Money & Finance in Economic Growth of India --- Dr. Anil … : Anuradha Prakashan, 1193 Pankha Road, Nangal Raya, New Delhi-110046 (India) Email : [email protected]

Money & Finance in Economic Growth of India --- Dr. Anil Dogra

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Book : Money and Economic Growth in India

Edition : First, 2011

Price : Rs. 250/-

Author : Dr. Anil Dogra

ISBN No. : 978-81-901827-3-0

© : Author

Publisher : Anuradha Prakashan,

1193 Pankha Road, Nangal Raya,

New Delhi-110046 (India)

Email : [email protected]


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DEDICATED

TO

DEAR PAPA


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INDEX

Chapter Contents Page No.1. Methodology and Plan of the study 9-371.1 Introduction and Background 91.2 Objectives 301.3 Hypothesis 311.4 Methodology 351.5 Sources of data 361.6 Chapterization 36

2. Financial Growth in India 38-972.1 Theoretical basis 382.2 Indicators of Financial Development 392.3 Growth of Monetary Assets 442.4 Intersectoral Financial Transactions 452.5 Position and Prospects of Capital Market in India 632.6 Trends in the Primary Market 822.7 Trends in the Secondary Markets 89

APPENDIX II 98-117

3. Money Finance and Savings-Investment in India 120-176

3.1 Hypothesis 1203.2 Money and Growth-neo-classical Approach 1233.3 Role of Money in lagging economics-

shaw-Mckmnon approach 1263.4 Real money balances as a factor of production :

Some econometric evidence for India 1293.5 Theoretical framework 1433.6 Savings in a barter economy 1443.7 Impact of Introduction of money on savings 1463.8 Non-Monetary financial Assets and savings 1503.9 Financial repression and financial intermediation 1523.10 Theoretical underprinnings 1563.11 Financial Deeping and saving propensity 1593.12 Econometric evidence on saving performance

in India 160


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3.13 Financial repression 164

APPENDIX III 177-178

4. Causality between money finance & 179-199Economic Growth in India

4.1 Empirical tests of causality between moneystock and money income in India 179

4.2 Results for causality between money andmoney Income 181

4.3 Implication for monetary policy 1874.4 Finance and Economic growth 189

APPENDIX IV 203-204

5. Macro-Economic Model of Finance EconomicGrowth and Monetary Policy in India 205-235

5.1 Theoretical structure 2055.2 Theoretical model 2075.3 Operationalizing the theoretical model data 2105.4 Empirical structure 2135.5 Monetary policy inflation and real growth in

India and some Asian countries 2165.6 Money supply and inflation 2175.7 The variability of inflation in Asian countries 2205.8 Monetary policy formulation 2315.9 Composition of money supply 231

APPENDIX V 236

6 Summary and conclusions 237-247

NotesBibliography


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List of Tables

No. Table No. Title Page1. 1.1 Interest rates and Saving 222. 1.2 Interest rates and Investment 233. 1.3 Interest rates and Financial Intermediation 244. 1.4 Interest rates and Economic growth 255. 2.1 Indicators of financial development 426. 2.2 Growth rates of financial indicators 437. 2.3 Money supply and monetary deepening 498. 2.4 Growth of Monetary Assets 509. 2.5 Gross Deomestic savings and its

composition (Rs. in Crore) 5110. 2.6 Composition of Total savings (Percentage) 5311. 2.7 Gross Domestic savings as a percentage

of GDP 5412. 2.8 Lending of Banking Sector 5913. 2.9 Lending of Surplus sectors 5914. 2.10 Finacing of Corporate Sector Investment

Saving-gap 6015. 2.11 Investment saving-gap of Govternment

& Instrument-wise Government sources 6216. 2.12 Instrument-wise lending of Banking Sector 6417. 2.13 Instrument-wise lending of Househol 6418. 2.14 Instrument-wise lending of OFI 6519. 2.15 Government and PCB Borrowing 6520. 2.16 Instrument-wise Government Borrowing 6621. 2.17 Instrument-wise borrowing of Corporates Sector 6622. 2.18 Issues of Financial Sector 6723. 2.19 Issues of Non-Financial Sector 6824. 2.20 Issues of Financial and Non-Financial Sector 6925. 2.21 New issues by Public limited Companies 8426. 2.22 Share of different Financial assets in

household savings 8427. 2.23 Structure of Bond issues in India 8528. 2.24 Structure of New Capital Issues 8529. 2.25 Secondary Market Indication 8630. 2.26 Index of Share Prices 8631. 2.27 Bombay Stock Exchange sensitive index 86


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32. 2.28 National Index of Share Prices 8733. 3.1 Estimate of parameters of Cobb-Douglas

Production function 13934. 3.2 Cobb Douglas production function sub-Period 14035. 3.3 Cobb Douglas production function sub-period

(1972-1992) 14136. 3.4 Cobb Douglas production function-Agriculture 14237. 3.5 Cobb Douglas production-Industry 14338. 3.6 Regression results Household savings and

Indicators of Financial Development 16739. 4.1 Regression results for causality between

Money and Money-income 18540. 4.2 F. Statistics for causality test 18641. 4.3 Regression results for causality test

between Financial variables and GDP 20042. 4.4 Regression results for causality test

between Financial variables and GDP 20143. 4.5 F. Statistics for causality test 20244. 5.1 Mechanics of Trends in Price Inflation in India 21845. 5.2 The Relationship between Long-run Money

Supply Growth and Inflation Rates 22046. 5.3 Inflation Trends (Average growth rate & its

variability) (X is average mean growth rateof consumer prices) 222

47. 5.4 Inflation Trends (Average growth rate & itsvariability) (X is average mean growth rateof GDP delators) 222

48. 5.5 Nomial Output Growth Trends (Averagegrowth rate and its variability) 225

49. 5.6 Real Output Growth Trends (Average growthrate and its variability) 225

50. 5.7 Money Stock (M1) and Factors Affecting M1(Rs. Crores as on last Friday) (Outstanding) 227

51. 5.8 Structural Composition of M1 (Expressed asPercentages to M1) (Outstanding) 228

52. 5.9 Monetary Stock (M1) and Factors AffectingM1 (Rs. Crores) Yearly Variations 229

53. 5.10 Structural Changes in Composition of M1(Expressed as percentages to M1) Variations 230


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Certificate

This is to certify that the work entitled Money Finance and

Economic Growth in India submitted by Mr. Anil Singh D.

Dogra represents his original work which was carried out by

him in the Department of Economics Faculty of Arts under my

guidance and supervision during the period October 1993 to

October 1996. I further certify that this work has not been

submitted in this university or elsewhere at any time.

Dr. S.M. Joshi

Reader

Department of Economics

Faculty of Arts

M.S. University of Baroda

Baroda

Place : Baroda

Date : 17th October 1996


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Chapter - 1

METHODOLOGY AND PLAN OF STUDY

1.1 INTRODUCTION AND BACKGROUND

The Indian Economy has accomplished almost fourdecades of planning and this has been a period in which theeconomy has achieved varying degrees of sucees and failureand this has also been an era of experiment which has taughtsome hard lessons to the policy makers. It is no denying the factthat in the course of the last four decades there has been aconstant need to arrange and rearrange priorities betweendevelopment objectives to adjust to circumstances as theyevolved, some of these circumstances relfected policy failurewhile others were a reflection of Mirco-economic inefficiencesand structural imbalances prevailing in the economy. The issueis whether the Indian Economy has shown the much neededresilience in combating both the Exogeneous and EndogenousEconomic crises as they evolved; Whether the Micro-Economicperformance has been sustained to the extent it was desired inview of constantly changing economic environment and alsochanging priorities between development objectes.

This experience of almost four decades has compelledpolicy makers to reevaluate and to give a fresh consideration toideologies, approaches and methods of organising production,consumption and exchange in the Indian economy. All theseefforts of policy makers have resulted into the process ofeconomic liberalization. The Indian economy has beenexperiencing the winds of liberalization. Since the early eightiesthe measures of this effect have been implementd in the areasof trad, taxation and industrial policies. However, it should benoted that these delibrate conscious attempts are morespecifically aimed at augmenting the long-term real growth ofthe economy through improving the resource allocation,strengthening resource mobilization and eliminating structuralimbalances in the Indian Economy.


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Recently there has been resurgence of interest, inspiredin large part by the works of Mckinnon and Shaw

1,2 in the role of

money and finance as a means of accelerating economic growthof the developing countries.

In fact, Money and Finance as instruments of financialdevelopment ar crucial to the process of economic growth.

The contemporary Macro theory has taken a peculiarstand on the role of the institution of money and the financialsystem in the economic processes of a market economy. Thoughit has paid a great deal of attention to the functioning of the moneyand the financial market and also its implications to the short-run stabilization policies, it had divorced the problems of theeconomic growth and development from the analysis of theproblems of the monetary and financial development of a society.This is probably why the growth models are cast in physicalterms and the growth path is shown to be neutral to the changesin the monetary and financial structure.

Attempts are recently being made to generalize the theoryof economic growth and development and overcome thedrawback. Tobin and other economists have tried toaccommodate real money balances in the neo-classical andKeynesian growth models. Gurley and Shaw and others haveemphasized the importance of financial intermediaries in thesaving-investment process.

During the 1960s, the question of how the domesticfinancial strcuture (consisting of the whole range of existingfinancial institutions, financial markets and financial instruments)could contribute to economic growth started to receive someattention. The extent to which financial development-defined asthe growth of domestic financial instituations, markets andinstruments could improve the process of financialintermediation-became important for raising domestic savingsand improving the quantity and quality of investment. Improvingfinancial intermediation was of crucial importance, according tothese early contributions, since high savings and more efficient


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investment would increase the overall growth performance of acountry.

There are some important ways, though limited by whichsociety can moblize its savings to accelerate economic growth;

1) Central planning in which a part or whole economysurplus of individual spending units as pre-empted anddistributed by the state on pre-determined criteria amongthose spending units which need investible resources.

2) The second method is implementing the fiscal policy inwhich the state appropriates part of the economic surplusof society and invests in state-susponsered enterprisesor private-enterprises.

3) Inflation, essentially is a fiscal device since it is a uniformtax-subsidy system.

4) Elaborate financial system, a debt-asset system, whichbrings about specialization of the functions of savingsand investments.

This last method for moblizing savings viz. an elaboratefinancial system, is the major theme of this purposed research.It is contended that apart from being an economically efficientsystem of mobilizing savings to promote efficient capitalaccumulation, an elaborate financial system enjoys huge externaleconomics in a decentralised economic system.

The external economies of the system of finance aremainly to two types. The evolution of a rudimentary financialsystem is marked by a financial claim, money which by beinguniversally acceptable at a fixed nominal exchange rate for realgoods reduces considerably the real costs of conductingexchange and promotes the development of organisedcommodity markets. It also reduces the risks of economictransactions and makes the cost of information about exchangepossibilities cheap. The emergence of money brings hugewindfalls of efficiency and welfare in a barter economy andsubsequent increases in the supply of these instruments keepadding to the overall economic efficiency of society, though at a


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slower rate, either by monetization of the hither to non-monetizedregions or greater accumulation and use of money instrumentsby the public. This form of external economy of finance is thesubject matter of our first hypothesis.

Second, in a decentralized world without finance,absence of proper conduits to hold savings is a constraint onthe intertemporal utility functions of the individuals. The desiredtime pattern of consumption of the society will probably beskewed for present consumption and against future consumption.The well developed financial system offers the savers a widearray of financial assets which are superior to the physical assetsas conducts of saving in terms of risk-return-liquiditycharacteristics and which can remove the institutional constraintson the intertemporal utility functions and results in a higherproportion of income saved.

The neo-liberal view appeared in the early 1970s mainlywith the work of Ronald McKinnon. It places the financial constraintdiscussed by the structuralists at the centre of the analysis.'Financial Repression', caused by monetary mismanagementin the form of excessive growth of the money supply anderroneous selective credit policies, is the major factor contributingto be structural problems, lack of investment, and inflation inTWCs. The main indicator of financial repression is theprevalence of negative real interest rates (Galbis, p33).3

The neo-liberal model is essentially an incomplete neo-classical model in disequilibrium. The assumptions are key :The first is that the economy is gragmented, so agents are facedwith different prices for factors of production, some factors areat time immobile, and agents have differential access totechnology, misallocation of resources is the result, and thismisallocation represses accumulation. Market inperfections meanthat factors cannot be treated symmetrically as in orthodoxanalysis. Instead, the capital market and its special problems isemphasized. The capital market must be improved before otherliberalizing policies can be carried out. The second assumptionis that money and real assets are not subsitutes but


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complements in the money demand function (McKinnon, p5).4

Money is an important difference between the neo-liberaland neo-classical models. What is similar in the two is that theprice level is determined by the demand for and the supply ofnomial money, individulas' expectations about future pricemovements are influential in determining real cash balances held,and the monetary authorities determine the real return on holdingmoney by controlling the nomial money supply. A, and the nomialrate of return to holders of money. But, the fragmented economychanges the demand for money function.

McKinnon's money demand function is based on twoassumptions about conditions in TWCs. Due to the lack oforganized finance, all economice units are assumed to beconfined to self-finance, so that saver's are equivalent to investorsand there is no private sector borrowing. The second assumptionis that the small size of firm/households makes indivisibilities ininvestment important. These assumptions mean that cashbalances are the only financial instrument available that can beaccumulated. Also, the restraint on external borrowing meansthat individuals cannot make the 'best' investments embodyingthe 'best' technology. Rates of return on physical capital are thusdispersed. It is the imperfection of capital markets which causesthe misallocation of resources, the use of inappropriatetechnology, and consequently unemployment. Government fiscalpolicy is assumed not to affect aggregate capital accumulationdirectly, so the only way public policy can affect accumulation isthrough the real return on holding money d-p. (McKinnon, pp56-57).5

Important to Mackinnon's model is the complementaritytheorem. The money demand function (which is really thedemand for money held in savings accounts since in aninflationary economy the opportunity cost of holding cash wouldkeep it at a minimum) is (M/P)d=f(Y,I/Y, d-p). Real money demandis a function of income, the ratio of investment to income(investment demand), and the real return on holding money. Allpartial derivatives are positive. I/Y does not enter the neo-classical


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money demand function, and it reflects MacKinnon's idea ofcomplementarity, because investors must save to invest, thedemand for real money balances is strongly affected by thepropensity to save (invest). If the desired rate of capitalaccumulation increases, the average ratio of real balances toincome will also increase. Therefore money demand is positivelyrelated to investment. The more discrete investments are, themore money has to be held. As the average rate of return oncapital is increased, the desired investment increases, so doesthe demand for money. This is the complementarity relationshipbetween money and physical capital. Money and physical capitalare not competing assets; money is a conduit through whichaccumulation takes place (McKinnon, pp-59-60).6

The policy implications are clear. Interest rates shouldbe responsive to the market rather than fixed by the authorities.Negative real interest rates, caused by fixing the interest rate ata low level to encourage investment in an inflationary economy,actually discourage investment by discouraging the saving thatnecessarily precedes it. High, or at least positive interest rates,are necessary because they will increase the return on holdingmoney, increasing saving. McKinnon realizes that at very highreal interest rates, investment would then be discouraged as inthe usual model because after interest rates were set free,borrowing to finance investment would take place; this is thepoint of freeing interest rate. Higher real interest rates ensureInvestment is allocated to areas of high return, so efficiency andproductivity will increase. Borrowing will allow 'best' investmentsto take place so that indivisibilities will be less significant andtechnology will become more appropriate. Overall, the greaterdegree of financialization will encourage more investment andimprove resources allocation, thereby increasing growth rates.

A rise in real interest rates should come from two sources: A non-inflationary monetary policy, and the gradual liberalizationof financial markets. Removing interest rate ceilings must begradual to prevent short-run problems of bankruptcy of financialinstitutions as they pay higher interest rates to depositors while

Money And Finance In EconomicGrowth Of India

Publisher : Anuradha Prakashan ISBN : 9788190182730Author : Dr. Anil KumarDogra

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Money & Finance in Economic Growth of India --- Dr. Anil … : Anuradha Prakashan, 1193 Pankha Road, Nangal Raya, New Delhi-110046 (India) Email : [email protected]