Project on Assessment of Key Issues Related to Monetary Policy
[Source: RBI Report on Currency & Finance 2003-04]

Module: 6 Monetary Transmission Mechanism

Introduction

Monetary policy affects its final goals - prices and output - with long lags. Policies responding only to the current state of the economy may be destabilising and monetary authorities are, therefore, required to be forward-looking in their approach. A forward-looking approach would, however, be contingent upon a broad understanding of the monetary transmission mechanism - the process through which changes in monetary policy instruments affect output and inflation. Moreover, the transmission lags are not only long but often also found to be variable. The variability of the lags has been accentuated by the ongoing financial deregulation, liberalisation and innovations in a large number of economies.

Reflecting the process of financial liberalisation, there have been changes in operating procedures of monetary policy. Notably, monetary aggregates have been de-emphasised as an intermediate target of monetary policy and, for an increasingly large number of economies, short-term interest rates have emerged as the operating target of monetary policy. In this context, the speed and size of pass-through from policy rates to market rates become critical. Concomitantly, concepts such as neutral real rate have been an issue of debate.

Like other Emerging Market Economies (EMEs), monetary policy in India has witnessed significant changes in its operating procedures and instruments. A multiple indicator approach has been put in placein lieu of the earlier monetary targeting approach. With gradual deregulation of financial markets and a move towards indirect instruments of monetary management, short-term interest rates have emerged as instruments of conveying the monetary policy stance. At the same time, rigidities in the market rates of interest have blunted the effectiveness of monetary policy actions. With the phased opening up of the Indian economy to external flows and increasing trade openness, the role of the exchange rate in the transmission mechanism has assumed importance.

Against this backdrop, this Module undertakes a discussion of issues related to monetary transmission. Section I provides an overview of various channels through which monetary policy affects output and prices. Cross-country empirical evidence on monetary policy lags and pass-through from policy rates to market rates is examined. The relevance of a neutral rate of interest as a guide for monetary policy formulation is also critically evaluated. Section II focuses on monetary transmission mechanism process in India. It dwells upon various policy efforts to impart flexibility to the interest rate structure in India. Estimates of interest rate pass-through in India are attempted. Finally, the Section undertakes an empirical exercise to understand the dynamics of output and prices in response to monetary policy shocks. Concluding observations are contained in Section III.

This Module addressed key issues relating to the process through which monetary policy actions affect output and prices. Despite substantial progress, there is still no unanimity on the precise channels of monetary transmission and these remain a "black-box". A few stylised facts that emerge from a survey of recent cross-country studies are:

1. pass-through from monetary policy signals to bank lending rates is only partial in the short-run;

2. output displays a hump-shaped response to monetary policy shocks;

3. prices are quite sluggish - almost unchanged for one year and it can take almost two years for monetary policy to have a noticeable effect on prices; and,

4. in the case of emerging economies, the lags may be somewhat shorter.

The effectiveness of monetary policy signals depends upon the speed with which the policy rates are transmitted to market rates of interest. Cross-country evidence suggests that this pass-through is only partial in the short-term. Although it increases over time, it still remains usually less than complete. The speed and size of the pass-through depend upon a number of factors such as volatility in the money market rates, the extent to which the policy change was anticipated and the maturity structure of bank balance sheets. Finally, monetary authorities in future will have to contend with implications of electronic money on the transmission process. The dominant view is that monetary policy is likely to remain a key instrument of macroeconomic stabilisation albeit its effectiveness could be weakened to some extent by the growing use of electronic money.

With structural reforms and financial liberalisation, monetary transmission channels in India have undergone a significant transformation. Monetary policy stance is now being increasingly signalled through variations in key policy interest rates. Financial prices - interest rates and exchange rates - are now an important part of the transmission chain. Although rigidities in the financial system have blunted the pass-through from policy rates to bank's lending rates, there is some evidence of an improvement in the pass-through in recent years. This has been possible through concerted efforts of the Reserve Bank to impar t greater flexibility to the interest rate structure. Concomitantly, this has also enabled a moderation in real lending rates for borrowers over time. This is expected to have a positive impact on investment demand in the economy.

Empirical evidence on transmission channels suggests that monetary policy impulses have the expected effect on output and prices. Furthermore, monetary policy measures are able to ensure orderly conditions in the foreign exchange market. The empirical results are, however, subject to a number of caveats. The transmission lags are average lags and are surrounded by a great deal of uncertainty. The study period has been one of significant structural changes in the Indian economy. In view of the ongoing structural changes in the real sector as well as financial innovations, the size of the effect as well as the precise transmission lags may differ in each business cycle.