Saturday, November 19, 2016

Ambit Capital Prediction of Sharp Drop in GDP Growth is a Joke

Ambit Capital Prediction of Sharp Drop in GDP Growth is a Joke

Vivek Dehejia

A widely publicized report (see here and here) by Ambit Capital has predicted a sharp drop in India’s GDP on the heels of the currency swap exercise. The report is available here.

These large estimates are at variance with other predictions and back of envelope or common sense predictions that the temporary drop in aggregate demand caused by the short run liquidity crunch might shave on the order of a quarter to a half percentage point of GDP growth over the relevant time horizon.

So what is going on?

The answer is that Ambit has completely changed the methodology by which they make predictions of GDP growth! They write:

In the light of the disruption caused by the demonetisation decision triggered by the Central Government on November 8, 2016 we suspend our current supply-side GDP model.

The model to replace it?

To quantify the impact of the demonetisation on GDP growth we rely on the ‘quantity theory of money’ (QTM).

One really doesn’t know whether to laugh or to cry. The QMT derives from the following accounting identity, known as the equation of exchange:


Basically, this says that the stock of money (M) multiplied by the velocity of its circulation (V) is identically equal (as a matter of accounting) to nominal GDP (PY), which may be broken into real GDP (Y) multiplied by the nominal price level (P).

This equation only becomes a theory if one assumes that one of the four components is fixed or is determined outside the equation. Thus, the usual interpretation of this equation in macroeconomics is that, when converted into growth rates, gives an estimate of long run inflation -- not of short run changes in GDP growth!

Thus if you assume that V is stationary in the long run and log differentiate the equation, you get the following:

% Change in M = %Change in P + %Change in Y

If you re-arrange, you get:

%Change in P = %Change in M - %Change in Y

In other words, assuming that velocity is stationary in the long run, the equation predicts that long run inflation is determined by the long run growth of the money supply once one adjusts for growth in real output.

Yet another interpretation is to take this as a basis for Milton Friedman’s “k percent” rule of classical monetarism. If you want to target growth in the monetary aggregate, and you would like (say) 2% inflation over time, then you should allow the money supply to grow at 2% plus whatever is the expected long run growth rate of real GDP.

Please note that nowhere in the above is the equation of exchange taken as a theory of real output determination in the short run! It may be seen as a short-cut theory of aggregate demand. In fact, in a research paper with my colleague Nicholas Rowe, published in 1998, we interpreted the equation in exactly this way. (See here.)
In a stylized theoretical model (that too, 1990s vintage!) it may be acceptable to use the equation of equation as a theory of aggregate demand, although that is not the current state of the art, which would employ some contemporary beefed up version of the textbook IS/LM or Mundell-Fleming model, or the optimizing DSGE type models.

The crux is this: Ambit gets its extreme predictions by an extreme and problematic modelling strategy, which is to throw out their supply side model, and assume that the dynamics of real output are entirely determined in the short run by the equation of exchange.

Thus, with a predicted sharp drop in the velocity of circulation, the “model”, if one even wants to call it that, predicts a sharp drop in real GDP, since, presumably, there is assumed to be no impact on the price level. Strictly speaking, though, note that their prediction should be of the impact on nominal GDP (PY), unless they assume absolutely rigid prices (P). In other words, even within their posited modelling framework, part of the predicted drop in nominal income may occur through a temporary drop in the nominal price level rather than drop in real GDP. They do not explain, so far as I could tell, why they assume all the action in their simplistic model comes from Y and not from P.

The bottom line: Ambit’s “model” from which their extreme prediction is derived is non-serious and would be laughed out of court by anyone serious about macroeconometric modelling of economic dynamics. It is frankly surprising that is has received so much play. Were it submitted to my upper division or graduate seminar, it would rate a B+ or so for effort.

Vivek Dehejia is an economics professor at Carleton University in Ottawa, Canada; a resident senior fellow at IDFC Institute in Mumbai; and a columnist, Mint. Follow him on Twitter @vdehejia.

Monday, November 14, 2016

Demonetization: Fact and Fiction

Demonetization: Fact and Fiction

Vivek Dehejia

Ottawa, Canada, November 14, 2016

The past week has witnessed a series of surgical strikes on our common sense, with commentary on the government’s demonetization of high denomination currency notes ranging from claims that it is a political masterstroke for Prime Minister Narendra Modi to claims that it is political suicide, from claims that it will be a bonanza for the economy to claims that it will be a disaster. It’s high time to separate fact from fiction, and conjecture (well founded or ill) from propaganda.

First, given that the old 500 and 1,000 rupee notes are being replaced with new 500 and 2,000 rupee notes, what is involved is, in effect, a one time wealth tax on black money. To be more precise, this will be a one time tax on unaccounted cash held in high denomination notes, and therefore represent a partial attack on black money. After all, black money that has been converted from cash into gold, property, or other assets will be unaffected, or at any rate, unaffected directly. (A crash in property prices, induced by demonetization, will indirectly affect the wealth of those who have parked money, whether illicit or otherwise, in the property market.)

That having been said, it would be hard to deny that those with large stashes of unaccounted cash are going to take a hit in the short run, and it will take a period of months if not years for an equivalent stock of black money in the newly printed currency notes to be built up. Black money will take a hit, at least for a while, and that cannot be a bad development.

Second, the costs of demonetization are the short run adjustment costs caused by a liquidity crunch during the transition period in which old notes are swapped for new notes. These are, literally, the shoe leather costs first year economics textbooks write about -- the cost of waiting in a queue to exchange or deposit legitimate stocks of old currency notes. There should be limited or no medium or long run effect on the level of aggregate demand in the economy, a bizarre claim being put out there even by some well known economists who ought to know better.

Thus, celebrated economist Kaushik Basu is quoted in the Financial Times as saying that the demonetization plan is a “very risky correction of money supply” and is likely to cause a drop in aggregate demand and thereby lead to slower growth. This is very puzzling indeed, considering that India now operates under a monetary policy regime known as inflation targeting, a fact which Basu most certainly knows. Thus, if a portion of the stock of high powered money is destroyed by some of the high denomination notes being burned -- literally or metaphorically -- the incipient drop in M1 can be fully offset by open market operations of the Reserve Bank of India. In more technical terms, the RBI, can, to a first approximation, fully “sterilize” the monetary effects of that demonetized currency which is “burned” and not deposited or exchanged for new notes.

More fundamentally, in a world of inflation targeting, unlike the world of the first year textbooks that Basu seems to have in mind, the money supply is endogenous, as the policy instrument is the central bank’s policy rate -- in India the repo rate, not adjustments to the money stock or its growth rate. Thus, in terms of our textbook analytics, the LM curve is horizontal at the central bank’s chosen interest rate, rather than vertical at a policy-determined money stock. The intersection of this horizontal LM curve with the downward-sloping IS curve determines the level of aggregate demand, at a given nominal price level. There is no role here for demonetization to play.

Third, armchair analysts of the short run impacts of demonetization have in some cases succumbed to a very basic confusion, that between a one time change in the price level and the rate of price inflation. Suppose that, because of changed consumer and producer behaviour, there is a one time shock to the price level. This level effect has no effects on the medium and long term rate of inflation, which is a function of the underlying growth in the stock of money, which, in turn, is a function of the central bank’s policy interest rate as determined by its inflation targeting policy framework. This confusion between levels and growth rates equally infects discussion of the Goods and Services Tax, in which it is wrongly argued that inflation will be the result when what is meant is a one time change in the price level.

Fourth, the beneficial effects of demonetization in the longer run are likely to be an increase in financial inclusion, as more of the unbanked are goaded to enter the financial system, and this can only be a good thing. Relatedly, to the extent that those inconvenienced during the liquidity crunch of the transition switch over permanently to debit and credit cards and electronic payments, the economy’s reliance on cash will diminish, although it will by no means disappear (nor should it, for that matter).

Fifth, and last, a long run solution to the problem of black money must tackle it at its source, and that means dealing with hot potato issues such as election finance.

Bottom line: Demonetization is likely to have some good effects, and its bad effects are overhyped by critics who either do not understand monetary economics or perhaps have a vested interest in seeing the laudable efforts of the government to crack down on black money fail. Let us give this a chance.

Vivek Dehejia is economics professor at Carleton University in Canada; resident senior fellow at IDFC Institute in Mumbai; and columnist, Mint, India. He may be reached at

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