Impact of Money Supply on India's Balance of Payments during 2000–2010

This paper attempts to analyze the effect of RBIs and commercial banks’ credit (loans extended) to the government and to the commercial sector on India's balance of payments. Only “below the line” items are considered that is only inflows in and outflows from India of foreign exchange are considered while studying the impact on India's balance of payments during 2000–2010. This approach is basically the monetary approach to the balance of payments which was developed in 1960s and 1970s at Chicago school and at IMF. Whether its flexible or fixed exchange rate, according to the monetary approach difference in the demand for money and the supply of money leads to the changein inflows of foreign exchange. According to the monetary approach excess supply of money over the demand for money leads to outflow of foreign exchange and excess demand for money than the supply of money in the domestic country leads to inflows of foreign exchange. This approach is basically based on price – specie – flow mechanism of David Hume and it is also based on G. Cassel's purchasing power parity theory”. Credit extended by RBI and the commercial banks to the government and to the commercial sector and also money multiplier have been taken as a supply of money. Interest rates, price level and real GDP growth have been considered as demand for money factors. Interest rates and demand for money for money have inverse relation that is as interest rate goes up demand for money reduces. And price level, GDP have positive relation with demand for money i.e. as real GDP and the price level go up demand for money also increases. Monetary approach is valid under the full employment situation. This study finds that monetary approach is not valid in India where the country is characterized with unemployment situation.