If there is too much money in circulation, both in terms of cash and credit, then the value of the legal tender decreases.

If there is too much money in circulation, both in terms of cash and credit, then the value of the legal tender decreases.

Increase in currency circulation – India's curious case

1 min read . 11 Oct 2020Anandadeep Mandal , Neelam Rani

• The difference, or the spread, in the yield of SWAPS and the Indian government bonds with a similar maturity replicates the pattern witnessed during the financial crisis of 2007-09  Currencyc in India rose 10% in October since March. The rise in cash in the economy along with falling bank deposits--down 5.7% during the same period--puts domestic banks and the Reserve Bank of India in a challenging situation as it triggers systemic liquidity crunch.

What is wrong with too much of cash in circulation?

If there is too much money in circulation, both in terms of cash and credit, then the value of legal tender decreases. This leads to "too much money chasing too few goods", causing demand-pull inflation. Given the current uncertainty amid the pandemic-induced induced supply shock inflation, an added demand-triggered inflation will only make matters worse.

But, what causes this excess money in circulation? Mostly, it is the result of government bond auctions and fiscal packages that are intended to boost economic recovery. While the measures have helped the economy--businesses and and people--it has increased the money in circulation.

Fall in bank deposits: The decline in bank deposits is also a pandemic-induced syndrome. Due to increased uncertainty and supply side shock, investors and consumers feel safe in keeping cash with themselves. Another event that has triggered the lack of deposits is the lockdown. During periods of restricted travel and lack of easily accessible technology across India, bank deposits have taken a hit.

However, all being said the Indian banking sector is far from any crisis. The difference, or the spread, in the yield of SWAPS and the Indian government bonds with a similar maturity replicates the pattern witnessed during the financial crisis of 2007-09. Though the widening of the spread suggests that there is a greater level of risk aversion in the market and a\liquidity that is caused by increased market risk, the spread is far from par zero. This indicates that the financial strength of the Indian central bank and the banking sector is not a threat.