Academic journal article IUP Journal of Applied Economics

An Empirical Analysis of Monetary Transmission in India in the Post-Reform Period: Relevance of the Banking Channel

Academic journal article IUP Journal of Applied Economics

An Empirical Analysis of Monetary Transmission in India in the Post-Reform Period: Relevance of the Banking Channel

Article excerpt

Empirical evidences on the transmission mechanism by which monetary policy affects the economy, particularly general prices and real activity, are essential, both for effective policy making and understanding the alternate macroeconomic theories. A consensus has largely been established on the influence of monetary policy on the economy through its impact on the spending decisions on consumption and investment. Banks play a central role in monetary transmission as monetary policy impulses through bank credit affect consumption and investment decisions of the individuals and thus affect the aggregate demand, which in turn transmits the impact to the final objectives of price and output stabilization. The present study attempts to empirically examine the nature and strength of monetary policy influence on inflation and real activity in India, with special emphasis on the role of banking channel in the transmission process. Considering the fact that the Reserve Bank of India adopted 'multiple indicator approach' in the conduct of monetary policy since April 1998, the present paper uses a Monetary Policy Indicator (MPI) to capture the policy stance appropriately. The empirical evidences reiterated monetary policy influence on inflation and real activity. The lag effect of monetary policy on inflation (about 18 months) was found to be longer as compared to real activity (about a year), implying the impact of policy shocks being realized initially in aggregate demand subsequently gets transmitted to prices. Monetary policy shocks were observed to have desired influence on interest rates and bank investments, while the effect on bank credit was observed with a lag of around one year. The empirical evidences revealed high importance of bank investment in the monetary transmission process, which seems plausible given the relevance and size of bank investment portfolio in the Indian context.

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Introduction

In the pursuit of price and output stabilization, monetary policy serves as the key constituent of the overall economic policy across the industrial and emerging economies. In the face of economic slowdown, monetary authorities adopt an expansionary policy to augment aggregate demand and endeavor to lift the economy up to its potential trajectory, while in an overheated economy, they espouse a tight money policy putting brake on price inflation. For effective conduct of monetary policy, the issues pertaining to the transmission mechanism by which the monetary policy affects the economy, particularly the prices and real activity, are vital. Mishkin (1996) presents a schematic description of working of various channels of monetary transmission. Banks play the central role in monetary transmission, as monetary policy impulses through bank credit affect consumption and investment decisions of the individuals and thus affect the aggregate demand, which in turn transmits the impact to the final objectives, prices and real activity.

Bernanke and Blinder (1988) developed an analogue to the simple IS-LM model which explained the monetary transmission mechanism through bank loans. Given the special nature of association between the banks and the bank-dependent customers, spending by these customers would decline as a response to fall in bank lending. Results from Bernanke and Blinder (1992) are consistent with the view that monetary policy works in part by affecting the composition of bank assets. They found that the maximum effect of monetary policy shocks on the deposits of the banks was realized in nine months, while the maximum effect on the bank loans was noticed after about two years. Thus, in the short run, banks responded to tight money policy by selling securities with little effect on loans, but there was evidence of the influence on loans in the long run. However, similarity in the nature of monetary policy impact on the unemployment rate and bank loans implied possibility of bank loans responding to real activity. …

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