The real interest rate assumes critical importance in the transmission of monetary policy to growth. The real interest rate is not 'real' in the sense that, unlike nominal rates, it is not directly observed. Consequently, monetary authorities are constrained to take a 'view' on the real interest rate to ensure the efficacy of policy intervention. The classical view of the real interest rate being determined by the real forces of saving (thrift) and investment (productivity) and unaffected by nominal variables such as monetary growth or inflation does not fit well with the operational conduct of monetary policy. In the short-run, given wage and price rigidities, monetary factors can influence real interest rates and even in the long-run, variations in the rate of monetary growth can have effects on real interest rates through Tobin-Mundell portfolio effects. Similarly, the Keynesian treatment of the interest rate as being purely a monetary phenomenon determined in the money market has to be regarded as only a partial explanation of the determination of interest rates. The concept of a 'neutral rate of interest' - a rate consistent with the stock and flow equilibrium of households and firms (savers and investors) at the natural rate of growth of the economy - reconciles the two approaches within the academic debate (Allssopp and Glyn, 1999). The synthesis identifies a host of real and monetary factors - savings, investment, technology and other preference shocks, stance of fiscal policy (size of public debt coupled with the absence/presence of Ricardian equivalence), the stance of monetary policy and its interventions, credit restraints, the efficiency of the financial system, the degree of financial liberalisation - as determinants of real interest rates in a general equilibrium framework.

There is a growing recognition that there is no unique fundamental equilibrium real long-term interest rate. Empirical evidence for the US, the UK, France and Germany suggests that the real interest rates increased from 1980s onwards over the levels prevailing during the 1950s and 1960s (Chadha and Dimsdale, 1999). The low real interest rates during the 1950s and 1960s reflected the greater policy weightage assigned to output expansion. The surge in real rates from 1980s onwards reflected tighter monetary policy to contain inflation. The response of short-term nominal interest rates to inflation has improved in the recent years -in other words, variability of real interest rates has declined - reflecting greater policy focus by the monetary authorities on inflation control. Higher real interest rates since the 1980s also reflected a looser fiscal policy stance (Ford and Laxton, 1999) and an overall tendency towards deregulation of financial markets.

The issue of the appropriate real interest rates for India has acquired a growing focus with the shift away from a planned economy to a market-determined economy in the context of financial sector reforms (Reddy, 1998). An important early input in this regard was the Report of the Committee to Review the Working of the Monetary System (RBI, 1985). Recognising that the depositor needs to be assured of a 'reasonably high positive real rate of interest' on savings to deter 'leakages' of financial saving in the form of gold, real estate and physical assets, it recommended a real positive interest rate of up to 3 per cent depending upon maturity, issuer and instrument: marginally positive real return on 91-day Treasury Bills, a positive real return of 2 per cent per annum for bank deposits of maturity of 5 years or more and a positive real return of 3 per cent per annum on 15-year government dated securities. There is also an influential view that the optimum real interest should be closer to the expected long-term growth rate of the economy; hence, for an economy, like India, growing at 6-8 per cent per annum, the optimum real rate would be higher than that for an economy growing at 2-3 per cent (Brahmananda, 2000). Measuring Real Interest Rates.

The principal wedge between real and nominal interest rates is inflation expectations. In practice, the real interest rate is typically measured as inflation adjusted nominal interest rates but this is an ex-post assessment of how inflation has eroded the returns on investment in some past period. To obtain a forward-looking ex-ante measure, the real interest rate may be defined as nominal interest rate less inflationary expectations. An important aspect in this context is the time horizon. Very short-term official interest rates set by government and overnight inter-bank interest rates are in a sense reflective of the real interest rates since over such horizons, prices are essentially constant (except episodes of hyperinflation).

Accordingly, the first step towards obtaining a forward-looking view of the real interest rate is to estimate inflation expectations. A variety of approaches has been employed to model inflation expectations, like collecting information on people's attitudes about the inflation outlook through surveys, observing differences in yields of nominal and indexed bonds, and drawing inferences from macroeconomic data. Inflation expectations could alternately be modelled through time-series based on econometric approaches. The real interest rate calculated by adjusting the representative nominal interest rate for inflation expectations would diverge from an ex-post measure depending upon the volatility of the inflation rate in the past.

The ex-post real interest rates (SBI Advance Rate less actual inflation) have remained high in the recent period (1995-2000), averaging around 8.7 per cent as against the average real growth rate of 6.6 per cent. On the other hand, ex-ante real interest rates (SBI advance rate less inflation expectations) averaged 7.5 per cent, lower than the ex-post rates over the same period. Real interest rates in India imbibe some of the rigidities characterising nominal interest rates: (i) household preferences for fixed rate deposits reduces the banks' flexibility to reduce interest rates in the short-run; (ii) relatively high-level of non-performing assets coupled with high non-operating costs imparts a stickiness to banks' lending rates; (iii) persistent and large volume of market borrowing requirements of the Government; and (iv) structure of administered rates on small savings. It is in the context of (iv) that the Report of the Expert Committee to Review the System of Administered Interest Rates and Other Related Issues (Chairman : Dr. Y.V. Reddy) (RBI, 2001) recommended that the interest rates on small savings and other administered instruments of various maturities be benchmarked, with a spread of a maximum of 50 basis points and with an objective to reduce the spread over a period to the secondary market yields of various government securities of corresponding maturities. Provident funds could be offered only on a floating rate basis, while for all other small savings, an option of fixed versus floating rates may be provided at the time of entry.

In the 1980s, with the erosion of the stability of money demand and the explanatory power of monetary aggregates on account of financial innovations, globalisation and the growing sophistication of financial markets, monetary authorities have increasingly resorted to interest rates, to the almost complete exclusion of monetary or reserve aggregates, both as sources of information for determining policy as well as operating instruments for conducting monetary policy. The main operating instrument for most central banks today is a short-term interest rate. Markets are the deepest in the short-end, allowing central banks to intervene in support of policy objectives without generating serious repercussions on market activity. Moreover, impulses from the short-end are transmitted relatively quickly across the term structure of interest rates and this makes for efficiency in intervention. The recent experience has shown that central banks have been proactively moving target interest rates in support of output/employment and financial stability considerations, even if this has meant a temporary departure from their commitment to price stability. A contractionary monetary policy is reflected in an increase in the nominal short-term interest rate. As wages and prices take time to adjust to the interest rate change, the higher nominal interest rates translate into higher real short-term as well as long-term interest rates which dampen investment and consumption leading to a fall in aggregate demand and contraction in output. Over a period of time, as wages and commodity prices begin to adjust, aggregate demand is restored and real activity, the real interest rate and the real exchange rate return to their fundamental levels. In consensus models underlying the reactions of monetary authorities under constrained discretion, the relationships of short-term (policy) interest rates and output via the real interest rate have come to be regarded as almost axiomatic: raise interest rates today and, given the lags in the operation of monetary policy, output (and inflation) contracts say 8-16 months hence. The key issue in this context is the sensitivity of consumption and investment to movements in the interest rates.

In India, interest rates as an instrument of monetary policy, were activated in the 1990s. With the financial sector reforms, the monetary management has been increasingly relying upon the use of indirect instruments like interest rates and open market operations including repos. During the pre-reform period, the Bank Rate had a limited role as a monetary policy instrument. It was activated and made as a signaling and reference rate in April 1997 linking it to rates at which accommodation is provided by the Reserve Bank. Changes in the Bank Rate are also seen as an integral part of the monetary policy stance of the Reserve Bank announced from time to time and provide a direction to general level of interest rates in the system. As such, the importance of the Bank Rate which influences cost and availability of credit in the economy has increased.

Along with the Bank Rate, the open market operations of the Reserve Bank have also been actively used. With the Reserve Bank's stance to move away from the sector-specific refinance schemes, the liquidity in the system is managed increasingly through the liquidity adjustment facility (LAF), which was introduced in June 2000. The operating procedures of the LAF including auction methods and periods are being refined periodically to make it more efficient. With a strategy for a smooth transition of call money market into a pure inter-bank market, the liquidity support available from the Reserve Bank has been rationalised. As such, the repo and reverse repo rates emerging from the LAF auctions essentially reflect the market conditions of availability of liquidity in the system along with the rate at which the liquidity is available from the Reserve Bank. The LAF injects/absorbs liquidity on a day-today basis in a flexible manner and in the process provides a corridor for the call money and other short-term interest rates. During the last decade, deposit interest rate structure in India has been, by and large, deregulated except the savings deposits rate, which is currently prescribed by the Reserve Bank. Commercial banks have been given virtual freedom to determine their lending rates. The interest rates, particularly at the short-end of the market, are more aligned and integrated. The economic agents are currently responding to changes in the interest rates. Nevertheless, there are quite a few rigidities in the structure of interest rates.

The Report of the Working Group on Money Supply (RBI, 1998b) found a positive impact of expansionary monetary policy on output, both through reduced interest rates and increased credit. A comparative assessment indicated that the output response operating through the interest rate channel was stronger and more persistent than that of the credit channel. Similar findings are reported from a comparison of monetary impulses transmitted through interest rate effects with that through liquidity effects for the period 1961-2000. The interest rate emerges as a significant factor explaining the variation in real activity in the 1990s as compared with a negligible impact in the 1980s (Dhal, 2000).

Thus, variations in short-term nominal interest rates by the monetary authority do have real effects in the short- and medium-term. However, the possibility of inflation bias - dynamic inconsistency - arising out of the policy discretion has provoked the search for specifying systematic, stable and predictable policy rules to guide the conduct of interest rate policy a la the Taylor's rule (Taylor, 1993) under which the nominal interest rates are calibrated to respond symmetrically to deviations of output from its potential growth path and inflation (expectations) from the target. Such rules or policy reaction functions, as they are euphemistically termed, reduce the inflation bias in growth oriented monetary policy (Svennson, 1999).