One of the curious questions about central banking from a learner’s angle is how does the RBI takes the decision about the amount of new currency to be issued?
First of all, the purpose of currency is to help us fulfill our purchase and selling. This is because people demand money to settle their transactions. So new money is to be issued to meet increased transactions. Transactions ultimately depends on our income. This means that if income (GDP growth) in an economy goes up, transaction will go up and the central bank should issue new currencies in accordance with increased GDP growth.
The RBI, while preparing its annual monetary policy, makes an estimate about the quantity of new money to be issued next year based upon its expectations about next year’s GDP growth. Higher the expected GDP growth, higher will be the new money supply.
Now a conventional simple equation will give us how the RBI will estimate the volume of new currency to be issued.
Suppose that GDP growth of the economy for the next year is 8 %, the amount of new money to be issued will be:
New money to be issued = 8 x 2 + 4 %
- Expected economic growth for the next year =9%
- Income elasticity of demand for money =2
- Four percent inflation is good for the economy = 4
(the income elasticity of demand for money says that people will demand double amount of money in accordance with the increase in their income. if your income has increased by Rs 10, you will demand currency of Rs 20 for making transactions).