Project on Monetary policy - Growth, Inflation and The Conduct of Monetary Policy
[Source: RBI Report of Currency & Finance 2001-2002]

Introduction & Brief Gist

The conduct of monetary policy has been engaging considerable attention in the context of the slowdown in the Indian economy (Year 2000). From financial markets and industry, the case for easy monetary policy has been expressed in terms of lower interest rates. With the upturn remaining elusive, an intellectual advocacy for monetary activism via monetisation of the fiscal deficit has been gaining ground. It is argued that neither credit nor commodity markets in India are supply-constrained and monetisation of the fiscal deficit does not cause inflationary pressures when the economy is demand-constrained (Patnaik, 2001). It is also pointed out that maximising seigniorage revenues may, in fact, be optimal in a situation where the budget constraint is hard (Rakshit, 2000). The revival of the call for monetary activism in India via the fiscal deficit is not new; indeed, it characterised the debate in the mid-1990s on some unpleasant monetarist arithmetic (Venkitaramanan, 1995) and why gentlemen prefer bonds (Moorthy, 1995). Against the welling tide of arguments for monetary easing, it is important to take note of a near solitary view that interest rate reductions in India have gone too far and it is necessary to recognise the country's specific vulnerabilities while formulating monetary policy response (Tarapore, 2001). The debate remains unsettled, and it is plausible that as the economy continues to be bound by the inertial dynamics of the downturn, more heat would be generated.

The argument for monetary easing is valid to the extent that monetary policy is essentially viewed as an instrument of stabilisation, working through aggregate demand to smooth oscillations of economic activity around the desired path. In accommodation of this perceived role, monetary policy in India has moved into contra-cyclical mode since 1997 with successive cuts in key interest rates and cash reserve requirements (CRR) signalling the monetary stance. Active liquidity operations have been undertaken to satisfy and stabilise the demand for bank reserves so as to ensure that growth is not constrained by the availability of credit. Reflecting this stance, nominal risk-free interest rates measured by yields on government securities are the lowest in the last two decades and real interest rates in the recent period, on an average, have been below the real growth rate of the economy .

This module attempts to contribute to the debate eclectically, within the limits of an empirical and country-specific framework. The structure of the module is as follows:

• Article I addresses the unfinished debate on neutrality and the role of monetary policy in the context of growth.

• Article II deals with the transmission of monetary policy to growth.

• Article III examines the macroeconomics of credit with a view to assessing the credit channel as a conduit of transmission of monetary policy.

• Article IV covers the constraints on operating monetary policy for revitalising growth. It covers issues related to the time inconsistency problem associated with a growth oriented monetary policy and the institutional arrangements under which the implicit 'inflation bias' in growth-centric monetary policy is minimised. This is followed by concluding observations.

In recent years, particularly in the 1990s, there has been an upsurge of interest in the operational framework of monetary policy. With the growing perception that the explanatory power of intermediate target regimes is getting eroded under the impact of globalisation and financial innovations, attention has shifted to the development of simple and flexible rules whereby monetary policy can directly achieve its objectives. Under these conditions, monetary policy operates with constrained discretion. The performance of a small, operational model for monetary policy in India suggests that under constrained discretion, monetary policy can be directed towards revitalising output growth in the short-run. The long-run inflationary consequences of current monetary policy action, however, need to be taken into account. Threshold inflation, i.e., growth-maximising inflation rate is estimated at 5 per cent. There are potential output losses involved in further disinflation. Sacrifice ratio estimates suggest that, in a low inflation environment, a one percentage point reduction in inflation leads to a decline in output by 2 percentage points below its potential. The interest rate channel is rapidly emerging as the dominant transmission mechanism, supported and reinforced by the credit channel. At this juncture, more evidence needs to be accumulated and fundamental analytical issues resolved before the new analytical framework for monetary policy can be validated.

Several landmark initiatives have been recently announced to correct for the known time inconsistency in the conduct of monetary policy. The decision to divest ownership functions in commercial banking, development of finance and securities trading entities, separation of supervisory functions in regard to co-operative banks, separation of public debt management function from monetary policy, changes in the operational conduct of monetary and fiscal policies suggested by Advisory Group on Transparency in Monetary and Financial Policies (Chairman: Shri M. Narasimham) and the tabling of the Fiscal Responsibility and Budget Management Legislation mark a new phase in the evolution of monetary policy in India in the new millennium.

The conduct of the monetary policy in India would continue to involve the constant rebalancing of objectives in terms of the relative importance assigned, the selection of instruments and operating frameworks, and a search for an improved understanding of the working of the economy and the channels through which the monetary policy operates.