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Project on Assessment of Key Issues Related to Monetary Policy
[Source: RBI Report on Currency & Finance 2003-04]
Module: 2 - Monetary Policy Framework In India
Intermediate Targets - from Broad Money to a Multiple Indicator Approach
As indicated earlier, central banks seek to achieve their final objectives through the control of intermediate targets. In India, these targets have evolved over time with changes in the overall operating environment of monetary policy and financial liberalisation of the Indian economy. This subsection presents a brief overview of the evolution of the intermediate targets - from broad money to a multiple indicator approach - in the conduct of the Reserve Bank's monetary policy.
The Reserve Bank 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 1967-68. Credit targeting, in fact, wove well into the concept of development central banking. Since inflation was largely thought to be structural, selective credit controls were used, from 1956, to regulate bank advances to sensitive commodities to influence production outlays, on the one hand and to limit possibilities of speculation, on the other. A Credit Authorisation Scheme (CAS), introduced in November 1965, required commercial (and later, co- operative banks, since 1974) banks to seek the Reserve Bank's prior approval before sanctioning large working capital limits. This additional measure of credit regulation was expected to perform the multiple objectives of keeping inflationary pressures under check and ensuring that credit was directed to genuine purposes. The elaborate process of credit regulation, however well intentioned, was not only the cause of delays in credit disbursal but also impeded efficient resource allocation by segmenting credit markets [Marathe Committee (RBI, 1983); Chakravarty Committee (RBI, 1985)]. It was in this context that the requirement of prior authorisation in respect of credit limits exceeding a threshold level under the Credit Authorisation Scheme was replaced by a system of post-sanction scrutiny in 1988. Selective credit controls were also abolished in the 1990s.
During the early 1960s, even as the analytics of money supply continued to be governed by the expansion in credit, the Reserve Bank began to pay greater attention to the movements in monetary aggregates. This accent on monetary aggregates was supported by several empirical studies which provided evidence of a stable money demand function in the Indian economy. By the early 1980s, there appeared to be a consensus that while fluctuations in agricultural prices and oil price shocks did affect prices, continuous inflation of the kind witnessed since the early 1960s could not occur unless it was sustained by the continuous excessive monetary expansion generated by the large-scale monetisation of the fiscal deficit.
Against this backdrop, the Chakravarty Committee recommended a monetary targeting framework to target an acceptable order of inflation in line with output growth (RBI, 1985). Changes in broad money were thought to provide reasonable predictions of average changes in prices over a medium-term horizon of 4-5 years, though not necessarily on a year-to-year basis. It was, in fact, argued that in the absence of a stable money demand function, the role of monetary policy in inflation management would itself be negligible. Thus, broad money emerged as an intermediate target of monetary policy and the Reserve Bank began to formally set monetary targets in order to rein in inflation. As the process of money creation is simultaneously a process of credit creation, it was also necessary to estimate the increase in credit required by the projected increase in output. The concept of monetary targeting adopted by the Reserve Bank was a flexible one allowing for various feedback effects.
The process of financial liberalisation, which gathered momentum in the 1990s, necessitated a re-look at the efficiency of broad money as an intermediate target of monetary policy. The Reserve Bank's Monetary and Credit Policy Statement of April 1998 noted that most studies in India show that money demand functions have so far been fairly stable. At the same time, it observed that financial innovations emerging in the economy provided 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 seemed to exercise some influence on the decisions to hold money. In a similar vein, the Working Group on Money Supply: Analytics and Methodology of Compilation (Chairman: Dr. Y.V. Reddy) observed that monetary policy exclusively based on the demand function for money could lack precision (RBI, 1998a) (Box III.7).
The Reserve Bank, therefore, formally adopted a multiple indicator approach in April 1998. Besides broad money which remains an information variable, a host of macroeconomic indicators including interest rates or rates of return in different markets.
Box III.7
Stability of Money Demand
In India, broad money emerged as an intermediate target of monetary policy from the mid-1980s following the recommendations of the Chakravarty Committee (RBI, 1985). The monetary targeting framework was based on the premise of a stable relationship between money, output and prices. At the same time, in view of ongoing financial innovations, a view emerged that monetary policy exclusively based on the demand function for money could lack precision. This necessitated a switch to a multiple indicator approach in which broad money remains an important information variable in the conduct of monetary policy. Notwithstanding this shift, the Reserve Bank's monetary policy statements continue to provide an indicative trajectory of broad money growth. Amongst the recent studies, Joshi and Saggar (1995), Arif (1996), Mohanty and Mitra (1999) and Das and Mandal (2000) found evidence in favour of money demand stability while Bhoi (1995) and Pradhan and Subhramanian (2003) found that financial deregulation and liberalisation in the 1990s did affect the empirical stability of broad money demand.
Against this backdrop, an attempt is made to examine stability of money demand in India. Following the literature, real broad money is postulated to depend upon real GDP. In order to assess the role of interest rates, the interest rate on deposits of 1-3 years maturity is included. As these variables turn out to be non-stationary, cointegration analysis is undertaken in the Johansen-Jesuelius framework, using annual data from 1975-76 to 2003-04. Based on trace as well as maximum eigenvalue tests, the null hypothesis of a single cointegrating vector cannot be rejected. The coefficients of the cointegrating vector have the expected signs1. Real money demand increases with real GDP and the estimated coefficient - although it cannot be interpreted as the elasticity - is close to the various estimates of income elasticity of money demand in India. As regards the interest rate, its coefficient is positive. This reflects the fact that time deposits are the predominant component of broad money and an increase in the interest rate on these deposits, therefore, leads to a shift of financial assets towards bank deposits. This analysis, therefore, confirms that real money and output are cointegrated, i.e., there exists a long-run relationship between these variables.
Following this, the short-run dynamics are examined using an error correction model. Results indicate that real GDP and interest rates are weakly exogenous to the system. As regards real money, the error correction results show that the coefficient on the error correction term is negative and statistically significant (t-value is 4.0)8 . Stability properties of the short-run model are examined by employing CUSUM and CUSUM SQUARE tests. Both these tests indicate that the path of the parameters has been within the two standard error bands. While this supports the stability of the parameters, the path of the parameters is not exactly horizontal. However, as noted by the Working Group on Money Supply (RBI, 1998), the predictive stability is equally important. Towards this purpose, the model is re-estimated up to 1999-2000 and multivariate dynamic forecasts for change in broad money are evaluated. The model under-predicts the demand for money. A number of factors may explain this behaviour. First, inflation has come down significantly since the second half of the 1990s and this could have increased the real demand for money. Second, monetary aggregates are inclusive of nonresident deposits and movements in these deposits have varied a lot from year-to-year, mainly in response to policy efforts to modulate these deposits. Third, the mergers in the banking industry have provided a jump to monetary aggregates. From these factors, it is evident that in the short-run, there can be deviations from the long-run equilibrium relationship. These results thus support the conclusions of RBI (1998) that monetary policy based solely on broad money could lack precision. At the same time, given the long-run relationship, there is a role for monetary aggregates to play. Accordingly, a multiple indicator approach in which broad money remains an important information seems to be appropriate. (Money, capital and Government securities markets) along with such data as on currency, credit extended by banks and financial institutions, fiscal position, trade, capital flows, inflation rate, exchange rate, refinancing and transactions in foreign exchange available on high frequency basis are juxtaposed with output data for drawing policy perspectives in the process of monetary policy formulation.
This large panel of indicators is sometimes criticised as a 'check list' approach, which tends to water down the concept of a nominal anchor for monetary policy. It is certainly true that a single intermediate target is much more theoretically appealing and operationally easier. At the same time, it is very difficult to find a variable, which would be able to encapsulate the larger number of factors, which need to go into monetary policy making at this stage of transition from a relatively autarkic administered economy to a relatively open market-oriented economic system. As channels of monetary policy transmission shift course as a result of financial liberalisation, the central bank has to naturally operate through all the paths that transmit its policy impulses to the real economy. As discussed in Section I, given the environment of high uncertainty in which monetary authorities operate, a single model or a limited set of indicators is not a sufficient guide for the conduct of monetary policy. The multiple indicators approach provides the required "encompassing and integrated set of data".
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1 LMR = -9.6 + 1.32 LGDPR + 0.02 DR
MR, GDPR and DR are real broad money, real GDP and nominal interest rate on deposits of 1-3 years. The prefix L denotes that variables are in logs. The VAR was estimated with three lags.
8 DLMR = 0.04 DLMR(-1) + 0.53 DLGDPR(-1) - 0.01 DDR(-1) + 0.08
DLMR(-2) + 0.05 DLGDPR(-2) + 0.003 DDR (-2) - 0.16 ECM(-1)-
R2 = 0.26 DW = 1.5
The variables are defined in the footnote in the previous article. The prefix D denotes that variables are in first-difference form while ECM is the error correction term.
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