ISSN: 1391 - 0531
Sunday March 9, 2008
Vol. 42 - No 41
Financial Times  

Controversy over money printing

When I entered the class room, all the students chorused, “the Central Bank has been countered by an analyst who has proved that the bank has printed money excessively all along.”

I looked at them as if I could not make it out what they were saying. One student, bolder than the others, waved a paper cutting of an article on the subject that had appeared in a popular daily recently.

“How has the writer said that the bank has printed money?” I questioned them in return.

“The analyst has given all the data relating to bank’s lending money in excessive amounts to the government. So, he has proved that money has been printed by lending to the government,” he answered.

“The Central Bank has to print money all the time, because people want money to do their businesses. There’s nothing strange about it,” I said. “But, what’s the point the analyst is making?” I asked them.

“The analyst says that bank’s money printing has led to inflation. In fact, it’s lending to government and the inflation rate has moved in the same fashion in the last two years. When this lending to the government was high, so was inflation. When lending was low, inflation had also been tamed. So, the current inflation is something which the bank itself has created,” he clarified.

“Kids…” I addressed them. “Your analyst is both right and wrong.” It was now their turn to look puzzled. I guessed that they were wondering how a person could be right and wrong at the same time. I felt that I owed them an explanation.

“A growing economy needs money and it’s the duty of the Central Bank to provide that money to the economy,” I began to explain. The students were staring at me attentively … “For instance, if you produce one coconut and the price of a coconut is 10 rupees, you need 10 rupees to trade that coconut. When you produce two coconuts, you now need 20 rupees to trade those two coconuts. If you don’t produce that money, trade cannot take place and people are subject to innumerable inconvenience. Imagine your embarrassment if you get into a bus and you don’t have enough cash to pay, because the Central Bank has not produced enough money” “But, how could the analyst be both right and wrong at the same time?” They turned my attention to the main issue.

I answered. “The analyst is correct when he says that the Central Bank’s lending money to the government creates new money or leads to money printing. This is because when the Bank lends one rupee to the government and if the government spends it, a new one rupee is now in the hands of the recipient of that money. It was not there earlier.”

“But, then, how can he be wrong?” The same student queried. Perhaps he would have thought that I was trying to hoodwink him. “He is wrong because what leads to inflation is not what was created by the Bank in its lending to government only. It’s the total money that’s created in the financial system that leads to inflation. In that context, money is created by both the Central Bank and commercial banks through their respective operations. That total money is the stock of money that chases after the goods and services and pushes up the prices.”

“So, money is created by commercial banks as well?” they exclaimed.

“Yes,” I said. “But the seeds are produced by the Central Bank. It’s like a farmer sowing one bushel of seed paddy and harvesting several bushels of paddy at the end. Just like the final harvest of a farmer depends on the amount of seed paddy he has sown, the total amount of money created by banks is dependent on the seed money created by the Central Bank.”

“The Central Bank creates seed money! I can’t believe that!” a girl in the front expressed her disbelief.

“Yes, indeed,” I answered. “That seed money is known as ‘reserve money’ or ‘base money’. Reserve money is created not only in Central Bank’s lending to the government. It happens when the Central Bank buys a US Dollar from a bank, because it has to give the selling bank the value of the dollar in rupees. It happens when the Central Bank lends money to a commercial bank. It happens when the Central Bank pays salaries to its employees. So, there’re numerous sources of so called printing of money. As a result, what’s necessary is to control the production of this total reserve money, so that, commercial banks can’t produce actual bank money in excessive amounts and contribute to inflation.”

“You mean to say that the Central Bank has a plan to limit the production of reserve money?” the same girl questioned.

“The Central Bank’s whole monetary policy is based on that plan. It announces its targets for reserve money at the beginning of the year and observes its strict realisation. It doesn’t allow excessive reserve money creation. So, all the so called money printing is in accordance with its plan. Not only that, the Central Bank has a very strict budget to control its expenditure as well, because that also leads to reserve money creation. So, at the end of the day, money printed by the Central Bank is the money needed by the economy.”

“What about the government’s borrowing? Isn’t it a problem?” they asked.

“Yes, it’s a problem. But as long as the government runs a budget deficit, you can’t help it. That’s why government’s medium term fiscal policy targets to reduce the deficit gradually. Remember, our country is notorious for having deficit budgets throughout its independence except in 1954 and 1955.

The nation should learn not to ask everything from the government. The government should be allowed to have fiscal prudence. The nation can enjoy low inflation only through that,” I said.


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