Inflation and Money Supply: Rate vs Quantity in RBI Policy

The Lift Line

“But the main point is that without an expansion in liquidity or money, no sustained increase in general price level is possible.” (C. Rangarajan and N.R. Bhanumurthy, Mint)

Why This Editorial Matters for Your Exam

In the news: In Mint of 20 October 2026, C. Rangarajan and N.R. Bhanumurthy argue that single prices such as food or crude oil can start inflation, but only more money or liquidity can sustain it, so every policy-rate change needs a matching change in durable liquidity.

In this op-ed in Mint of 20 October 2026, C. Rangarajan (former governor of the RBI and former chairman of the Economic Advisory Council to the Prime Minister) and N.R. Bhanumurthy (director, Madras School of Economics) ask a question most inflation debates skip: can the general price level keep rising without growth in the supply of money? Their answer is no, and from it they draw a lesson for the RBI: a policy-rate change works only if the quantity of money and liquidity moves with it.

For context, it lands two weeks after the RBI’s Monetary Policy Committee raised the repo rate to 5.50 per cent on 7 October 2026 (our explainer: RBI MPC raises repo rate to 5.50 per cent), and alongside, as background, the RBI’s foreign-exchange steps of 10 October (RBI’s Foreign Exchange Risk Reserve and FX curbs). Read it with three other columns on the same theme today: Ajit Ranade on how India’s high interest burden muddles the RBI’s task, and the Business Standard columns on the RBI’s rupee fix and the FCNR swap and on confronting the economy’s trade-offs. For the case the Indian Express made for the hike, see RBI’s focus on inflation is timely.

GS Paper 3: Indian economy, mobilisation of resources and growth; inflation; monetary policy and its transmission. Prelims: RBI Act provisions on the inflation target and the MPC, policy-rate corridor, US Fed tools, Operation Twist, core inflation measures.

Background and Context

Two ways to run monetary policy: price or quantity

A central bank can act on the price of money (an interest rate) or on its quantity (reserve money, liquidity, the money supply). The authors note that “In the last few decades, the policy focus has moved towards the interest rate: i.e., the price rather than quantity (money).” India’s own framework is built around a rate: under the RBI Act, the Monetary Policy Committee determines “the Policy Rate required to achieve the inflation target”. The authors’ point is that, in equilibrium, “both price and quantity are determined”, so a central bank that announces a rate is also, whether it says so or not, deciding how much liquidity to supply.

The policy setting in October 2026

As background, the US directive the authors cite sits in that Implementation Note, issued with the FOMC statement of 16 September 2026 and taking effect on 17 September 2026. It reads: “Undertake open market operations as necessary to maintain the federal funds rate in a target range of 3-3/4 to 4 percent.” The rate is the target; the open market operations, which change the quantity of reserves, are how it is hit.

“Money matters”: the Fed Chair’s words

Kevin Warsh took the oath as Chairman of the Federal Reserve on 22 May 2026, after the US Senate confirmed him as Chair on 13 May; his term as Chair ends on 21 May 2030. For context, his keynote at the Jackson Hole Economic Policy Symposium on 28 August 2026 came before that decision. In that speech, titled “In Our Time” and his first Jackson Hole speech as Chair, he listed money as the sixth of his principles:

“Sixth, money matters. It’s not fashionable these days, but my view is that money has something important to do with monetary policy. We should pay attention to money created by the central bank and money that comes from the banking and financial systems. It’s true that financial innovations and other factors alter the mechanics that link the monetary base, the velocity of money, and the broader economy. But that is scarcely a reason to ignore the ultimate effects of money on financial conditions and prices.”

Why “inflation excluding precious metals” is in the conversation

The authors open by noting that “regulators and analysts have been talking about inflation excluding precious metals.” The RBI’s own measure here is a core measure, not headline inflation. For background, the minutes of the MPC meeting held from 3 to 5 August 2026, on May-June data, record: “core (CPI excluding food and fuel) inflation remained unchanged at 3.9 per cent during May-June. Excluding precious metals, core inflation remained even lower at 2.3-2.5 per cent”. The Governor’s Statement of 7 October 2026 has newer data: core inflation rose to 4.2 per cent in August after three months at 3.9 per cent, and to 2.9 per cent excluding precious metals. The authors accept that such measures are useful but say they do “not constitute an explanation of the behaviour of the general price level”. For the latest price data, see our report on September’s CPI inflation.

“Operation Twist”: the history behind the term

“Operation Twist” was first a 1961 initiative of the Kennedy Administration and the Federal Reserve. President Kennedy announced the programme on 2 February 1961, and on 20 February 1961 the Fed issued what a later Federal Reserve Bank of San Francisco study calls “an extremely rare public statement explicitly endorsing Operation Twist”. The Fed revived the idea on 21 September 2011 as what it calls the maturity extension program (“referred to by some as ‘operation twist’”): it would buy $400 billion of Treasury securities with remaining maturities of 6 to 30 years by the end of June 2012 and sell an equal amount with 3 years or less to run. It extended the programme on 20 June 2012 to the end of that year.

The Analysis

1. A single price is not the price level

The authors start with a household. If food prices rise, its nominal income is fixed and its demand for food is inelastic, then it has less to spend on everything else; demand for other goods falls and their prices are pushed down, “thus mostly not affecting the general price level”. The same holds for the economy as a whole, they argue, “without committing any fallacy of composition”. Hence their core claim: “For the general price level to increase, nominal income must increase and this can happen only with an increase in money supply or liquidity.”

A crude-oil shock fits the same frame. It “may lead to a cost-push rise in the prices of several commodities”, but on its own it cannot explain an overall rise in prices. The authors cite Milton Friedman, who, addressing an Indian audience several decades ago, said: “It is true that [an] upward push in wages produced inflation, not because it was necessarily inflationary, but because it happened to be the mechanism which forced an increase in the stock of money.” Their summary: “while individual prices can trigger inflation in the short-run, it is an adjustment in liquidity at the macro level that sustains inflation in the medium- and long-run.”

They are careful to add that “This is not a throwback to the days of the Quantity Theory of money”, whose limitations “are many”. The claim is narrower: no money, no sustained inflation.

2. The rate and the quantity are one decision

“Rate-change decisions are concomitant with decisions on the quantum of money or liquidity,” the authors write. The US directive above is their evidence: every Fed rate announcement comes with an instruction to the New York Fed’s Open Market Desk to adjust the supply of reserves until the market rate sits inside the target range. Since 2008-09, they add, “the term ‘quantitative easing’ has become part of the vernacular of central banks”. Warsh’s “money matters” passage, delivered before the September decision, makes the same point from inside the Fed.

3. The authors’ evidence for India

The authors present their own estimated “price equation” for India on annual data for 1994-2024:

They then tried “various price specifications with policy rates and its variants” and “could not find any interest rate being significant”. Their reading: “the direct transmission of a rate change on prices appears to be unclear, while transmission from quantity to prices appears plausible.” This is the authors’ own estimate, offered in a newspaper column; a reader should treat it as their evidence, not as a settled finding of the literature.

4. Why the rate channel is murky

The textbook story of a rate hike, which the authors quote from M.H. de Kock’s Central Banking, needs two conditions: that the central bank’s discount rate have “a prompt and decisive influence on money rates and credit conditions”, and that there be “a substantial measure of elasticity in the economic structure” so that “prices, wages, rents, production and trade might respond to changes in money rates and credit conditions.”

The first link, from the policy rate to market rates, is clear. The authors ask what comes after it: does a higher rate change the supply or the demand for goods? Even the classics disagreed on which rate matters. Keynes stressed the long-term rate: as investment changes, income changes through the multiplier. R.G. Hawtrey stressed the short-term rate (bank rate): it alters the cost of holding inventories, and so the supply of goods. By contrast, the old Cambridge version of the quantity theory gives a simple path for money: if people hold more money than they want, they spend the excess, and prices rise.

In a unified market, the authors add, short and long rates move in the same direction, and any attempt to make them move in opposite directions (“often called ‘operation twist’”) “will fail, as the US Fed found out”. That last judgement is theirs; the evidence on the 1961 episode, discussed in The Debate below, is more mixed.

5. Three conclusions for policy

1. Watch spreads, not one rate. “Watching the call money rate alone is not enough.” The call rate is “the shortest money rate”; bond yields, in the US and in India, “have been sending strong signals”. “The policy rate is a good signal. But its transmission must be seen across a spectrum of interest rates.”
2. Back rate changes with durable liquidity. “Changes in the policy rate must be followed by appropriate changes in durable liquidity such as reserve money and money supply.”
3. Rate and liquidity are one decision. It “appears as if rate changes are decided by the Monetary Policy Committee and liquidity decisions are taken by the RBI administration”, but the two are concomitant: “The desired interest-rate changes can happen only after liquidity decisions, even though there may be occasions when liquidity changes may be directed at other objectives like exchange-rate stability.”

The third point bites now. The RBI’s recent foreign-exchange steps affect rupee liquidity too: as Ajit Ranade notes in his Mint column today, “Dollar sales reverse part of the liquidity injection by withdrawing rupees” (his argument). Liquidity managed for the rupee and liquidity needed for the repo hike are the same pool.

Data and Institutions Vault

Prelims-grade facts:

India’s framework (RBI Act, 1934):

• Section 45ZA: the Central Government, in consultation with the RBI, determines the inflation target in terms of the CPI, once in every five years.
• Section 45ZB: the Monetary Policy Committee determines the Policy Rate needed to achieve the target; its decision is binding on the RBI.
• MPC composition: the Governor (Chair), the Deputy Governor in charge of monetary policy, one RBI officer and three members appointed by the Central Government.
• Rates from 7 October 2026: repo 5.50 per cent; SDF 5.25 per cent; MSF and Bank Rate 5.75 per cent.
• RBI core measure: core inflation (CPI excluding food and fuel) 4.2 per cent in August 2026, after three months at 3.9 per cent; excluding precious metals, 2.9 per cent (RBI Governor’s Statement, 7 October 2026).

The US Federal Reserve:

• FOMC, 16 September 2026: target range raised by 1/4 point to 3-3/4 to 4 per cent; vote 12-0.
• Implementation Note, same date: directive to the Open Market Desk (Federal Reserve Bank of New York), effective 17 September 2026.
• Kevin Warsh: confirmed as Chair 13 May 2026; oath 22 May 2026; term as Chair ends 21 May 2030.
• Jackson Hole, 28 August 2026: Warsh’s keynote “In Our Time”: “money matters” is the sixth of his principles.

Operation Twist:

• 1961: announced by President Kennedy on 2 February; Fed endorsement on 20 February.
• Effect (FRBSF Economic Letter, 2011): “a significant but moderate 0.15 percentage point reduction in longer-term Treasury yields”.
• 2011-12: the Fed’s maturity extension program: buy $400 billion of 6 to 30 year Treasuries, sell an equal amount of 3 years or less.

⚠️ Watch the trap: The FOMC statement of 16 September 2026 announces the target range; the instruction to the Open Market Desk sits in the separate Implementation Note of the same date, effective 17 September. And the RBI’s “excluding precious metals” figure is a core inflation measure, not headline CPI.

The Debate

The authors’ case. Single prices start inflation; money sustains it. Since rate and quantity are set together, a policy-rate change without a matching change in durable liquidity is a signal without a mechanism. Their own estimate for India finds money growth significant and no interest rate significant, and the rate channel’s later links are theoretically contested.

The other side.

• Velocity is not stable. Warsh, whom the authors quote, concedes in the same passage that “financial innovations and other factors alter the mechanics that link the monetary base, the velocity of money, and the broader economy.” A looser money-price link is why central banks moved to rates in the first place.
• Causation can run both ways. Friedman’s line, as the authors quote it, says the wage push “happened to be the mechanism which forced an increase in the stock of money”. Money there follows prices and wages. The policy question then becomes why the authorities accommodate, which is a question about the rate and the reaction function as much as about the quantity.
• India’s law is rate-based. Section 45ZB gives the MPC the Policy Rate. A shift to money targets, or a formal MPC role in liquidity, would need a change of framework, not only a change of emphasis.
• “Operation Twist will fail” is too strong. The Federal Reserve Bank of San Francisco’s study of 1961 finds “a significant but moderate 0.15 percentage point reduction in longer-term Treasury yields”: a small effect, not none.
• One equation is not the literature. A single annual regression over 1994-2024, with a dummy for two crises, is suggestive; whether rates fail to matter or act with long lags is a question for more tests.

The balanced verdict. The authors’ strongest point is institutional, not statistical. Whoever sets the rate, the liquidity that makes it hold is managed day to day, sometimes for other ends such as the rupee. If the RBI is tightening on rates while its foreign-exchange and liquidity operations pull the other way, transmission weakens. Watching spreads and durable liquidity alongside the repo rate is a sound discipline, whatever one thinks of money targets.

How to Think About This

For any inflation question, separate three pairs. Relative price versus general price level: a food or crude shock changes relative prices; a sustained rise in all prices needs more nominal spending. Trigger versus sustain: a supply shock can start inflation; money and expectations keep it going. Price versus quantity: the repo rate is the signal; reserve money and the money supply are the plumbing that carries it. A good Mains answer uses all three, then asks which rate (short or long) and which liquidity (temporary or durable) the policy actually moves.

Diagram-in-Words

The figure shows the authors’ chain: a single price can trigger inflation, but only more money sustains it; policy can act through the rate or through the quantity of money, and the authors’ three conclusions follow.

Takeaway Box

• Core idea: food and crude can trigger inflation, but without more money or liquidity there is no sustained rise in the general price level.
• Key fact: under RBI Act s.45ZB the MPC sets the Policy Rate; the repo rate has been 5.50 per cent since 7 October 2026.
• Evidence: the authors’ own price equation for India (1994-2024) finds M3 growth significant and no interest rate significant.
• Counterpoint: velocity shifts with financial innovation, money can follow prices, and Operation Twist (1961) had a significant but moderate effect.
• Mains use: monetary transmission, durable liquidity, interest-rate spreads, relative versus general prices.

Revision Flowchart

Sources:

• C. Rangarajan and N.R. Bhanumurthy, Mint, 20 October 2026
• FOMC statement, 16 September 2026
• FOMC Implementation Note, 16 September 2026
• Kevin Warsh, Jackson Hole keynote, 28 August 2026
• Federal Reserve, Warsh oath of office, 22 May 2026
• RBI, Minutes of the Monetary Policy Committee Meeting, 3 to 5 August 2026
• RBI, Governor’s Statement, 7 October 2026
• Ujiyari explainer on the 7 October 2026 repo hike

Source: Inflation and Money Supply: Rate vs Quantity in RBI Policy — Ujiyari.com | Free UPSC & State PCS Editorial Analysis