Rangarajan & Bhanumurthy: Can price levels rise without growth in money supply?

Summary

The impact of changes in the broad availability of money on an economy's general price level -- or inflation -- is clearer than the role of interest rate shifts. Here's what an analysis of academic theory as well as India's empirical record shows -- and what monetary policymakers must consider.

Discussions on inflation in India centre around causes that lead to an increase in prices of specific commodities such as food or crude oil. Even Consumer Price Index (CPI) data is issued with food inflation marked apart from headline inflation.

Of late, regulators and analysts have been talking about inflation excluding precious metals. While this is useful, it does not constitute an explanation of the behaviour of the general price level. It is true that an increase in crude prices may lead to a cost-push rise in the prices of several commodities, but the overall increase in the general price level cannot be explained by these factors.

Take the situation of a household. Suppose food prices increase; given the fixed nominal income of the household, if its demand for food is inelastic, higher food prices will leave the household with less income to spend on other commodities. This means that demand for other commodities will go down, pushing down their prices, thus mostly not affecting the general price level.

The key assumption is that the nominal income of the household (its budget constraint) does not change. The same analogy holds good at the national level without committing any fallacy of composition. For the general price level to increase, nominal income must increase and this can happen only with an increase in money supply or liquidity.

Several decades ago, strangely, while addressing an Indian audience, Milton Friedman said, "It is true that [an] upward push in wages produced inflation, not because it was necessarily inflationary, but because it happened to be the mechanism which forced an increase in the stock of money."

Thus, while individual prices can trigger inflation in the short-run, it is an adjustment in liquidity at the macro level that sustains inflation in the medium- and long-run.

This is not a throwback to the days of the Quantity Theory of money. The limitations of that theory are many. But the main point is that without an expansion in liquidity or money, no sustained increase in general price level is possible. This is where policy comes in.

In the last few decades, the policy focus has moved towards the interest rate: i.e., the price rather than quantity (money). But it needs to be noted that in equilibrium, both price and quantity are determined. In fact, post 2008-09, the term 'quantitative easing' has become part of the vernacular of central banks.

Rate-change decisions are concomitant with decisions on the quantum of money or liquidity. Indeed, US Fed policy announcements are always accompanied by instructions to the Open Market Desk at the Federal Reserve Bank of New York to undertake open market operations (OMO).

For example, the 17 September 2026 statement of the Federal Open Market Committee instructs the Open Market Desk to 'Undertake open market operations as necessary to maintain the federal funds rate in a target range of 3-3/4 to 4 percent.'

Even before this, during his first Jackson Hole speech on 28 August 2026, Fed chair Kevin Warsh said, "Money matters... It's not fashionable these days, but my view is that money has something important to do with monetary policy.

We should pay attention to money created by the central bank and money that comes from the banking and financial systems. It's true that financial innovations and other factors alter the mechanics that link the monetary base, the velocity of money and the broader economy. But that is scarcely a reason to ignore the ultimate effects of money on financial conditions and prices."

This brings us to the question: Which is a better signal -- price or quantity? This is partly an empirical issue. The quantity (money) impacts the price level more plausibly than the rate. Almost all macro models have a price equation in which money supply is an independent variable, which is found to be statistically significant with a theoretically appropriate positive sign.

A simple estimated 'price equation' for India with money supply and output on annual time series data from 1994-2024 is as follows: CPI Inflation = 2.98 + 26.86 *(M3 Growth) - 4.61 * (Output growth) + 4.35*Dummy + 0.51*AR(1), where M3 growth is found to be significant at 5% while output growth is insignificant (but with a negative sign).

[Note that M3 or 'broad money' includes not just currency in circulation, but also demand and time deposits with banks as well as other deposits with RBI; dummy used for the 2008 crisis and covid shock and AR1 is a 'first-order autoregressive' term; what's notable here is the large M3 coefficient].

However, for various price specifications with policy rates and its variants, we could not find any interest rate being significant. In other words, the direct transmission of a rate change on prices appears to be unclear, while transmission from quantity to prices appears plausible.

The usual explanation of how a rise in policy rate influences the economy runs as follows:

"For its successful application, therefore, the theory underlying the discount-rate policy required, firstly, that the discount rate of the central bank should have a prompt and decisive influence on money rates and credit conditions within its area of operation, particularly when it was desired to raise money rates and contract credit, and secondly, that there should be a substantial measure of elasticity in the economic structure in order that prices, wages, rents, production and trade might respond to changes in money rates and credit conditions." (M.H. de Kock, Central Banking, Page 179)

There is also fussiness beyond the impact on borrowing. Let us say that a rise in the policy rate leads other rates in the market to rise. The transmission mechanism up to this point is clear. Beyond that, does it affect the supply or demand of commodities?

The old Cambridge version of the Quantity Theory of money argued that if the money held increases over the desired level, the excess leads to additional spending, causing prices to increase. Thus, the explanation of transmission via quantity is far clearer than through the rate.

On the impact of interest rate changes, there is no clarity on which rate is relevant. While Keynes emphasized the long-term rate, R.G. Hawtrey argued in favour of the short-term rate (bank rate). Keynes's explanation is that as investment changes, income changes through the multiplier process. Hawtrey argued that short-term rates affect the cost of holding inventory and thus the quantity held, which affects the supply of goods and services.

In a unified market, both rates change in the same direction. In fact, any attempt to make short and long rates move in opposite directions (often called 'operation twist') will fail, as the US Fed found out. The transmission mechanism beyond change in all interest rates needs more clarity.

Three broad conclusions emerge from our analysis:

First, it is important to look at interest rate spreads. Watching the call money rate alone is not enough. In fact, it is the shortest money rate. Bond yields not only in the US but even in India have been sending strong signals recently. The policy rate is a good signal. But its transmission must be seen across a spectrum of interest rates.

Second, changes in the policy rate must be followed by appropriate changes in durable liquidity such as reserve money and money supply.

Third, it appears as if rate changes are decided by the Monetary Policy Committee and liquidity decisions are taken by the RBI administration. But actually, these two, as mentioned earlier, are concomitant decisions. The desired interest-rate changes can happen only after liquidity decisions, even though there may be occasions when liquidity changes may be directed at other objectives like exchange-rate stability.

The authors are, respectively, former chairman, Economic Advisory Council to the Prime Minister, and former governor, RBI; and director, Madras School of Economics.