Module: 4
Parameters of Monetary Policy in India
[Lecture by Dr Y V Reddy, Deputy Governor of the Reserve Bank of India, at the 88th Annual Conference of
The Indian Econometric Society at Madras School of Economics, Chennai, 15 January 2002.]

Objectives

It is generally believed that central banks ideally should have a single overwhelming objective of price stability. In practice, however, central banks are responsible for a number of objectives besides price stability, such as currency stability, financial stability, growth in employment and income. The primary objectives of central banks in many cases are legally and institutionally defined. However, all objectives may not have been spelt out explicitly in the central bank legislation but may evolve through traditions and tacit understanding between the government, the central bank and other major institutions in an economy.

Of late, however, considerations of financial stability have assumed increasing importance in monetary policy. The most serious economic downturns in the recent years appear to be generally associated with financial instability. The important questions for policy in the context of financial instability are the origin and the transmission of different types of shocks in the financial system, the nature and the extent of feedback in policy and the effectiveness of different policy instruments.

Monetary policy is known to have both short and long-term effects. While it generally affects the real sector with long and variable lags, monetary policy actions on financial markets, on the other hand, usually have important short-run implications. Typical lags after which monetary policy decisions begin to affect the real sector could vary across countries. It is, therefore, essential to understand the transmission mechanism of monetary policy actions on financial markets, prices and output. Central banks form their own views on the transmission mechanism based on empirical evidence, and their monetary strategies and tactics are designed, based on these views. However, there could be considerable uncertainties in the transmission channels depending on the stages of evolution of financial markets and the nature of propagation of shocks to the system.

The four monetary transmission channels, which are of concern to policy makers are: the quantum channel, especially relating to money supply and credit; the interest rate channel; the exchange rate channel, and the asset prices channel. Monetary policy impulses under the quantum channel affect the real output and price level directly through changes in either reserve money, money stock or credit aggregates. The remaining channels are essentially indirect as the policy impulses affect real activities through changes in either interest rates or the exchange rate or asset prices. Since none of the channels of monetary transmission operate in isolation, considerable feedbacks and interactions, need to be carefully analysed for a proper understanding of the transmission mechanism.

The exact delineation of monetary policy transmission channels becomes difficult in the wake of uncertainties prevalent in the economic system, both in the sense of responsiveness of economic agents to monetary policy signals on the one hand, and the proper assessment by the monetary authority of the quantum and extent of desired policy measures on the other. The matter is particularly complex in developing countries where the transmission mechanism of monetary policy is in a constant process of evolution due to significant ongoing structural transformation of the economy.

It is important to distinguish strategic and tactical considerations in the conduct of monetary policy. While monetary strategy aims at achieving final objectives, tactical considerations reflect the short run operational procedures. Both strategies and tactics for monetary management are intricately linked to the overall monetary policy framework of a central bank. Depending upon the domestic and international macroeconomic developments, the long run strategic objective could change, leading to a change in the nature and the extent of short run liquidity management.

The strategic aspects of monetary management crucially depend on the choice of a nominal anchor by the central bank. In this regard, four broad classes of monetary strategies could be distinguished. Two of these, viz., monetary targeting and exchange rate targeting strategies, use a monetary aggregate and the exchange rate respectively as an explicit intermediate target. The third, viz., multiple indicator approach, does not have an explicit intermediate target but is based on a wide range of monetary and financial indicators. The fourth, viz., inflation targeting, also does not have an intermediate target, but is characterized by an explicit final policy goal in terms of the rate of inflation.

In the 1970s when monetary policy came into prominence, many countries adopted either money supply or exchange rate as intermediate targets. During the late 1980s, these paradigms started to change following globalization, technological advancements and large movement of capital across national boundaries.

In view of difficulties in conducting monetary policy with explicit intermediate targets, of late, some countries are switching to direct inflation targeting, which works by explicitly announcing to the public the goals for monetary policy and the underlying framework for its implementation. In this framework, the monetary authorities have the freedom to deploy the instruments of monetary policy to the best of their capacities, but are limited in their discretion of policy goals. The framework is advocated on the ground that it clearly spells out the extent of central bank accountability and transparency.

In reality, monetary policy strategy of a central bank depends on a number of factors that are unique to the country and the context. Given the policy objective, any good strategy depends on the macroeconomic and the institutional structure of the economy. An important factor in this context is the degree of openness of the economy. The more open an economy is, the more the external sector plays a dominant role in monetary management. The second factor that plays a major role is the stage of development of markets and institutions: with technological development as an essential ingredient. In a developed economy, the markets are integrated and policy actions are quickly transmitted from one sector to another. In such a situation, perhaps it is possible for the central bank to signal its intention with one single instrument.

Operating procedures refer to the choice of the operational target, the nature, extent and the frequency of different money market operations, the use and width of a corridor for market interest rates and the manner of signaling policy intentions. The choice of the operating target is crucial as this variable is at the beginning of the monetary transmission process. The operating target of a central bank could be bank reserves, base money or a benchmark interest rate. While actions of a central bank could influence all these variables, it should be evident that the final outcome is determined by the combined actions of the market forces and the central bank.

The major challenge in day-to-day monetary management is decision on an appropriate level of the operating target. The success in this direction could be achieved only if the nature and the extent of interaction of the policy instruments with the operating target is stable and is known to the central bank. As the operating target is also influenced by market movements, which on occasions could be extremely volatile and unpredictable, success is not always guaranteed. Further, success is also dependent on the stability of the relationship between the operating target and the intermediate target. In a monetary targeting framework, this often boils down to the stability and the predictability of the money multiplier. In an interest rate targeting framework, on the other hand, success depends upon the strength of the relationship between the short-term and the long-term interest rates. Finally, the stability of the relationship between the intermediate and the final target is critical to the successful conduct of the operations.

Transparency in monetary policy is emphasised in the recent years on the ground that it leads to a reduction in the market's uncertainty about the monetary authority's reaction function. It is further argued that greater transparency may improve financial market's understanding of the conduct of monetary policy and thus reduce uncertainty. The limits to transparency are also recognised since publishing detailed results of a central bank's economic projections may eliminate an element of surprise, which is useful on occasions with respect to the central bank's operations in financial markets.

In the conduct of monetary policy, although the experiences and the choices made by individual countries vary, recent surveys highlight a number of common features, viz.,