Nilanjan Banik and Guido Cozzi
The continuation of the Russia-Ukraine war is raising the fear of an imminent stagflation (a combination of inflation and unemployment led by a low growth). Worldwide inflation numbers are on the rise. In April 2022, the US, the largest economy in the world recorded 8.3%, short of March’s 41-year high inflation of 8.5% but higher than the expected figure of 8.1%.
Inflation number for India is no different with the present day Consumer Price Index (CPI) is inching towards the 7% mark. And all of that may explain two back to back set of events, with the Reserve Bank of India (RBI) increasing the policy repo rate by 40 basis points and a day later the Federal Reserve increasing the benchmark interest rate in the US by 50 basis points.
All of these may indicate that the primary objective of both these central banks is to initially control inflation, and later the exchange rates. From a layman perspective, inflation happens when there is a mismatch between demand and supply of output. Managing inflation is to manage demand-side factors, supply-side factors, or a combination of both, affecting availability of output (GDP). Demand management policy refers to use of fiscal and monetary policy when there is inflation characterised by a positive output gap (difference between demand and supply of output).
Advocates of demand-side factors causing inflation believe in this story of increase in inflation is because of demand-side factors or higher income resulting from higher growth. Recent data showcase that worldwide economic growth is slowing. Higher inflation expectation led by war and the resultant higher commodity and fuel price has led to a fall in consumer purchasing power. This may lead to a self-fulfilling prophecy, with industry leaders not willing to invest leading to a further fall in employment generation and growth.
The present inflationary factor has more to do with the supply-side shock, and under such condition it does not make sense to follow a tightening monetary policy to control inflation. And yet the Central Bankers are advocating, and in some cases such as India resorting to a surprise quantitative tightening. And all of these may be to control the value of exchange rate from depreciating further.
In economics, there are two ways to determine the correct exchange rate. One, the goods market approach where the correct value of the exchange rate is based on the assumption of law of one price (LOOP) using the concept of purchasing power parity. Two, the asset market approach, where the exchange rates will adjust to equalize interest rates differential between two countries
If LOOP holds true then the real exchange rate (nominal exchange rate times the relative price between two nations) is one. Using this relation, it is easy to show that if domestic inflation is higher than the US inflation, the rupee is expected to depreciate against the dollar. In the asset market approach (read, interest parity theorem), a quantitative tightening in the US is likely to reduce FED purchase of government bond, reducing the fiscal deficit and appreciating the US dollar against other national currencies. This may hasten outflow of capital from developing countries such as India to the US, depleting India’s foreign exchange reserve as well as further depreciating Indian Rupee.
It is to be noted, during the last eight months India’s foreign exchange reserve has fallen from the record high of $642.4 billion dollar in September 2021 to below the $600 billion mark in May 2022. Since October 2021, foreign portfolio investors have been a net seller in the Indian stock markets tanking both the NIFTY and SENSEX. And Indian rupee fell to all-time low against US dollar, breaching Rs 77 to a dollar.
The surprise move to hike the repo rate is an indication that RBI want to arrest the further fall in Rupee. The size of money multiplier in India is around 5.5. It means for each unit of central bank money creation, the Indian private banks would generate more bank deposits, which effectively multiplies the money in circulation by at least five. Such multipliers effectively discourage the central bank from buying government debt. For each crore rupee of bonds they buy, at least five crore rupees would be injected into the system, primarily by commercial banks. This monetary expansion is highly inflationary, with an impact on depreciating the value of Rupee.
But there is a better way to arrest this fall in the value of Rupee and contain fiscal deficit, and all of that can happen through use of digital Rupee. What if RBI propose to impose a 100% reserve requirement on the digital Rupee. This will imply that commercial banks will not be able to multiply the digital Rupee and transform them into creating money with an inflationary pressure on economy.
RBI can start selling government bonds and start absorbing Indian currency in circulation. The withdrawal of traditional Indian Rupees reduces the number of Indian Rupees in circulation by five times as much as the introduction of digital Rupee increases it. This way, the RBI could buy with digital Rupees five times as much government debt, and on net no new money will enter the economy. The RBI would swap a money multiplier of five for a money multiplier of one. In Italy, Becchetti and Cozzi recently estimated that the digital euro may neutralize up to 75% of government debt. This will help the RBI achieve the twin target of controlling the inflation and hastening the slide of Indian Rupee further.
Read another piece by Nilanjan Banik on China- The China Effect – Sounding the Death Knell of Many Domestic Industries in IMPRI insights.
Read another piece by Nilanjan Banik on the Gig economy- The Challenge with India’s Gig Economy in IMPRI insights.
Nilanjan Banik, Professor, Mahindra University, India.
Guido Cozzi, Professor, University of St. Gallen, Switzerland