Academic journal article IUP Journal of Applied Economics

Monetary Policy Transmission in India: A Post-Reform Analysis

Academic journal article IUP Journal of Applied Economics

Monetary Policy Transmission in India: A Post-Reform Analysis

Article excerpt

Introduction

Economists and politicians have been heard to advocate in the recent times that the stabilization of output and inflation be left to monetary policy. Fiscal policy has lost its luster, partly because of the concern over persistently large budget deficits and partly because of the doubts that the political system can make tax and spending decisions in a timely way to achieve desirable stabilization outcomes. The recent debt crisis in Greece and Ireland bears testimony to the fact as to how a poor fiscal policy can result in undesirable outcomes. Meanwhile, monetary polic y has been ever more at the center of macroeconomic policymaking.

Monetary policy is a powerful to ol, but sometime s has unexpected or unwanted consequences. There are many instances of how a loose monetary policy has led to crisis, for example, the main causes of the recent financial crisis in the US lie in the loose monetary policy of the Federal Reserve. But also during the same time, the Reserve Bank of India (RBI) with its efficient monetary policy, to a great extent, prevented the effects of the financial crisis. Therefore, to be successful in conducting monetary policy, the monetary authorities must have an accurate assessment of the timing and effects of their policies on the economy, thus requiring an understanding of the monetary transmission mechanisms through which the monetary policy affects the economy.

Since the beginning of the 1990s, the analysis of monetary transmission mechanism in emerging economies has gained importance due to structural and economic reforms and subsequent transitions to new policy regimes. However, these economies have specifications different from those of industrialized countries. Monetary policies in emerging economies are constrained by the world's major central banks, i.e., the Federal Reserve Bank, the European Central Bank and the Bank of Japan. Hence, the analysis of monetary transmission mechanisms in emerging economies requires a model specification different from that of developed countries. A model misspecification may bias the results. The so-called price- puzzle is one of the consequences of model misspecification (Sims, 1992). Therefore, we need to take important external exogenous variables like the Federal funds rate, the US GDP and other variables into the model.

Accompanying the reforms post 1991, there has been a considerable shift in the conduct of monetary policy by the RBI. In the macroeconomic policy, India's preference so far has been for the 'money-based' stabilization. Instead of targeting the broad money growth as it did earlier, the RBI began to rely on assembling information on an array of indicators, such as data on currency, credit extended, fiscal position, trade, capital flows, interest rates, inflation rate, exchange rate, refinancing and transactions in foreign exchange. The RBI now actively uses a combination of open market operations, auction of government securities and private placements to maintain medium and long-term interest rates. In short, the RBI has adopted market-oriented monetary policy instruments and operating procedures. In the new monetary policy framework, issues related to monetary transmission mechanisms have gained much importance. Some studies have examined specific transmission channels of monetary policy in India (Al-Mashat, 2003; Prasad and Ghosh, 2005; and Pandit et al. 2006). This paper examines the three channels of monetary transmission in India-the bank lending channel, the asset price channel and the exchange rate channel.

The paper is structured as follows: it reviews the previous works on monetary transmission mechanisms and proposes a benchmark Vector Autoregression (VAR) model in order to estimate the dynamic responses of GDP, prices and interest rates to an unanticipated monetary policy tightening. Subsequently, it analyzes the empirical findings and offers the conclusion.

Literature Review

Bernanke and Blinder (1992) used the structural VAR model to show that a change in the Federal funds rate affects bank assets (loans) and bank liabilities and showed that bank loans form an important component of monetary transmission. …

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