revised version of the above, a commonality
can also be placed between the indicators.
The research paper will start out with the current economic outlay of the country, complete
with the existing money supply measurement used, interest rates prevailing in India, method
of inflation calculation followed (index) and any other relevant information that would have

3
an effect on their inflation. An ADF (Augmented Dickey Fuller) Test to judge the variability
of the data provided for both the variables, the M3 supply in the country as well as the CPI
(post 2012). If sufficient fluctuation is determined the two sets of data will be put, I a regression
model to show their relationship.

1.2 MONETARY POLICY:

Monetary Policy consists of the actions of the competent authority of the country i.e. Central
Bank, currency board or other regulatory committee that determines the size and rate of growth
of the money supply which in turn effects the interest rates. The country carefully analyses all
the macroeconomic variables that effect a country’s price levels, consumption behaviours,
supplier cost and unemployment rate and formulate the monetary policy to stabilize these levels
and ultimately achieve economic growth. Monetary policy I maintained by the central banks
actions of open market operations (buying and selling government bonds) changing the rate at
which the commercial banks of the country borrow from it and the ratio that the central bank
maintains pertaining to the cash receipts that the commercial banks have to keep with the
former. Benchmark interest rate, such as LIBOR and the Fed funds rate, affect the demand for
money by raising or lowering the cost to borrow- in essence. When borrowing is cheap, firms
will take on more debt to invest in hiring and expansion; consumers will make larger, long term
purchases with cheap credit; and savers will have more incentive to invest their money in stocks
or other assets, rather than earn very little- and perhaps lose money in real terms- through
savings accounts. Policy makes also manage risk in the banking system by mandating the
reserves that banks must keep in hand. Higher reserve requirements put a damper on lending
and rein in inflation.

In recent years, a trend of unconventional monetary policy has become more common. This
category includes quantitative easing, the purchase of varying financial assets from commercial
banks. In the United States, the Fed loaded its balance sheet with trillions of dollars in Treasury
Notes and mortgaged backed securities between 2008 and 2013. The Bank of England, the
European Central Bank and the Bank of Japan have pursued similar policies. The effect of
quantitative easing is to raise the price of securities, therefore lowering their yield, as well as
to increase total money supply. Credit easing is a related unconventional monetary policy tool,
involving the purchase of private-sector assets to boost liquidity. Finally, signalling is the use

4
of public communication to ease markets’ worries about policy changes: not to raise interest
rates for a given number of quarters.

The monetary policy that is followed by most countries can be categorised as:
 Expansionary Monetary Policy
 Contractionary Monetary Policy

1.3 EXPANSIONARY MONETARY POLICY:

Expansionary Monetary policy is when the central bank uses its tools to stimulate the economy
by increasing the money supply, lowering interest rates and thereby increasing aggregate
demand. That in turn boosts the growth as measured by Gross Domestic Product (GDP). It
usually diminishes the value of the currency thereby decreasing the exchange rate.
Expansionary Monetary Policy is used to ward off the concretionary phase of the business
cycle.
Expansionary Monetary policy is most prevalent after the recession period and when
unemployment is a keen problem in the economy.
To increase the supply of money the government can:
 Buy government bonds
 Lower Interest rate
 Lower the reserve ratio

The effect of Expansionary Monetary Policy:

Chart 1.1: Effect of the Expansionary Monetary Policy

Money Interest Investme Aggregat Unemplo

supply rate nt level e demand
Real GDP
yment Price rise
Inflation
rise rise
rise decline rise rise decline

5
The central bank of the country can increase the flow of money by buying government
securities like Treasury notes from its member banks (open market operations). Since banks
have more money to lend which decreases the interest rates. The more attractive interest rates
will encourage savings and investment by investors. An increase in investment of companies
will have a two-fold effects, more investment would translate to increased workers to keep up
production levels which would lead to an increase in the unemployment, the second effect is
on net spending in the economy. Given the high investment and increased employment rates,
the incomes of the people will rise, hence they can devote more amount of personal disposable
income in consumption, hence aggregate demand rises. The increased production and
consumption will lead to an increase the overall Gross Domestic Product. As the consumption
and demand rises, people would not mind purchasing goods and services at a higher price,
given scarcity of goods due to hyped demand and the rising income levels. This increase in the
price will lead to an overall increase in the price level and thus lead to inflation.

1.4 CONTRACTIONARY MONETARY POLICY:

Contractionary Monetary policy is when the central bank uses its tools to stimulate the
economy by decreasing the money supply, rising interest rates and decreasing aggregate
demand. That in turn will lead to a decline in the growth as measured by Gross Domestic
Product (GDP). It usually increases the value of the currency thereby affecting the exchange
rate more favourably.
Contractionary Monetary Policy is used to ward off the expansionary phase of the business
cycle.
Contractionary monetary policy is appropriate when economy is in expansion and inflation is
a problem.
To increase the supply of money the government can:
 Sell government bonds
 Higher Interest rate
 Higher reserve ratio

6
The effect of Contractionary Monetary Policy:

Chart 1.2: Effect of the Contractionary Monetary Policy

Money Investme Aggregat Unemplo

supply
Interest
nt level e demand
Real GDP
yment
Price Inflation
rate rise decline decline decline
decline decline decline rise

The central bank of the country can decrease the flow of money by selling the government
securities like Treasury notes to its member banks (open market operations). Since banks have
less money to lend which increases the interest rates. interest rates will discourage savings and
investment by investors. A decrease in investment in companies will have a two-fold effect,
less investment would translate to decreased workers’ employment and to keep costs low there
is a high degree of employee attrition, also production would decrease corresponding to a
decreased level of investment which would lead to a decrease in the aggregate demand of goods
by the consumers. A fall in the demand would lead to a decrease in the overall consumption in
the economy, lowering the real GDP of the country. With a fall in the aggregate demand, the
producers would lower the prices in order to sell their stock, which would lead to a fall in the
price or the price level of the country, thus decreasing the overall inflation rate of the country.

7
1.5 OPERATIONAL DEFINITIONS

1. Inflation: Inflation is defined as an increase in the general level of prices for goods and
services of a particular country. It is measured as an annual percentage increase. As
inflation increases, every unit of currency owned purchases a smaller percentage of a
good or service. The value of said currency does not stay constant and varies with the
inflation. The value of the currency is observed in terms of the purchasing power, which
is the real, tangible goods that money can buy. When the inflation of a country rises,
there is a decline in the purchasing power of money which is representative of the fall
in the value of money.
For Example: When the inflation rate is 5%, then a loaf of bread will cost 10 units in a
year. After inflation, the same quality of money cannot purchase that load of bread as
its value has fallen.

1.5.1 CAUSES FOR INFLATION:

 When the government of a country will print more money, the money supply in
the country will increase, the prices will thus increase to keep up with the
increase in current, leading to inflation.
 Higher taxes on consumer products leads to inflation.
 Demand pull inflation, wherein the economy demands more goods and services
than what is produced.
 Cost push inflation or supply shock inflation, wherein non availability f a
commodity would lead to increase in price. Cost push inflation can be caused
by Rising Wages and Import Prices.
 When the country borrow money, they have to cope with the high interest
burden payable leading to an increase in the prices of the borrowing country.
 Increase in production and labor costs, have an immediate impact on the price
of the final product, resulting in inflation.

2. Monetary Policy: The central bank of the country is the prime player in maintaining
the country’s GDP, Price Level and the amount of liquid money that follows into the
economy. The methods through which the central bank maintains the above is through

8
 its policies regarding monetary policy and fiscal policy. The Monetary Policy is the
macroeconomic policy laid down by the central bank which involves management of
the money supply and the interest rates and is the demand side of the economic policy
used by the government of a country to achieve certain macroeconomic objectives like
inflation, consumption, growth and liquidity.

1.6 TOOLS OF MONETARY POLICY:

- Repo and Reserve Repo Rate: This is a transaction wherein the securities are sold
by the RBI and simultaneously repurchased at a fixed price. The fined price is
determined in context to an interest rate called the repo rate. The higher the repo
rate, the costlier the funds are for banks and hence, higher will be the rate that bank
pass on to the customers. A high rate signals that access to money is expensive for
banks, lesser credit will flow into the system and that help bring down liquidity in
the economy.

- Bank Rate: This is the re-discounting rate that RBI extends to banks against
securities such as bills of exchange, commercial papers and any approved securities.
Chart 1.3: Trend of the Repo and Reserve Repo

Repo and Reserve Repo

(November 2008-January 2017)
9
8
7
6
5
4
3
2
1
0
May-09

Nov-09
Nov-08

May-10

Nov-10

May-11

Nov-11

May-12

Nov-12

May-13

Nov-13

May-14
Aug-13

Nov-14

May-15

Nov-15

May-16

Nov-16
Feb-09

Aug-09

Feb-10

Aug-10

Feb-11

Aug-11

Feb-12

Aug-12

Feb-13

Feb-14

Aug-14

Feb-15

Aug-15

Feb-16

Aug-16

Repo Rate Reserve Repo

Source: craytheon.com

9
It can be seen from the graph above that the Repo and the Reserve repo rate are always parallel
to each other but at no point will they dissect as this would mean the amount of money supplied
to the commercial banks is the same as the rate at which it the central bank re-discounts to the
commercial bank which would have a negligible effect.

- Cash Reserve Ratio (CRR): The percentage of a bank’s total deposit that is
required to be kept in cash with the Reserve Bank. The Central bank can change the
ratio to a limit. A high percentage means banks have less to lend, which curbs
liquidity, a low CRR does the opposite. The RBI can reduce or raise CRR to tighten
or ease liquidity as the situation depends.

- Statutory Liquidity Rate: Percentage of banks’ total deposits that they are needed
to invest in government approved securities. The lesser the SLR, the more the banks
have to lend to customers.

Chart 1.4: Trend of the SLR & CRR

Statutory Liquidity Ratio and Cash Credit Ratio

(April 2008 to January 2017)
30

25

20

15

10

0
Apr-14
Apr-08

Apr-09

Apr-10

Apr-11

Apr-12

Apr-13

Apr-15

Apr-16
Aug-08
Dec-08

Aug-09
Dec-09

Aug-10
Dec-10

Aug-11
Dec-11

Aug-12
Dec-12

Aug-13
Dec-13

Aug-14
Dec-14

Aug-15
Dec-15

Aug-16
Dec-16

SLR CRR

Source: craytheon.com
The above graph plots the trend in the SLR and the CRR from Aug 2008 to Dec 2016 but they
flow parallel to each other. The CRR is lower than the SLR because the latter is inclusive of
the former, hence the difference between the two is the percentage of bank deposits that the
commercial bank keeps with the central bank other than in cash.

10
 - Open Market Operations: This refers to the Central Government’s buying and
selling of government securities by RBI to regulate short tern money supply.
Inducing liquidity would mean the RBI will buy government securities and inject
funds, and if it wants to curb the amount of money, it will sell these t banks, thereby
reducing the amount of cash that banks have. This can be used even outside the
monetary policy review to manage liquidity on a regular basis.

Chart 1.5: Trend of the Monetary Policy Rates

Given above is a consolidated graph of all the tools that are at the Central Bank’s disposal when
it comes to the monetary policy from March 2002 to March 2006.

11
1.7 MONETARY INFLATION:
Demand-Pull Inflation: This approach can be summarized as “too much money chasing too
few goods”. In other words, if demand is growing faster than the supply, prices will rise.
Inflation rises as real Gross Domestic Product rises and unemployment falls, as the economy
moves along the Phillips Curve.
Cost-Push Inflation: This is inflation caused by substantial increase in the cost of important
goods or services where no suitable alternatives are available. This was very evident in the Oil
Crisis that prevailed in the Western world in the 1970s.

1.7.1 Money Supply:

Money Supply or money Stock is the total amount of monetary assets available in an economy
at a specific time. This includes currency in circulation and demand deposits with the public.
There are four measures of money supply in the country:
M1= Currency notes and coins with the public +Demand deposits with the banks + Other
deposits with the RBI
M2= M1+ Savings deposit with Post Office Savings Bank
M3= M1+ Time Deposits with the Banks
M4= M2 + Total Deposits with the post office savings organization excluding National Savings
Certificates (NSC)
In this particular research paper, we will take M3 as the money supply since it includes the
currency, demand deposits and also the time deposits and it helps gauge the impact of the
money supply on the inflation rate more comprehensively than the other measures.

12
1.8 TREND IN THE MONEY SUPPLY (M3)
(From Jan-2000 to Dec 2016)
Chart 1.6: Trend of the Money Supply (M3)

Money Supply
140000

120000

100000

80000

60000

40000

20000

0
May-02

Jun-13
Jul-03

Jul-10
Apr-05

Jun-06

May-09

Apr-12

May-16
Dec-09
Mar-01

Dec-02

Nov-05

Nov-12
Feb-04
Sep-04

Mar-08

Feb-11
Sep-11

Mar-15

Dec-16
Jan-00
Aug-00

Jan-07
Aug-07

Jan-14
Aug-14
Oct-01

Oct-08

Oct-15
Money Supply

Source: Database for the Indian Economy

Money Supply M3 in India is expected to be around 123895.37 INR Billion by the end of this
quarter (according to Trading Economics global macro models and analysis expectations).
Looking forward we estimate Money Supply M3 in India to stand at 129752.43 in a year’s
time in the Long Term, the Indian Money Supply M3 is projected to trend around 153012.28
INR Billon in 2020.
Table 1.1 : The Forecast of M3 in India from 2016 to 2020

FORECAST M3

Actual 121452

Q1/17 123895

Q2/17 125816

Q3/17 127773

Q4/17 129752

2020 153012

Source: tradingeconomics.com

13
1.9 TRENDS IN THE CONSUMER PRICE INDEX
(From Jan-2012 to Dec-2016)

The Consumer Price Index or the CPI is a comprehensive measure used for the estimation of
price changes in a basket of goods and services representative of consumption expenditure in
an economy.
The calculation involves the estimation of CPI which is quite rigorous. Various categories and
sub-categories have been made for classifying consumption items on the basis of Consumer
Categories like urban or rural or combined. Based on those indices and sub indices obtained,
the final overall index of price is calculated mostly by a country’s National Statistics Agency.
It is one of the most important statistics for an economy and is generally based on the weighted
average of the prices of the basket of commodities based on their importance and their
relevance. Inflation is measured using CPI. The percentage change in this index over a period
of time gives the amount of inflation over that specific period, i.e. the increase in prices of a
representative basket of goods consumed.
Chart 1.7: Trend of the Consumer Price Index

Inflation Rate
14.00

12.00

10.00

8.00

6.00

4.00

2.00

0.00
Jan-12

Jan-13

Jan-14

Jan-15

Jan-16
May-12

Nov-12

May-13

Nov-13

May-14

Nov-14

May-15

Nov-15

May-16

Nov-16
Mar-12

Mar-13

Mar-14

Mar-15

Mar-16
Jul-12

Jul-13

Jul-14

Jul-15

Jul-16
Sep-15
Sep-12

Sep-13

Sep-14

Sep-16

Inflation Rate

Source: Inflation.eu

14
1.10 MONETARY POLICY AND INFLATION:

Money supply primarily is important because it is linked to inflation by the equation of

exchange. (Fisher, 1911)

M*V=P*Q

Where:
 M is the total currency in the nation’s money supply
 V is the velocity of money
 P is the average price of all the goods and services sold during the year
 Q is the quantity of assets, goods and services sold during the year

The above equation represents an identity which is true by definition rather than by mere
economic behaviour. The value of one is dependent on the value of the others. The velocity of
money has no independent measure and can only be estimated by dividing PQ by M. The
velocity of money is stable and predictable, being determined mostly by financial institutions
hence changes in M can be used to predict changes in PQ. V is required in order for the equation
of exchange to be useful as a macroeconomics model or as a predictor of prices.
The equation for demand for money which describe more regular and predictable economic
behaviour is being used by most macroeconomists over the equation of exchange.
Predictability of the velocity of money is equivalent to predictability of the demand for money,
since in equilibrium real money demand is simply Q/V.
In practice, macroeconomists almost always use real GDP to measure Q, omitting the role of
all transactions except for those involving newly produced goods and services. But the original
quantity theory of money did not follow this practice: PQ was the monetary value for all new
transactions, of real goods and services or of paper assets.

15
 CHAPTER II

Review of Literature

16
LITERATURE REVIEW:

2.1 John Roberts (2004) attempts to portray that a change in the monetary policy of the country
will result in a shift in the relationship between unemployment and inflation. Roberts applies
multiple ways through which the monetary policy has changes, the first being its degree of
change to the fluctuations of output and inflation in the early 1980s period. The ability to
forecast the monetary policy is also evident. Policy changes by the government affect various
relationships on expectations formation, holding fixed the behavioural relationships, others
unchanged, the monetary policy changes can affect the signal for upcoming inflation.
The main aspect measure is the economy’s volatility with changes in the monetary policy using
the variables on Interest Rate (In this case the federal funds rate) and the output gap. The other
model used ins the FRB/US model. This paper points out that the change in the policy result in
large deductions in out gap volatility in both the models i.e. FRB/US and the three equation
model, the former showing larger reductions. The monetary policy explained the reduction in
output gap volatility, however the paper does not quite the reduction in the volatility of GDP
growth in the FRB/US model. The monetary policy also forecasts a large decrease in the slope
of the reduced form Phillips Curve, which relates to its accountability in the matrix of inflation
and unemployment.

2.2 Hogen and Yoshiko (2015) portray the core inflation and the volatile factors and their
relationship with the monetary policy. Economic slack is the ability for an economy to grow
quickly with a U-turn. The monthly figures of the CPI or the WPI are in turn affected by various
factors of the money supply and interest rates, the trend of inflation needs to be identified by
the central bank which will indicate the economic slack measured by the output gap as well as
expected inflation. The main objectives that Hogen, Kawamoto and Nakahama have specified
are estimation of new measures of core inflation, the link between the core inflation measures
and the business cycle by estimating the various Phillips curves showing relationship with the
output gap and the developments in inflation particularly in Japan.
The authors follow two delineated approaches, one wherein the volatile items in the price index
are excluded and core inflation is measured, the other wherein the structure of the economy is
more important and is considered rather than just volatile factors. The parameters of
measurement of the Consumer Price Index as per this study was fresh food and energy
products. The analysis showed that the measures of core inflation that simply exclude volatile

17
items still closely follow the business cycle as measured b the output gap, while measures such
as the mode and the weighted median are much more weakly linked to developments in the
output gap.

2.3 Ryo Kato and Hisata (2005) through their paper aim to study the monetary innovations
adopted. The objective of this paper is to investigate how the monetary policy, often called the
variance of innovations to a monetary policy reaction function, affects long-term interest rates
and yield curves. The authors examine the relationship between the monetary policy instability
and the term structure of interest rates. They show how the long-term interest rates are
positively related to monetary policy uncertainty, with the magnitude increasing with Maturity.
Monetary Policy mainly consist of the money supply by the central bank and the prevailing
interest rate of the country, the paper shows that the interest rate (in the long term) are positively
related to monetary policy uncertainty with the magnitude increasing with maturity. The C-
CAPM forecasts that an increase in the volatility of consumption leads to lower interest rates
because higher uncertainty encourages households to increase savings. But in the model
presented by Kato and Hisata the focus s on monetary policy uncertainty which is referred to
as conditional variance of the forecast errors of a monetary policy rule, whereas the former
model focuses on volatility of growth rates of consumption as a source of uncertainty.

2.4 Vikesh Goyal, Hanif (2004) The inflation and Economic Growth is studies by the authors
in Fiji and the data has been provided by their central bank, the Reserve Bank of Fiji. This
paper reviewed the aforementioned relationship in two senses: the different economic theories
and the recent empirical literature. Through the former they ascertained the Aggregate Demand
and Aggregate Supply framework to more comprehensively equate inflation to growth. The
latter revealed a much weaker negative correlation that exists between inflation and growth,
while the change in output gap bears significance.
Talking about the economy of Fiji and their inflationary performance, there exists a less robust
link between the two variables, given the current structure of the economy and the factors
which influence inflation. The correlation coefficient showed only a weak negative link, while
causality was shown to run from economic growth to inflation. The conclusions provided the
Fiji policymakers evidence that points to the importance of maintaining low inflation, to pursue
high economic growth.

18
2.5 Saurabh, Mani and Mishra (2014) aim to show the trend of India’s inflation rate with the
output which is denoted by the Gross Domestic Product. The objective is to find out the impact
of inflation on the performance of the Indian Economy specifically in the agricultural,
industrial and the service sector. The data for these three years are specifically drawn up and
are weighed against the prevailing inflation rate using a regression model.
Given the data that the research provided, the relationship between GDP and inflation rate are
quite low significant and having low positive relations. The impact of the inflation in the period
of study (2000-2013) on agricultural growth, industry growth and the service growth are very
lowly significant. Data also points to the relationship and impact between the regression values
of the two variables which is quite low. GDP factor cost and inflation rate are interdependent
to each other.

2.6 Jamuna A (2016) aimed to portray the impact of inflation on the overall Indian economy
but through the use of some key economic indicators. Given the economic condition of India
in the past two decades, especially in the period of 2008-2009 when the country experienced
its highest and lowest rate of inflation, the author Jamuna analyzed the inflation rate with the
GDP trend of the last 11 years from 1999 to 2011, through a co-efficient of correlation method
and a trend analysis. The first test determines that the coefficient of correlation is 0.302 which
means that a single factor affects the growth up to 0.3 shows a strong impact on the economy.
The author also said that the growth is always lesser than the level of inflation in India, though
the trend values for growth is predicted at a growing rate for the years 2012-2015, the trend
value for inflation is also predicted to be higher than that of trend value for growth.

2.7 Adam Klaus and Billi Roberto (2004) bring out the relationship between an inflation
conservative Central Bank ad an endogenous fiscal policy. This papers studies the fiscal and
monetary policies without commitment in a dynamic, stochastic sticky-price economy with
monopolistic distortion. There exists a trade off between generating private utility and nominal
interest rates, wherein monetary policy determines nominal interest rates and fiscal
policy provides public goods generating private utility. Public spending rises as the lack of
fiscal commitment is furthered in the economy and lack of monetary inflation gives rise to too
much inflation, thus the optimal inflation rate internalizing this distortion is positive.
When fiscal policy is determined before monetary policy each period, the monetary authority
should focus exclusively on stabilizing inflation. Monetary conservatism then eliminates the

19
steady state biases associated with lack of monetary and fiscal commitment and leads to
stabilization policy that is close to optimal.

2.8 Raghbendra Jha (2008) in his paper evaluates the inflation targeting in the country and
highlights that with so much widespread poverty in the country, inflation should not be the
main concern while formulating the monetary policy. Inflation targeting is a monetary policy
regime in which the central back of the country has an explicit target inflation rate for the
medium term and announces this inflation target to the public.
The assumption is that the best that the monetary policy can do to support long term growth of
the economy is to maintain price stability. However, inflation targeting is explained in this
paper but is found to be incomplete. The relationship between Inflation targeting and the
change in the volatility of exchange rate in the country is also portrayed. This paper states that
the effect of Inflation targeting has not brought down the inflation rate to a large extent or
changed the volatility of the exchange rate, but has maintained a low inflation rate.

2.9 Willi Semmer and Zhang Wenlang (2004) portray a problem in the monetary and fiscal
policy interactions which is an important issue for the euro area, since the member states of the
Economics and Monetary Union of the European Union. The paper’s main concern is with the
evidence on the monetary and fiscal policy interactions in the European area with the financial
superpowers of France, Germany and Italy. The paper studied in particular the
counterproductive monetary and fiscal policy of the Italian economy in the period between
1979 and 1998.
The State-Space model with the Markov-switching for some Euro-area countries which
explores time-varying interactions by studying monetary and fiscal policy interactions. There
appears to be some regime changes in monetary and fiscal policy interactions in France and
Germany, but the interactions between the two policies are not strong. Moreover, the two
policies have not been accommodative but counteractive to each other. Finally, the paper deals
with the exploration of forward-looking behaviour in policy interactions and find that
expectations do not seem to have played an important role in the policy designs.

2.10 Sudhakar Patra and Kabita Kumari Sahu (2012) aim to study the core economic indicators
like GDP, the most widely accepted index in the country (CPI, WPI) in the South East Asian
Countries from 2000-2008. The authors through this study have analysed the change and the

20
trend in the change of the inflation and its consequent effect in the production of the studied
countries. The countries that were put under the scope are: Afghanistan, Bangladesh, Bhutan,
India, Maldives, Nepal, Pakistan and Sri Lanka.
In the course of the study it was found that India has an average rate of inflation at 5%, Sri
Lanka had the highest, Bhutan also followed a low rate of inflation and Maldives has rising
trend of inflation. The authors drew out a relationship between monetary policy (money
supply), GDP and the inflation rate in the country. A negative co-relation between inflation
and GDP existed with Nepal, and a positive one in Bangladesh, India, Pakistan and Sri Lanka
at constant prices. Whereas there existed a negative co-relation between rate of inflation and
changes in money supply in Bangladesh, Nepal and Pakistan and a positive one in Sri Lanka.
Pakistan showed a hike in their CPI mainly because of the hike in the oil price and food
inflation. The authors concluded that when looking at inflation from the purview of money
supply and the GDP the inflation scenario in the South East Asian countries is adverse to
economic development i.e. above 5% in most of the studied countries.

2.11 Branimir Jovanovic and Marjan Petreski (2012) Zhu tested out the Impossible Trinity in
modern economics by the study of the land-locked country of Macedonia. The impossible
trinity propagates that a country cannot have all three of the following at the same time: a fixed
foreign exchange rate, free capital movement and most importantly independent monetary
policy. The author also employs the Keynesian theory to empirically analyse the above on the
Macedonia. The official reserves are included while calculating the interest rate to account for
any limitations that these impose on the monetary policy when the exchange rate is fixed. Also,
the foreign interest rate is included in order to reflect the necessity of following a foreign
monetary policy. The period of study in this Balkan nation is from 1997 to 2011.
The results indicated that despite the fixed currency the monetary policy focused mainly on the
domestic objectives. Also, there was a massive fluctuation between the conduct of the
monetary policy for the first half to the latter half of this period. In the earlier period, when the
importance of the reserves seemed to be at an all time high, the response to inflation was far
more aggressive, while the output gap seemed to be important only in the later period possibly
due to the stronger monetary policy transmission. To conclude, the results point out that the
monetary policy has likely moved from adaptive to rational from the earlier to the latter period.

21
2.12 Jeffrey Amato, Andrew Filardo, Gabrielle Galati, Perter von Goetz and Feng Zhu (2005)
have studied the exchange rates and monetary policies carried out by various Central Banks
that participated at the Autumn Meeting of Central Bank Economists on “Exchange rates and
monetary Policy”, which the Bank of International Settlements hosted on the 28th and 29th of
October, 2004. The paper has been divided into two parts, with the former focusing on the
approaches that the central banks have found most useful in formulating their exchange rate
behaviour and the latter that examines the actual experience that the countries have had in
inculcating their exchange rate while formulating their monetary policy. The authors describe
the efforts to explain exchange rate behaviour ex post and then to predict the forward evolution
ex ante. They then summarise the banks’ research on the linkage between exchange rates and
inflation, output, profits and the current account.
The authors have concluded that there is an indefinite link between the exchange rate variability
and the performance various sectors of the economy. The paper does recognise that there is a
significant negative impact that a sustained high level of the exchange rate can have on the
tradable sector. It is also difficult to know the extent to which the exchange rate variability is
constraining the growth of the tradable sector. If variability could be reduced - without other
negative consequences - this paper makes the judgement that it is likely the tradable sector
would perform better. The lack of certainty about the impact of exchange rate variability on
exporters means that the costs of various monetary policies need to be taken into account to
ensure that they do not outweigh the benefits.

2.13 Andreas Schabert (2005) analyses the relation between the interest rate targets and money
supply in a relatively bubble free rational of expectations equilibrium of a standard cash in
advance model. The paper examines the contingent injections of money into the economy
which is aimed to implement the interest rate sequences that satisfy interest rate target rules.
An interest rate target with a positive inflation feedback corresponds to the growth of the money
rates rising with inflation. When prices are not completely flexible, this translates to the fact
that a non-destabilizing money supply cannot comprehend an implementation of a forward-
looking and an active interest rate rule. The author has also included an alternative model with
an interest elastic money demand. The implementation of a Taylor-rule will then require a
money supply that leads to explosive or oscillatory equilibrium sequences. In contrast, an
inertial interest rate target can be implemented by a non-destabilizing money supply, even if
the inflation feedback exceeds one, which is found in interest rate rule regressions.

22
When econometricians find significant coefficients on lagged interest rates in an interest rate
regression model, the origination is in a non-destabilizing adjustment of the outstanding stock
of money than being an indication for inertias as the monetary strategy’s fundamental
component. Under a particular money supply regime, the coefficients of an inertial interest rate
target rule are not uniquely identified. The author concludes that the findings of this study is
an indication that the assumption of frictionless financial (money) market is not as useful for a
full understanding of monetary policy implementation.

2.14 Daniel L Thorton (2012) through his paper states that when a country forms its monetary
policy, it forms it by targeting a very short term interest rate. Since the late 1980s the Federal
Reserve has implemented the monetary policy by adjusting its target for the overnight federal
funds rate. Money’s role in the monetary policy has at best been tertiary. Several influential
economists have said that money’s role is irrelevant for monetary policy: The Central Bank
effects the economic activity and inflation by firstly controlling a very short term nominal
interest rate, secondly by influencing the participation of financial markets’ expectation of the
future policy.
The monetary policy is now conducted by targeting a very short term interest rate. The
aggregate demand is controlled by adjusting the interest rate target by the Fed and the other
central banks. Against the back-drop, Daniel L Thortons’ paper suggest that the main core
feature of money is that it guarantees “final payment” and is mandatory for the price
determination in the economy which determines the demand and supply. The author also offers
an alternative perspective: namely that money is absolutely mandatory for the Central Bank’s
control over the level of prices and the monetary authority’s ability to control interest rates is
exaggerated.

2.15 Nicholas Krus (2012) in his paper talks about the currency board and monetary
equilibrium. This paper provides an in-depth analysis of the money supply and the
corresponding currency boards in order to check the stability of the monetary system. The
neglect by policymakers, economist and various forecasters, it enjoyed a resurgence in the
1990s. Although no new currency boards have been established since the late 1990s,
economists continue to consider them from time to time as a possibility of monetary reform in
some countries. This paper has hypothesized that there are certain circumstances under which
a currency board maintains monetary equilibrium while an unorthodox currency board may

23
have not. By taking a balance sheet model approach, one can make more definitive conclusions
about the workings and efficacy of various currency boards.
This paper provides an improved framework to support a better understanding of the dynamics
of a currency board and gives some evidence that orthodox currency boards may maintain
equilibrium while unorthodox ones may not.

24
 CHAPTER III

RESEARCH METHODOLOGY

25
3.1 TITLE:
“The Impact M3 Money Supply on the Inflation Rate of India post the CPI 2012 Change”

3.2 STATEMENT OF THE PROBLEM:

A study of the impact of the Monetary Policy on the Inflation in India (based on CP1 2012
Urban and Rural Combined) from 2012 to 2016

3.3 THEORETICAL FRAMEWORK:

Chart 3.1: Theoretical Framework of the Research

3.4 TYPE OF RESEARCH:

The methodology followed will be divided based on the indicators of monetary policy and
inflation which will differ from country to country. The indicators that will be considered will
be, for monetary policy, money supply primarily M2 and M3 data and Interest Rates of India.
For inflation only two Consumer Price Index post the 2012 change using the combined Urban
and Rural basket. The Statistical model will specifically be an Augmented Dickey Fuller Test

26
and a Regression model wherein the dependent variable will be the Inflation rate i.e. the
Consumer Price Index and the independent variable will be the Money supply based on the M3
data of India.

3.5 RESEARCH OBJECTIVES:

The objectives of this paper are as follows:
 To study the monetary policy of India
 To understand the impact of the policies on the inflation
 To study the influence of monetary policy on the overall GDP of the country
 To show trends in the economies of India
 To interpret findings and draw logical conclusions

3.6 RESEARCH HYPOTHESIS:

3.6.1 HYPOTHESIS OF STUDY:
Null Hypothesis: There is no relationship between the money supply of the country and the
inflation rate.
H0= Monetary Policy and Inflation Are Independent
Alternative Hypothesis: There is a clear relationship between the monetary policy of the
country and the inflation rate.
H1= Monetary Policy and Inflation rate are related to each other

3.7 RESEARCH QUESTION:

What is the impact of the monetary policies on the inflation of various countries?
 Hypothesis testing analysis will be used by T-value.
 Period of study: 2012 to 2016

3.8 RESEARCH GAP:

There is a qualitative justification of the impact of the money supply on the inflation rate, this
research aims to show the relationship between the two variables in a quantitative manner.

27
3.9 TIMELINE OF STUDY:
The study will be for a 5-year period, from 2012 to 2016, and will also contain forecasts for
the future money supply in the country, attached at the end of the report will be suggestions to
the Ministry of Finance and the Reserve Bank of India to further study the inflation and
monetary policy.

3.10 DATA COLLECTION (Secondary):

The data for this paper has been collected from secondary sources of private as well as public
domains, specifically:
 Trading Economics website
 Reserve Bank of India Website
 Ministry of Finance, Government of India
 Economic Survey of India
 Database for the Economy in India
 World Bank Metadata (World Bank, 2016)
 Planning Commission

3.11 UNIT ROOT TEST:

A unit root test test whether a given time series variable is non stationary and possesses a unit
root. The null hypothesis is generally defined as the presence of a unit root and the alternate
hypothesis is either a stationarity, trend stationarity or an explosive root depending on the trend
used.
In general, the approach to unit root testing implicitly assumes that the time series to be tested,
which can be written as:
Yt= Dt+ zt+ et
Dt: Is the deterministic component (trend, seasonal component etc.)
zt: Is the stochastic component
et: Is the stationary error process
Statistical stationarity: A stationary time series is one whose statistical properties such as mean,
variance, autocorrelation, etc. are all constant over time
The task of the test is to determine whether the stochastic component contains a unit root or is
stationary

28
3.12 AUGUMENTED DICKEY FULLER:
In statistics and econometrics, an Augmented Dickey-Fuller test (ADF) tests the null-
hypothesis of a unit root in a present time series sample. The alternative hypothesis is different
depending on which version of the test is used, but is usually stationarity or trend stationarity.
It is an augmented version of the Dicky-Fuller test for a larger and more complicated set of
time series models.
The Augmented Dickey Fuller (ADF) statistic, used in the test, is a negative number. The
greater the negative value, the stronger the rejection of the hypothesis that there is a unit root
at some level of confidence.

3.13 REGRESSION:
Regression analysis is a statistical tool for the investigation of relationship of variables.
Usually, the objectives of the analysis is to ascertain the casual effect of one variable upon
another-the effect of a cost increase on the aggregate supply in the economy, for example, or
the effect of changes in money supply on the inflation rate. In the case of this paper, it would
be to ascertain the latter.
 Independent Variable= Money Supply M3
 Dependent Variable= Inflation Rate (CPI)

Given the perspective, money supply is the independent variable and the inflation rate are
regression functions of the independent variable.
The formulae adopted for the sake of this research is:

Where,

Xi = Money Supply M3
Yi = Inflation Rate (CPI)
-x = Mean of Money Supply M3
-y = Mean of Inflation Rate (CPI)
β0= Regression Equation
29
3.14 STATISTICAL SOFTWARE USED:
 Microsoft Excel
 E-Views
E-Views or Econometric Views has been used to prove the test of Unit Root and the
ADF test. The tool can be used for general statistical analysis and econometric analysis,
such as cross-section and panel data analysis and time series estimation and forecasting.

3.15 LIMITATIONS:
This study suffers from certain limitations that may hinder the level of accuracy and the level
if impact that the money supply will have on the inflation rate of the country. The current
research analysis cannot disregard these hindrances and has to work with them, in order to
ascertain the result:

 The CPI index has been changed following the change of calculation by the RBI (post
2012), hence data only post 2012 has been taken;
 Variables are not the exact indicators of the said definitions;
 M3 taken, which does not completely justify the money supply, but is the best indicator
of the four measures of money;
 The regression analysis follows only simple error;
 The ADF test is subject to a small margin of Standard Error;

30
 CHAPTER IV

DATA ANALYSIS

31
4.1 AUGUMENTED DICKEY FULLER TEST: Monthly Average of M3

Table 4.1: The results of the Augmented Dickey Fuller Test on M3 Monthly Average
Null Hypothesis: MONTHLY_AVERAGE has a unit root
Exogenous: Constant
Lag Length: 0 (Automatic - based on SIC, maxlag=10)

t-Statistic Prob.*

Augmented Dickey-Fuller test statistic -1.077712 0.7192

Test critical values: 1% level -3.544063
5% level -2.910860
10% level -2.593090

*MacKinnon (1996) one-sided p-values.

Augmented Dickey-Fuller Test Equation

Dependent Variable: D(MONTHLY_AVERAGE)
Method: Least Squares
Date: 02/12/17 Time: 03:07
Sample (adjusted): 2012M02 2017M01
Included observations: 60 after adjustments

Variable Coefficient Std. Error t-Statistic Prob.

MONTHLY_AVERAGE(-1) -0.006600 0.006124 -1.077712 0.2856

C 1473.487 606.7331 2.428559 0.0183

R-squared 0.019632 Mean dependent var 827.6443

Adjusted R-squared 0.002729 S.D. dependent var 735.7740
S.E. of regression 734.7693 Akaike info criterion 16.06976
Sum squared resid 31313382 Schwarz criterion 16.13957
Log likelihood -480.0927 Hannan-Quinn criter. 16.09706
F-statistic 1.161464 Durbin-Watson stat 1.803810
Prob(F-statistic) 0.285624

Chart 4.1 : The trend of Monthly average of M3 as determined by the ADF test

Monthly Average
130,000

120,000

110,000

100,000

90,000

80,000

70,000
I II III IV I II III IV I II III IV I II III IV I II III IV I
2012 2013 2014 2015 2016 2017

32
4.2 AUGUMENTED DICKEY FULLER TEST: Inflation Rate (CPI)

Table 4.2: The results of the Augmented Dickey Fuller Test on Inflation Rate
Null Hypothesis: INFLATION_RATE has a unit root
Exogenous: Constant
Lag Length: 1 (Automatic - based on SIC, maxlag=10)

t-Statistic Prob.*

Augmented Dickey-Fuller test statistic -1.926950 0.3180

Test critical values: 1% level -3.548208
5% level -2.912631
10% level -2.594027

*MacKinnon (1996) one-sided p-values.

Augmented Dickey-Fuller Test Equation

Dependent Variable: D(INFLATION_RATE)
Method: Least Squares
Date: 02/12/17 Time: 03:14
Sample (adjusted): 3 60
Included observations: 58 after adjustments

Variable Coefficient Std. Error t-Statistic Prob.

INFLATION_RATE(-1) -0.073599 0.038194 -1.926950 0.0592

D(INFLATION_RATE(-1)) 0.360796 0.131164 2.750731 0.0080
C 0.543881 0.287706 1.890403 0.0640

R-squared 0.160566 Mean dependent var 0.045233

Adjusted R-squared 0.130041 S.D. dependent var 0.739398
S.E. of regression 0.689649 Akaike info criterion 2.145070
Sum squared resid 26.15885 Schwarz criterion 2.251645
Log likelihood -59.20703 Hannan-Quinn criter. 2.186583
F-statistic 5.260160 Durbin-Watson stat 1.834677
Prob(F-statistic) 0.008121

Chart 4.2: The trend of Inflation Rate as determined by the ADF Test
Inflation Y-o-Y
12

11

10

3
5 10 15 20 25 30 35 40 45 50 55 60

33
4.3 REGRESSION ANALYSIS: Money Supply (M3) and Inflation Rate
(CPI)
Table 4.3: The results of the Regression Model of M3 and Inflation Rate

Regression Statistics
Multiple R 0.811668247
R Square 0.658805343
Adjusted R Square 0.652819471
Standard Error 1.40294361
Observations 59
ANOVA
Significance
df SS MS F F
6.30301E-
Regression 1 216.6257983 216.6257983 110.0600601 15
Residual 57 112.190294 1.968250772
Total 58 328.8160923

Predicted
Observation 3.40999206978588 Residuals
1 3.981084702 -0.347593391
2 3.890320317 0.312693164
3 3.985162482 0.40080243
4 4.22562667 0.822450253
5 4.317458624 1.750502541
6 4.439318403 1.33303932
7 4.476342395 1.280236552
8 4.457704622 1.010398112
9 4.811665875 0.013625307
10 4.901949288 0.361208606
11 5.064415789 0.62596078
12 5.197669651 0.581224822
13 5.302200656 0.309189629
14 5.376667874 0.035488662
15 5.558478876 -0.562642074
16 5.621026973 -1.208037797
17 5.699300886 -1.958652507
18 5.819904452 -2.128629285
19 5.823061923 -0.42460434
20 5.827128148 -0.818492569
21 6.168211712 -1.30287722
22 6.338063963 -1.084123508
23 6.453634128 -1.083915818
24 6.59571998 -1.402058008
25 6.655837867 -2.376361884
26 6.712075319 -3.444663453
27 6.895882319 -2.27915758

34
28 6.968175118 -1.339327273
29 7.048378755 -0.019909004
30 7.130583951 0.256803437
31 7.176094435 -0.405737619
32 7.206170851 0.514759382
33 7.460141957 0.412397874
34 7.636648532 -0.002341275
35 7.723522322 -0.452511935
36 7.789425405 0.298110275
37 7.91393752 1.550689631
38 8.07586299 3.42941026
39 8.299527289 2.511283522
40 8.385870842 2.10975598
41 8.409484353 1.570946175
42 8.478405376 1.313879491
43 8.615117263 0.903920813
44 8.683921986 0.342447183
45 8.899387338 0.200817161
46 9.114221737 0.948018927
47 9.192463314 1.697589042
48 9.312612251 1.202634857
49 9.362205875 1.091859595
50 9.431064734 0.127758795
51 9.542730757 -0.260030335
52 9.561481835 0.140010702
53 9.628857135 0.619255055
54 9.716293137 0.438232249
55 9.858113091 -0.058558525
56 9.896580806 -0.132271042
57 10.13210425 -1.082330495
58 10.27776045 -2.246086246
59 10.35347064 -4.096487403

Chart 4.3: The trend of Residual Value of 59 observations based on the Regression
Model
Residual Value
4
3
2
1
0
-1
-2
-3
-4
-5

Residual Value

35
4.4 INTERPRETATION: ADF Test

4.4.1. Monthly Average of Money Supply:

The first ADF test is on the money supply primarily the M3 of the RBI from 2012 to 2016 to
correspond with the data on inflation which was only available for the same period as the CPI
calculation changed in the year 2012.
Below are the observations of the ADF Unit-Root Test:
 The Augmented Dickey-Fuller test points that the data on money supply has a unit root.
 The probability of the data is 0.7192 which is more than 0.05.

The above two points point out that the data is non-stationary and hence the null hypothesis
can be rejected.

4.4.2. Year on Year Inflation (Based on CPI):

The second ADF test calculates the Unit root and determines whether the Inflation based on
the CPI is stationary or non- stationary. The inflation above is calculated from January 2012 to
December 2016 so as to include the calculation of CPI post the changes made by the RBI. The
inflation follows a constant trend for a small period followed by a random trend. The inflation
in the 2014 period is the most, indicated by the bar graph. In current times the inflation rate is
very low pointing to the high rate of depositing in bank accounts, which has reduced the
quantity of money in the economy, increasing its value and thereby decreasing the inflation
rate, as corresponding to the graph.
Below are the observations of the ADF Unit-Root Test:
 The Augmented Dickey-Fuller test points that the data on Inflation (based on CPI) has
a unit root.
 The probability of data is 0.3180 which is more than 0/05.

The above two point out that the data is non-stationary and hence the null hypothesis can be
rejected.

36
4.5 INTEREPRETATION: Regression Analysis

R: Correlation
This measure explains how two variables move in relation with each other
Determines Overall Regression Accuracy
R Square: Coefficient of determination /Co-Variance
The proportion of variability in Y that is explained by the independent variable X.
Determines Overall Regression Accuracy
Standard Error: Variability
Measures variability of actual Y values as opposed to standard Y values
Before the interpretation of the Regression analysis the two the X and Y variables are:
 Dependent Variable, Y axis: Inflation rate (based on CPI)
 Independent Variable, X axis: Money Supply (M3)

4.6 ANALYSIS:
Multiple R: This is the Correlation Co-efficient and tells how strong the linear relationship is.
For example: A value of 1 means a perfect positive relationship and a value of zero means no
relationship at all. It is the square root of R Square.
The Multiple R in the above regression analysis is 0.811668247 which means there is a positive
relationship between Money Supply (M3) and the inflation rate.
R Square: This is R2, the co-efficient of Determination. It indicates how many points fall on
the regression line. For Example: If the value of R square is 0.80, then the Y variable’s value
is affected by the X variable 80% of the time.
The R square in the above regression analysis is 0.658805343 which means that 65.88% of the
time the value of Y-Variable i.e. Inflation rate is affected by the X-Variable i.e. money supply.
P-Value: The p-value of the above regression analysis is 1.01816E-40 which is less that 0.05
at 5% significance level, which means that the results of the above regression analysis is
statistically significant and reliable.

H0=There is no relationship between the monetary policy represented by the supply of money
and the Inflation rate calculated on the basis of the CPI of the country.

Based on he above ADF and Regression analysis, the Null Hypothesis is disproved.

37
H1= There is a substantial relationship between the monetary policy represented by the money
supply and the Inflation rate calculated on the basis of the CPU of the country.
Based on the Regression analysis:
 There is a positive relationship between M3 and Inflation rate i.e. Multiple R is
0.811668247
 The money supply affects the rate of Inflation in the country almost 65.88 % of the time

The above two points prove that the money supply indeed has an impact of the inflation rate in
the country, thus proving the Alternate hypothesis.

38
 CHAPTER V

FINDINGS & CONCLUSIONS

39
5.1 FINDINGS AND CONCLUSIONS:
The objective of this study was to determine whether inflation and money supply were
independent of each other and the impact of the money supply of the country on the inflation
rate. The following are the findings that were arrived at:
 The inflation rate post 2012 was used as the base and the analysis was done from then
to December 2016 and there existed a positive relationship between the two variables
based on the tests conducted.
 The inflation rate of the country as measured by the year on year change In the post
2012 CPI (Rural and Urban combined) has fallen from mid 2016 to the end of 2016,
with the current rate at 3.41%. Corresponding to this change the money supply in the
country has always followed an increasing trend, but in the mid months of 2016 to the
end of 2016 the money supply is more fluctuating.
 The trend of money supply and inflation are inversely proportional to each other, the
increase in the money supply of the country will lead to a decrease in the overall value
of money which will lead to a fall in the price level and an ultimate relaxation of the
inflationary pressure in the economy. Correspondingly, a decrease in the supply of
money in the economy will lead to an increase in the overall value of the money as it is
in scarcity, the price level will go up and hence it will lead to more stringent inflationary
pressures in the economy.
 In the Augmented Dickey Fuller test we determine that the two variables are non-
stationary and that the Null Hypothesis (Ho) is disproved.
 The correlation in the regression analysis has empirically pointed out that there is a
positive relationship between the two variables.
 Regression analysis was also carried out to find out the degree of impact of the
independent variable on the dependent variable. In this analysis the Independent
variable was the Money Supply as represented by the M3 figures, and the Y axis
(Dependent) was the Inflation rate calculated on the basis of the Consumer Price Index
(post 2012). It was found that the money supply of the country will influence will effect
monetary policy 65.88% of the time.
 The results of the two tests ran are highly conclusive and prove the Alternate
Hypothesis (H1) = There exists an impact of the monetary policy on the inflation rate
of the India.

40
5.2 SUGGESSTIONS:
5.2.1 ECONOMIC DATE:
The need for data that not only serves the longevity purpose but is also genuine is extremely
important. All the data that has been collected in this research is limited to a period of 2012-
2016 due to the limited amount of economic data available. This poses as a major threat to the
conduct of research and analysis of data from a particular time series. Much of the data has
been refigured and altered very minutely to increase sample size to make way for analysis and
interpretation.

5.2.2 POLICY CHANGES:

If core economics indicators used to measure key economic variables are subject to several
changes in the study, this hinders the findings. The government is continuously changing the
way certain indices are to be calculated, this will affect any sort of data that is studied using
such indices. The government recently (2012) changed the way the Consumer Price Index was
suppose to be calculated, taking 2012 as the base year and dividing their basked into three sets:
urban, rural and combined. The analysis could only be completed for a period post the change
in the calculation (2012) because the CPI before the change would show inconsistent data.

5.2.3 INDICATORS AND FACTORS:

The economic indicators of the country are also subject to multiple changes and corrections
before the formulae and the calculations are carried out. Certain global indicators will not have
that much of an effect on the economy of the country as the other factors will. Similarly, the
indicators have not been clearly demarcated as either historic, average or measured. The data
analysis could suffer due to the gap in the understanding and the data interpretation.

5.2.4 INFLATION
The analysis done one inflation that the Consumer Price Index is also a correlated measure of
the Money Supply (M3). Hence, the essence of the finding is that inflation does depend on the
supply of the money. With the rising money supply lower inflation which is based on the
Demand-pull, which falls because of falling share in income and lower interest rates. Money
supply can hence be used in future as a temporary measure of controlling inflation.

41
 5.2.5 FISCAL POLICY
The central bank of the country has the authority to control the flow of money through the
monetary policy and its spending levels and tax via the fiscal policy. From the spending by the
government to the policy of the tax laws, each factor of the fiscal policy has either an impact
on the inflation or as a result its effect with the monetary policy. Hence, there seems to be a
tremendous scope for analysis of the fiscal policy of the country.

5.2.6 MONETARY POLICY

Another important measure that was calculated in-depth in this analysis is the monetary policy
of the country. The amount of supply of money into the economy effects the inflation rate to a
substantial effect to a point where it can be used as a control mechanism for inflationary
pressure and the tools of monetary policy are very delicate when it comes to the interest rate,
unemployment and the overall price level. Hence the Reserve Bank of India must be careful
with its tool. The money supply as examined in this paper has a tremendous degree of impact
on the inflation rate.

42
5.3 CONCLUSION
Money is the cause for all greed in this world and this statement is none more true than while
estimating the money supply and inflation effect in a country like India. The boon and bane for
all worldly desires in the world has to be money and the effect of it on the livelihood of the
people is so evident. At first the aimed at showing the trend of inflation and money supply but
it went on the prove the relationship between the due subject to a period limitation.
The crux of this paper was to show the degree of impact of the monetary policy particularly
the M3 measurement as compared to the Inflation rate of the country. The indicators here would
be the M3 money supply for the monetary policy and the year on year Inflation rate based on
the differences of the year on year CPI.
The positive relationship between the money supply and the inflation rate of the country which
is highly responsive and correlation is ascertained using the Regression model. The impact of
the change in the monetary policy can also be seen in the similar nature or trend in the graph
which is continuously increasing while calculating the ADF test for the monthly average of the
money supply. The graph for the trend and nature of the ADF test to study the degree of
stationarity of the Inflation rate is a random walk with mixed variation of rates as the years go
on.
The paper has also very comprehensively and numerically defined both money supply and the
monetary policy including both the inflation and the monetary polices followed in the country.
The null hypothesis has been disproved by the first test itself and the Regression model has
established the relationship and the degree of impact on the inflation rate. The hypothesis has
been tested using secondary data collected from public, government-authorised sources as well
as well public-funded sources, some of them are as revered as the World Bank, International
Monetary Fund, etc.
Along with the research, one can also find the variables that have been rviewed in this paper.
These variables will be relevant when the data is being analysed and the interpretation the
limitations of the research in whatever regard. These are critical for further studies for the
project.
This paper indeed studied the monetary policy and the inflation rate (2012-2016) both
independently and as a part of the regression from Jan=2008 2012 to Dec- 2016

43
Bibliography

44
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REFERENCES

Main Article.
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Others
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 Thorton l Daniel (2012) Monetary Policy: why money matters and interest rates don’t-
 Krus, Nicholas (2012): The Money supply in currency boards.

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