The large capital inflows can occur due to heavy foreign direct investment (FDI) and portfolio investment by foreign institutional investors (FII) as it happened in some years in India, especially in 2006-07, 2007-08 and 2010-11.In the absence of intervention by RBI under the flexible exchange rate system, these large capital inflows will cause appreciation of Indian Rupee. Because of the stable conditions in the market for government securities (and the borrowing facilities against government securities as collateral extended by the RBI to banks), banks are not even encouraged to hold on to their surplus cash on grounds of speculation. are such as depend mainly on the behavioural choices of the public and banks. This also affects the money supply in the same manner as the Government borrowing from the banking system.There is, however, an important difference. 90 and therefore create demand deposits of Rs. The three demand curves in the market for H are upward-sloping straight lines going through the origin in accordance with the hypotheses of equations CThe same story is told in Figure 15.2, though in a different way- This figure depicts the equilibrium of the market for reserves and the consequent determination of the equilibrium amount of DD.
Thus RBI did not intervene sufficiently to prevent the appreciation of rupee between Oct. 2006 and Oct. 2007.This is because such intervention leads to the increase in money supply that is likely to cause inflation in the Indian economy. In contrast, money multiplier takes into account these leakages of currency from the banking system and therefore measures actual increase in money supply when the cash reserves with the banks increase.The money multiplier can be defined as increase in money supply for every rupee increase in cash reserves (or high-powered money), drainage of currency having been taken into account.
order) of the Government. Therefore, c is a behavioural ratio. 60,000 crore were kept apart in special deposits with RBI and were not meant to be used by the Government.It should be noted that if the foreign exchange reserves are used to import goods in short supply, it will help in lowering inflation rate for two reasons. M= 1+c /c +r (1=t) H. (15.11) The above, ultimately, is the key equation of the H theory of money supply. The borrowers from banks as well as sellers of securities (the government and others) will spend the funds received from banks.

A rise in t reduces m and thereby the supply of money decreases. A part of the currency issued is held by the public, which we designate as CA part of these currency reserves of the banks is held by them in their own cash vaults and a part is deposited in the Reserve Bank of India in the Reserve Accounts which banks hold with RBI. Thus more high-power money (i.e., rupee currency) would come into circulation in the Indian economy.

This implies that the supply of foreign exchange exceeds demand for it. 72 and keep Rs.

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