Amaresh Samantaraya article (‘Looking for Logic’, November 8, 2008) has presented what he sees as evidence of a relationship between money growth and inflation in India. However, if we are seeking the answer to the question ‘what drives inflation?’ an observed positive relationship between money and inflation per se does not take us forward.
As pointed out by James Tobin, over three decades ago this observation is entirely consistent with monetary growth responding to investment plans in the real economy. Methodologically, in the presence of alternative explanations of the same phenomenon, the only credible econometric practice is to pit alternatives against one another. A particularly strong form of this is ‘non-nested hypothesis testing’.
In the only such test of inflation explanations for India that I am aware of, I have demonstrated (‘Pricing and Inflation in India’, Oxford University Press) that a structuralist explanation encompasses, i.e., leaves no further explanatory power to, the monetarist one. My version of the structuralist model had comprised the price of food, the cost of imported raw materials and the effect of wage-resistance in the non-agricultural sector. Practitioners may suitably tailor the contemporary version to present-day conditions.
However, that the monetarist model does not work for India, or anywhere else for that matter, is not a criterion by which to judge the RBI. In my view, a central bank must be judged primarily on the skill with which it governs the financial system including the external sector. Here, in the past decade and a half or so the Bank’s record is sterling. In the crisis of 1991 it shored-up the country's balance of payments thus stabilising India’s macroeconomy. More recently, it showed its independence as special interest groups had hectored the government for full capital-account convertibility and a free rein to the FIIs. This detachment has helped India stave off the meltdown in the US that is the source of our present discontent.
Pulapre Balakrishnan, New Delhi
