CHAPTER2

MONETARY POLICY AND ITS

TRANSMISSION MECHANISM

A PRIMER

2.1. THE ROLE OF MONETARY POLICY-THEORETICAL ISSUES*

The conduct of monetary policy or any other public policy in a given period is influenced by

the prevailing socio-political conditions, economic thinking, and empirical evidence. Global

perspectives on the role and effectiveness of monetary policy have evolved over time being

influenced by developments in monetary theory as well as interpretations of monetary

history. "Opinions have fluctuated widely with respect to what monetary policy can

contribute, how it should be conducted to contribute the most and what are the possible

channels through which monetary policy actions influence economic activity."

Early classical theorists held the view that the economy could be dichotomized into tWo parts

- the monetary sector and the real sector- such that economic forces originating in the

monetary sector does not affect the real sector. Economic activity, according to the classical

economists, is determined by non-monetary factors, and money is purely a medium of

exchange having no independent role in determining economic activity; money is neutral.

The classical view of money is encapsulated in the well-known equation of exchange:

MV=PY

* Important References used in writing this Section include: Bofinger (2002); Friedman, M. (I 968); Friedman, B.M.

(2000); Jadhav (1994, 2003); Rasche & Williams (2005); Walsh (1998) among others.

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where M = stock of money; P = general price level; V = income velocity of money; and Y =

aggregate output.

It is postulated that output is determined in the real sector by non-monetary factors, money

stock by policy makers and velocity by institutional factors. With output at full-employment

equilibrium and velocity constant in the short run, the classical view is that variations in

money supply would have a corresponding effect only on the price level. Interest rate being a

non-monetary phenomenon in the classical doctrine is not affected by the stock of money.

Any linkage betWeen the monetary and real sectors is, therefore, absent in the classical set up

and demand management policies are unwarranted.

The emergence of Keynesian economics in the 1930s challenged the premises and

prescriptions of the classical theory. The legacy of the Great Depression in the United States

and other industrialized nations was that monetary policy is ineffective. Keynes' new theory

provided a plausible explanation of the phenomenon in terms of deficiency of effective

demand and suggested a feasible course of policy action. Keynes challenged the classical

faith in market forces and pleaded for the end of Laissez faire. He suggested that problems

associated with deficiency of aggregate demand could be resolved by expansionary fiscal

policy. With Keynes fiscal policy, therefore, came to the center stage while monetary policy

was relegated to the background. This perspective can be seen to be prominent in the writings

of Keynes and the Keynesian economists in the 1940s through the 1960s.

In a Keynesian framework monetary policy is seen to be passive and directed mainly at

influencing interest rates, which are considered important in influencing investment. A

change in money supply (M) leads to a change in interest rate (r) that in tum causes a change

in investment (I). The change in investment influences income (Y) via the multiplier. Thus

the chain is:

The conditions most favourable for change in money supply to produce the desired effect on

income are: (a) inelastic demand for money, (b) elastic investment demand and (c) a high

marginal propensity to consume (MPC). A change in money supply would have minimal

- 14-

effect on income if demand for money is elastic and investment demand is inelastic. Under

these circumstances the policy implications are clear. Monetary policy has no impact. If

income is to be raised expansionary fiscal measures need to be taken.

Neo-Keynesians stretched the arguments further to claim that government interventions

could remedy market failures. The Phillips Curve relationship introduced by them in the late

1950s was used in support of their argument. The curve postulated a stable and inverse

relationship between inflation and unemployment, which reinforced credibility of the

Keynesian demand management policies. The Keynesian policy prescriptions had wide

acceptance during the post- Depression period. The minimalist perspective on the role and

effectiveness of monetary policy can be seen in the Report of the Radcliffe Committee in the

UK, and in the first two reports of the Kennedy Council of Economic Advisers (1962 &

1963) in the USA.

The Keynesian paradigm started losing ground with the emergence of the phenomenon of

stagflation in the early 1970s. The neo-Keynesian Phillips Curve relationship failed to

explain the simultaneous incidence of a high inflation, a high unemployment rate, and

stagnating I falling output. Subsequently Friedman & Phelps demonstrated that the Phillips

Curve provided at most a temporary trade-off between inflation and output and that in the

long run no such trade-off existed.

The 1960s also saw the rise of monetarism building on the works of Friedman & Schwartz

(1963), Friedman & Meiselman (1963), and Andersen & Jordan (1968). The events of the

early 1970s caused a significant polarization in the professional world; the monetarist

paradigm, which did not have much influence during the 1950s and 1960s, began to receive

considerable favour. With monetarism the faith in money and monetary policy was

reaffirmed.

There are several planks in the monetarism platform. The most important is that sustained

inflation is a monetary phenomenon and that central banks should be held responsible for

maintaining price stability. The monetarists contend that central banks should control the

stock of money in the economy, and not focus on targeting short-term interest rates, as the

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mechanism of achieving the inflation control objective. Inflation control is, however, not the

only concern of the monetary authorities, according to the monetarists. Many of them

(Friedman, Brunner, Meltzer & others) find monetary policy as having significant effects on

short-run fluctuations in real output, though not affecting long-run output growth.

The monetarist view of the role of money, therefore, is much broader. According to the

monetarists, money supply is the major systematic determinant of economic activity in the

short run although in the long run it influences only prices. Monetarism postulates that a

change in money supply affects rates of return on different assets that in tum affect aggregate

demand. When aggregate demand changes aggregate spending (GNP) changes. It says that

for practical purposes the aggregate demand (AD) curve is affected only by changes in

money supply. The monetarist view may be stated as "only money matters". While the

Keynesians believe that money supply has only an indirect effect on aggregate spending, the

monetarists assert that it has both indirect and direct effects.

The monetarist analysis operates in the framework of the quantity equation of exchange and

relies heavily on the analysis of trends in velocity. Monetarists argue that the velocity of

money is relatively stable (in extreme cases constant). Now if V is constant then movements

in M will affect nominal GNP correspondingly. Fiscal policy is irrelevant according to the

monetarists because if V is stable there is simply no way through which taxes and

government spending can exert any influence. Monetarists also claim that markets are

sufficiently competitive such that How and What would be solved efficiently without the

visible hand of government and that prices and wages are relatively flexible. Since M drives

nominal GNP and since wages and prices are fairly flexible around potential output, this

implies that money moves real output only modestly and for a short period. The main effect

of M is on P. Thus except for a short period M moves mainly prices, fiscal policy moves

nothing, and Y stays near potential output. Associated with the stress on money is also an

emphasis on inflation as a policy problem in contrast to the Keynesians' traditional focus on

unemployment.

As regards the role of monetary policy the monetarists assert that monetary policy can

• prevent money itself from being a major source of economic disturbance;

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• provide a stable background for the economy-keep the machine well oiled;

• contribute to offsetting major disturbances arising from other sources such as large

fiscal deficits through an appropriate rate of monetary growth.

We can summarise the debate between monetarists and Keynesians as it stands as follows.

The Keynesians do not accept the monetarist view that money is all that matters. However,

they do recognize the weakness of their earlier position that money does not matter and

concede that money is important but fiscal policy as well as animal spirits too contributes to

fluctuations in aggregate demand. Monetarists, on the other hand, go to the extreme to

suggest that inflation is always and everywhere a monetary phenomenon. The difference

between the monetarists and the Keynesians now concerns with how monetary policy should

be used for economic stabilization rather than regarding whether monetary policy can affect

output and prices. The debate is referred to as the controversy involving "rules versus

discretions".

While Keynesians favour interventions in economic activity, the monetarists do not.

Monetarists consider the private sector to be inherently stable. They, therefore, advocate a

constant money growth rule, which, according to them, would provide an environment that

permits it to work effectively. According to monetarists, discretionary policies are useless,

misadjusting, and destabilizing in view of the various lags (such as data lag, recognition lag,

implementation lag, and the effectiveness lag) that they involve. Keynesians, on the other

hand, do not accept the constant money growth rule. They see the need for discretionary

monetary and fiscal policies to keep a usually unstable private sector on track. According to

them, policy makers can anticipate shocks and design policies accordingly to combat them.

These developments profoundly affected the course of monetary policy in the 1970s and

1980s. Subject to the existence of a stable relationship between money, output and prices,

monetary management favoured prescriptions of a money target consistent with the

macroeconomic objectives.

Around the late 1970s, the so-called New Classical Economics came into prominence

subsequent to the work of Lucas, Sargent, Wallace, McCallum, Barro, and others. With the

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rational expectations hypothesis of the new paradigm in macroeconomics came a new line of

criticism of Keynesian analysis and the consequent policy ineffectiveness proposition. The

rational expectations revolution revived interest in the money-neutrality proposition and

provided a new direction to monetary policy formulation.

The monetarist arguments are based on the assumption of an adaptive expectations

hypothesis whereby economic agents adjust current expectations solely in the light of errors

committed in the previous periods. In contrast, in a rational expectations world, individuals

form their expectations on the basis of rational judgment in a forward-looking framework;

they are assumed to utilize all available information and knowledge about the working of the

economy to form expectations. That means, apart from random events, people's expectation

about future fully reflect the actual events. An implication of this is that since expected

events are the same as actual events, discretionary policies are ineffective in influencing real

economic variables. Thus the transmission of monetary impulses to economic activity could

be observed only in case the monetary shocks are unanticipated. The initial interpretations of

this paradigm are that, in any macroeconomic model, the assumption of rational expectations

would render monetary policy ineffective in influencing real output, both in the short-run and

long-run. Hence there is no role for monetary policy in output stabilization; and the general

conclusion that follows is that governments should abstain from active demand management

policies (especially monetary policy). Subsequent research demonstrated that it is the

interaction of the rational expectations hypothesis and an assumption of perfectly flexible

wage and I or prices that generates the policy ineffectiveness proposition. The outgrowth of

this insight is the ''New Keynesian" approach.

The New-Keynesians, on their part, recognize the role of rational expectations. In their

response to the New Classical theory, they explain how markets could fail to clear even in

the presence of rational agents because of inherent rigidities. The arguments for price

rigidities center on imperfect markets, long term contracts, co-ordination failures and

information costs. In a world of imperfect competition since output tends to be lower and

prices higher, social welfare gets adversely affected. This could be taken care of through

government intervention. As such there exists a reasonable case for fiscal and monetary

- 18-

policy to play an active role in the real world as opposed to the prescriptions put forward by

the New Classical School.

The Real Business Cycle models appeared on the scene during the 1980s and 1990s building

on the contributions of Kydland and Prescott. They focus on non-monetary factors as the

driving forces behind business cycles. The advocates of Real Business Cycle theory launched

the fiercest attack, citing policy irrelevance in the conduct of monetary policy. The

proponents such as Plosser, King and others argue that the causation is reverse in that it is

real shocks to the economy such as innovations in technology that generates monetary

disturbances. Therefore there is no scope, whether in the long run or short run for monetary

policy to affect the economy. As a matter of fact, money seems to have largely disappeare~

from discussions on monetary policy in recent times. As King (2002) notes: " .... There is a

paradox in the role of money in economic activity. It is this: that as price stability has become

recognized as the central objective of central banks, the attention actually paid by central

banks to money has declined."

The changing views of the role and effectiveness of monetary policy do not point to any

definite conclusion. The debate over the issue remains live and real in the contemporary

macroeconomic thinking. The Monetarists as well as the Keynesians continue to hold their

beliefs although as a result of intense debate and cross-fertilisation of ideas over the years the

two major schools have come closer to each other. Besides, it appears· that the policy

ineffectiveness proposition of the New Classical School stands on certain extreme

assumptions, pointing to a number of constraints that could be faced in any meaningful

conduct of monetary policy. Nevertheless, there seems to be a near consensus that sustained

money supply growth in the long run will show up in prices rather than in any significant

impact on output. International empirical evidence too exhibits such trend. This in tum leads

to the view that in developed countries price stability should be regarded as the single I

primary objective of monetary policy. However, although some analysts are skeptic about

whether discretionary monetary policy can effectively dampen economic fluctuations, the

general view is that monetary policy definitely has a role in influencing stability and growth

of an economy in the short run.

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2.2. RELEVANCE OF MONETARY POLICY IN THE DEVELOPING

COUNTRIES OR EMERGING MARKET ECONOMIES (EMEs)*

In developing countries the scenario with respect to the role and effectiveness of monetary

policy is somewhat different. It has generally been acknowledged that monetary policy can

play a limited role in the developing countries. Several reasons such as the existence of a

large non-monetised sector, the narrow size of the money and capital markets coupled with a

limited array of financial stocks and assets, a high proportion of currencies in the total money

supply, the presence of non-bank financial intermediaries, a high level of liquidity enjoyed

by commercial banks (in some cases) are advanced to explain the restrictive role.

However, notwithstanding the limitations, some unique problems faced by the developing

countries make the case for activist monetary policy.

I. In developing countries, concentration of output usually in a smaller range of goods

and services and relative underdevelopment of financial markets make diversification

of risks very difficult. These countries thus become more vulnerable to shocks-both

internal and external, which underscores the need for counter-cyclical mol)etary

policy.

2. The underdeveloped state of financial and non-financial markets in developing

countries might inhibit the operation of market forces in some spheres of economic

activity. This may induce the authorities to use monetary policy to direct credit to

sectors regarded as central to the nation's development strategy. The credit

availability channel of monetary policy transmission thus assumes a special

significance for growth in developing countries, which have large unutilized potential

of real resources, but inadequate financial resources and external financing

constraints reflect a gap between the potential investment of various sectors and the

availability of internal funds to meet such financing needs.

3. Due to various structural rigidities, control of inflation through a typical

contractionary policy may not be easy in developing countries. The root cause of

• Major references used for this section: Ghatak (1995); Jadhav (2003); Pandit et. al (2006).

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inflation could be a fiscal distortion like a high fiscal deficit. A supportive monetary

policy by complementing fiscal discipline can contribute to offsetting major

disturbances arising from large fiscal deficits through an appropriate rate of monetary

growth.

4. Most of the developing countries are generally vulnerable on the balance of payment

(BOP) front. They also suffer from limited and uncertain access to international

capital market. A larger role could, therefore, be assigned to monetary policy for

maintaining orderly conditions in their BOP.

5. Since in developing countries inflation affects relatively the poorer sections of the

society, who have almost no hedges against it, there is a social dimension of monetary

management in these countries. Monetary policy is required .to ensure that inflation

is kept below the level beyond which the adverse consequences begin to set in.

Apart from the theoretical evolutions discussed in section 2.1, the radical transformation

of the financial environment that have occurred in consequence of the impact of

liberalisation and financial innovations during the 1990s have influenced central banking

in industrially advanced countries in several ways. These in turn have considerably

impacted monetary policy making in developing countries like India in recent times.

Thus alongside the emergence of price stability as the major goal, safeguarding the

financial stability has gained importance in the conduct of monetary policy due to

growing concern for preventing financial crises. Prescriptions of prudential norms and

effective supervision have also emerged as major policy concerns in order to guard

against the liquidity and credit risks that arise in the process of executing transactions,

which have grown both in volume and value.

2.3. ALTERNATIVE CHANNELS OF THE MONETARY POLICY TRANSMISSION

MECHANISM

The monetary policy transmission mechanism (MTM) is the term used to describe the

various routes through which changes in monetary policy affect output and prices in an

economy. It usually depicts the impact of a change in the monetary policy instrument (e.g.,

short-term interest rates or base money) on intermediate variables (e.g., broad money or

domestic credit) and final objectives (output and inflation). The major channels of the MTM

that have been identified in modern financial systems are the interest rate channel; the credit

channel; the asset price channel; and the exchange rate channel. How these channels function

in a given economy depends on its financial structure and macro-economic environment.

There are detailed surveys of literature in this area (Mishikin, 1995, 1996, 2001; Taylor,

1995; Bernanke & Gertler, 1995; Walsh, 1998). We present here a brief description of these

channels.

• Interest Rate Channel

The interest rate channel is the most conventional model of monetary transmission. It is also

called the money view or money channel. The channel works through the direct interest rate

effects -- which affect not only the cost of credit but also the cash flows of debtors and

creditors. A shift in policy leads to a change in money supply that for given money demand,

leads to a change in money market interest rates. This in turn leads to changes in bank loan

rates for borrowers, which may affect investment decisions, and in deposit rates which may

affect the choice between consuming now or later. There will thus be a corresponding impact

on aggregate demand. The propagation of monetary policy actions along the term structure of

interest rates depends upon various factors including the organization of financial markets

and the state of expectations. Using the simple scheme of Mishkin (1995), the traditional

interest rate channel can be represented as follows:

A M => A r => { A II AC } => A Y

A monetary contraction (expansion) increases (decreases) the nominal interest rate (liquidity

effect). An increase (decrease) in the nominal interest rate gets reflected in a corresponding

increase (decrease) in the real rate of interest due to rigidities. This in turn decreases

(increases) both investment and consumption and thereby leads to a fall (rise) in output.

• Credit Channel

The traditional interest rate channel is not sufficient to explain several stylised facts

(Bernanke -& Gertler, 1995). In order to account for these facts it has proved useful to

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broaden the analysis and include the banking sector. In countries with poorly developed or

tightly regulated financial systems, monetary policy is likely to affect aggregate demand

more by altering the quantity or availability of credit than through the effects of changes in

the price of credit (interest rates). This is true especially when lending controls or guidelines

on the quantity of credit itself are present as it happens in several developing countries.

Binding ceilings on interest rates often force banks to use non-price means of rationing loans

and thus enhance the role of the credit availability effects. Moreover, direct government

involvement in the loan market either through official development banks or through fiscal

subsidies of commercial bank loans produces similar effects. Even in liberalised highly

developed markets, credit changes operating in addition to interest changes have been

identified as important factors influencing economic activity. The credit channel can be

considered under two streams:

(a) Bank-Lending Channel

The bank-lending channel operates through changes in banks' balance sheet items, i.e., in

deposits and loans. A monetary shock affects the availability of loanable resources on the

liabilities side of the banks' balance sheet. An expansion, for example, increases these funds

and induces lending on the part of the banks both directly and indirectly, which creates an

increase in the cash flow to firms and households. This in turn enhances their spending and

output rises. On the other hand, a contraction in high-powered money reduces deposits or

their rate of growth. A banking sector balance sheet constraint limits the ability to lend and

thus creates cash flow and other problems at the firm and house hold level. Perception of

these problems further complicates the supply of funds on the part of banks. Thus

expenditure is credit-constrained and output falls. Using the Mishkin framework, the

operation of the bank-lending channel can be represented as:

!1M => !1 deposits => !1loans =>firm problems => !1loans => { !1 I I !1C } => !1 Y

(b) Balance Sheet Channel

Monetary policy may affect the availability of credit more directly through effects on the

value of assets of both borrowers and lenders. As changes in monetary conditions lead to

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changes in asset prices, the value of collaterals for bank loans may be affected. This impact

on the value of collateral of borrowers may induce changes in the access of borrowers to

credit. In addition, where a large proportion of bank assets is invested in equities or real

estates, decline in asset prices reduces their capital-asset ratios. This could force banks to

tighten the supply of credit. This has an adverse effect on investment and demand.

Schematically, the operation of the balance sheet channel is as follows:

L\ M :::::> L\ r :::::> L\ asset prices :::::> L\collateral values :::::> L\ borrowing :::::> A I :::::> A Y

• Asset Price Channel

Policy induced interest rate changes also affect the level of asset prices, particularly those of

bonds, equities and real estates in the economy. Higher short-term interest rates may lead to a

decline in bond prices where long term fixed interest bond markets are important. As such

markets develop; this channel of transmission may be strengthened.

Another means by which asset price changes triggered by monetary policy actions can affect

aggregate demand is described by the so-called q-theory of investment, pioneered by James

Tobin. For example, if the· monetary policy stance happens to be easier, equity prices may

rise. This would lead to an increase in the market price of firms relative to the replacement

cost of their capital. This, in tum lowers the effective cost of capital as newly issued equity

can C9mmand a higher price relative to the cost of real plant and equipment. Hence even if

bank loan rates react little to the policy, easing monetary policy can still affect the cost of

capital and hence investment spending. Policy induced changes in asset prices may also

affect demand by altering the net worth of the households and enterprises Such changes may

trigger a revision in income expectations and cause households to adjust consumption. An

increase in interest rates depresses asset prices and the consequent reduction in wealth of

households pulls down their consumption. Similarly policy induced changes in the value of

assets held by firms alter the amount of resources available to finance investment.

Schematically, the asset price channel is:

M-l- (t) :::::> r t (-l-) :::::>discounted cash flow -l- (t) :::::>Tobin q -J.. (t)=:>I -J.. (t) :::::> Y-l-(t)

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These effects on demand and prices can get further reinforced through a financial accelerator

mechanism. The initial decline in economic activity, resulting from depression of asset price

and weakening of balance sheet due to an increase in interest rates in tum reduces the cash

flow of firms and households. This further heightens their vulnerability to financial distress

thereby leading to a second round of expenditure reduction. In this way changes in monetary

conditions may lead to prolonged swings in economic activity even if the initial monetary

policy action is reversed soon after.

• Exchange Rate Channel

For an open economy with flexible exchange rates monetary policy induced changes in

money supply or rates of interest can influence the level of income through exchange rates

and net exports (NX). Thus,

M~ (t) => r t (~) => EXCHt (~) => NX~ (t)=>Y~(t)

When the exchange rate is floating, a tightening of monetary policy raises interest rates,

which in tum increases the demand for domestic assets and hence leads to an appreciation of

the exchange rate. This appreciation can feed through to spending through the relative price

effect and the balance sheet effect. The price effect tends to reduce the demand for domestic

goods, which become more expensive relative to foreign goods. The lowering of the

domestic prices for imports due to appreciation of the exchange rate also leads to an increase

in the demand for imports. These lead to a reduction in net exports, and, hence in aggregate

demand.

In many countries households and firms hold foreign currency debt either contracted abroad

or intermediated through domestic banking system. Unless such debts are fully offset by

foreign currency assets, changes in the exchange rate may significantly affect net worth and

debt to asset ratios leading to important adjustments to spending and borrowing. Where

domestic residents are net debtors to the rest of the world, as is the case in many EMEs, a

large appreciation of the exchange rate may lead to an improved balance sheet position that

may give rise to marked expansion of domestic demand. Thus the balance sheet effect tends

to offset and in some cases may even dominate the relative price effect.

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Alternatively, monetary policy interventions in an open economy can impact upon capital

inflows through changes in interest parity conditions. Inflows and outflows of capital, for

instance, respond directly to policy induced changes in interest rates. Schematically, the

capital flow channel can be represented as:

ll. M => A r => ll. interest rate differential => ll.capital flows => ll. I => ll. Y

The following flow charts provide a simplified summary of the monetary policy transmission

mechanism.

Figure 2.3./A.. The Monetary Policy Transmission Mechanism

POLICY RATE

~ ~ ~ 1

Market ~

Exchange Relative Money& Other Asset ~ ""'-Rates Rate Prices ~ Credit Prices -

'1 + ~ ~

Expenditure Net Expenditure Inflation Net & Investment Export & Investment Expectations Wealth

r Expenditure

& Investment

.. ~ , 1 Aggregate Import Aggregate Aggregate Wages Aggregate Demand Prices Demand Demand Demand

! Inflation ... ....

~ Rate

-26-

Figure 2.3./B. Monetary policy transmission channels

[ MONETARY POLICY

I 1 TRANSMISSION CHANNELS

I I

I I

I Interest Rate J I Exchange Rate I I Asset Prices I r1 Credit j--

Bank lending Balance· ,.....

sheet 1-

l REAL ECONOMY I I

Source: Bank of England (1999) and Small & de Jager (2001)

2.4. ANALYTICAL FRAMEWORK OF MONETARY POLICY: A GENERAL

OVERVIEWt

2.4.1. INTRODUCTION

A central bank conducts its monetary policy within a carefully crafted analytical framework

based on a suitably chosen strategy. The analytical framework normally consists of the

objectives, the intermediate and operating targets and the operating procedures focusing on

the instruments employed. In selecting an appropriate strategy, it is to be seen that the

strategy ensures effectiveness, transparency, accountability, flexibility, continuity, and

independence.

2.4.2. ALTERNATIVE MONETARY POLICY STRATEGIES

Following discussions in the literature, we may identify the following strategies that central

banks could consider:

• Interest Rate Targeting

The strategy involves the use of a short-term interest rate (such as the overnight inter-bank

rate) as an intermediate target. This is the primary operating target used by many monetary

tlmportant references for this section are: Devine & McCoy (1998); Andrew Crocket (2002); Bofinger (2002).

-27-

authorities today. That changes in this variable can immediately and accurately be measured

is the advantage of this strategy. However, the effectiveness of this strategy is reduced

because of difficulties in the identification of a rate of interest that is most relevant for

economic decision-making.

• Exchange Rate Targeting

For small open economies, the pegging of exchange rate to an anchor country, which has

reputation of price stability and with which the country has close economic links, is

considered particularly appropriate. Major advantages of this strategy are that exchange rates

are immediately and accurately measured; easily understood by the public; they respond

immediately to changes in the operating target (interest rate); and have a broad impact on the

economy. An important disadvantage of this strategy is that a central bank that pegs its

exchange rate has to give up a substantial degree of control over its domestic monetary

policy. The policy followed by the anchor country may not always fit the requirements of the

pegging country. Another difficulty relates to the formulation of an 'exit strategy' from a

fixed peg when a given exchange rate becomes unsustainable as per market beliefs.

• Nominal Income Targeting

It is often argued that if a central bank focuses solely on price stability then that may

undermine the objective of output stabilisation in the short run. The nominal income I GDP

targeting strategy emerged as a possible solution. However, a nominal income target is

difficult to measure and control because estimates of income growth can be imprecise and

prone to changes over time. Moreover, political complications may arise. If the announced

target is perceived to be too low, the monetary authority might be accused of being anti­

growth.

• Monetary Aggregate Targeting

The strategy was widely adopted in the 1970s following the persuasive advocacy of

Friedman and the Chicago School. The monetary authority targets the supply of a monetary

aggregate--usually a broad measure of money. The supply ofthe monetary aggregate is kept

on a predetermined growth path. The targeted growth in the monetary aggregate is

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determined from estimates of real potential growth in output, any trend in the velocity of

money and an inflation rate deemed consistent with the price stability objective.

Monetary aggregate targeting has the advan~age of increasing the transparency of monetary

policy, limiting the discretion of the authorities, and also making the monetary authorities

accountable for liquidity growth on which they could perhaps be assumed to be having a

more direct control. However, monetary aggregate targeting depends on a stable relationship

between money and prices, i.e., on the stability of the money demand relationship.

• Inflation Targeting

By the end of the 1990s a number of central banks adopted formal inflation targets. The

inflation targeting strategy is currently in vogue in many industrialised countries and an

increasing number of emerging market economies (EMEs) as well. With its focus on the

ultimate target of inflation control, direct inflation targeting has no intermediate target.

However, in practice, following this strategy needs to adjust interest rates such that the

forecasted inflation rate, which becomes de facto an intermediate target, is consistent with

the ultimate target of price stability. To determine the appropriate level of interest rates, the

monetary authority monitors all economic variables that influence inflation including the

growth of money. This contrasts with a monetary targeting approach where the focus is

limited to controlling the growth of money.

A basic rationale for having a formal, quantitative inflation target is the idea .that over the

long run monetary policy can determine an economy's average inflation rate while it cannot.

determine its average output and employment. Yet another hoped-for advantage of having a

formally stated inflation target is that it facilitates monitoring and evaluation of the central

bank's performance by political authorities as well as the public However, an inflation

targeting strategy requires a detailed explanation of the transmission mechanism between

policy instrument changes and inflation to ensure credibility.

• Combined Strategy

In practice, considerable overlap exists between the strategies of monetary aggregate and

inflation targeting. Both pursue the same objective, both are forward-looking and both

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employ a wide variety of indicators. No monetary authority has practiced the pure form of

monetary aggregate targeting. A central bank that adopts monetary aggregate targeting also

monitors a range of economic indicators on which it bases its monetary policy decisions.

However, a particular emphasis is placed on monetary aggregates. Similarly, those

authorities that pursue inflation target, along with a range of economic indicators, also

monitor monetary aggregates in the assessment and designing of monetary policy actions.

Therefore, since neither policy is pursued in its pure form in practice, some combination of

the strategies could well be considered. A strategy that encompasses elements of both

delivers sufficient flexibility.

2.4.3. OBJECTIVES OF MONETARY POLICY

Objectives/ goals/ aims refer to some final or long-term magnitudes with respect to certain

variables of interest such as inflation, output or employment, which policy-makers try to

achieve.

In recent times, there seems to be wide consensus that the chief objective of monetary policy

is to achieve and maintain price stability. An environment of price stability is regarded as

conducive to greater certainty and consequently to savings mobilisation, efficient allocation

of resources and sustainable economic growth.

Price stability literally means zero inflation rates. But it has been found internationally that

the true rate of inflation is below the measured rate in many countries. This means that an

inflation rate of zero would imply price deflation. Hence, price stability, in practice, is

defined as a low and stable rate of inflation conducive to growth.

Monetary policy affects inflation not . directly but via its impact on aggregate demand.

Monetary authorities, therefore, do have a role to play in the stabilisation of output and

employment even if price stability is the goal of monetary policy. This is reflected in the

charters of various central banks, where attainment and maintenance of maximum levels of

output and employment appear as important monetary policy objectives. However, even in

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such cases it is agreed that central banks can contribute to growth and employment objectives

through maintenance of low and stable inflation.

While price stability remains a key objective of monetary policy, central banks in EMEs are

obliged to operate with multiple objectives of price stability, growth, employment and social

justice. This is so because central banks in these countries are assigned an important role in

promoting economic development. Besides, in EMEs that are relatively open, exchange rates

often emerge as a key policy issue. Exchange rate management, thus, appears as another

monetary policy objective in many developing countries.

Globalisation and integration of the economies with the rest of the world have thrown up new

challenges for monetary policy. Swings in trade flows and especially in capital flows have

become common. These have imparted a high degree of uncertainty and volatility to

exchange rates which have serious implications for financial stability. Developments during

the 1990s suggest that while price stability is necessary for financial stability, price stability,

. per se, is not sufficient to generate financial stability (Schwartz, 1995; Mishkin, 1996; Issing,

2003). In recent years, therefore, particularly after the financial crises of the 1990s, the

concern for financial stability has become an integral part of monetary policy formulation.

Apart from price stability and financial stability, availability of credit for productive purposes

remains an important objective of monetary policy at least in developing and emerging

economies. Bank credit is important not only because it finances growth but also because it is

an important channel of monetary policy transmission mechanism. In fact, the credit channel

augments the effects of the traditional interest rate channel.

To conclude, while traditionally central banks have pursued the twin objectives of price

stability and growth, considerations of exchange rate stability and financial stability are also

kept in view while pursuing the basic objectives, particularly after globalisation and

liberalisation. The objectives of monetary policy are inter-related and there are trade-offs as

well, which involve cons~ious policy choices.

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2.4.4. INTERMEDIATE TARGETS

Intermediate targets are variables that policy-makers choose to focus on because the ultimate

targets are difficult to monitor or control by contemporaneous policy actions. They are the

variables that provide information on current and future behaviour of objectives. Variables

that could be used as indicators, are money supply, bank reserves, and bank borrowing from

the central bank, exchange rate and interest rates (if not administered).

Intermediate targets I indicators are required due to the uncertainty that arises between the

use of policy instruments and the ensuing effectiveness in achieving the objectives. The

uncertainty results from the long lags and complexity in the transmission of policy actions

and the consequent impact on inflation. Intermediate targets also guide policy decisions of

the monetary authority and facilitate the communication of policy actions to the public.

The choice of the intermediate target is very critical. A variable to be considered as an

appropriate target for monetary policy should (a) bear a stable and predictable relationship

with the ultimate objectives and (b) be amenable to direct central bank control in a

reasonably predictable manner. The selection of the intermediate target is also conditional on

the channels of transmission of monetary policy. Thus in the choice of targets there is always

a trade-off between controllability of the target and the attainment of the end objective.

The concept of a formal intermediate target actually took shape with the monetarist

persuasion of money targeting in the 1960s (Friedman, 1968). In the 1970s, evidence of a

stable relationship between money, output and prices (the basic requirement of money

targeting) prompted central banks to give more weight on money in their policy

deliberations. A number of central banks in the developed countries including Germany,

Japan, the UK and the USA adopted money targets in the mid-1970s.

During the 1980s, a spate of financial innovations started imparting volatility to the

behaviour of monetary aggregates and the velocity of money especially in market-based

economies like the US. The consequent instability in the demand for money functions

undermined the efficacy of monetary targeting. Central banks in those countries, therefore,

started de-emphasising the role of monetary aggregates in the conduct of monetary policy.

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They have either switched over to a 'menu' or 'check list' approach or have abandoned

monetary targeting altogether. However, in bank-based economies, especially in Europe

(e.g., France, Germany and Switzerland), financial innovations led to substitution towards

instruments that could be considered as part of money and thus could be accommodated by

simply redefining monetary aggregates. As such money demand continued to remain

relatively stable in those countries. In view of this, in some advanced countries monetary

aggregates continue to have importance in the process of monetary policy formulation.

At the instance of advanced countries, developing countries also began to adopt money

targeting in the 1980s. A money target is deemed particularly important in their case because

quantity-based channels dominate the process of monetary policy transmission and the

absence of developed financial markets renders price signals less reliable in these countries.

Money targets are also seen as the most effective way to discipline government finances.

With shifts away from monetary targeting regime, short-term interest rates have emerged as ·

the operating target of monetary policy in many economies; both developed and developing.

However, due to the absence of fully developed and integrated financial markets, central

banks in EMEs still need to rely on quantitative targets in their conduct of monetary policy.

Particularly, due to high information and transaction costs, credit markets continue to be

regulated in order to direct the flow of credit to productive sectors of the economy. Thus

even if short term interest rates are used in these economies, monetary policy still aims to

influence aggregate demand by altering the availability of credit along with changes in the

price of credit. Therefore money targets although, diminishing in importance, still play a

major role in the transmission mechanism.

A number of central banks have also switched away from any sort of intermediate target.

These are the inflation targeting central banks that directly target inflation. The adoption of

inflation targeting in EMEs, however, is complicated by the lack of fiscal, financial and

monetary institutions (Mishkin, 2004).

With various uncertainties in respect of the current and prospective functioning of the

economies increasing since the 1990s due to ongoing structural reforms and financial

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globalization, central banks find a single or limited set of indicators insufficient to guide

monetary policy formulation. Thus many of them now follow a multiple indicator approach

and monitor a large number of macroeconomic indicators, which carry information about the

ultimate objectives.

2.4.5. OPERATING PROCEDURES

Operating procedures refer to the implementation of monetary policy by central banks

through various instruments and are designed to be applicable to whatever strategy is finally

chosen. The instruments provide the means through which a central bank can control its

operating target , signal the stance of monetary policy adequately and precisely , make it

capable of providing and withdrawing liquidity and influence the structure of the banking

system vis-a-vis the central bank.

Depending on the strategy chosen, an intermediate variable is targeted. This target variable is

attained through steering the operating target. For controlling the operating target a range of

monetary policy instruments and procedures are employed. Central banks normally adopt

either bank reserves or a very short-term interest rate (usually the overnight inter-bank rate)

as the operating target.

The instruments that a central bank has at its disposal can be broadly classified into direct

and indirect instruments. Typically, direct instruments include required cash I liquidity

reserve ratios and credit and interest rate directives. The directives may take the form of

prescribed targets for allocation of credit to preferred sectors I industries and prescription of

deposit and lending rates. The indirect instruments generally operate through the price

channel. They include repurchase (repo) and open market operations (OMOs), standing

facilities (refinance) and market based discount window.

The practical choice between direct and indirect instruments is not easy. Direct instruments

are effective. But they are considered inefficient in terms of their impact on the financial

markets. On the other hand, the use and efficacy of indirect instruments depend on the extent

of the supporting financial markets and institutions.

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Monetary policy is implemented by fixing a range of value of an operating targe~. The choice

of an appropriate bandwidth for the target range is, however, beset with a trade-off between

flexibility and credibility. The target range should, in practice, try to ensure a balance

between the two attributes. The choice of an appropriate time horizon within which the target

is to be attained also requires a balance such that it is neither too long nor too short.

Considerations of inflationary expectations demand the target to be sufficiently current to be

relevant to policy makers while a very short time horizon may force the monetary authority

to respond to shocks which would otherwise fade out in the long run in an effort to reach the

target within the time frame.

The choice of the range is equivalent to setting a rule for monetary policy. Various rules have

been proposed in the literature such as the money rule (changes in money supply at a

predetermined rate), the Taylor rule (change in interest rate based on deviation of growth and

inflation from their potential I desired values) etc. A rule-based system imparts transparency

by providing certainty about future policy response. However, such a system is inflexible and

it becomes ineffective in its response to unanticipated shocks. In practice, therefore, central

banks follow an approach of constrained discretion.

Besides, there is the issue of deciding on the manner and means of communicating monetary

policy actions to the public. The publication of a target, details of its deviations and the

policy responses of the central bank thereto is desirable.

In response to financialliberalisation the operating procedures of monetary policy have been

changing all over the world with an increasing shift away from direct to indirect instruments.

This is in consonance with the preference for market-based instruments reflecting the market

orientation of monetary policy. Most central banks have, therefore, gradually de-emphasised

the use of reserve requirements and prefer OMOs as a tool of monetary policy. Alongside

advanced economies, the operating procedures of monetary policy in EMEs have also been

undergoing similar changes. The CRR has, however, remained a powerful instrument of

monetary policy in developing economies since their financial markets are not yet mature

enough for OMOs.

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The operating procedures of monetary policy most central banks now pursue have largely

converged to one of the following three variants (Jadhav, 2003):

~ A number of central banks estimate the demand for bank reserves and then carry out

OMOs to target short-term interest rates.

~ A second set of central banks estimate market liquidity and carry out OMOs to target

bank reserves, while allowing interest rates to adjust.

~ A third set of central banks modulates monetary conditions in terms of both the

quantum and price of liquidity, through a mix of OMOs, standing facilities and

minimum reserve requirements and changes in the policy rate with the aim of

containing the overnight market interest rate within a narrow corridor of interest rate

targets.

FIG. 2.4.1. An Analytical Framework of Monetary Policy

Standing facilities -deposit -lending

Direct inflation targeting

Inflation

Open market operations

term interest rate

Hybrid­intermediate target plus principal indicator

PRICE STABILITY

Source: Devine & McCoy (1997)

Minimum reserve requirements

Monetary aggregate targeting

Broad

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Instruments

Operating Target

Monetary strategy

Intermediate Target

Ultimate Target I Objective

2.5. ANALYTICAL FRAMEWORK OF MONETARY POLICY-THE INDIAN

SPECIFics+

Against the backdrop of the general overview of the analytical framework of monetary

policy, we now attempt a brief review of the conduct of monetary policy in India.

2.5.1. OBJECTIVES

Monetary policy in India is an arm of economic policy. Hence its objectives are no different

from those of the overall economic policy. The Reserve Bank of India (RBI) formulates and

administers monetary policy in India. It has since independence till the 1990s, broadly

pursued the twin objectives of (a) maintaining a reasonable degree of price stability and (b)

ensuring an adequate flow of credit to productive sectors of the economy to help accelerate

the rate of economic growth. The relative emphasis between the two objectives has varied

over time depending on evolving circumstances. In essence, the aim has been to maintain a

judicious balance between price stability and growth. This is so because even if the two

objectives complement each other in the long-run, in many contexts there might be short-run

trade-offs between them.

Initially, this spirit oflndia's monetary policy was set by the First Five Year Plan document

through the concept of developmental central banking. It required the RBI to expand the

supply of credit and money commensurate with the rapid development and diversification of

the economy. This excessive expansion exercise naturally led to rising prices and endangered

macroeconomic stability. This provides reasons behind the adoption of the policy of

"controlled expansion", i.e., a policy of "adequate financing of economic growth and at the

same time ensuring reasonable price stability".

By the 1960s, conduct of monetary policy was reduced to a passive accommodation of

budget deficits resulting from growing public investments undertaken to ensure rapid

: Maj~r references used for writing this section include Ahluwalia et.al (2002); Bhole (1985); Gupta (2002,

2003); Jadhav (2003); Jalan (1992, 2002); Joshi & Little (1994); Mohanty et. al (1997); Reddy, Y.V. 1990d,

2002, 2004); ROCAF (2003-04)

economic growth. This began to spill over to inflation. Concerns, therefore, began to be

expressed over the inflationary consequences of large fiscal deficits. The concerns gathered

momentum during the 1970s as inflation trended up to 9% during the period. In the light of

persistent high inflation, the Chakraborty Committee (1985) recommended that price stability

should be considered as the dominant objective of monetary policy in India. It was

recognised that price stability provides monetary stability and with it the atmosphere and

environment needed for promoting growth and attainment of social justice. The Chakraborty

Committee presumed precisely the target of 4% as the acceptable rate of inflation. Against

this, the objective of monetary policy has been to keep the inflation rate around 4 to 5

percent.

However, questions have often been raised about the efficacy of monetary policy in

containing inflationary pressures by itself since in developing countries like India frequent

supply shocks, presence of structural imbalances and fluctuations in agricultural output have

an important bearing on prices. Nevertheless, it has widely been agreed that a continuous

increase in prices cannot occur unless it is sustained by excessive monetary expansion.

According to Dr. Rangarajan (1995), "Money also matters" must be distinguished from

"Money does not matter" or "Money alone matters." The control of money supply thus has

an important role to play in any scheme aimed at controlling inflation in India.

The case for price stability as the dominant objective gathered momentum in the early years

of financial liberalisation. Price stability was seen to be critical to sustain the process of

reform (RBI, 1993). This acquired a new urgency as strong capital flows after the

liberalisation of the external sector began to push inflation up. The very fact that inflation

could be reined in during the second half of the 1990s by tightening monetary conditions

appear to demonstrate the potency of monetary policy in ensuring price stability (RBI, 1997).

There is now a wide consensus that price stability should continue to be a key objective of

monetary policy in India. However, whether price stability should be the sole over-riding

objective of monetary policy has emerged as the major issue of debate in recent years.

-38;.

There has been a conscious attempt on the part of the RBI in recent years to maintain orderly

conditions in the forex market and to curb destabilising and self-fulfilling activities. This has

assumed strategic importance with the opening up of the Indian economy and in the face of

growing cross-border capital flows. Accordingly, financial stability is now being recognised

as a key consideration in the conduct of monetary policy in terms of (a) ensuring

uninterrupted financial transactions; (b) maintenance of a level of confidence in the financial

system among all the participants and stakeholders; and (c) absence of excess volatility that

unduly and adversely affects real economic activity (Reddy, 2004a).

To sum up, in a broader framework, the objectives of monetary policy in India continue to be

price stability and growth. These are pursued inter alia through ensuring credit availability,

exchange rate stability as well as overall financial stability. All these reflect the overall

objectives of economic policy.

2.5.2. INTERMEDIATE TARGETS

The RBI did not have a formal intermediate target till the 1980s. Bank credit-aggregate as

well as sectoral-came to serve as a proximate target of monetary policy after the adoption

of credit planning from 1967-1968 (Jalan, 2002). Credit targeting, in fact, fitted well into the

concept of developmental central banking.

Money supply and the volume of bank credit were considered as the two major intermediate

variables. But the RBI sought to control the former through the latter. The basic premise of

the Reserve Bank's policy had been that variation in bank credit was the major factor, which

influenced economic activity in India.

The RBI sought to regulate the volume and direction of the flow of bank credit in the light of

its return flow in the slack season and demand for it in the busy season. The action used to be

taken in accordance with the estimate and judgment about the capacity of banks to advance

credit. This in tum was based on the information about the rate of growth of resources,

particularly deposits of banks. Although the Bank did try to regulate bank credit in general,

the attention had come to be necessarily concentrated on the regulation of bank credit to the

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private or commercial sector. After the nationalisation of 14 major commercial banks in

1969, increased emphasis was placed on the flow of credit to the priority sectors of the

economy.

During the 1960s, even though money supply continued to be governed by the expansion of

bank credit, the Reserve Bank began to pay greater attention to movements in monetary

aggregates. Narrow money was the monetary aggregate in use then for policy purposes. This

was due to the dominant viewpoint that a broader monetary aggregate would be difficult to

control. Reserve money was not considered very relevant within the policy framework. The

relative neglect of reserve money reflected the perception that a large part of reserve money

was outside the control of the Reserve Bank. The money multiplier in such circumstances

was regarded as volatile and as a mere ex-post mechanistic formula (Jalan, 2002).

When the financial system was not well developed and had not diversified, the use of bank

credit, as the most important indicator was not inappropriate. But with macroeconomic

developments and diversifications questions about the relevance of using bank credit as the

primary target of monetary policy began to arise. The elaborate process of credit regulation

impeded resource allocation by segmenting credit markets. The conduct of monetary policy

in such a framework was very difficult and its overall demand management stance was often

undermined by exemptions granted for specific sectoral credit allocations. The pre­

occupation with bank credit and that too with bank credit to the private sector as an indicator

I target of monetary policy needed to be changed.

By the early 1980s, the consensus that continuous inflation was predominantly the outcome

of a continuously excessive monetary expansion generated by the monetisation of fiscal

deficits also provided grounds for targeting money supply directly.

In this scenario, the Chakraborty Committee (1985), which formed the main basis of

monetary policy in India since the mid-1980s, recommended a monetary targeting strategy to

be pursued. Accordingly, monetary policy in India used to be conducted tilll9.97-1998 with

broad money (M3) as an intermediate target. Based on estimates of the expected rate of

growth in real income and a tolerable level of inflation the targeted monetary expansion used

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to be set. For aiming at the intermediate target (M3), the underlying operating target was

reserve money, particularly bank reserves. There was, therefore, a desired level of reserve

money expansion consistent with the targeted level of broad money expansion. The order of

reserve money expansion, however, had to be consistent with the likely fiscal and external

payments position since the main sources of reserve money expansion are the net RBI credit

to Government and net acquisition of foreign exchange assets. The targeted expansion used

to be publicly announced through the Governor's statement on monetary and credit policy.

As the process of money creation is simultaneously a process of credit creation, it was also

required to estimate the increase in credit needed by the projected increase in output. The

RBI, in practice, did not adopt a mechanically fixed money supply growth rule. Rather it

followed a flexible monetary targeting approach, which allowed feedbacks from

developments in the real sector.

As mentioned above, a stable demand function for money and a stable and predictable money

multiplier condition the applicability of a monetary targeting framework. A number of

studies did suggest that the money demand function in India has remained fairly stable with

respect to a select set of variables. In fact, factors such as financial innovations and large

movements of funds across the border, which have contributed to instability in demand for

money in the industrial economies, were then yet to have any major impact in India. Studies

have also supported the stability of the adjusted money multiplier. Given these and the

problems of information and lags in policy formulation, there was certainly a case for

monetary targeting, a! beit, not a rigid monetary target.

The growing complexities of monetary management consequent upon the process of

financial liberalisation, which gathered momentum in the 1990s, called for a re-look at the

efficacy of broad money as an intermediate target of monetary policy. This was reinforced by

the monetary experience during 1997 ahd 1998 when external shocks-most notably during

the East Asian crisis-impacted the Indian economy. Besides, there was the concern about

the stability of the money demand function in the context of emerging financial innovations

and deregulation of interest rates during the 1990s.

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In this connection, we may quote Dr. Bimal Jalan from his observations in the Monetary and

Credit Policy Statement of April, 1998: "Most studies in India have shown that money

demand functions have so far been fairly stable. However, the financial innovations that have

recently emerged in the economy provide some evidence that the dominant effect on the

demand for money in the near future need not necessarily be real income as in the past.

Interest rates too seem to exercise some influence on the decision to hold money".

The contemporaneous report of the Working Group on Money Supply (1998) also made

similar observations.

The RBI, therefore, formally switched away from monetary targeting and broad based its list

of policy indicators. In 1998, it adopted a multiple indicator approach. Besides, broad money,

a host of macroeconomic indicators including interest rates or rates of return in different

markets along with such data as on currency, credit extended by banks and financial

institutions, fiscal position, trade, capital flows, refinancing and transactions in foreign

exchange, available on high frequency basis are juxtaposed with output data for drawing

policy prescriptions in the process of monetary policy formulation.

In the new framework, although the exclusive use of a monetary aggregate has been de­

emphasised, it remains an important indicator of monetary policy stance perhaps due to the

following reasons:

1. the quantity of money continues to play an important role in determining prices;

2. money demand functions in India have remained relatively stable; and

3. money stock target is relatively well understood by the public at large since it gives a clear

signal to market participants.

2.5.3. OPERATING PROCEDURES

The relative efficacies of the various instruments and the environment in which they have

been applied have undergone significant changes over time, particularly during the 1990s.

Accordingly, we discuss the operating procedures of monetary policy with reference to two

sub-periods: prior to 1990s and in the 1990s and onwards.

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• Operating Procedure-Prior to 1990s

The Reserve Bank has had a range of monetary policy instruments at its disposal, which

included both direct (quantity) and indirect (price) instruments with their relative importance

changing from time to time.

The Bank Rate (BR) has been an important instrument of monetary policy in India since pre­

independence days. It has been the signaHng rate and has been used to regulate refinance

available to banks from the RBI against rediscounting of eligible papers. The objective has

been to change the cost and availability of refinance and to change the amount of lendable

resources of banks in accordance with the short-term aim to meet seasonal needs for funds

and the long-term aim to limit the expansion of credit.

However, the role of the BR as an instrument of monetary policy was limited in India due to

the underdeveloped nature of the bill market and a part of the market (unorganised part) not

being under the control of the RBI. Changes in the BR have been infrequent during the

period. The RBI started with a cheap money policy and had fixed a low BR (3%) and did not

change it till Nov. 1951 when it was raised to 3.5%. The BR was changed ten times between

1951 and 1981 among which the downward change was only once (1968). It remained

particularly static in periods 1951-57, 1958-62 and 1974-81. The gradual rise in BR was to

10% in July 1981. Thereafter it remained unchanged for another ten years (1981-91). It was

raised to 11% in July 1991 and further to 12% in Oct. 1991. The BR then again lost its

significance till the announcement of its reactivation in April1997.

Thus, on the whole, there has been a hesitation on the part of the RBI to change BR rapidly,

boldly and as many times as required despite substantial growth in the financial sector and

the pressures on liquidity growth that price level exerted at different points of time during the

period (Bhole, 1985).

The unwillingness to change straightaway the BR led the RBI to experiment with various

differential interest rate systems. Initially this was in the form of a 'quota cum slab' system

introduced in Oct. 1960. This was followed by a similar one based on the net liquidity

-43-

position of borrowing banks in Sept. 1964. Under the quota cum slab system, banks were

given a basic quota equal to a certain percentage of the statutory cash reserve that could be

borrowed at BR with additional quota available at higher rates. Also different slabs were set

in such a way that as banks moved from lower to higher slabs they were required to pay a

higher interest rate. Since the system made no distinction between banks with different asset

distribution it was replaced by the Net Liquidity Ratio (NLR) system in 1964.

Under the NLR system, the interest rate charged by the RBI came to be linked with the level

of a given bank's net liquid assets as a percentage of its demand and time liabilities. For

every percentage point drop in the ratio, the cost of borrowing from the RBI increased. This

system was in operation between 1964 and 1975. The minimum NLR was increased from

28% in 1964 to 39% in1974. The ratio was most actively used in 1971 and 1973 (in each

year it was raised thrice upwards). The minimum NLR acted like an escalator clause. By

raising it the RBI tried to induce banks to lend less to the commercial sector and utilise more

of the deposits for holding liquid assets.

Two other instruments deserve mention in this context. Refinance used to be automatically

available under the traditional BR technique. With effect from Nov. 1973, refinance facilities

wefe made available on a semi-discretionary basis and quantitative ceilings were imposed on

the availability of refinance. Under this system of discretionary cum quantitative rationing of

refinance, the BR continued to exist but its importance suffered a further setback because

now the control of refinance came to be effected through non-price measures. Since May

1977, all refinance and rediscounting facilities were placed on a discretionary basis except

for the amount provided by banks for public procurement and distribution of food, exports

and small-scale industries. Although variations in discretionary lending by the RBI

(refinance) lead directly to changes in high-powered money, this was not very effective in

practice. This is because refinance was primarily aimed at favoured priority sector activities

and was thus varied within narrow limits. The adoption of quantitative credit control

technique appears to have been under the illusion that it would take care of both the pattern

and volume of credit independently of what was happening to high-powered money. But with

many years of overshooting of credit targets, the illusion was dispelled. On the whole, the

new system was not much conducive to the effectiveness of monetary policy.

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Prior to 1990s, the administrative regulation of the interest rate structure has been used as an

important technique of monetary management in India. Almost all interest rates in organised

financial markets were set through administrative fiat. In some cases the precise level was

fixed, in others there were ceilings or floors or both. This applied not only to interest rates

relevant to Government's own borrowing and lending but also to commercial banks, other

financial institutions and even to corporate deposits, debentures and preference shares. The

only exception was the rate of return on ordinary shares.

The RBI started fixing lending rates of banks since 1960. The regulation of lending rates,

ipso facto, led to the regulation of deposit rates since 1964. This was done mainly to maintain

a balance between the lending rates and the cost of funds. The lending rates and deposit rates

were changed normally along with change in BR till about 1975 to bring about an

appropriate alignment between the BRand other rates. Afterwards, however, other rates have

often been changed without changing the BR. This was perhaps an official acceptance of the

defunctness of the BRas the most important link in the structure of interest rates.

The administered interest rate policy appears to have been designed to serve two purposes,

namely, to support the activities of particular sectors and groups through preferential lending

rates and to finance the Government's large borrowing programmes as cheaply as possible.

In fact, particularly since 1970, multiple interest rate prescriptions were put forward based on

a variety of criteria such as economic activity, commodity, location, specific group of

borrowers etc. In this process, an element of cross-subsidisation got built into the system and

it became increasingly complex, resulting in market fragmentation. The complex structure

virtually left no role for market forces to play in pricing and allocation of credit. It also

adversely affected the viability of banks by reducing their profitability. To limit this, the

deposit rates had to be kept low while the lending rates were set very high. The real yield on

Government securities was negative in most years between 1970 and 1985. All this has

materially contributed to the weakening of monetary policy in India. Accordingly, the

Chakraborty Committee (1985) made a number of recommendations to rationalise the

existing system in pursuance of which various reform measures started being taken since the

latel980s.

-45-

For regulating the lendable capacity of banks, reserve requirements have been the direct, easy

to use and very powerful tools in the hands of the RBI. They consisted of two ratios-the

Cash Reserve: Ratio (CRR) and the Statutory Liquidity Ratio (SLR). With the gradual

downgrading Jf the BR as an instrument of monetary policy, the two ratios became the active !

policy instruments, particularly since the 1970s.

Under the RBI Act 1934, banks are required to maintain a certain percentage of their deposit

liabilities in the form of cash balances with the RBI. This is the CRR. The SLR refers to the

liquid assets which the banks have to maintain (in the form of cash, gold and unencumbered

Government securities), over and above the cash under CRR, as a certain percentage of their

total demand and time liabilities under Section 24 of the Banking Regulation Act 1949.

Till 1962, two separate cash ratios were fixed in respect of demand liabilities (5%) and time

liabilities (2%). In 1962, the separate cash ratios were merged and CRR came to be fixed as a

percentage of both types of liabilities with the maximum of 15%. The actual minimum cash

ratio fixed in 1962 was 3%. Since Nov. 1973, the Bank also had the provision of using a

marginal CRR. Although the RBI was empowered to vary the CRR between 3% and 15%

since 1962, it remained unchanged for the next ten years or so. Thereafter, however, this

technique has been actively and quite flexibly used to control money supply and the volume

of credit. During a period of about 9 years (June 1973-January 1982), the CRR was changed

13 times with 3 downward changes. Within this period, 1973, 1974 and 1981 were the years

of most active use of this technique. Until 1981, the maximum level reached by CRR was

9%. However, the upward trend, which started in 1973, took it to its legal upper limit of 15%

in early 1991.

The trend in SLR has also been firmly upward. Although the original Act had prescribed the

minimum SLR to be 25%, since 1970, the RBI has gradually raised it and the banks have

complied. Between March 1970 and Oct. 1981, it was raised ten times. Its level increased

from 25% to 35% during this period. By an amendment of the Banking Regulation Act in

1983, the RBI was empowered to increase the ratio upto 40%. Consequently, in eight steps it

was raised to 38.5% in 1991.

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Monetary control has been reasonably successful in spite of the rising fiscal deficits because

of the aggressive use of the two ratios over the period. While the CRR affected reserve

money directly by immobilising banks' cash holdings, the SLR impacted reserve money

indirectly by altering the monetisation of fiscal deficits. However, the changes in the reserve

ratios have almost been unidirectional (upwards). It is, therefore, argued that they have not

been genuine monetary policy instruments but fiscal policy instruments raising resources for

the Government. In fact, the use of SLR technique does not restrain total expenditure in the

economy. It may restrict only the private sector expenditure while helping to increase

Government expenditure. In other words, it merely distributes bank resources in favour of the

Government sector.

By law and in practice, monetary management in India severely constrained the scope for an

independent monetary policy. The Government's borrowing requirement had to be met in

substantial degree by the banking system in general and the RBI in particular. Since the RBI

does not have control over Government deficits and is required to lend to cover them the two

ratios were used largely to secure a balance between fiscal deficits and an acceptable growth

of money supply.

Government's reliance on the Reserve Bank was due to its inability to borrow enough from

the market. The reason was that the interest rates offered by the Government on its borrowing

were much below the market rate. Naturally, there was very little voluntary subscription to

Government loan in the market. Hence a captive market was created for Government

borrowing through prescriptions of higher SLR. Besides the banks, certain other financial

institutions such as the LIC, the GIC and the Provident Funds were under obligation to invest

substantial parts of their funds in Government and other approved securities.

But with the gradual weakening of the fiscal position even this captive market did not prove

adequate to meet the credit needs of the Government. The Reserve Bank had to provide for

the excess through adhoc Treasury Bills at relatively low interest rates. These and other

statutory liabilities not only crowded out the private sector but also weakened the once

vibrant Government securities market by disallowing the interest rates and maturity period of

securities to reflect essentially the perceptions of the market and investors.

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Clearly, there was the need to drastically reduce this dependence of the Government on the

RBI. With this in view, the Chakraborty Committee (1985) made a number of

recommendations. Principally, the Committee recommended raising of interest I discount

rates on Government borrowing in the expectation that higher rates would increase public

subscription to Government loans and would thereby considerably reduce the dependence of

the Government on the RBI. Accordingly, the RBI in consultation with the Government

implemented a comprehensive set of changes, which will be touched upon in due course.

OMOs involve the purchase and sale of securities by the central bank. The purchase of

securities leads to an increase in bank reserves and thus provides the basis for a multiple

expansion of credit, deposit and money. On the other hand, sale of securities by the central

bank will have the effect of reducing the bank reserves and, therefore, results in a multiple

contraction of credit. OMOs are regarded as the primary instrument of monetary policy in

developed countries. In developing countries, however, the applicability of OMOs is

somewhat limited. OMOs fulfill the functions of steering interest rates, controlling liquidity

and signaling the stance of monetary policy. During the pre-reform period, OMO was the

least used instrument although the Reserve Bank had wide powers for its use. OMO seemed

to have existed but in little more than name. This is because the market for Government

securities was almost entirely a captive market with the Government borrowing programme

being undertaken at cheap administered interest rates, which were far from being

competitive. OMOs were, therefore, employed by the Reserve Bank primarily to assist the

Government borrowing programme and to maintain orderly condition in the Government

securities market. In other words, the Reserve Bank policy was one of what is known as

"leaning with the wind", i.e., to conduct OMO to subserve debt management objective. This

does not mean that OMOs have not contributed anything at all to monetary management.

They have indirectly helped in the regulation of supply of bank credit to the private sector.

Since inflation in India is believed by many to be structural, various selective credit control

measures were used from 1956 to regulate bank advances to sensitive commodities (like food

grains, oil seeds, cotton, vegetable oils etc.) to influence production outlays, on the one hand

and to limit possibilities of speculation and rising prices, on the other. Under the Banking

-48-

Regulation Act, 1949, Section 21 empowered the RBI to issue directives to the banking ' .

sector regarding their advances. The directives related to:

~ the purpose for which advances may or may not be made;

~ the margins to be maintained in respect of advances against specific commodities;

~ fixing of ceiling on the amounts of credit for certain purposes; and

~ discriminatory rates of interest charged on certain types of advances.

After nationalisation the banks were asked to ensure that total lending to priority sectors

should by 1979 reach a level of not less than one-third of outstanding credit. Later on, a

target was set that 40% of bank credit should be channeled to these sectors by 1985. As a

result, the pattern of bank credit changed substantially since 1969 when lending to priority

sectors was only 14% of total lending. The corollary, of course, was a decline in the

proportion of bank credit going to non-priority sectors.

A major route through which intervention in the field of allocation of credit was effected was

the Credit Authorisation Scheme (CAS) introduced in 1965. Under this scheme, banks were

required to obtain the Reserve Bank's prior authorisation while sanctioning any fresh credit

limit of a given value and beyond to any single party with certain types of credit facilities

being exempted. This additional measure of credit regulation was expected to perform the

multiple objectives of keeping inflationary pressures in check, ensuring that credit was

directed to genuine purposes as per plan priorities and curbing excessive inventory holding.

The CAS introduced delays in the process of making loans since RBI approval of an

individual loan was time consuming. Doubts did develop regarding whether this measure was

at all required given the regulations in respect of priority sector lending. The CAS, however,

had some use in controlling aggregate credit in the context of cash credit system (overdraft

system). Under this system, borrowers were given credit limits, which they utilised at their

discretion. The reserve Bank could prevent over generous credit limits being established by

banks. But this was a very blunt instrument of credit control. The requirement of prior

authorisation under CAS was replaced by a system ofpost-sanction scrutiny in 1988.

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On the whole, it may be said that until the end of the 1970s much reliance was placed on

moral suasion and other selective credit control measures to achieve quantitative credit

targets without taking into account the fact that these measures were unlikely to be very

effective in the context of strong reserve money growth (Joshi & Little, 1994 ).

• · Operating Procedure- In The 1990s and Onwards

A major attempt to rationalise the existing financial structure in order to improve the

operating procedures of monetary policy was first undertaken on the basis of

recommendations of the Committee to Review the Working of the Monetary System (the

Sukhamoy Chakraborty Committee) in 1985, followed by those of the Working Group on

Money Market (the Voghul Committee) in 1987. Accordingly, the Reserve Bank in

consultation with the Government implanted a comprehensive set of changes since the late

1980s to allow market forces to play a more dominant role in influencing market liquidity.

Alongside requisite regulations, efforts were made to impart greater flexibility and

competitiveness to the financial system through the process of liberalisation.

Although the seeds of financial liberalisation were sown in the mid-eighties, it was only in

the 1990s that the process of financial liberalisation gathered momentum consequent upon

the then severe BOP crisis. Following the recommendations of the Committee on the

Financial System (Narasimham Committee) in 1991 and in consonance with the international

experience of financial liberalisation, the Indian economy witnessed major financial and

structural transformations in the 1990s and thereafter. The most significant set of changes

initiated in the Indian financial system which has great implications for the operation and

effectiveness of monetary policy addressed a number of issues such as (a) monetary-fiscal

interlinkage; (b) structure of interest rates; (c) development of money market and securities

market; and (d) external sector reforms.

From the middle of the 1950s to the end of March 1997, there was an agreement by which

monetisation of fiscal deficit was automatic. This practice of automatic monetisation of fiscal

deficits was identified as the principal factor adversely affecting central bank independence

and the effective conduct of monetary policy. With automatic monetisation of the budget

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deficits the RBI was left with the task of neutralising the expansionary impact of deficits.

There was, therefore, the need to de-link budget deficit from its monetisation, which was

finally recognised and implemented.

Two agreements between the Government and the RBI were effected in 1994 and 1997 to

phase out and ultimately to do away with adhoc Treasury Bills. Thus by 1997-98, recourse to

automatic monetisation was no longer available to the Government as a financing option.

Instead, a system of Ways and Means Advances (WMA) has been introduced to

accommodate temporary mismatches in Government's receipts and payments.

This moving away from the practice of automatic monetisation gave the Reserve Bank more

freedom in matters of monetary control and management based on its own perception.

Monetisation has now become a matter of discretion and portfolio decision of the central

bank. The discontinuation of automatic monetisation of deficits has also made the

Government conscious about the true costs of its borrowing programme by moving

borrowing from the administered interest rate to market determined interest rate system. This

is expected to impart fiscal discipline.

The fiscal-monetary coordination has also been strengthened through the enactment of the

Fiscal Responsibility and Budget Management (FRBM) Act, 2003. The FRBM Act places

limit on deficits and at the same time prohibits borrowing from the RBI from the fiscal year

2006-07 except by way of WMA or under exceptional circumstances. Recourse to the FRBM

Act is crucial for the objective of maintaining price stability and more importantly, to

stabilise inflation expectation in the economy.

De-linking of budget deficits from its monetisation has also been instrumental in the '

reorientation of the interrelationship between the RBI and the banking sector. Over the years,

CRR and SLR had to be maintained at very high levels because of mounting fiscal and ,

monetised deficits. Consequently, pre-emption of bank deposits had been very high. This

also constrained the profitability of the banking sector. Easing of these constraints was thus

an important agenda of the reforms process. More recently, there has been a steady policy

-51 -

induced reduction in reserve requirements, which have implications with respect to both

CRR and OMOs as instruments of monetary policy.

The reform of the interest rate structure, which had become very complex and resulted in

market segmentation, inefficient allocation of resources, reduction in bank profitability,

tendency towards financial repression and crowding out, constituted an integral part of

financial sector reforms. Guided by the light of recommendations of the Chakraborty .

Committee, the RBI began to deregulate interest rates beginning with the removal of

restrictions on the inter-bank market as early as 1989. This was supported by the process of

putting the market-borrowing programme of the Government through the auction process in

1992-93. There was also a phased deregulation of lending rates in the credit markets. At

present, banks are free to fix their lending rates on all classes of loans except small loans

below Rs.2 lakhs and export credit. The deregulation of deposit rates started later. Banks are

now free to offer interest rates on all classes of deposits except savings deposits. Interest rates

on NRI deposits are linked to international interest rates and are modulated from time to time

depending on the macroeconomic and BOP situations.

The process of interest rate deregulation had to be supported by the development of the

market structure. Specifically, the issues of missing short-term markets and absence of active

trading in short term instruments needed to be addressed. As per recommendations of the

Chakraborty Committee and the Voghul Committee, several money market measures were

undertaken. Effective Mayl989, all interest rate ceilings on money market instruments were

withdrawn. To encourage the use of commercial bills and short-term liquidity in the banking

system, inter-bank participation certificates, certificate of deposits (CDs) and commercial

papers (CPs) have been introduced. The market was to determine Interest rates on CDs and

CPs. The capital markets have also grown in prominence. There has been a spate of financial

innovations. This has blurred the distinction between banks and non-banks. With non-banks

and the capital market beginning to play a greater role, whether the monetary transmission

mechanism would experience an alteration has surfaced as an issue in this context. Some of

the fundamental aspects of reforms in the Government securities market are-making the

interest rates on Government paper market related and substantial reduction of the maturity

period of securities to a maximum of 10 years; adoption of new techniques of floatation and

-52-

introduction of new instruments, particularly Treasury Bills of varying maturities on auction

basis; and allowing repos on all central Government dated securities and Treasury Bills of all

maturities effective Aprill997. All these have increased the depth of the Government

securities market and made it vibrant.

A parallel process of market development, both spot and future, supported the introduction

of new instruments. The Discount and Finance House of India (DFHl) was set up to promote

a secondary market in various money market instruments. Introducing non-bank participants

initially widened the call money market. They are being phased out with the parallel

development of a repo market outside the Reserve Bank. These apart, for dealing in

Government securities well-capitalised Primary Dealers (PDs) were set up. The Reserve

Bank also issued guidelines for institution of Satellite Dealers (SDs) in DEC.l996.

For increasing inter-linkages, the development of markets was supported by withdrawal of

balance sheet restrictions through rationalisation of directed credit programmes as well as

investment limits (moderation in the levels of statutory pre-emption in terms of CRR and

SLR). The withdrawal allowed the financial intermediaries to operate not only in the primary

segments but also across all segments of the financial markets including equity and foreign

exchange markets.

The external sector of the economy has also witnessed far-reaching changes. There has been

substantial elimination of quantitative control on imports alongside reduction in tariff. A

market based exchange rate system has been operational since March 1993 with occasional

intervention from the RBI against speculative attacks or for a perceived need for correction

against overvaluation. There have been significant steps towards capital account

convertibility. In addition, relaxing restrictions on overseas borrowing and investment

activities have encouraged foreign direct investment and greater access to external capital

markets.

All these have brought about large foreign exchange inflows in the form of direct and

portfolio investment. Capital inflows help to augment resources but at the same time they

have an expansionary impact on money supply to the extent they add to the total foreign

-53-

exchange assets of the RBI. Similarly, greater access to international capital markets has

enabled the corporate sector to access funds at rates lower than the domestic interest rates.

Thus a new set of factors has entered which have a bearing on the expansion of money and

credit. Some of these structural changes add to the degrees of freedom for the monetary

authority while others make monetary control more complex.

Consequent upon the liberalisation and progressive opening up of the Indian economy during . the 1990s, there has been a comprehensive change in monetary policy operations. The

Reserve Bank has moved from a monetary targeting approach to a multiple indicator

approach. Short-term interest rates have emerged as operating targets I instruments to signal

the monetary policy stance alongside bank reserves. With reforms, there seems to have been

shifts in monetary policy transmission channels with the rate channels gaining in importance

alongside quantum channels in transmitting policy impulses. Moreover, in the face of swings

in capital flows, swift policy actions have become urgent to balance the domestic and

external sources of monetisation and thereby ensure financial stability. To address these

issues the Reserve Bank has introduced a liquidity management framework broadly in line

with the cross-country experiences with regard to changes in operating procedures of

monetary policy in response to the challenges of financialliberalisation.

During the 1990s, the Reserve Bank has gradually shifted from direct to indirect instruments

in consonance with the increasing market orientation of the economy. Within the liquidity

management framework, the Bank now tries to modulate liquidity to steer monetary

conditions to the desired trajectory. For this purpose, it employs an array of instruments

which affect both the quantum and price of liquidity. The management of liquidity is being

achieved by a mix of policy instruments including OMOs, repos and variations in reserve

requirements and standing facilities reinforced by changes in policy rates like the BR and

repo I reverse repo rate.

Reserve Bank' reliance on OMOs (which were not much effectively used in the pre-reform

period) has considerably increased in the 1990s. The liquidity management in the system is

increasingly being undertaken through OMOs, both outright and repos. The scope for OMOs

-54-

has been enhanced both by the efforts taken to develop a secondary market for Government

securities and the market related rates being offered on Government paper.

Bank reserves, which continued to be an operational target of monetary policy in the 1990s,

have been controlled by changes in reserve requirements affected mainly through the

instrument of CRR. However, the use of reserve requirements, which have been the principal

instruments for modulating monetary conditions in the pre-reform period, has gradually been

de-emphasised. They are considered as a tax on intermediation. Consequently, these ratios

are being reduced systematically. The statutory minimum for SLR has been brought down to

25% from 38.5% in the early 1990s. CRR has also been gradually lowered from its legal

upper limit of 15% in early 1990s to 5% with some minor upward adjustments to deal with

the evolving liquidity situation. However, until the Reserve Bank is able to effectively make

use of the other market based instruments of credit control in achieving the desired changes

in money supply, CRR will remain as an instrument of monetary control. In fact, the use of

CRR as an instrument of sterilisation, under extreme conditions of excess liquidity and when

other options are exhausted cannot be ruled out.

The refinance window of the RBI has provided an additional instrument for influencing

reserves in the 1990s. The RBI provides two types of refinance facility to banks-export

credit refinance and general refinance. While the former is formula based, the latter facility is

provided to enable banks to tide over their temporary liquidity shortages. A Collateralised

Lending Facility (CLF) within the Interim Liquidity Adjustment Facility (ILAF) has replaced

the general refinance window since 1998.

A significant development in the context of the shifts in monetary policy operations has been

the resurrection of the Bank Rate in April 1997 as a reference rate and as a signaling device

to reflect the stance of monetary policy. The interest rates on different types of

accommodations from the RBI including refinance were linked to the BR. While repo rates

signal shifts in short term liquidity management, changes in BR are used to signal the

medium term perspective of the central bank. The activation of the BR has endowed the RBI

with an important instrument. It is to be noted in this context that the announcement impact

of Bank Rate changes has been pronounced on the prime lending rates of commercial banks.

-55-

The switch to indirect instruments began in the early 1990s. The RBI introduced OMOs

including repo operations in 1992-93 to sterilise surplus capital flows, which began to pour in

with the liberalisation of the capital account. Although the RBI has not been in favour of

using CRR, nevertheless it had to raise CRR more than once to contain monetary and hence

inflationary impact of capital flows. Once inflation was reined in during the later half of the

1990s, the RBI was free to cut CRR. This was especially done since the onset of domestic

slowdown demanded easing of monetary conditions.

The short-term liquidity management has been aided by conduct of repos on a regular basis.

Originally, the tenure ofrepo operations, introduced to sterilise capital flows in 1992, was 14

days. To absorb very short-term liquidity and to even out money market rates, especially

overnight call money rates, the RBI started conducting 3-4 day repos. The repo rates, apart

from reflecting liquidity conditions, provided a floor for the overnight call money rates. The

recurring instability in the financial markets during the second half of the 1990s emphasised

the need for an effective management of liquidity on a day-to-day basis. The tenor of repo

operations was thus reduced to daily auctions by 1997-98 to stabilise markets.

The RBI introduced the ILAF following the recommendations of the Committee on Banking

Sector Reforms in April 1998 as a mechanism for management of short term liquidity

through a combination of repos, export credit refinance facilities and CLFs supported by

OMOs. Within the ILAF framework, liquidity was injected by the RBI through CLF and

export credit finance to banks and liquidity support to PDs. All these facilities were available

subject to quantitative limits for specified duration and at the Bank Rate. Absorption of

liquidity was through repo supplemented by OMOs in Government dated securities and

Treasury Bills by the RBI.

The ILAF later evolved into a full-fledged Liquidity Adjustment Facility (LAF) by June

2000. The LAF has since been emerging as the principal operative instrument of monetary

policy in India. Liquidity management in the system is now carried out through daily reverse

repo and repo operations under LAF supported by OMOs in the form of outright purchase I

sale of Government securities. The LAF has enabled the Reserve Bank to modulate short­

term liquidity under varying fmancial market conditions. At the same time it helps to

-56-

transmit interest rate signals to the market. Under the LAF, liquidity is injected through

reverse repos and it is absorbed through repos on almost a daily basis (with effect from Oct.

29, 2004, the nomenclature of repo and reverse repo has been inter-changed as per

international usage).

The principal strength of the LAF has been the degree of flexibility imparted to day-to day

monetary management. Also, the LAF would gradually replace other windows of liquidity

support. The Reserve Bank would thus be able to phase out sector specific refinance

facilities, which had earlier resulted in market segmentation. In addition, it has enabled the

Reserve Bank to set an informal corridor for the short-term interest rates consistent with the

policy objectives given by the repo and reverse repo rates. To provide unique ceilings and

floors, the RBI has increasingly been resorting to pricing its liquidity at the repo rate in

recent years. Apart from WMA, which are still at the Bank Rate, all other forms of liquidity

support are at the repo rate.

However, as the primary instrument of monetary policy, the LAF has to mediate between the

several objectives of monetary policy. The quantum of absorption (injection) of liquidity and

the price have to be determined keeping in view not only the daily liquidity position in the

markets but also the medium term impact on price stability and growth.

Persistent capital flows since 2001-02 posed a challenge to the LAF operations. The liquidity

impact of these large inflows till 2003-04 was managed mainly through LAF and OMO. The

stock of Government securities with RBI declined progressively in the process. The burden

of sterilisation, as a result, increasingly fell on LAF operations. Thus instead of absorbing

liquidity of a short term and temporary nature, the LAF window was absorbing funds of a

relatively permanent nature. To address these issues, a Market Stabilisation Scheme (MSS)

was introduced in April 2004. Under this scheme, based on an agreement between the

Government and the RBI, Government of India dated securities and Treasury Bills are being

issued to absorb liquidity. Operationalisation of MSS to absorb liquidity of a more enduring

nature is expected to reduce considerably the burden of sterilisation on the LAF window.

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2.5.5. CONCLUSION

Formulation of monetary policy in India over the years has not been based exclusively on

any of the theoretical approaches or models of monetary policy. Relevant economic thinking

(Monetarist, Keynesian, Radcliffian etc.), contemporaneous cross-country experiences and

domestic compulsions have guided its formulation from time to time.

Initially, the tone for India's monetary policy was set by the concept of developmental

central banking. The RBI was to have as its purpose the promotion of such monetary, credit

and exchange conditions as are most favourable to the deyelopment of the Indian economy.

Accordingly, prior to the 1990s, the Reserve Bank has broadly pursued a policy of controlled

expansion aimed at achieving a balance between price stability and growth.

The conduct of monetary policy in India has traditionally proceeded with the help of an

intermediate target. Prior to the mid-1980s, bank credit -aggregate as well as sectoral- has

served as the proximate target of monetary policy. However, since the later half of the 1980s,

a monetary targeting approach has been followed till 1997-98 based on the recommendation

of the Chakraborty Committee (1985). Accordingly, broad money (M3) emerged as the

relevant intermediate target with reserve money being the operating target. The long run

stability of money demand and of the adjusted money multiplier prior to 1990s and the

presence of information and implementation lags led to the presumption in favour of

monetary targeting.

The instruments of monetary policy have been impressive in their range including both direct

(quantity) and indirect (price) instruments. However, they have all been operated in a

command control manner. Also, the traditional instruments have often been modified

significantly which perhaps has not been conducive to administration of these techniques.

There has during the period been a tendency towards moving away from the cost effects to

the availability (non-price rationing) effect in the regulation of refinance from the RBI and

commercial bank credit. More reliance has, therefore, come to be placed direct instruments of

monetary control. The CRR evolved as the principal instrument of control with the traditional

instruments, the BRand the OMOs loosing significance. Consequently, monetary policy has

tended to be blunt and jerky. Also, prior to the 1990s, very much reliance has been placed on

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moral suasion and other selective credit control measures without fully recognising their

potential in the context of strong reserve money growth.

Over the period, monetary management in India severely constrained the scope for a

monetary policy that was independent of the Government budget. In fact, fiscal dominance

during the 1970s and 1980s changed the contours of the operating framework of monetary

policy. The use of many instruments, viz., the SLR, credit and interest rate directives, OMO,

have come to be influenced by the considerations of debt management and Government

finance. The instruments also had to bear a disproportionately large burden of distributing

credit in accordance with the so-called plan priorities. The outcome has been a very complex

system with market segmentation, inefficient allocation of resources, and complacency about

fiscal deficits, lessening of viability of banks, crowding out and thus increasing complicacy

in the operation of monetary policy.

On the whole, Indian monetary policy has been conservative prior to the 1990s. Monetary

restrictions have been quickly imposed whenever inflation has shown a tendency to go out of

hand. The adoption of the monetary targeting approach in the mid-1980s seems to have been

compatible with the aggressive moves to prevent accelerating inflation. As a result, although

the success with price stability has varied over time in response to the evolving monetary­

fiscal inter-relationship, fluctuations in agricultural output and oil price shocks, the trend rate

of inflation has remained fairly low even in the face of various exogenous shocks.

Monetary growth has been higher in the 1970s and 1980s compared with the 1960s. This has

been reflected in somewhat higher inflation. But it is notable that though fiscal deficits have

more than doubled as a proportion of GDP since the mid-1970s, money supply growth has

not shown a large increase. This speaks for the efficacy of monetary policy instruments.

In consonance with the international experience, economic liberalisation through various

structural and financial sector reforms were introduced in the early 1990s in order to infuse

some degree of efficiency, competitiveness and flexibility into the system. There has thus

been a transition from a control-oriented regime to a regulated but liberalised regime. With

the shift from a planned and administered interest rate system to a market oriented financial

-59-

system the several measures undertaken have rejuvenated the process of price discovery. In

an administered interest rate and exchange rate regime, the quantity variables dominated and

transmitted monetary policy impulses. However, external and financial sector reforms have

since enhanced the sensitiveness of the quantity variables to their market determined prices,

i. e., interest rates and exchange rate. Consequently, rate channels of monetary policy

transmission have relatively gained in importance. With its progressive opening up and

growing integration with the global economy, the Indian economy has to deal with not only

the usual supply shocks but also to manage external shocks emanating from swings in capital

flows, volatility in the exchange rate and the global business cycles. All these have led to a

significant transformation in the monetary policy framework in India.

As regards objectives, price stability and ensuring adequate credit flow to support growth

continue to remain as the basic objectives of monetary policy. However, maintaining

financial stability has emerged as an additional key objective in the new situation. Issues of

prudential regulation, accountability, transparency and central bank independence while

ensuring monetary-fiscal coordination are also influencing the design of monetary policy in

recent years.

With deregulation and liberalisation of financial markets and increasing openness of the

economy there has been a shift from a monetary targeting framework to a multiple indicator

approach. Short-term interest rates have emerged as indicators of monetary policy stance.

However, while the exclusive use of broad money, as an intermediate target has been de­

emphasised, the growth in broad money continues as an important information variable for

monetary policy.

The various measures have enabled a shift from direct to indirect instruments in consonance

with the increasing market orientation of the economy. In line with the international trend,

the Reserve Bank has introduced a liquidity management framework within which market

liquidity is now modulated through a mix of open market (including repo) operations and

changes in reserve requirements and standing facilities reinforced by changes in the policy

rates, including the LAF rates and the BR. The relative importance of OMOs in monetary

management has increased substantially while that of the reserve ratios has been diminished.

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In the post reform era in India, the economy was clearly on an upswing during 1991-6, but a

prolonged decline set in after that. Recent years have shown some signs of recovery and the

economy seems to have been propelled to a higher growth path. As regards price stability, it

is only since the 2nd half of the 1990s that both inflation and inflation expectations have

moderated substantially. While the rejuvenated monetary policy framework played an

important role in this regard, it can reasonably be argued that the achievements were due to

combinations of monetary, fiscal, competition and administrative policies. Actually, the

Indian economy has been passing through a phase of transition from a relatively closed to a

progressively open economy and therefore faces additional complexities. In this transitional

phase a new framework for monetary policy can be validated only after some more

experience and evidence is gathered.

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