Money Supply & Prices in India:A Co-integration Analysis

The RBI's approach to money supply over the years reflects its preoccupation with price stability. This has been further compounded by ‘monetary policy framework’ imposed on it recently by Govt. of India. The link between money supply and prices primarily and explicitly originates from ‘Fishers equation of exchange’: the earliest testament of quantity theory of money. It suggests the existence of direct, positive and long run relationship between general level of prices and money supply in the economy. However, the debate over the validity of quantity theory is evenly poised both on theoretical and empirical fronts. Against these backdrops, the present study is an attempt to explore the possible existence of a long term relationship between money supply and prices in the context of Indian economy. The study follows econometric methods such as Engle-Granger (1987) test for co-integration and Error correction Model (ECM). The findings of the study confirm the existence of a positive long term relationship between money supply and prices in the context of Indian economy during the period taken into consideration. Also, the ECM is found to be valid which indicates that the short run behaviour of prices due to changes in money supply deviate from that of long run equilibrium but those deviations from the equilibrium are eventually corrected in the long run. Nevertheless, this study more or less confirms the validity of quantity theory of money in the aforesaid context.