By Madhu Srinivas, IFMR Finance Foundation
Monetary policy plays a significant role in determining the trajectory of a country’s economy. While not directly affecting the structure of a financial system, the policy significantly influences the actions of economic agents of the financial system, including financial institutions. In that respect, the mechanics and effectiveness of transmission is of considerable interest to us. In this post, which is the first in a two-part series, we take a brief look at the mechanics of Monetary Policy Transmission in general and how it operates in India.
Dr. Raghuram.G. Rajan, former RBI Governor, in a statement after assuming office on September 4, 2013 observed that:
“The primary role of the central bank, as the RBI Act suggests, is monetary stability, that is, to sustain confidence in the value of the country’s money. Ultimately, this means low and stable expectations of inflation, whether that inflation stems from domestic sources or from changes in the value of the currency, from supply constraints or demand pressures.” While there are many views on the objectives of monetary policy, the above statement captures the broad commonalities among the various views and could be taken as the official stance of RBI. This is further strengthened with the RBI formally adopting Inflation Targeting Framework.
It is generally accepted in literature that monetary policy has limited effects on aggregate supply or productive capacity. However, in the presence of credit constraints, the ability of firms to expand capacities is impacted, thus affecting aggregate supply. Following the financial crisis of 2008-09 overall monetary policy transmission seems to have weakened in most Advanced Economies (AE). In contrast, recent evidence suggests that the interest rate channel, one of the many channels for monetary policy transmission, is strengthening in many Emerging Market Economies (EMEs), including India. This can be attributed, among other things, to reduced fiscal dominance, more flexible exchange rates and development of market segments.
Prior to the recommendations of the Expert Committee to Revise and Strengthen the Monetary Policy Framework (Chair: Dr.Urjit Patel, 2014), India was following reserve targeting as the mechanism for monetary policy transmission – i.e., base money, borrowed reserves, and non-borrowed reserves. However, we have moved towards a formal, interest rate targeting regime (based on CPI) and away from the earlier reserve money system. One of the main reasons for moving from a money aggregate system to an interest rate regime is the erosion in stability and predictability of the relationship between money aggregates, output and prices. This erosion was further exacerbated with the proliferation of financial innovations, advances in technology and progressive global integration.
Mechanics of Transmission
The transmission mechanism can be characterised by the Taylor’s rule of thumb (a simplified version of one of the main quantitative tools used by central bankers to arrive at a nominal policy interest rate) –
i =π + r* + 0.5(π –π*) + 0.5 (y – y*)], or [ i =π* + r* + 1.5(π –π*) + 0.5 (y – y*)]
i = nominal interest rate
π = rate of inflation
π* = inflation target
r*= neutral real rate
(y-y*) = output gap
The policy transmission mechanism broadly involves two steps –
- Transmission from the policy rate to key rates in the financial markets
- Transmission from the financial markets to final objectives like inflation, employment and output
The effectiveness of transmission in both steps depends to a large extent on the structure of the financial system. The three main components of the system which determine effectiveness are –
- The size and reach of the system – given that the formal financial system does not intermediate for most economic agents in India, this weakens transmission
- The magnitude of financial frictions – a recent empirical study suggests that the relative scarcity, or impediments, in the provision of public goods in India, such as – enforcement of property rights, efficiency and impartiality of the legal system, adequacy of accounting and disclosure standards – tend to enhance the frictions in the financial sector and, to that extent, impede policy transmission
- The degree of competition in the financial sector – there is evidence that the banking sector is highly concentrated in India, suggesting a low degree of competition in the sector
In sum, it can be said that the structure of the financial sector in India tends to weaken the monetary policy transmission.
Channels of Transmission
Monetary policy transmission in India happens through the following channels –
- Interest Rate channel – Empirical studies show that there exists bi-directional causality between call money rates and interest rates in other segments such as the government debt market, credit market or equities market and the forex market. Also studies have shown that the transmission through this channel is asymmetric, i.e the extent of policy rate transmission is different between liquidity surplus and liquidity deficit conditions, with the transmission being more effective during liquidity deficit conditions. One reason could be that banks would be more dependent on liquidity provided by RBI during tight liquidity conditions and hence more sensitive to the short term interest rate influenced by RBI.
- Credit channel – India is banking-dominated economy, even though the role of equity and debt markets has been rising the past few years. High-dependence on bank finance makes the bank lending and the balance sheet channels particularly important for monetary transmission, which is also seen through Granger causality tests. In terms of balance sheet effects, credit growth is seen to have an inverse relationship with movements in the policy rate. A 100 basis points increase in policy rate reduced the annualised growth in nominal and real bank credit by 2.78 per cent and 2.17 per cent, respectively.
- Exchange Rate channel – The exchange rate channel works primarily through consumption switching between domestic and foreign goods. This channel is weak in India with some evidence of weak exogeneity. This is mainly because of India’s limited integration with world financial markets and RBI’s intervention in forex markets. Despite all this, it is found that exchange rate depreciation is a key source of risk to inflation.
- Asset Price channel – Empirical evidence for India indicates that asset prices, especially stock prices, react to interest rate changes, but the magnitude of the impact is small. With the increasing use of formal finance for acquisition of real estate, the asset price channel of transmission has improved. However, during periods of high inflation, there is a tendency for households to shift away from financial savings to other forms of savings such as gold and real estate that tend to provide a better hedge against inflation. To the extent that these acquisitions are funded from informal sources, they may respond less to contractionary monetary policy, thus weakening the asset price channel in India.
In all this, it should be borne in mind that there is considerable lag in the transmission of monetary policy. In India, monetary policy impacts output with a lag of 2-3 quarters and WPI inflation with lag of 3-4 quarters, with the impact persisting for 8-12 quarters. Also as can be seen from the above summary of channels, the interest rate channel is the strongest.
In the next post, we will take a closer look at the impediments to policy transmission in India and also list the recent measures taken by RBI/Government to overcome these impediments. Finally we will look at what recent empirical evidence has to say on effectiveness of policy transmission in India.
 Report of the Expert Committee to Revise and Strengthen the Monetary Policy Framework (Chair: Dr. Urijit Patel, 2014)
 Bouis (2013) et al, OECD Working Paper No. 1081
 Mohanty, M.S. and P. Turner (2008): “Monetary Policy Transmission in Emerging Market Economies: What is New?”, BIS Policy Paper No.3, January
 Gumata, N., A Kabundi and E. Ndou (2013): “Important channels of transmission of monetary policy shock in South Africa”, ERSA Working Paper No. 375, Cape Town
 Urjit Patel Committee Report (2014)
 Mishra, Montiel and Sengupta (2016) :“Monetary Transmission in Developing Countries – Evidence from India”
 Urjit Patel Committee Report (2014)
 Bhupal Singh (RBI 2011) :“ How asymmetric is the monetary policy transmission to Financial markets in India”
 Ibid , Chart IV.1
 Pandit, B.L. and P. Vashisht (2011), “Monetary Policy and Credit Demand in India and Some EMEs”, Indian Council for Research on International Economic Relations, Working Paper No.256, Khundrakpam (2011) and Khundrakpam and Jain (2012)
 Ray, P., H. Joshi and M. Saggar (1998): “New Monetary Transmission Channels: Role of Interest Rate and Exchange Rate in the Conduct of Monetary Policy”, Economic and Political Weekly, 33(44), 2787-94
 Mishra, Montiel and Sengupta (2016): “Monetary Transmission in Developing Countries – Evidence from India”
 Urjit Patel Committee Report (2014), Table IV.1
 Singh, B. and S. Pattanaik (2012): “Monetary Policy and Asset Price Interactions in India: Should Financial Stability Concerns from Asset Prices be Addressed Through Monetary Policy?”, Journal of Economic Integration, Vol. 27,167-194
 Urjit Patel Committee Report (2014)