Digital Currency and Inflation Problem

Policymakers around the world are torn between controlling inflation and supporting growth. In the context of Covid-19, the onus was on the government to pursue deficit financing to keep the economy afloat. Central banks aided this activity by lending easy money through quantitative easing, boosting the money supply and decreasing interest rates.

The Russia-Ukraine conflict has altered the global economic landscape. Higher commodities and oil costs and supply-side flaws drove the inflation up. Consumer price inflation in India, a significant importer of crude, is approaching 8%. In the United States, inflation reached 8.3 percent in April, one of the highest levels in four decades.

The Reserve Bank of India hiked the policy repo rate by 40 basis points in an unexpected move to curb inflation. The Fed raised the benchmark interest rate in the US by 50 basis points a day later. The goal of both of these central banks is to manage inflation as well as exchange rates as a contributing element to it.

How War Affects the Industry

Inflation expectations due to the war have resulted in higher commodity and gasoline prices, resulting in a decline in consumer purchasing power. This could lead to industry leaders being unwilling to invest, resulting in a further decline in job creation and growth.

The current inflationary element is primarily related to a supply-side shock. A strong monetary policy to limit inflation makes little sense in such situations. To regulate the value of the currency rate, central bankers appear to be resorting to quantitative tightening.

Quantitative tightening in the United States is likely to diminish the Fed’s purchases of government bonds, lowering the fiscal deficit and strengthening the US currency against other national currencies. This might speed the flight of capital from developing countries like India to the United States, depleting India’s foreign exchange reserves and further devaluing the rupee. The increasing inflation in poorer countries has exacerbated the outflow.

Money Booster

The unexpected move to raise the repo rate indicates that the RBI intends to prevent the rupee from falling further. In India, the money multiplier is approximately 5.5. It means that for every unit of central bank money created, Indian private banks generate more bank deposits, multiplying the money in circulation by at least five. These multipliers effectively deter the central bank from purchasing government debt. Commercial banks would pump at least five crore rupees into the system for every crore rupee of bonds purchased. This monetary expansion is very inflationary, causing the rupee to depreciate.

But a better solution to stop the rupee’s depreciation and keep the fiscal deficit in check is to employ a digital rupee. In response to the success of private cryptocurrencies, central banks are developing central bank digital currencies (CBDCs) that will transform payment systems. China has begun testing its digital yuan, the European Central Bank is building the digital euro, and the Fed is considering generating digital dollars.

The Reserve Bank of India (RBI) can begin selling government bonds and absorbing Indian cash in circulation. The elimination of traditional Indian rupees reduces the number of rupees in circulation by five times that of the introduction of the digital rupee. The RBI would exchange a five-fold money multiplier for a one-fold money multiplier. Becchetti and Cozzi of Italy have predicted that the digital euro may eliminate up to 75% of government debt. This will assist the RBI in meeting its dual objectives of controlling inflation and limiting the rupee’s further decline.

Inflation Is Coming

Consider the normal reaction to unexpected inflation by monetary authorities involved in extended quantitative easing. The central banks should deplete excess reserves by selling certain government and corporate bonds to the banking sector to recover the bloated balance sheet. Lenders with low liquidity, in turn, sell their loan assets. Tightening reduces inflation.

Commercial institutions lose deposits but do not sell income-generating credit assets as compensation unless liquidity decreases. Instead, they can sell other assets. Balance the account with idle cash from the central bank.

Monetary authorities now owe us more than commercial banks. The size of the balance sheet remained stable, and the decline pursued by the sale of bonds to the private sector did not materialize. As these plans become more difficult to reverse, digital cash will make current asset purchase programs quasi-permanent.

The central government’s immediate goal is to stem the decline of cryptocurrencies by providing citizens with a secure and sovereign alternative to Bitcoin. This is something Elon Musk cannot refuse as payment to Tesla. However, in the case of China and the US, the promotion of digital currency adoption is to attack and defend the disproportionate role of the US dollar in the global economy.

What Is the Cause of Such High Inflation?

Many Americans are discovering that their salaries aren’t going as far as they used to as prices continue to rise across a wide range of expenditure areas. That’s probable because the year-over-year inflation rate, measured by the Consumer Price Index, was 9.18% in June.

Energy commodities like gasoline and services like electricity are not strongly weighted in the CPI. However, energy prices have grown dramatically, with petrol prices climbing 60% yearly.

While petrol prices have dropped in the last month, they remain expensive. The national average for a gallon of gasoline is $4.285 as of July 28. Many service rates are reduced due to people not flying or staying in hotels. Many of these costs have risen in the last year. The current unemployment rate is 3.6%. There is a high demand for workers and significant salary growth. Labor is the most important input in the production of services. Generally, it is around half of any production cost on the service work.

In other words, a tight labor market has increased labor costs, which has increased the cost of services paid for by consumers.

In conclusion

The trend and endurance of inflation must be closely monitored. Perhaps the combination of robust fiscal stimulus and liberal monetary easing has uncalled the pricing genie, which quantitative easing alone could not do after the 2008 financial crisis. If that is the case, monetary officials should hope that public acceptance of digital currency remains lukewarm, as it is in China’s current pilots. Anything hotter would be dangerous.