Monetary system

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krishnan Srinivasan (Querist)
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12 April 2009 i have doubt on few things...
* How money is created in India.??and how you value it in this monetary systems..?
*Why it is valued in terms of US dollars often?
*Did we have this much debt by the time of independence? or it's after 1991 ..??
* Since money is created out of thin air in bank loans and things you cannot avoid inflation or recession..Monetary system is failure do we know that while we framed this system..???

Sachidanand Singh

Sachidanand Singh (Expert)
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13 April 2009 Let us take that by money we mean M3 as defined in India. It is currency with public, bank's deposits (time and demand) and certain deposits with RBI.

The question is how can these be created?
1. Currency with public can obviously be created when government decides to create currency - measured by what is called currency liability of the Government. Money is created when currency is doled to public.
2. Bank deposits are created when we place some currency or some cheques with our banks. As currency with public is also counted as money, depositing currency will not create money - the increase in deposits will be accompanied by a simultaneous fall in the currency in circulation. Depositing a cheque too will not create money if the cheque is drawn on a deposit account. Increase in depositors' account will be offset by a fall in drawee's deposit account and net money creation will be nil. But if I deposit a cheque drawn on someone's (even mine) borrowal account money gets created. It means money is created whenever banks make a loan - either to corporates, individuals or even to the governments
3. Say, a foreign tourist encashes a traveller's cheque. This encashment increases the currency in circulation without a corresponding drop in any deposit account. Thus money gets created whenever banks buy forex
4. Finally (for me as I cannot think of anymore) whenever a bank closes its books and posts profits it creates money, a part of which later goes as dividend towards increasing the deposits of its shareholders. The part that is not distributed - reserve and surplus - net of the other assets of the banks - constitutes a source of money.

Why is it valued in dollars?

In India it is not valued in dollars. I keep track of my money in INR and so do you, I am sure. Only foreign exchange reserves are valued in dollars. Reserves are maintained by RBI and RBI keeps it in different currencies, predominantly in dollars, to be sure. It is reported in dollars for convenience sake. It will nor be very clear if RBI announces that it has x billion of SDRs, y billion of euros, z billion of pound sterling, w billion of yen and q billion of USD. So it converts everything into USD and announces. It keeps most of its reserves in USD (as do China and Japan who have far more reserves than us) because of two reasons: a) Most of the transactions between resident (Indians) and non-residents are dollar denominated b) Most of the internationally traded commodities – gold, crude etc are priced in dollars

Did we have this much debt at the time of independence?: I trust you are referring to public debt. No we did not.

Since money is created out of thin air in bank loans and things you cannot avoid inflation or recession. Monetary system is failure do we know that while we framed this system..???

I beg to differ. For centuries money was created i.e. notes were issued against some store of value called specie usually gold, at times silver. Those days were more disastrous. The last such attempt was Brettonwood when US committed to maintain dollar at a fixed parity with gold. Other countries promptly devalued their currencies and US lost on exports and employment. With Vietnam war, US unilaterally backed out of gold standard though it had given its solemn pledge. Before that Churchill had introduced gold standard for UK and met with more disastrous results in 1920’s. This is not a topic that I can cover in short. Your monetary policy has bee crafted by brilliant people like Jha, Patel, Rangachary, Jalan, Reddy etc. Have trust that they knew a thing or two.

I have seen some websites crying hoarse over over-supply of money. Some have a valid point or two. It is true that RBI has not always been free from political influence. Only last year Chidambaram was trying his best to scuttle the tight money policy Reddy wanted. These are the prices one pays for democracy.

Unfortunately, unlike arithmetic we do not have one correct answer in economics. More unfortunately the subject of economic experiments are living and thinking beings (unlike those of say chemical experiments) and the behaviour of these subjects change with changes in policies. We talk about ceteris paribus but we know that it is an illusion. Different monetary policies would definitely have different effects – may be some better / some worse. But to say that the monetary policy has failed is rather strong.

The ultimate objectives of monetary policy are employment and growth. Intermediate objectives (through which the ultimate objectives are achieved) are inflation, exchange rate stability and interest rates. I do not think the policy has failed, certainly not since 1994. (Pl remember before mid 1995 we did not even have the auction of government debt.)