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Elasticities relevant to monetary policy

P. R. Brahmananda

THE general approach to economic policy and monetary policy is widened by the introduction of the concept of economic or business activity. The latter has to be captured by combining the indicators of groups of economic or business activities. It is these activities that directly or indirectly contribute to generation of real national product. In measuring activity, agriculture, industry, mining, trade, transport, real government expenditure and real gross investment have been included.

This is a comprehensive measure and, as the geometric mean of different activities were taken without assigning separate weights to each component, and as these activities together contribute fundamentally to national income, it might be proper to relate policy measures to the projections of the above index. In this article we introduce two additional concepts in terms of elasticities to examine the inter-relations.

Monetary policy seeks to respond to economic activities. The professed goal is to increase the activities, in general, through time to bring about a steady and high rate of increase in real national income. In our system, the Reserve Bank of India projects growth rates of broad money M3, and narrow money M1 based on assumptions regarding the growth rate of income.

Our approach is to link M3 and M1 to the index of economic activity and then to link economic activity to income. Thus there are two or rather three elasticity measures. The elasticity measure links the proportionate growth of two indicators. The monetary authority may have an implicit estimate of the projected growth rate of economic activity and, by estimating the measure of elasticity of real money magnitudes to economic activity, it may plan for projected growth rates of M1 and M3. Here, implicit in the growth rate of M3 is the measure of the growth rate of credit with which, directly or indirectly, the RBI is concerned.

Theoretically, there has to be a one-to-one correspondence between the growth rate of money magnitudes and the growth rate of economic activity index. If the growth rate of money magnitudes exceeds the latter, there may then be generated inflation, which can partly be moderated by import surpluses provided forex reserves are abundant and can be drawn upon without hurting the exchange rate targets.

Anyway, the growth rate projections of money magnitudes have to have some link with projected economic activity measures, rather than directly with projected income growth rate measures. For example, a drought reduces the measure of economic activity in agriculture and from this is generated some reduction in other activities, ultimately culminating in a reduction in national income.

The elasticity of economic activity to M3 would have been reduced. Hence, the growth rate of M3 has to be correspondingly reduced. Here, one may take the view that imports of agricultural products can be liberally allowed by running down exchange reserves. In that case, the index of agricultural production itself cannot be prevented from being reduced. What happens is the measure of decline in non-agricultural activities can be partly reduced.

It is incorrect to assume that overall economic activity will remain the same simply because we can increase imports and run down the reserves. Since direct activity in agriculture itself will be reduced, there will be effects on employment, direct and indirect, flowing from agriculture and related activities.

The Graph depicts the course of three elasticity measures for successive five-year periods from 1947-48 to 1951-52 to 1997-98 to 2001-02.

In each period the percentage growth rates have been derived from regression exercises (log form). During the first quinnquennium after Independence, the elasticity measure of broad real money to activity was negative at about - 0.8. However the elasticity of real national income to activity was close to 3. This indicates that economic activity in that period helped increase national income nearly three-fold, though monetary authorities pursued a policy of reduction in growth rate of M3.

During the First Plan period, there is more than a one-to-one correspondence between the two elasticity measures, the elasticity of broad money to economic activity and the elasticity of real national income to economic activity. During the Second Plan period, the elasticity of broad money to economic activity was 1.5 but the elasticity of activity to income was just 1.

In the Third Plan period, monetary authorities further stepped up the growth rate of M3 in relation to the growth rate of economic activity. Fortunately, the growth rate of real income was close to the that of M3. Thus, the two elasticity measures were close to each other.

It was between 1977-78 and 1981-82 that the elasticity of broad money to economic activity went up as high as 4.17 but the elasticity of income to economic activity was just 1.59. Also, from 1987-88 to 1991-92, the elasticity of broad money to economic activity was 3.22, though the elasticity of income to activity was just 0.7.

From 1992-93 to 1996-97, the elasticity of real M3 to real economic activity was about twice that of the elasticity of income to economic activity. There was significant inflation during this period as well. In the latest period, 1947-48 to 2001-02, the elasticity of real M3 to economic activity is about 2.4, but the elasticity of income to economic activity is just 1.11.

Fortunately, from 1977-78 onwards, the M1 growth rate has been somewhat lower than the M3 growth rate, also in real terms. The public's preference among currency, current deposits to currency, current deposits and fixed deposits has been tilted in favour of the latter.

People's demand for financial assets is growing. But the economy is not generating proportionately real assets pari passu with generation of financial assets. This is at the heart of the economic crisis today. With more and more demand for interest-yielding financial assets, many of them somewhat dubious, we are generating more scope for scams than we should have done.

The elasticity of real assets to financial assets is, unfortunately, rather low. The way out is to link the growth of financial assets directly to the growth of real productive assets and to reduce the growth rate of nominal M3.

Growth of real productive assets should be the goal of economic activities. But if the elasticity of M3 to real economic activity remains higher than the elasticity of real national income to real economic activity, there is a serious problem of the futility of monetary policy because we are not in a position to link growth of M3 with growth of real productive assets.

We may add that the problem is not so much with the RBI as with the fiscal authorities, who are the primary cause for the difference between the two elasticity measures.

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