Channels of Monetary Policy Transmission in India: A Post-Reforms Macro-econometric Analysis.

AuthorKaur, Ramandeep


The channels of monetary transmission are often referred to as a black box implying that we know that monetary policy does influence output and inflation but we do not know for certain how precisely it does so. This is because not only different channels of monetary transmission tend to operate at the same time but they change over time also. According to the observations of Bernanke and Gertler (1995), to a large extent, empirical analysis of monetary policy has treated monetary transmission mechanism as a "black box." As a result, questions remain: does monetary policy affect the real economy? If so, what is the transmission mechanism by which these effects take place? Therefore, the transmission channels through which monetary policy is conducted are often subtle and complex. While the aim has always been to target a real variable such as aggregate output or employment, the selection of the correct channel of monetary transmission in order to execute the desired plan is often impeded by the structural issues of a given economy's internal context. The story of the channels of monetary transmission, although without doubt built upon certain fundamental theoretical blocs, is an empirical issue.

The working of each monetary transmission channel (and there are several of them) depends on a plethora of factors, ranging from the overall stage of macroeconomic development to the nuances of micro-structures of domestic financial markets. Those factors differ tremendously in different regions and regimes of the world, thus, necessitating differentiated and/or regional approaches to the study of monetary transmission channels. So, several factors influence the path through which monetary policy impulses get transmitted to the different sectors of the economy. These are: i) Structure of the economy; ii) Position of financial markets; iii) Degree of financial market integration; iv) Availability of several monetary policy tools; v) Fiscal stance and the pattern of financing fiscal deficit; vi) Central bank's autonomy in conducting monetary policy; vii) Determination of interest rates, exchange rate and various other prices in the economy; and viii) Degree of openness in the economy.

Thus, the rapidly changing structure of the economy tends to influence the effects of given monetary policy measures which requires that it is essential for monetary authorities to continuously reinterpret monetary transmission channels according to the changing economic environment (Kaur R, 2019). The paper is an endeavor in the same direction and addresses the issue of identification of appropriate channels and instruments of monetary policy transmission mechanism.

Literature Review

Several Indian and international researchers have endeavored to examine the channels of monetary policy transmission mechanism e.g., Kulkarni and Huth (1988), Ray et al. (1998), Verma and Pal (2007), Kaushal and Pathak (2012), Mohanty (2012) and Khundrakpam and Jain (2012) are of the view that interest rate channel has emerged as the most important channel of monetary policy transmission mechanism in India especially during the post reform scenario. According to Padhan (2006), money supply and bank credit are equally important in the transmission mechanism of monetary policy during both the pre- and post-deregulation periods. As per the findings of the study, interest rate channel is more strong and important than quantum channel in transmission mechanism of monetary policy during deregulation period.

Samantaraya (2003) suggested that in the long run, money neutrality proposition holds good for the Indian economy and in the short-run monetary policy positively impacts the real output, particularly in the post-reform period, mainly through the rate channels. Bhattacharyya and Sensarma (2005) pointed out that increasing reliance on indirect instruments, great market integration and technological innovations improved the channels of communication between RBI and the financial markets and facilitated the conduct of monetary policy.

Mengesha and Holmes (2013) have empirically examined the relevance of monetary policy transmission in case of Ereitrean economy. It has been concluded that the channels of official exchange rate and interest rate are not active, however, the credit channel and effective exchange rate channel are in action. Babatunde and Olatunji (2017) have conducted an empirical analysis with the application of structural modeling through VECM framework to understand the working of interest rate channel of monetary policy transmission mechanism. It has been found that the interest rate and exchange rate play very effective role in the success of monetary policy.

Data Sources & Construction of Variables

The empirical analysis is confined to the post-reform period using the monthly data spanning over the years 1991:M4 to 2017:M12. The Tornquist Index of Moneyness is used as an indicator of monetary policy stance while the wholesale price index (WPI) has been used as indicator of prices. The index of industrial production (IIP) has been taken as a proxy variable for real output because the monthly series of GDP for the period covered under the study is not available (Arora et al, 2018).

To define the interest rate channel of transmission mechanism, the 91-day treasury bills rate (TB) and Call Money Rates (CMR) have been used. However, to define asset price channel, the use of BSE Sensex (BSE) has been preferred. Moreover, to define the credit channel, Total Bank Credit (BC) and Total Deposits (TD) as credit and deposit variables, respectively are used. The expectation channel has been defined through a variable called expected Call Money Rate. The deseasonalized Call Money Rate (DCMR) has been used as a proxy variable for defining expectation channel. However, the exchange rate channel has been defined by using the variables, Exchange Rate in terms of Rupees per U.S. Dollar (ER) and Net Exports (NX).

Different instruments of monetary policy namely, Statutory Liquidity Ratio (SLR), Prime Lending Rates (PLR), Bank Rate (BR), Cash Reserve Ratio (CRR), Net Sale of Dated Securities (DSNS), Dated Securities Rates (DSR), Repo Rate (RR) and Reverse Repo Rate (RRR) have been utilized to test the effectiveness and importance of each instrument of monetary policy transmission in India during the study period. Further, different variables such as Currency with public (CWP), Demand Deposits (DD), Time Deposits (TD), Prime Lending Rates (PLR), Rate of interest on Demand Deposits (RDD) and average Rate of Interest on Time Deposits (RTD) are used for the construction of Tornquist Index of Moneyness.

Source of data for the variables namely, WPI, IIP, BSE, BC, ER, NX, SLR, BR, CRR, DSNS, DSR, RR, RRR, CWP, DD, TD and CMR is Handbook of Statistics on Indian Economy. The monthly data on PLR, Rate of interest on Demand Deposits (RDD) and Rate of Interest on Time Deposits (RTD) have been collected from the head office of SBI under...

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