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Stop Buying Dollars, Curb Money Supply & Inflation

The RBI is unhappy about inflation, it seems. To a large extent, inflation is caused by an increase in the money supply, largely by the central bank adding money. [1]

Summary: There are only that many rupees available today, as much as RBI has “printed” or has in reserve. If the RBI prints more money that goes into the system and inflates rupee prices, because the goods produced are now spread across a larger number of rupees. (yes, there are nuances)

The Multiplier

Money multiplies when in the system – for instance I put in Rs. 1000 in bank A as a deposit; the bank can lend about Rs. 900 of that to someone else who, let us say, puts it back into Bank A as a deposit, which then lends 90% of that, and so on.

Before and after the multiplier effect comes into play, let’s to see how much “base money”, or in RBI terms, reserve money exists. This is the money that the RBI has effectively printed. I use the term effectively, because nowadays we don’t need to print money as notes anymore; RBI can directly credit accounts with money, it’s just a flip switch.

M3 – that is, after we consider the multiplier effects – is also charted. M3 is the “broad” money supply – that is, it includes the reserve money and the resulting multiplier.

In M3 is the currency with the public (part of reserve money), Demand deposits (money in current accounts etc.), Time deposits (in FDs) and the outlier “others”.

m3 components

While there is no stopping money supply growth, it’s interesting to see where the growth of money has happened. Get’s look at M3 versus just the currency printed – what’s grown faster?

m3 vs currency printed

Currency growth is starting to moderate but is still very high at 16%+.

For most of the time before Dec 2009, we had currency growth of less than the M3 growth. But in 2010, the M3 growth moderated, and currency growth went to 20%+.

This is ridiculous, because RBI controls how much currency is printed; it can bloody well stop printing, if it were really serious about inflation. Remember this is not today that we are serious about inflation; the RBI has been raising rates since March 2010!

RBI Repo rate history

Now let’s get to the point.

The Dollar Equation

Why does the RBI print rupees? It can’t just print for no reason. It needs to add something on the “assets” side of the balance sheet. It will either buy Indian bonds from banks and give them rupees, or buy dollars and give rupees. The rupees thus created adds to the base money supply which will eventually, over time, add to the broad money supply.

How does the dollar matter? Well, it turns out RBI have been continuously buying dollars. In the last one year it has bought over $31 bn dollars – sure, some of that is a euro move against the dollar, but even $30 billion is a lot – that’s about 1.3 lakh crores, which accounts for most of the increase in currency from 8.25 lakh cr. to 9.61 lakh crore in the last one year.

Effectively, had we stopped buying those dollars, we would have had a much smaller increase in money supply. (The RBI did buy some Indian government bonds too but that’s a good thing; we should not be owning dollars) The increase, to $310 billion from about $280 bn, does very little for us, doesn’t it?

And then: in just the last two months, since April 1, 2011, the RBI has bought over $4.5 billion. That’s about 35,000 crores, another 4% increase in our money supply. This, when inflation is so high that the RBI got its knickers in a twist and raised interest rates 50 bps instead of the regular 25 bps.

I would rather have the dollar at Rs. 40 (it’s Rs. 44 today) than interest rates going bonkers. As would most of us, I imagine. The RBI should simply stop buying dollars.

If I’m missing anything please comment below.


To understand this better, you need to go through the excellent set of tutorials by Salman Khan at the Khan Academy, starting from this one:

  • Praveen says:

    If dollar goes to 40., I bet half of the mid-sized IT companies will go out of business

  • Jagadees says:

    I guess if dollar goes to 40, profit margins of many BPOs and IT companies will take a hit. with US fed hell-bent on debasing the dollars, these IT companies should adopt strategies to meet these changing demands. They cant expect govt to create favorable environment all the time.
    One tragic thing – US fed policy makes all emerging countries like india, china to print money and buy more dollars to peg their currencies. But one day all these folly policies will end in hard landing for sure 🙁

  • Akshay says:

    I’m not sure I follow the argument:
    1. The central bank controls money supply – I’m not an economist but have been reading (& trying to understand) MMT and would love to hear your views on the below:
    2. Currency printed is dwarfed by deposits – why are we not looking at the growth of deposits ?
    3. “Why does the RBI print rupees? It can’t just print for no reason. It needs to add something on the “assets” side of the balance sheet. It will either buy Indian bonds from banks and give them rupees, or buy dollars and give rupees. The rupees thus created adds to the base money supply which will eventually, over time, add to the broad money supply.”
    * I don’t understand the causality you are establishing – ‘because it prints rupees, it needs something on the asset side’; is still not answering why it prints rupees.
    Could the purchase of dollars be an effort to keep a lid on rupee appreciation ?

    • 1. Lemme go through these and get back to you, thanks!
      2. Deposit growth is M3 Growth, not reserve money growth. I.E. it’s part of the “multiplied” money supply. Let’s put it this way – RBI gives ICICI Bank Rs. 100, who lends it to you. You put the Rs. 100 back as a deposit in ICICI. Then ICICI lends Rs. 90 to me, which I put back as a deposit in ICICI. and so on. But let’s just take these two transactions. RBI gave Rs. 100, but the total deposits in the system are Rs. 190 (and total credits taken is also Rs. 190).
      3. Exactly – the RBI is trying to stem rupee appreciation but *it has no need to*, because it’s creating a bigger monster, inflation. I mean, if inflation is more important, then we should shut up and stop the darn dollar buying – and even the RBI has expressed the need to curb inflation even at the cost of growth, as recently as April! And since that time, it has continued to purchase dollars. That just doesn’t make sense.

  • Kaushik says:

    I hope our RBI governor has an overall idea how to deal with it coming year and reads your blog if not clear.
    I mean if $ goes to 40,maybe IT cos will feel the pain+employees will get lesser salary but simultaneously if the inflation is also brought down as a result,employees wont feel that pain.

  • Nerus says:

    Its good that you are trying to explain to the public some of the reasons for our inflation, but it is immature to call the RBI’s moves “ridiculous”.
    The RBI knows the consequences of its actions, and has made an informed decision to act the way it has acted. Although RBI is independent of the Government, monetary policy is always political, and consequences of an appreciated Rupee has political effects. For example, a suppressed rupee will allow farmers (who constitute 60% of India) to get a higher price for their produce (due to expensive imports). This brings political dividends. A depreciated Rupee allows for a more competitive industry, leading to more employment. On the other hand, the negative effect of inflation hurts another important constituency of the UPA – the poor.
    Such decisions are political, meaning it hurts some, and benefits others. It must always be assumed that the decision was taken after consideration.

    • Nerus: Thanks. If you consider giving a higher price to farmers for their produce, then inflation is not a bad thing at all, especially considering the basket we measure. At some point, monetary policy has to dissociate itself from politics; as much as we try to keep the RBI independent of the government.
      There is no reason to not call this move “ridiculous”. If they are a) raising rates by 50 bps to reduce inflation and stating that controlling inflation at the cost of growth is acceptable and b) at the same time fuelling inflation by buying dollars, it cannot but be ridiculed. Effectively, by making loans more expensive RBI hurts the common man, the regular borrower. But by making the dollar dearer, it helps exporters and injures the common man more through higher costs of petrol and such. Just because we get the data a month later doesn’t mean we should stay quiet and not question the RBI? Perhaps I use hyperbole, but that’s how I am.
      (I apologise for harsh language to those sensitive about it. In my world there are no heroes, and you have the right to call me what you will. I might not like it, I might not agree with it, I might not deserve it, but you retain that right, sir.)
      The concept of depreciated rupee to employment is so old school; we are not an export oriented economy, or a largely manufacturing driven one. We are a service and trading economy for the most part. Cheaper imports will fuel more employment in the medium term, even if it hurts in the short term. RBI understands this far better than me, but if the problem is that they believe their policy has political dividends, then I, as a member of the public, want to bring to their attention that there is also a political price to pay; hence this outcry.

  • Akshay says:

    thanks for responding – I look forward to your views on MMT.
    On point 2 – I think what I’m trying to say is that the money multiplier taught in old economic textbooks is not how it works (fractional reserve banking has banks taking deposits, multiplying them as much as possible, subject to the reserve ratio, and making a much larger amount loans).
    In practice, banks don’t wait for the reserves to be available to issue loans. They make loans first and then borrow the reserves in the interbank market. The loans come first, not the reserves. Banks are never constrained by reserves or reserve ratios. Banks are capital constrained.
    The central bank uses reserves in the system to help the it hit a target interest rate. So, the central bank provides the system with enough reserves to meet any reserve ratio at its target rate. The reserves are about helping set interest rates, not about pyramiding money on a reserve base.
    The trade-off seems fairly obvious: Rupee appreciation hurts exports, employment and depreciation causes inflation – combating this with higher interest rates has an impact on growth. India isn’t the only EM facing this situation – the result of the almost 0% interest rates & the repeated liquidity pumping by the US.
    However, I am still not convinced on you policy prescription – shouldn’t we rather be talking about capital controls ?

    • Akshay, two points: first the credit writedowns piece works on the US where interest rate targets are on overnight rates; India has no such target, so our reserve targeting can’t be used to help set interest rates; in fact, if so, we should be withdrawing reserves because we intend to raise rates.
      Second, the point I’m arguing is that reserve money growth causes inflation; forget the multiplier effect. Reserve money growth is coming from dollar purchases. If the rupee were a currency that other countries held, then I would agree with you that reserve creation might originate in credit growth; but that is simply not true.
      Capital controls: Yes, that may be a practical intermediate step, but wholly unnecessary. We might end up with a recession anyhow, might as well let the rupee appreciate.