The logical evolution of the monetary policy setting in the 1970s was in the direction of credit rationing as an integral element of developmental planning. The rationing of credit evolved with food credit being given the first charge, followed by the prescribed priority sector lending, sectoral limits for credit deployment and selective credit controls. Sectoral credit targets became the proximate targets for monetary policy which was operated through allocations of non-food commercial bank credit.

Selective credit controls were strengthened by the institution of the Credit Authorisation Scheme in 1966-88 and with the nationalisation of banks, the institutional apparatus for conducting monetary policy through the credit channel, to the virtual exclusion of other channels, was complete. Refinance was provided in order to make up for the shortfall of credit targets in relation to demand. The quantitative credit planning implied a reduced role of the interest rate as an equilibrating mechanism in the credit market. The interest rate structure was complicated and administered, rendering it inflexible and sterile as an instrument of monetary policy. The policy of setting up interest rate ceilings up to 1987-88 in situations of excess demand reinforced the rationing of bank credit in order to influence aggregate demand.

The conduct of monetary management has undergone significant changes in the 1990s in terms of objectives, framework and instruments, reflecting broadly the progressive liberalisation of the Indian economy. The Reserve Bank announced a multiple indicator approach in 1998-99, which accords the necessary flexibility to respond to changes in domestic and international economic and financial market conditions more effectively. The monetary stance of the Reserve Bank in the recent period has been to ensure that all legitimate requirements for credit are adequately met consistent with the objective of price stability. Liquidity operations are conducted with a view to ensuring that the demand for reserves is stable and adequately satisfied so that credit projections consistent with the macroeconomic objectives of growth and inflation are achieved. Simultaneously, progressive improvements in the modes of delivery of bank credit have been pursued.

The genesis of the credit view is essentially traced to a critique of the standard macroeconomic literature which treats the financial structure as irrelevant to real outcomes (Modigliani and Miller, 1958). There has, however, been a long standing alternative tradition in the literature beginning with Fisher (1933) and Keynes (1930) and upheld in more recent years by Bernanke (1983), Blinder (1987), Gertler (1988) and others which has asserted a central role of the credit market in the propagation of cyclical fluctuations. In this alternate view, deteriorating credit-market conditions - sharp increases in insolvencies and bankruptcies, rising real debt burdens, collapsing asset prices - are not passive reflections of a declining economy, but are themselves major contributors to the depression. Abandoning the classical view of the financial system just acting as a 'veil' and merely accommodating the real sector requirements, the credit view literature incorporates credit market imperfections into the standard macroeconomic models to show the crucial role of credit behaviour in explaining even "garden-variety" cyclical fluctuations (Bernanke, Gertler and Gilchrist, 1999). The two key assumptions in the credit channel are that banks cannot shield their loan portfolios from changes in monetary policy and that borrowers cannot fully insulate their real spending from changes in the availability of bank credit. Monetary policy works by affecting bank assets, i.e., loans, in addition to bank liabilities, i.e., deposits and the credit channel is a supplement, not an alternative, to the usual money channel (Box V.2).

Empirical examination of the credit view associates the severity of Great Depression of the early 1930s in part with financial distress associated with the deflation experienced during that period (Bernanke, 1983). Interest in the credit channel has revived in the early 1990s with the growth record in Asia and Latin America being associated with a bank credit boom and narrowing of intermediation spreads. The large devaluations and interest rate shocks of end-1994/early 1995 in Latin America and at the end of 1997-98 in Asia are attributed with having eroded the deposit base and created large non-performing loans, leading to a credit squeeze which prolonged the recession beyond the period warranted by the initial monetary tightening. As bank loans form a crucial input for provision of working capital as well as households' spending decisions in a typical emerging market economy, the bank credit squeeze led to a drop in the real GDP concentrated in non-tradeable sectors (Catao and Rodriguez, 2000). Some evidence of credit view is also found in Finland for the period 1980-1996 (Anari et al, 1999). Recent empirical work on the co-behaviour of limits on borrowing and the "buffer stock" have established the effects of credit market imperfections on consumption demand (Deaton, 1991) as well as investment demand via the impact of the balance sheet (Hubbard et al, 1995). The cross-country experience in developed economies as well as the developing economies suggests that given the existence of credit market imperfections as well as bank dominated credit markets, bank credit acts as a "financial accelerator" amplifying both the economic downturns as well as upswings by a far greater degree than warranted by initial monetary shocks.

resulted in a certain disenchantment with the credit view that was regarded as the 'ruling orthodoxy'. The restriction on operational freedom for the banks in the form of statutory pre-emptions for food procurement, exports, agriculture, small scale sector, vulnerable sections, core industries and sick industries implied that the channel of credit allocation to few pockets of the commercial sector could transmit very limited influence on the real economic variables (Vasudevan, 1978). Nevertheless, even with the advocacy for monetary targeting, full credence was given to the 'credit view' as the creation of money was viewed as simultaneously the creation of credit (RBI, 1985). While monetary expansion leads to an increase in prices, credit expansion facilitates an increase in investment and expansion in output. The issue before the policy maker is to balance the output gains of credit creation with the inflationary consequences of money creation. In the context of a macroeconomic model, it was shown that the price effect of a given expansion in money supply is higher than the output effect (Rangarajan, 1997).

Studies conducted in the early 1990s have raised a number of interesting features of the Indian credit market. First, there appears to be a switch from a regime of credit rationing to a situation of demand constraint in the loan market in 1993-94. Second, the presence of excess liquidity in the system had failed to stimulate production. Third, the increase in commercial bank credit to the government had been far in excess of the requirement under the SLR (Rakshit, 1994). In the context of credit-supply constrained firms in the Indian industry, three major findings have been reported. First, bank credit does influence inventory accumulations. Second, the size of external finance premium depends on the financial conditions of firms and third, bank dependent small industries suffer most during the period of quantitative credit control (Mukhopadhyaya, 1998). Stylised Facts in India.

An analysis of macroeconomics of credit holds the key to an understanding of the role of monetary policy in the context of the possibilities of revitalising growth in the Indian economy for four reasons. First, the credit velocities have progressively become more stable than money velocities over the recent years. The ratio of GDP to bank credit to commercial sector, after having declined from 7.7 in 1970-71 to 3.8 in 1984-85, has remained stable thereafter around that value. The ratio of GDP to net bank credit to government decreased from 9.2 in 1970-71 to 4.6 in 1986-87 but stabilised thereafter around that value. The money (M3) income velocity has declined from 4.4 in 1970-71 to 1.9 in 1999-2000.