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Falling income velocity, rising money multiplier — A worrying paradox

P. R. Brahmananda

ACCORDING to monetary policy, the Reserve Bank of India has to operate through the variations in reserve money to influence changes in the money multiplier. By influencing the rate of interest, especially in the short run, it influences the growth rate of nominal national product. In recent years, in RBI thinking, it is broad money (M3) that is predominantly used in discussions.

In theory it is narrow money that affects nominal national income, with real income being given by real factors. Narrow money, given real income and certain other factors, influences the price level and, through changes in the latter, it influences nominal or money national income.

M3 in a large sense is supposed to affect both price level and the nominal value of assets, mostly financial. By using M3, the RBI wants to shoot two birds with one arrow! It would, however, be more proper analytically to relate M1 to price levels, and M3 to the demand for financial assets.

One reason why M3 is preferred is because information on M1 cannot be quickly provided. M1 is a component of M3 and, in recent years, it is a decreasing component of M3 in India. The proportion of M1 to M3 was around 87 per cent in the 1950s. It has come down currently to about 28 per cent. M1 consists of currency and demand deposits, whereas M3 consists of the above two and time deposits.

It seems that people prefer to hold a higher and higher proportion of M3 in the form of time deposits. This implies an economy in current deposits and a sparing use, even of savings deposits. In earlier years, current deposits used to yield some interest. Now this is not so, and there are charges. Savings deposits yield a moderate interest and for households it is a convenient asset for "holding money on the wing" or "money-sitting", to use Robertson's phrases.

Till about five years ago fixed deposits used to yield high interest and households preferred to put an increasing proportion of their assets in that form. Interest rates have fallen drastically primarily because of administrative reasons in a narrow money market.

The RBI started stepping up the growth rate of M3 from 1996 onwards till around 1999. Thereafter, the growth rate of M3 is being slowly brought down year after year. This is not due to any special policy measures, but because of the effect of falling interest rates, especially on time deposits.

Most depositors seek to keep their time deposits relatively inactive. The interest on time deposits is added on to them and most of the interest income is ploughed back. Hence, in India, if the interest rates are being cut, the growth rate of time deposits should also tend to slow down. Hence, the M3 growth rate also becomes lower and lower.

On the other hand, the M3 multiplier starts moving up steadily. The money (M3) multiplier is found by dividing M3 by reserve money. This means that, for any given increase in reserve money, the growth of M3 becomes ever higher.

But now there is a snag. With the M3 multiplier going up, it does not follow that the income velocity of M3 remains the same. Actually, it may start moving down. More and more of M3 is held just in the form of M3 as such. The active proportion of M3 becomes lower and lower. Consequently, the money or nominal national income grows at a lower rate than M3. The GDP at market prices, for which latest data is more easily available as a multiple of M3, starts falling.

The Graph depicts the growth rate of M3, the course of the money (M3) multiplier and the course of the GDP MP velocity of M3 from 1990-91 to 2001-02.

The M3 growth rate per year (the growth rate of M3 as a yearly average of months) was around 17 per cent in the early 1990s. It moved up to around 20 per cent in 1994-95 but fell to about 16 per cent in 1995-96. Thereafter it started moving up and had reached about 20 per cent in 1998-99. Fortunately, it is now trending down slightly and was about 16 per cent in 2001-02.

What is also important is the upward drift in the M3 multiplier in the 1990s. From around 3 in the early 1990s, and till 1995-96, it started moving up and, in 2001-02, it was as high as 4.5. One unit of reserve money was leading to a 4.5 times increase in M3.

Why the M3 multiplier is going up at such a fast rate is a matter that needs further examination. The transaction velocity of M3 is moving continuously up. Current deposits, savings deposits and fixed deposits are all turning over faster and faster. The biggest change is in current deposits whose velocity of transactions must have increased phenomenally in recent periods.

The Graph also shows that the nominal income velocity of M3 has been falling. It was 2.20 in the early and mid-1990s. But it has now dipped to 1.64. Whereas the money multiplier has been rising sharply, the income velocity of M3 has been sliding down.

This means that the real transactions leading to increase in real income for a unit of M3 must be going down. M3 increases are reflected in an increasing number of money and financial transactions per unit of M3. But this high turnover in M3 is not reflected in similar measure of increase in nominal income. Nominal income is real income multiplied by the measure of price level.

In recent years, the rate of increase in price level has been partly moderated. The rate of increase in real income has been fluctuating and, by and large, has dropped compared to the soaring period prior to 1996-97. So, what does the increasing transaction turnover of M3 achieve? If the same unit of increase in real income requires a larger and larger number of nominal transactions, it should be a cause for worry. This may explain why the financial sector is growing faster than real national income.

There is a view that the reforms have been faster in the financial sector than in the real sector. If this view is correct, and it should probably be, the increases in M3 multiplier reflected in increases in money and financial transactions per unit increase in nominal income, simply means that probably, money and financial pyramiding is taking place on a larger and larger scale in the Indian economy.

This may be due to the increasing incidence of speculation in search of quick capital gains and profits, and also to the decreasing cost of transaction and turnovers because of lower and lower interest rates.

Since real capital formation is not being increased pari passu with changes in money magnitudes, and higher growth rates in real terms are not accruing, the incentive of cheaper money is simply reflected in lower income velocities.

This should be a cause for serious worry at all levels. If real assets cannot be had with good returns for increase in savings and investments, the holders of liquid assets will turn to commodities and the inflation rate will start moving up and up. The excess liquidity has to be pumped out before we can prevent rising inflation rates.

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