Macroeconomic Theory and

Policy

Take Home Assignment

How does interest rate respond to changes in money supply, as suggested
by economic theory?

There are two scenarios to be looked at while considering how interest rates change
with respect to the money supply. In the first case, where the Money Supply is
greater than the money demand, people have more money than their actual
requirement. The best possible use they see for this extra cash is to invest it in
instruments such as Bonds etc. and earn interest on it. This results in an increase in
the demand for bonds, subsequently leading to increase in the bond prices. This
increase in demand for bonds therefore leads to a reduction in the interest rates.
Thus when the money supply is more the interest rates fall.

In the case where Money supply is less than the money demand, people sell bonds
to get liquid money. This leads to a fall in both the demand for and price of bonds.
Therefore, interest rates rise to stimulate demand. Thus when the money supply is
less the interest rate increases.

Study the data on Indian economy from 1990 onwards and find the trends
in interest rates on short term deposits and Broad Money.

It can be seen from the data and graph given below; there is a continuous increase
in the Broad Money supply in India from 1990 onwards. It can also be noted from
the graph that while it took around 9-10 years to reach around 1000000 crore, it
took only 4-5 yrs to cross the next 1000000 crore. After that there has been a very
rapid increase in the Broad Money to the extent of approx 2.5 times the previous
increase in approximately the same time span of 4-5 years. We believe this increase
from 1999 onwards is largely attributable to the introduction of various reforms
which facilitated the inflow of cash from the foreign markets through FDIs and FIIs.
The graph below shows dips and increases in the average interest rate from 1990
onwards, however the general trend is that the interest rates are going down. We
believe the rise in the interest rates from 2004 onwards can be attributed to the
rising international interest rates which had an impact on the domestic interest
rates.

The basic trend observed from the above two graphs is that there is a continuous
increase in the Broad Money and a general trend of interest rates going down. This
is in tandem with the economic theory that suggests that there exists an inverse
relationship between the interest rates and money supply i.e. the broad money.

Does theory suggest any relation between price levels and interest rates?

In order to understand the relationship between the price levels and the interest
rates, we start with the scenario when the interest rates are high. In this case
people invest more than they spend i.e. decrease in the consumer expenditure. This
leads to decrease in the aggregate demand and therefore reduction in the prices.

The low interest rates encourage people to spend money as there is no incentive to
invest it. This results in an increased demand for a variety of goods. The demand
soon outstrips the supply. Hence price, which is dependent on demand and supply,
goes up.

Therefore, there exists an inverse relation between the price levels and the interest
rates.

Study the data on Indian economy from 1990 onwards and find the trend
in interest rates on short term deposits and Consumer Price Index.

The general trend for the consumer price index shows a continuous increase. It
must be noted that the dips which are present in the graph for AL and IWF are due
to variations in the base years.1

It can be observed that there is a fall in interest rates for short term deposits from
1990 onwards. This can be perceived to have encouraged people to increase their
spending since there was not a high incentive to invest the money. This in turn
could have resulted in a sharp increase in the demand for a variety of goods. This
steadily increasing demand would have at one time exceeded the supply. We
believe this demand-supply imbalance has resulted in the prices of various baskets
of goods going up and therefore a rise in the Consumer Price Index.

From your observation, comment on the relative importance of money

supply and price levels as determinants of the short term interest rates.

1
Base : 1986-87 = 100 for Agricultural Labour and Base : 2001 = 100 for Industrial Worker
 From our preliminary analysis, we have already seen that both money supply and
price levels share an inverse relationship with the interest rates on short term
deposits and the data has been found to corroborate the existing theory regarding
the same. Thus, we can see that both money supply and price levels since 1990
have been moving in the same direction, that is, upwards.

We believe that money supply has a larger and more direct impact as a
determinant of the short term interest rates. As we know that when the money
supply increases, people tend to invest more thereby bringing down the interest
rates due to an increase in the demand for investment instruments. Whereas in the
case of price levels, there is an indirect relationship, this is because when the prices
levels increase due to inflation the government responds by decreasing the interest
rates. It can also be observed that when the prices go up, the transactional demand
for money rises thereby bringing the interest rates down.

Appendix Table:
CPI Avg.
Broad Money Interest
Year Interest
IW IWF UNME AL (in Rs. Cr.) Rate
Rate
1990-91 193 199 161 803 265828 9.0-10.0 9.5
1991-92 219 230 183 958 317049 12 12
1992-93 240 254 202 1076 364016 11 11
1993-94 258 272 216 1114 431084 10 10
1994-95 284 304 237 1247 527596 11 11
1995-96 313 337 259 1381 599191 12 12
1996-97 342 369 283 256 696012 11.0-12.0 11.5
1997-98 366 388 302 264 821332 10.5-11.0 10.75
1998-99 414 445 337 293 980960 9.0-11.0 10
1999-00 428 446 352 306 1124174 8.5-9.5 9
2000-01 444 453 371 305 1313220 8.5-9.5 9
2001-02 463 466 390 309 1498355 7.5-8.5 8
2002-03 482 477 405 319 1717960 4.25-6.0 5.125
2003-04 500 495 420 331 2005676 4.0-5.25 4.625
2004-05 520 506 436 340 2245677 5.25-5.5 5.37
2005-06 542 527 456 353 2719519 6.0-6.5 6.25
2006-07 579 575 486 380 3310068 7.5-9.0 8.25
2006-07 125 126 486 380 4017882 8.25-8.75 8.5
2007-08 133 136 515 409 4764019 8.0-8.75 8.37
2008-09 145 153 561 450 - 6.5-7.5 7
Base Years for CPI are as follows:

1982 =100 for IW

1984-85 =100 for UNME

1986-87 = 100 for AL

2001 = 100 for IW