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

Module: 2 - Monetary Policy Framework: Module Overview

Module 2 titled "Monetary Policy Framework: An Analytical Overview" covers issues relating to objectives, intermediate targets and operating procedures of monetary policy. It explores the rationale for price stability objective of monetary policy and discusses the trade-offs between inflation and growth that a central bank faces. The role of institutional developments - central bank independence and fiscal rules - in contributing to monetary stability is also addressed. It is followed by a discussion on strategies and tactics of monetary policy, with a focus on key changes during the 1980s and 1990s in the intermediate targets, instruments and operating procedures to meet the evolving challenges. Issues in liquidity management to ensure stable conditions in money markets are also covered. The Module also revisits issues related to stability of money demand.

The framework of monetary policy has undergone far-reaching changes all over the world in the 1990s, mainly in response to the challenges and opportunities of financial liberalisation. There is, first of all, a clearer focus on price stability as a principal - though not necessarily the sole - objective of monetary policy. Besides, with the deregulation of financial markets and globalisation, the process of monetary policy formulation has acquired a much greater market orientation than ever before, inducing a shift from direct to indirect instruments of monetary control. This has been accompanied by several institutional changes in the monetary-fiscal interface to ensure that central banks possess the autonomy to anchor inflation expectations.

Monetary management is now further complicated by the increasing trade and financial openness. The opening up of the capital account, while necessary for efficiency of capital, exposes the economy to sudden switches in capital flows. This, in turn, can lead to large changes in exchange rates over short periods of time, not necessarily related to fundamentals. Volatility in capital flows and exchange rate impacts not only domestic demand and inflation, but also has implications for the maintenance of financial stability. Central banks are thus concerned not only about price stability but also financial stability. With exogenous shocks hitting the economy at different points of time, the stabilisation of the real economy as well as financial markets requires a multi-pronged response from central banks. In a way, central banks have, therefore, emerged as the primary shock absorbers in the system.

The process of globalisation and liberalisation has thus necessitated a widening of the mandate of central banks. At the same time, for their policies to be effective, monetary authorities have been required to modify the way in which they conduct monetary policy. Central banks in emerging markets also face a similar set of issues. A special challenge in their case has been the need to calibrate the changes in the operating procedures of monetary policy with the pace of transition from an administered regime of interest rates to a market-based process of price discovery. Accordingly, intermediate targets, instruments and operating procedures of central banks have been evolving in the recent decades.

In consonance with international experience and the liberalisation process initiated by structural reforms of the early 1990s, the monetary policy framework in the Indian economy has also witnessed a major transformation. The Reserve Bank adopted a three-pronged strategy of financial liberalisation. Improvement in the allocative efficiency of the financial system entailed deregulation of financial prices, including the institution of a market-determined exchange rate regime in March 1993. This was supported by the development of financial markets - spot and futures - of varying tenors and degrees of risk. Finally, the withdrawal of balance sheet restrictions on financial intermediaries through rationalisation of directed credit programmes as well as investment limits facilitated development of the inter-linkages between markets, essential for the process of price discovery. In tune with the process of financial liberalisation, the Reserve Bank, like other central banks in most emerging market economies (EMEs), has shifted from direct to indirect instruments of monetary policy. The Reserve Bank has been able to develop an array of monetary levers that are designed to manage market liquidity in order to achieve the overall objectives of price stability and credit availability for growth and to ensure orderly conditions in the financial markets. These developments have been facilitated by initiatives to limit the fiscal dominance of monetary policy through measures such as reducing statutory pre-emptions, raising Government debt at market-related rates and phasing out of the automatic monetisation through ad hoc Treasury Bills. As a result, monetary policy emerged as a key instrument of stabilisation in the face of macroeconomic shocks, especially as fiscal policy continues to be handicapped by the persistence of large deficits.

A key development that shaped the conduct of monetary management during the 1990s was the progressive opening up of the Indian economy to capital flows. Accordingly, monetary policy had to contend not only with the usual supply shocks emanating from the vagaries of the monsoon but had to increasingly manage external shocks emanating from surges and ebbs in capital flows, volatility in the exchange rate and global business cycles. Concomitantly, maintaining financial stability has emerged as an additional key objective of monetary policy, apart from price stability and credit availability. In view of all these developments, the Reserve Bank had to make necessary modifications in its conduct of monetary policy. Intermediate targets, instruments and operating procedures have, therefore, evolved over time and these issues form the subject of this module.

The first Section (articles 2 to 5) surveys the cross-country experience in the evolution of the monetary policy framework in terms of objectives, intermediate targets and instruments. The role of institutional developments - central bank independence and fiscal rules - in contributing to monetary stability is also addressed. Section II (remaing articles)traces the process of monetary policy evolution in India. It analyses the shifting perspectives on intermediate targets in the switch from monetary targeting to a multiple indicator approach. It also discusses the changes in the operating procedures that became necessary to conduct monetary policy in an effective manner.