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

Module: 6 Monetary Transmission Mechanism

Monetary Transmission

With the shifts in instruments and operating procedures of monetary policy during the 1990s, issues relating to monetary transmission in India continue to be an active area of research. As discussed in Module 2, the fiscal dominance during the 1970s and 1980s changed the contours of the operating framework of monetary policy - the traditional instruments, the Bank Rate and open market operations, began to loose their efficacy and gave way to credit planning and reserve requirements as key instruments of monetary management. In order to infuse a degree of efficiency, the 1990s witnessed a shift from a planned and administrated interest rate system to a market-oriented financial system. Measures were taken to rekindle the process of price discovery in the financial markets. These measures included :

• deregulation of interest rates, beginning with the removal of restrictions on the inter-bank market as early as 1989;

• putting the market borrowing programme of the Government through the auction process in 1992-93;

• a phased deregulation of lending rates in the credit markets;

• the development of short-term money markets through introduction of money market instruments, such as commercial paper, short-term Treasury Bills and certificates of deposits;

• phasing out of ad hoc Treasury Bills; replacing cash credit with term loans; reduction in statutory reserve requirements; institution of a liquidity adjustment facility (LAF); and,

• development of a repo market outside the Reserve Bank.

The various measures enabled a shift from direct instruments of monetary control to indirect instruments in consonance with the increasing market orientation of the economy. The Reserve Bank is now able to influence short-term interest rates by modulating the liquidity in the system through LAF operations. Accordingly, monetary policy signals are increasingly transmitted to the real economy through modulations in the Bank Rate as well as the repo rate (now called the reverse repo rate) in contrast to the earlier reliance on reserve requirements and credit ceilings/sectoral allocation of credit (see Modules 2 and 4). Against this brief overview, an assessment of the monetary transmission mechanism in India is attempted here.

The relationship between money, output and prices has been extensively analysed in India. With the initiation of reform measures in the 1990s, more recent studies have also focussed on the role of the interest rates and exchange rates in the transmission mechanism. Changes in money supply lead to changes both in output and prices, although the price effects of an increase in money supply are stronger than the output effects. The Working Group on Money Supply (RBI, 1998) found a strong unidirectional causation running from real output to real money. Besides, the output response operating through the interest rate channel turned out to be stronger and more persistent than that of the credit channel.

In the context of the reforms and their implications for monetary transmission channels, Ray, Joshi and Saggar (1998) found that interest rates and exchange rate matter in the conduct of monetary policy in the post-liberalisation phase (April 1992-March 1997). They found that interest rates and exchange rate which were exogenous in the pre-reforms period turned out to be endogenous in the post-liberalisation phase: disequilibria in money market endogenously impacted the interest rates and the exchange rate. This evidence was interpreted as supportive of policy shifts in re-defining transmission channels. In the context of this study, it needs to be noted that the financial markets - money markets, debt markets and forex markets - have undergone significant shifts mainly from late 1990s onwards. A comparison of monetary impulses transmitted through interest rate effects and through liquidity effects for the period 1961-2000 indicates that the interest rate channel has emerged as a significant factor for explaining the variation in real activity in the 1990s as compared with its negligible impact in the 1980s. The liquidity effect, although significant, diminished in terms of magnitude.

Al-Mashat (2003) analysed the key channels of monetary transmission for India in a vector error correction framework and found:

1. the impact of shocks on key macroeconomic variables is larger when the exchange rate is introduced in the model which suggests the importance of the exchange rate channel;

2. little evidence that bank lending channel plays a very important role; and,

3. response of interest rates to macroeconomic disturbances is larger than that during the 1980s.

A brief survey of these recent studies shows that monetary policy impulses are beginning to impact output and prices through interest rates and exchange rate movements in addition to the traditional monetary and credit aggregates. As discussed in the earlier section, lags of monetary transmission can vary from one business cycle to another. This may be all the more in case of countries like India where significant changes in the monetary policy operating framework as well as financial liberalisation took place during the 1990s. In particular, it needs to be stressed that most of the refinements in the operating procedures of monetary policy that have permitted short-term interest rates to emerge as instruments of signalling monetary policy stance have taken place only from 1997 onwards when the Bank Rate was re-activated. These efforts were strengthened with the introduction of a full-fledged LAF in 2000. These refinements in the operating framework along with ongoing measures by the Reserve Bank to impart greater flexibility to the interest rate structure of the commercial banking system are expected to increase the efficacy of the monetary policy signals. An attempt has been made here to extend the recent empirical work on monetary transmission in India using a vector auto-regression (VAR) framework.

Empirical results show that monetary measures have the expected effect on output, prices and exchange rate (Box VII.6). Illustratively, monetary tightening is associated with a reduction in both output and prices. As regards exchange rate, it appreciates following a monetary tightening. This shows that monetary tightening measures to ensure orderly conditions in the foreign exchange market have the desired impact. Turning to the issue of the lags in transmission, empirical results suggest relatively quick effects. The peak effect of an interest rate shock on output as well as prices occurs around six months after the shock. The relatively quick response of prices in response both to interest rate and broad money shocks appears to be in line with evidence for EMEs albeit in contrast to the inertial response of prices in the context of advanced economies where prices are almost unchanged for one year after a monetary policy shock. As noted earlier, monetary policy lags may be shorter in emerging economies. Illustratively, Fung (op cit.) found that, in East Asian economies such as Indonesia, Korea and Malaysia, prices decline immediately after a monetary policy tightening. He attributes greater price flexibility in these economies to the labour markets being relatively less rigid. Thus, the Indian experience in regard to price dynamics appears to resemble the East Asian economies. In India, shorter transmission lags could perhaps reflect a variety of factors such as wage/price indexation and concerted policy efforts to contain inflation. Monetary policy measures are often supplemented with supply-side measures to contain inflation, given the key role of supply shocks in the inflation process in India. The public distribution system in India could also be an important contributory factor. These hypotheses would, however, need to be explored further.

In the context of a market-determined exchange rate system and opening up of the economy, estimates of pass-through from exchange rate movements to inflation are an important input to monetar y policy formulation. The dynamic behaviour of prices and exchange rate emerging from the VAR analysis provides an estimate of exchange rate pass-through. According to these impulse responses, exchange rate pass-through is 0.04, i.e., a 10 per cent depreciation of the exchange rate increases wholesale prices by 0.4 per cent. Almost 60 per cent of this pass-through takes place within one year while 80 per cent of pass-through is completed within two years of a shock to the exchange rate. These estimates of the exchange rate pass-through are subject to a number of caveats. First, the study period has been characterised by a significant opening up of the economy. Openness of the Indian economy as measured by the ratio of merchandise imports to GDP has increased from 9.8 per cent in 1993-94 to 13.2 per cent in 2003-04 (see Module 4). Second, and more importantly, the substantial decline in tariffs could have perhaps allowed domestic producers to absorb some part of exchange rate depreciation without any effect on their profitability. Furthermore, the increased threat of imports at low impor t duties in an environment of a phased reduction in non-tariff barriers could have reduced the exchange rate pass-through. Perhaps, these factors can explain as to why pass-through estimates based on a longer time-span 1976-2004 (see Module 4) are almost double of the estimate emerging from the exercise based on the sample period of 1993 onwards. At the same time, it must be stressed that the pass-through estimates from the post-1993 period based on the VAR exercise are rather imprecise. Thus, the estimates of pass-through would need to be evaluated on an ongoing basis, before a definitive conclusion is reached.

The empirical results are illustrative of the evolving channels of transmission and accord with a priori beliefs. These are, however, subject to a number of caveats. First, the transmission lags are average lags and are surrounded by a great deal of uncertainty. In view of the ongoing structural changes in the real sector as well as financial innovations, the precise lags may differ in each business cycle. This is all the more as the period of the study was characterised by the ongoing process of structural reforms in the Indian economy involving financial deregulation and liberalisation. This period was also marked by heightened volatility in the international economy, including developments such as a series of financial crisis beginning with the Asian crisis. Moreover, as noted earlier, the period under study has been marked by sharp reductions in customs duties and increasing trade openness which could have impacted the transmission process. The 1990s was also marked by global disinflation. Thus, overall the period has been one of substantial ongoing changes in various spheres of the Indian economy as well as its external environment. In this context, the observations of the Bank of England (1999) become all the more relevant: "the actual outcome of any policy change will depend on factors such as the extent to which it was anticipated, business and consumer confidence at home and abroad, the path of fiscal policy, the state of the world economy, and, the credibility of the monetary policy regime itself".

Second, the study period has been characterised by significant shifts in the monetary policy operating framework from a monetary-targeting framework to a multiple indicator approach. Third, the study period has been marked by a sluggish pass-through from policy rates to bank lending rates which weakens the intended policy impact. The empirical estimates of interest rate pass-through undertaken in this Module suggest that the size of the pass-through has increased in the recent years, with implications for transmission. Fourth, in recent years, consumer demand, especially in the form of housing credit and personal loans, has been an important driver of bank credit. Housing loans which were only 2.8 per cent of bank credit in March 1995 have more than doubled and formed 6.5 per cent of bank credit in March 2003. In future, changes in monetary policy stance could have a stronger effect on private consumption behaviour with implications for transmission channels and lags. Illustratively, a cut in policy interest rates will increase cash flow of households and have a positive impact on private consumption and output and vice versa in case of a monetary tightening. This might increase the effectiveness of a given change in monetary policy stance. Finally, the above empirical exercise is constrained by the use of industrial production as a measure of output in the absence of a reasonably long quarterly time series on total GDP of the economy. In view of the significant structural shifts towards the services sector and the inter-linkages between agriculture, industry and services, the results of this empirical exercise should be considered as tentative and would need to be ratified with a comprehensive measure of output, as also by considering alternative techniques.