When the economy badly needs support in times of crisis, one question circulates like wildfire - “Why can’t the government ask RBI to print tonnes of money?” Well, here’s why.
Crisis tests the robustness of an economy. Consider 2020, for instance. Once the virus began its hunting spree, the wrecks of the ship started crying out. The entire nation was in the grip of the deadly virus. Health infrastructure was utterly out of place. Companies laid off their employees. Migrant laborers were forced to return home. And there was little indication that the virus would go underground in less than a year.
Sustaining for so long without an active income source while meeting the family’s daily expenses and healthcare costs would be a tough nut to crack for a majority of the population. Naturally, it was on the government to step up and pull the nation out of the crisis. It had to loosen its purse strings completely. But it actually couldn’t have done much without help.
But why? And who can actually help the government?
Why does the RBI print money?
People often raise the question that if the government earns revenue in the form of taxes, why can’t it just come out and spend it all? Well, it actually does (judiciously or not, that’s different). And sometimes its expenditure exceeds the revenues, as we name it - Fiscal Deficit. The government aims to keep the deficit under the target of around 3.5% of GDP (but for FY22, the target is set at 6.8%!) And as a matter of fact, the actual figures are expected to be significantly more this year.
But the government still has to go out and spend - on health, on people, on hospitals, on oxygen supply, on vaccination drives, and whatnot. With revenues curbed due to lockdown, the government gets into a tough spot to manage it all alone. So, the only way out is to borrow and spend.
Now, the government can borrow from several sources - from people, from private investors, foreign countries, etc. However, in times of crisis, none is really willing to lend. So, now what?
The government knocks on the door of the ‘lender of last resort’ - the RBI. But borrowing from the RBI is not like borrowing from others. People lend you the money they’ve saved, the money that was already in the system. But if the RBI wants to lend, it has to print new money, like money that didn’t exist 10 minutes ago! And this is termed as ‘Monetizing the deficit’.
The thing is, this increases the money in circulation. And why is it exactly a pain point, you ask?
Perils of printing money
Suppose only two persons are residing in a country with an income of Rs 10 p.a. each, and the only good produced in the economy is 2kg of rice. At present, suppose 1kg rice costs Rs. 10. So, both the persons earning Rs. 10 each can buy 1kg of rice each and feed their families.
Imagine, all of a sudden, the government starts printing more money, and then, each of them has Rs 20. But the supply of rice remains the same, i.e., 2 kg. With more cash in hand, the demand for rice has gone up (each of them can now afford the entire 2 kilograms of rice).
The shopkeepers know the fact that now each of them can shell out Rs 20 for rice. So, to meet the entire demand, they’ll double the price of rice. So, now a Kg of rice would cost Rs 20! And that’s how more money can lead to a rise in prices, besides other effects.
Therefore, the printing of money should always match the total production of goods and services in the country, or else inflation can destroy the economy.
Major factors to be considered while printing new currency
Inflation is the increase in the prices of goods and services over time. It's an economic term that means you have to spend more to buy a gallon of milk, fill your gas tank or get a haircut. Inflation increases your cost of living as it reduces the purchasing power of each unit of currency.
And excessive money in supply can actually lead to ‘hyperinflation’. History says it all. In the year 2008, Zimbabwe witnessed 2,31,000,000% inflation! Meaning a sweet that cost them $1 in 2007 would require $231 Mn in 2008. Ridiculous, isn’t it?
Gross Domestic Product
GDP is the final value of the goods and services produced within the geographic boundaries of a country during a specified period, usually a year. GDP growth rate is an important indicator of the economic performance of a nation.
GDP is another critical factor that affects the amount of money to be printed in the economy. The government prints money of the same value, as its value has gained into their economy or, in a simple way, GDP. So, rising economic productivity - GDP increases the value of money in circulation since each currency unit can subsequently be traded for more valuable goods and services.
The point worth noting is, the government gives people the same amount of physical currency as a medium of exchange as the value it is getting in return from GDP and inflation.
Minimum Reserve System
Currency issued in the country relies upon the reserves RBI has with it after meeting all its liabilities.
Now by reserves, it means the following:
1. Bullion reserves
2. Foreign exchange reserves
3. Balance of Payment (BOP) only receivables.
In India, currencies are supplied by the RBI with the backing of bullion reserves, foreign exchange reserves (foreign currencies), and Balance of payment(only receivables). For the new issue of currencies, the RBI follows the Minimum Reserve System at present. The (MRS) Minimum Reserve System has been followed since 1956.
Under MRS, the RBI has to keep a minimum reserve of Rs 200 crore comprising gold bullion and gold coin, and foreign currencies. Out of the total Rs 200 crores, Rs115 crore should be in the form of gold bullion or gold coins. The purpose of shifting to MRS was to expand the money supply to meet the increasing transactions in the economy. RBI follows some principles or rules for issuing new currencies based upon the people’s economic growth and transaction needs. Read more about RBI’s moratorium policy.
Soiled and Mutilated note
Soiled note means a note which has become dirty due to usage and includes a two-piece note pasted together wherein both the pieces presented belong to the same note and form the entire note.
Mutilated banknote is a banknote, of which a portion is missing or composed of more than two pieces.
Soiled and mutilated banknotes that are not fit for circulation are withdrawn from circulation after duly accounting for them in the RBI records. These are then burnt in the incinerators provided at the regional offices of the RBI under strict vigilance and supervision of the RBI officials. The accounting of these banknotes makes it possible for the RBI to print the new banknotes to replace the burnt currency notes.
After getting checked with Inflation, GDP, and clearance of old notes, The Issue department, and Management department of RBI will come with an estimate of the currency required and put the demand sheet in front of the central government for approval.
Coordination between RBI & GOI
RBI discusses with the Government of India with respect to the denomination, designing, and security features of the banknotes to be printed in the country and circulated.
The minting of Re.1 currency coins (formerly Re.1 currency notes) and other coins fall within the jurisdiction of the GOI. After getting approval, it will follow up the process of printing and minting.
Besides, the RBI pays dividends to the government. This is also taken into consideration while making policies.
Methodology to evaluate the need for currency
The projected GDP figure is available from Govt, CMIE, and RBI's own Research Wing (D)
We know the cash with RBI and Banks -under Note stock account (N)
Then there is replacement demand due to the destruction of soiled notes (R)
Total Notes to be printed = D - N + R
In India, a 5% extra is added to meet the emergency. This will be counter-checked from Regional Offices and Banks estimates and consolidated and checked in DCM Central Office, RBI Mumbai.
Then denomination-wise breakup is taken for printing, and a print order is given to printing presses and printed in 4 quarters, and remittances planned accordingly. The RBI Issue Department monitors the entire procedure.
The bottom line
By now, you must be clear that saying and doing are two completely different things. It takes nothing to sit at home in the comfort of your couch and spell out claims that the RBI should rain money in the economy. But it’s not that easy-peasy in reality.
So, the next time someone tells you - “The government should get more and more money printed and transferred to us”, share this article with them.