How India’s dual economy of cash and credit impacts inflation..

An interesting article by Pronab Sen of National Statistical Commission.

He says one has to understand India’s inflation game via dualism between cash and credit:

The notion of ‘dualism’ – that a country can be viewed as having two distinct sectors – has a long and rich history both in development economics as well as in popular Indian discourse4.  I propose a specific form of dualism: that the Indian economy is composed of two sub-economies – a credit economy and a cash economy5.  In the credit economy, all transactions within it are mediated through the banking system; whereas in the cash economy, all transactions are in cash. The key assumption is that all transactions between these two sub-economies are carried out only in cash. I further assume, following Friedman, that the average price level of goods produced by the cash economy is determined by the amount of liquidity or the stock of currency available in the cash economy – along with other factors affecting demand.
In such an economy, if the production in the cash economy is adversely affected by a shock (say, a monsoon failure), the prices of agricultural products will rise since the liquidity available will now exceed the availability of goods. If we further assume that food (a major component of agricultural output) is an essential good so that its demand in the credit economy is inelastic (not responsive to changes in prices), then consumers in the credit economy will withdraw currency from their banks for purchase of food. This will increase the supply of liquidity in the cash economy, leading to a further increase in prices.
Even when production returns to normal (say during the next harvest), food prices will not decline to the original levels since there would now be more liquidity in the cash economy than earlier. This permanent increase in the price of food relative to all other goods will continue to induce further flows of cash from the credit economy into the cash economy, leading to further increases in food prices. This process will continue until such time as the induced shift in demand towards credit economy goods eventually leads to a zero net transfer of currency between the two sub-economies7
In the credit economy, so long as the currency reserves held by banks exceeds the minimum levels required for precautionary purposes, there will be no reduction of credit available. Thus, there can be a fairly extended period of food inflation with no change whatsoever in any of the monetary aggregates (M0 or M3)8 . The inflationary process in such a case is supported by a compositional change in the holdings of currency from passive bank reserves to active circulation in the cash economy.
Multiple linkages and is confusing as well..

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