Project on Assessment of Key Issues Related to Monetary Policy
[Source: RBI Report on Currency & Finance 2003-04]

Foreword & Introduction

The process of financial and external liberalisation during the last couple of decades worldwide has impacted upon the conduct of monetary policy in a significant manner. Increasing trade openness, higher volume and sharp swings in capital flows as well as greater volatility in exchange rates are some of the key stylised facts of the 1990s. As a result, economic developments abroad have an increasingly high degree of influence on domestic output and prices. Simultaneously, risks of contagion have increased manifold, posing threats to macroeconomic and financial stability. Consequently, these developments have necessitated refinements in objectives, strategies and tactics of monetary policy, even though central banks have had a noteworthy success in terms of their inflation objective.

The structural reforms process was initiated in India in the early 1990s in order to place the economy on a higher growth path on a sustainable basis. These reforms encompassed almost all sectors of the Indian economy and, among others, necessitated changes in the monetary policy framework. The conduct of monetary policy has been changing in response to the process of financial liberalisation. The increasing volume of cross-border trade in goods and services along with that of financial flows have enhanced inter-dependence in monetary policy formulation across countries. Sharp swings in capital flows and volatile exchange rate movements have emerged as key concerns in monetary management in the emerging market economies. Accordingly, all central banks are paying greater attention to financial stability considerations in their overall design of monetary policy formulation. Financial innovations have also induced significant transformation in the operating procedures of monetary management. Concomitantly, there is now a growing recognition of the need to impart to central banks a greater degree of independence, especially from the budgetary compulsions of the Governments, in order to stabilise inflationary expectations for ensuring price stability.

In India, the conduct of monetary policy during the 1990s has been shaped by wide-ranging structural reforms during this period. This necessitated significant changes in the monetary policy framework in terms of objectives, instruments and targets. The changes had to be dovetailed with a simultaneous process of evolution of financial markets in consonance with the aim of enhancing allocative efficiency through the process of price discovery. At the heart of monetary reforms lay the containment of the fiscal dominance of monetary policy. In contrast, with the opening up of the economy, monetary management had to contend increasingly with challenges emanating from the large volume and sudden switches in capital flows and episodes of volatility in the financial markets. In this milieu, while price stability and credit availability remained twin objectives of monetary policy, financial stability has gradually emerged as a key consideration in the conduct of monetary policy.

In India, as stated earlier, structural reforms were initiated in the early 1990s and that these reforms encompassed all sectors of the economy and involved reorientation towards a market-based economy to foster greater efficiency and growth. Concomitantly, these reforms also impacted upon the monetary policy framework. The opening up of the economy posed a number of challenges to monetary management. Nonetheless, the period has witnessed significant gains in terms of reduction in inflation as well as in containing inflation expectations. Efforts to improve credit availability have also paid rich dividends. Finally, financial stability was maintained in India, even when many other developing and emerging market economies witnessed episodes of financial instability. This Project undertakes a detailed discussion of all these issues. While the focus of the Project Report is on the evolution of monetary policy in India and the challenges facing it, different modules present these developments against the recent theoretical developments in the field of monetary economics and the accumulated cross-country empirical evidence.

Against this backdrop, the project is focused on the theme of "Monetary Policy" and deals with the developments since the early 1990s. It begins by addressing the changes in the monetary policy framework in terms of objectives, intermediate targets and operating procedures of monetary policy. This is followed by a discussion on monetary management in an open economy, especially in view of the multiple external shocks impacting the economy during the period of reform. The project then attempts an assessment of the effectiveness of monetary policy in achieving its key objectives, viz., inflation and credit availability. Issues relating to the monetary transmission mechanism are also addressed in the context of the financial sector reforms and the concomitant shifts in the operating procedures of monetary policy. Finally, the project examines issues related to financial stability. An overall assessment of the conduct of monetary policy in India indicates that the Reserve Bank has been successful in maintaining price and financial stability, even in an environment characterised by repeated shocks, both domestic and external. Efforts to improve credit delivery mechanism have also started yielding dividend in recent years. These are covered in the initial Overview.

The project is divided into seven modules covering different areas of monetary policy. Each module in turn spreads over a number of articles. You can visit the different modules through the links below and thereafter navigate further to the individual articles under each of the modules concerned.

• Module: 1 - Structure & Framework of Monetary Policy in India - An Overview

• Module: 2 - Monetary Policy Framework in India - An Analytical Overview

• Module: 3 - Monetary Policy in an Open Economy

• Module: 4 - Monetary Policy and Inflation

• Module: 5 - Bank Credit

• Module: 6 - Monetary Transmission Mechanism

• Module: 7 - Financial Stability

• Epilogue - Concluding Assessment.