Monetary Policy

1. MONETARY POLICY
Mridul Saggar
(Professor of Practice, IIMK)
questions & correspondence: mksaggar@iimk.ac.in
PGP 26 Economic Environment Lecture-18 & 19: IIM, Kozhikode
November 27, 2023

2. 2
What will we cover in this lecture?..
▪ What are Monetary Policy Frameworks (MPF)?
▪ What are Monetary Policy Operating Procedures
(MPOP)?
▪ Monetary Policy Transmission
▪ Inflation targeting and its critical assessment
▪ The importance of Central bank independence
▪ How has Monetary Policy Framework evolved in
India?
▪ The current stance of Monetary Policy in India
and the challenges it face
▪ A Recap of Inflation & the Phillips Curve
▪ What is Monetary Policy?
▪ What are the objectives (goals) of Monetary
Policy?
▪ What are the instruments of Monetary Policy?
(Direct & Indirect Instruments)
▪ What are Unconventional Monetary Policies
(UMPs)
▪ How does Monetary Policy actions transmit to
its goals? (Monetary Policy Transmission)

3. 3
Does Phillips Curve Exist & if YES, what is its shape?
Shape of the Phillips Curve Can be:
▪ Downward sloping convex to the origin
▪ Vertical
▪ Backward bending
▪ Flat Horizontal

4. What is Monetary Policy?
▪ Monetary Policy is application of Monetary Theory and Application of set of Monetary Instruments to achieve Monetary Objectives.
Typically, but not always, the policy is operated by the monetary authority (central bank) through control of money supply and short-term
interest rates.
▪ Monetary Policy is important, because economies are subjected to endogenously propagated business cycles. It seeks to operate the economy
close to its potential output level by undertaking counter-cyclical stabilization and not allow it to wander much from there, else generate
booms and busts cycles that prove to be inflationary or deflationary entailing severe multi-year costs.
▪ Monetary policy aims to keep output gaps small and, therefore, its efficacy depends on prediction of business cycles with reasonable
precision, considering lags in monetary policy transmission. However, these transmission lags are long and variable making the task difficult.
Contractionary
monetary policy
Expansionary monetary and fiscal policies
Trough
Peak
Potential GDP
Time
Negative Output Gap
Positive Output Gap
Peak
Actual GDP
Real
GDP
Expansion
Boom
Bust
3

5. Genesis of Monetary Policy
5
▪ The use of “fiat money” was first recorded in China around 1000AD
▪ first central bank (Sveriges Riskbank) was established only in 1866.
▪ The Great Depression of 1929-39 & the Great inflation of the 1970s
(breakdown of Phillips curve) – what went wrong?
▪ During 1978-80 annual CPI inflation in US surged from ~6% to ~ 15%.
Volcker raises the fed funds target from ~ 10% to ~ 20% in the 1980s.
▪ In 1989, RBNZ was given operational independence to achieve and
maintain price stability
▪ The global financial crisis of 2008, the world changed and so did the
monetary policy that resorted to unconventional tools
▪ We saw synchronous aggressive monetary tightening during 2021 & 2022,
but global monetary policy is somewhat diverging now with EME central
banks having broadly completed tightening and AE central banks need
some more tightening to reach their terminal rates in this cycle

6. What is the Role (Objectives/ Goals) of Monetary Policy?
6
▪ Growth?
▪ Improving micro-economic performance?
▪ Improving macroeconomic performance?
▪ Long-run improvement in growth?
▪ Higher growth in short-run?
▪ Sustainable growth?
▪ Higher sustainable growth?
▪ Inclusive growth?
▪ Balanced growth across regions?
▪ Potential level of output?
▪ More credit?
▪ Financial Stability?
▪ Low Inflation?
▪ Price stability?
▪ Higher level of employment?
▪ Full employment?
▪ NAIRU?
▪ maintaining natural rate of interest?
▪ Maintaining neutral rate of interest?
▪ Maximizing welfare of the
population?
▪ Some of the above?
▪ All of the above?

7. What are the instruments of monetary policy?
6
Instruments
Outright Open
Market
Operations
(OMO)
Reserve
Requirements/
Cash Reserve
Ratio(CRR)
Statutory
Liquidity Ratio
(SLR)
Refinance
Facilities
Marginal
Standing
Facility
Policy Repo
Rate
(overnight/7-
day/ 14-day)/
Bank rate
Standing
Deposit Facility
(SDF)/ Reverse
repo rate
Sterilisation
bonds/ Market
Stabilisation
Scheme (MSS)
Term Repos/
Long-Term
Repo
Operations
(LTROs)
Repos &
Reverse Repos/
Liquidity
Adjustment
facility (LAF)

8. Taxonomy of Direct vs Indirect Instruments of
Conventional Monetary Policy Tools
8
▪ Direct Instruments: they have one-to-one correspondence between
instruments and policy objectives and come from regulatory powers of the
central bank rather than market interactions
➢ Examples: directed credits, interest rate ceilings and floors, statutory
liquidity ratios, bank-by-bank rediscount quotas and reserve requirements
▪ Indirect instruments: they are market-based instruments generally aimed
to change the supply of bank reserves or central bank liquidity for non-
banks and have gained popularity over the last three decades replacing
central banks dependence on direct instruments that were conceived to be
market distorting. They involve lesser degree of regulation
➢ Examples: Open market operations – central bank repos/ reverse repos,
outright transactions in purchase and sale of securities, typically near zero
risk sovereign bonds; rediscount windows; primary market sales of central
bank paper; collateralised loans from central banks; credit auctions; FX
swaps

9. What is this?
9

10. Monetary Transmission: A Black Box that we can try to
peek into
10
This was Black Box. Black box is:
▪ A usually large, square room with black walls used as a space for theatrical
performances
▪ Something that is mysterious, especially as to function.
▪ A device or theoretical construct with known or specified performance
characteristics but unknown or unspecified constituents and means of operation.
▪ The Cockpit Voice Recorder + Flight Data Recorder
Bernanke, Ben S., and Mark Gertler. 1995. "Inside the Black Box: The Credit
Channel of Monetary Policy Transmission." Journal of Economic Perspectives, 9(4):
27-48.

11. Monetary Transmission Mechanism..(1)
Interest Rate Channel
11
▪ Given that prices are sticky, real interest rates (i.e., inflation adjusted
nominal interest rates decline first in the short-run then in the long-run, in
line with the term structure)
▪ A decline in real interest rate lowers the opportunity cost in consumption
and investment causing private domestic demand to expand
M ↑ → i ↓ → I ↑ → Y ↑
where, M = monetary base (currency and bank reserves)
i = real interest rates
I = investment spending
Y = income (GDP) or output)

12. Monetary Transmission Mechanism..(2)
Exchange Rate Channel
12
▪ Contractionary monetary policy raises interest rates and
appreciates domestic currency, which reduced net exports and
contracts aggregate demand
▪ Increased interest rate also brings in capital inflows that add to
appreciation pressures
M ↓ → i ↑ → S ↑ → NX ↓ → Y ↓
where, S = exchange rate (↑ is appreciation),
NX = net exports (exports – imports), Y=GDP

13. Monetary Transmission Mechanism..(3)
Asset Price Channel
13
▪ Monetary policy also operates through the link between
money and stock or property prices.
Question to think: Does asset class matter for transmission?
(Liquid equities vs Illiquid houses and consumer durables).
Through Tobin q:
M ↓ → Ep ↓ → q ↓ → I ↓ → Y ↓
where, Ep = stock prices, q = the ratio of market value of the firm
to replacement cost of its assets
Through Wealth Effect on Consumption:
M ↓ → Ep↓ → W↓ → C↓ → Y ↓
where, W = net wealth; C= consumption

14. Monetary Transmission Mechanism..(4)
Balance Sheet Channel
14
▪ EFP is the difference in cost between funds raised externally
(equity and debt) and internally (retained earnings)
M ↓ → i ↑ → EFP ↑ → net cash flow ↓ → adverse
selection ↑ & moral hazard ↑ → lending ↓ → I ↓
→ Y ↓
Where EFP = external finance premium

15. Monetary Transmission Mechanism..(5)
Bank Lending Channel
15
▪ Effect is through demand and supply of bank loans as distinct
from balance sheet affects
M ↓ → i ↑ → EFP ↑ → bank loans ↓ → I ↓ → Y ↓

16. Keynesian Liquidity Trap
16
▪ A liquidity trap occurs when interest rates fall so low
(approaching ZLB) that everyone prefers to hold cash and not
bonds. They expect interest rates to follow one-way street,
rising at some point in future and not fall any more. Staring at
potential losses on bond holding they hold cash. So, if money
supply is increases (shift LM to the right), interest rates and
output level remains unchanged. Monetary policy cannot
stimulate spending by increasing monetary supply or cutting
interest rates any further. Only Fiscal expansion can aggregate
demand up (rightward shift of IS)
Liquidity
Trap

17. Zero Lower Bound (ZLB) on Nominal Interest Rates
attenuates monetary policy efficacy
17
▪ when the short-term nominal interest rates fall to near zero, causing a
liquidity trap, conventional monetary policy is rendered ineffective.
▪ Negative nominal interest rates are ordinarily unlikely to be acceptable
to saver as he can rather hold cash.
▪ This problem was experienced by Japan in the 1990s
▪ ZLB was also in evidence after Fed lowered Fed funds rate to 0-0.25%,
but desisted from negative rates even though Taylor Rule suggested
target Fed funds rate at below 6%.
▪ Post-GFC, however, several European economies, including Sweden,
Denmark and euro area s started experimenting with negative interest
rates giving rise to UMPs

18. What are Unconventional Monetary Policy Tools (UMPTs)? …(1)
18
▪ Negative Interest Rate Policies (NRIP): They were unconventional as
they imply that the owner of excess reserves incurs a cost for placing
them with the central bank, thus defying conventional wisdom that
ZLB is to be avoided for risk of falling into liquidity trap. They
influenced the formation of agents’ future rate expectations and opened
up the possibility of ELB below ZLB.
▪ Expanded central bank Lending Operation (LOs): In many
jurisdictions, lending is an integral part of the central bank’s toolkit,
consisting of short-maturity operations designed to facilitate the
implementation of interest-rate policies. Unconventionally, starting
GFC, central banks created new, large such facilities or extended ones
to provide ample liquidity to a wider array of financial institutions
under considerably looser conditions allowing lower-quality collateral
for longer horizons and at a lower cost..
Negative bond yields in 2017

19. What are Unconventional Monetary Policy Tools (UMPTs)?...(2)
19
▪ Large Scale Asset Purchase Programs (LSAPs): central banks made
large-scale purchases of assets going beyond short-term treasury
instruments, stretching OMOs unconventionally. The purchases
included longer-term and private sector assets, often not just for
providing liquidity but in a bid to directly influence asset prices.
These APPs in many cases represented a form of credit allocation and
fell outside the scope of conventional monetary policy. Purchases of
government and private sector debt reduced interest rates and
associated risk premia, and thus helped improved monetary
transmission in face of breakdown of markets. This lowered
borrowing costs and stimulated real economy.
▪ Forward Guidance (FG): FG as a UMPT signaled central bank’s
willingness to pursue ultra-accommodative monetary policies for an
enduring period of fixed time (time-dependent) or till specified
conditions prevail (state-dependent). This helped shape private sector
expectations and improved their risk appetite to spend or invest. But
these commitments also came in way of timely withdrawal of
monetary accommodation.

20. Why Depositors Accept Negative Interest Rates?
20
▪ “Conventional wisdom is that interest rates earned on investments
are never less than zero because investors could alternatively hold
currency. Yet currency is not costless to hold: It is subject to theft and
physical destruction, is expensive to safeguard in large amounts, is
difficult to use for large and remote transactions, and, in large
quantities, may be monitored by governments. ….in times of turmoil,
investors accept zero or negative nominal yields as a fee for safety” -
Richard G. Anderson & Yang Liu, Fed St. Louis (January 2013)
▪ “Thanks to debit cards, online payments and smart phone wallets,
physical cash has become relatively more burdensome and costly. An
ECB study found cash 11 times more costly as checks for handling
most transactions” – Out of Bounds, Greg, WSJ, March 4, 2015

21. Central banks caught behind the curve but have managed to arrest inflation
21
-5
0
5
10
15
20
Jan-20
Feb-20
Mar-20
Apr-20
May-20
Jun-20
Jul-20
Aug-20
Sep-20
Oct-20
Nov-20
Dec-20
Jan-21
Feb-21
Mar-21
Apr-21
May-21
Jun-21
Jul-21
Aug-21
Sep-21
Oct-21
Nov-21
Dec-21
Jan-22
Feb-22
Mar-22
Apr-22
May-22
Jun-22
Jul-22
Aug-22
Sep-22
Oct-22
Nov-22
Dec-22
Jan-23
Feb-23
Mar-23
Apr-23
May-23
Jun-23
Jul-23
Aug-23
Sep-23
Oct-23
Inflation in Emerging Market Economies (EMEs) %
Russia (17.8,6.7) Brazil (12.1,4.8) South Africa (7.8,5.9)
India (7.8,4.9) China (2.8,-0.2)
Figures in bracket are peak inflation rate & available latest month's inflation rate, respectively
-2
0
2
4
6
8
10
12
Jan-20
Feb-20
Mar-20
Apr-20
May-20
Jun-20
Jul-20
Aug-20
Sep-20
Oct-20
Nov-20
Dec-20
Jan-21
Feb-21
Mar-21
Apr-21
May-21
Jun-21
Jul-21
Aug-21
Sep-21
Oct-21
Nov-21
Dec-21
Jan-22
Feb-22
Mar-22
Apr-22
May-22
Jun-22
Jul-22
Aug-22
Sep-22
Oct-22
Nov-22
Dec-22
Jan-23
Feb-23
Mar-23
Apr-23
May-23
Jun-23
Jul-23
Aug-23
Sep-23
Oct-23
Headline Inflation in Advanced Economies (AEs) %
UK (11.1,4.6) Euro area (10.6,2.9) US (9.1,3.2)
US (PCE) (7.0,3.4) US (Core PCE) (5.4,3.7) Japan (4.0,3.3)
Target (2.0)
Figures in bracket are peak inflation rate & available latest month's inflation rate,
respectively

22. After aggressive tightening, AE central banks have reached their terminal rates,
while most EM central banks are already into easing cycles
22
0
50
100
150
200
250
300
350
400
450
500
550
600
650
700
750
800
850
900
Iceland
(850)
Czech
Rep
(675)
New
Zealand
(525)
US
(525)
UK
(515)
Canada
(475)
Euro
area
(450)
Norway
(425)
South
Korea
(300)
Japan
(0)
Basis
points
Policy rate changes in Advanced Economies
H1:2021 Q3:2021 Q4:2021 Q1:2022
Q2:2022 Q3:2022 Q4: 2022 Q1:2023
Q2:2023 Q3:2023 Q4:2023 (till 27th Nov)
figures in brackets give basis point increase in policy rates in current tightening cycle so far
-1250
-1000
-750
-500
-250
0
250
500
750
1000
1250
1500
1750
2000
2250
2500
2750
3000
3250
Hungary
(1240,
-150)
Brazil
(1175,
-150)
Peru
(750,-75))
Mexico
(700)
Russia
(1575;
-1250;
750)
S.
Africa
(475)
India
(250)
Indonesia
(250)
China
(-40)
Turkey
(200;
-1050;
3150)
Basis
points
Policy rate changes in Emerging Market Economies
H1:2021 Q3:2021 Q4:2021 Q1:2022
Q2:2022 Q3:2022 Q4: 2022 Q1:2023
Q2:2023 Q3:2023 Q4: 2023 (till 27th Nov)
figures in brackets give basis point increase/decrease in policy rates in current tightening /
easing cycle so far

23. After massive quantitative easing (QEs), major central banks are now
undertaking slow-paced quantitative tightening (QT)
23
Based on data available till November 27 2023
US$26.2 tn
42.7% of GDP

24. What is the Role for Monetary Policy (Objectives/ Goals) of various central banks?
24
▪ Prime goal of monetary policy is to have low and stable inflation; but how low?
▪ RBI: “It is expedient to constitute a Reserve Bank for India to regulate the issue of Bank notes
and keeping of reserves with a view to securing monetary stability in India and generally, to
operate the currency and credit system of the country to its advantage”. Since 2016 its goal has
been reset as “the primary objective of monetary policy is to maintain price stability while
keeping in mind the objective of growth”.
▪ The Federal Reserve Act mandates that the Federal Reserve conduct monetary policy "so as to
promote effectively the goals of maximum employment, stable prices, and moderate long-term
interest rates." Even though the act lists three distinct goals of monetary policy, the Fed's
mandate for monetary policy is commonly known as the dual mandate.
▪ The primary objective of the ECB’s monetary policy is to maintain price stability. This means
making sure that inflation – the rate at which the prices for goods and services change over time
– remains low, stable and predictable.
▪ Reserve Bank of Australia (RBA) has inflation targeting goal but explicitly sys it manages trade
offs and seek to achieve financial stability through monetary policy

25. Monetary Policy Framework
25
▪ Monetary policy framework is the catch all term in
which monetary policy is framed and conducted. It
consists of instruments, how they are calibrated and
used, operational targets, operating procedures,
intermediate targets, and ultimate goals.
▪ To achieve the established ultimate goals, intermediate
targets are required as there is a time lag between the
implementation of monetary policy and the realization
of these goals the monetary policy
Popular form of monetary policy frameworks
include:
▪ Direct controls, such as that on credit or interest rates
▪ Monetary targeting
▪ Interest rate targeting
▪ Inflation targeting
▪ Fixed Exchange rates
▪ Currency boards

26. The Case for Inflation Targeting in Theory
26
▪ Precursor to Rogoff’s seminal paper: Much of the early rational expectations (RE)
school believed that the way for monetary policy to be effective was to introduce
surprises. Unanticipated monetary policy mattered, anticipated monetary policy did not
as agents already build them into their expectations. However, Kydland & Prescott
(1997) demonstrated time-inconsistency of monetary policy explaining that you can
only surprise once and once agents build that surprise into their expectations, future
monetary policy surprises become ineffective. Therefore, monetary policy needed to
be consistent and credible. With this the focus was back on delegation for the conduct
of monetary policy.
▪ Barro and Gordon (1981,1983) focused on the credibility problem in the form of an
inflationary bias but did not deal directly with independent central banker
▪ Rogoff’s paper & more: It was Kenneth Rogoff’s seminal paper in QJE(1985), “The
Optimal Degree of Commitment to an Intermediate Monetary Target”, that first
circulated as an IMF WP in 1982 that introduced the idea of instituting an independent
central bank as a solution to the time-consistency problem highlighted by Kydland and
Prescott (1977) and Barro and Gordon (1981, 1983). Rogoff’s model showed that
independent central banker can overcome the problem of Inflationary bias (i.e.
outcome of discretionary monetary policy that leads to a higher than optimal level of
inflation.
▪ Carl Walsh (1995) and Persson and Tabellini (1993) have argued that the apparent
trade-off between credibility and flexibility arises because the delegation mechanism is
restricted to ad hoc incentive structures. If instead an inflation contract ensuring an
optimal incentive structure were introduced, the best feasible equilibrium would prevail
with full credibility.

27. Inflation Targeting in Practice
27
▪ RBNZ 1990
▪ Bank of Canada 1991
▪ Bank of England 1992
▪ Bank of Sweden 1993
▪ Reserve Bank of Australia 1993
▪ Turkey Central Bank (TCBM) 1996
▪ Bank of Israel 1997
▪ Czech National Bank 1997
▪ National Bank of Poland 1998
▪ Brazil Central Bank (BCB) 1998
▪ ECB (since inception in 1998)
▪ Chile Central Bank (BCC) 1999
▪ SARB 2000
▪ Bank of Indonesia 2000
▪ Bank of Thailand 2000
▪ Korea 2001
▪ Bank of Mexico 2001
▪ Iceland 2001
▪ Norway 2001
▪ Philippines 2002
▪ Bank of Japan 2013
▪ Reserve Bank of India 2016
▪ CB Sri Lanka 2024 (Likely)

28. 28
What are the monetary policy operating procedures
(MPOPs) that the central banks use
▪ The MPOPs are a set of procedures that help central bank maintain its operating target
▪ The operating target of monetary policy is an economic or financial variable, which the central bank wants
to control, and indeed can control, to a very large extent on a day-by-day basis through the use of its
monetary policy instruments.
▪ It is typically the variable the level of which the central bank decides, generally as a collegiate decision of a
monetary policy decision making committee like the Monetary Policy Committee (MPC).
▪ The operating target thus (i) gives guidance to the implementation officers in the central bank what really to
do on a day-by-day basis in the inter-meeting period, and (ii) serves to signal the stance of monetary policy
to the public.
▪ Typically, it is the short-term inter-bank interest rate that is used as an operating target – mostly overnight
uncollateralized, but also collateralized overnight or or the 7-day/14-day repo rates.

29. Evolution of Monetary Policy Framework in India
29
▪ Credit budgeting till mid-1980s
▪ Monetary Targeting with feedback: 1985-1998
▪ Multiple Indicator Approach: 1998-2016; with interest rate as MPOP started since 2011
▪ Transition to Inflation Targeting started in 2014 and inflation targeting has been formally
adopted since 2016.
Bottom Line: No one size fits all; MPFs chosen must suit country-specific conditions.
However, with deepening of financial markets, interest rate operating target helps. credibility of
monetary policy is important

30. ▪ Credit budgeting worked exclusively through direct
instruments of monetary control and repressed price signals in
the economy
▪ Monetary targeting worked well for sometime. Money demand
function was stable till early 1990s and enabled Reserve Bank
to relay on monetary aggregates
▪ However, with deregulation of interest rates, development on
active debt markets and financial innovations, money demand
function became instable
30
Monetary Targeting was a distinct improvement from credit budgeting;
but with financial innovations money demand became instable

31. ▪ Quantity Variables
Money, credit, fiscal deficit, rainfall, IIP,
services sector activities, export-
import, BoP, capital flows etc.
▪ Rate Variables
Money market rates, lending/deposit
rates, yield on G-sec, inflation rates,
asset prices, exchange rates etc.
▪ Interest rate operating targeting
Gradually the rate variables gained
prominence over quantity variables
▪ The two policy options:
Make an announced switch to interest
rate operating target or let there be
gradual shift?
An announced shift has an advantage
of better guidance to markets in a
transparent fashion that can prepare
markets well. The transition gets
better appreciated. It can be
accompanied by buy-ins from key
stakeholders.
31
Multiple Indicator Approach was a black box but worked well for long
supported by introduction of short-term intertest rate as operating target
Reserve Money
as operating
target
Interest rate
operating
targeting

32. Augmenting Interest Rate operating procedures through with
forward-looking surveys: The RBI approach
32
Forward-looking Surveys
▪ Industrial Outlook Survey (IOS)
▪ Order Book, Inventories & Capacity Utilisation Survey (OBICUS)
▪ Services and Infrastructure Outlook (IOS)
▪ Professional Forecasters’ Survey (PFS)
▪ Credit Conditions/ Bank Lending Survey (BLS)
▪ Inflation Expectations Survey of the Households (IESH)
▪ Consumer Confidence Survey (CCS)
These surveys along with projections of growth and inflation are
continuing in the current Inflation targeting regime as major inputs
for MPC decisions

33. 33
Evolution of Monetary Policy Operating procedures in India
…monetary targeting phase
▪ During reserve money as operating target, it was important to
monitor the reserve money growth adjusted for reserve
requirement changes
▪ Formal research work in RBI in early 1990s suggested that
both narrow and broad money demand had become instable
with break points detected much earlier
▪ This prompted the shift to interest rate targeting -5
0
5
10
15
20
25
30
Apr-09
Jul-09
Sep-09
Dec-09
Mar-10
Jun-10
Aug-10
Nov-10
Feb-11
May-11
Jul-11
Oct-11
Jan-11
Y-o-Y
growth
in
per
cent
Reserve Money Adjusted Reserve Money

34. 34
MPOP of RBI with interest rate as operational target
▪ Introduction of LAF in June
2000 was a game changer in
the Indian debt markets and
enabled the switch to interest
rate targeting down the line
▪ It enabled the interest rate
channel of monetary
transmission to become the
cornerstone of monetary
policy
▪ However, objectives and
instruments were blurred
during multiple indicator
approach
▪ Also, sudden surge in capital
flows posed liquidity
management problems

35. 35
Gains from shift to interest rate targeting through LAF
▪ It helped the transition from direct instruments of
monetary control to indirect and, in the process, certain
dead weight loss for the system was saved.
▪ It provided monetary authorities with greater flexibility
in determining both the quantum of adjustment as well as
the rates by responding to the needs of the system on a
daily basis.
▪ It enabled the Reserve Bank to modulate the supply of
funds on a daily basis to meet day-to-day liquidity
mismatches.
▪ It enabled the central bank to affect demand for funds
through policy rate changes.
▪ Most importantly, it helped stabilise short-term money
market rates. The call rate was largely maintained within
a corridor set by the repo and reverse repo rates
imparting stability to the financial markets in general

36. 36
▪ Two policy rates rater one confused markets
▪ Shifts from system liquidity surpluses to deficit or vice a
versa can cause fluctuations in interest rates that can be
wide and destabilizing. This is especially important for
EMEs where the width of the corridor are large, often of
100 bps or more.
▪ Fixing a policy rate in the middle of the interest rate
corridor have distinct advantages of (i) transparent and
clear communication to markets on stance and intended
rates, (ii) stabilizing the demand for bank reserves
around a very small range around the policy rate, (iii)
lesser interest rate volatility and (iv) improved monetary
transmission
▪ Symmetric corridors are in general better than
asymmetric corridors, though in some circumstances
asymmetric corridors can be used effectively for limited
periods
Was LAF as it was started the best way to stabilize short-term
interest rates in an interest rate targeting regime?

37. 37
Sterilisation through Market Stabilization Scheme (MSS) was an important
instrument for managing liquidity during interest rate targeting
▪ Faced with surges in capital flows, the need to intervene to prevent
large misaligned appreciation of the rupee, sterilization of liquidity
became an issue as RBI ran out of G-secs on its books
▪ On March 25, 2004, RBI signed an MoU with GOI to issue T-bills
and dated securities under Market Stabilisation Scheme (MSS) with
sequestering of the proceeds of MSS. These proceeds were held by
the GOI in a separate account with RBI.
▪ These sequestered amounts could be used only for the purpose of
redemption and / or buy back of the Treasury Bills and / or dated
securities issued under the MSS.
▪ India’s sterilization instrument was unusual. While countries like
Chile, China, Colombia, Indonesia, Korea, Malaysia, Peru,
Philippines, Russia, Sri Lanka, Taiwan and Thailand were issuing
central bank securities for sterilizing, Indian preferred to use G-secs
▪ Advantages: (i) markets remained unified and didn’t have to price
differently, (ii) central bank averted possible losses on its balance
sheet maintaining its high quality, (iii) sterilization was taken up in
a big way, (iv) instrument was also used to impart liquidity through
its unwinding when required.

38. RBI’s current short-term interest rate corridor
38
Rate of
interest
X+25 bps
X
X-25 bps
MSF Rate
(Ceiling)
[6.75%]
Policy Rate
(Repo Rate)
[6.5%]
Standing Deposit
Facility (Floor)
[6.25%]
Liquidity
Illustrative Call Money
Rate oscillations

39. Proposed Glide Path for Disinflation by Urjit Patel Committee
5.9
9.2
10.6
9.5 9.5
10.0
9.5
8.0
6.0
4.0 4.0 4.0 4.0
6.0 6.0 6.0 6.0
2.0 2.0 2.0 2.0
0
2
4
6
8
10
12
2007-08
2008-09
2009-10
2010-11
2011-12
2012-13
2013-14
2014-15
2015-16
2016-17
2017-18
2018-19
2019-20
per
cent
Transition Path to IT
CPI-Combined (yoy)
▪ The Committee to Revise and
Strengthen Monetary Policy
Framework (Chairman: Dr. Urjit
Patel) submitted its report in 2014
advocating introduction of Inflation
Targeting Framework in India
▪ It suggested a glide path to 4% as
inflation target with an upper
tolerance band of 6% and lower
tolerance band of 2%
▪ After introduction of inflation targeting
this was successfully achieved
▪ It also suggested headline inflation
measure as new CPI that was All-Indi
monthly index in place of weekly WPI
inflation

40. Tryst with Destiny: RBI and GOI achieved an institutionalised modern
monetary policy framework implemented since Oct 2016
▪ The Committee to Revise and Strengthen Monetary Policy Framework (Chairman: Dr. Urjit
Patel) had submitted its report in 2014 advocating introduction of Inflation Targeting
Framework in India
▪ A landmark ‘Agreement on Monetary Policy Framework’ was signed between President of
India acting through the MOF, GoI and the RBI on February 20, 2015.that formally paved the
way for inflation targeting
▪ RBI Act amended as part of the Finance Act, 2016 (Union budget 2016-17) that reset the
primary objective of the monetary policy explicitly to maintaining price stability, while keeping in
mind the objective of growth. It also provided RBI with legal mandate for inflation targeting
through decision-making by Monetary Policy Committee (MPC).
▪ The 6-member MPC was set up: Governor (Chairperson of the MPC with a casting vote in
case of a tie) and DG in-charge of monetary policy are ex-officio members; one more member
from RBI (appointed by the Central Board) and three external members (appointed by the
GOI) as experts in the field of economics or banking or finance or monetary policy. External
members appointed for a 4-years non-renewable term.
▪ Majority voting with each member having one vote. Governor cannot veto but has a casting
vote. The MPC will meet at least 4 times a year. It currently meets at least six times a year in a
bi-monthly cycle of scheduled meetings and at time have met additionally in off-cycle meeting
40

41. What has been impeding monetary transmission in
India over the years?...(1)
41
Fiscal Dominance of Monetary Policy in India
▪ Automatic monetization of fiscal deficits till the early 1990s → Supplemental Accords in
the 1990s → FRBM Act in 2000s → Inflation Targeting MPA in 2010s: Fiscal dominance
has reduced considerably but not waned all together
▪ SLR remains a distortion, enabling financial repression by borrowing sometimes even at
negative real interest rates → Is being gradually reduced/replaced by LCR (currently SLR
at 18%)
▪ Small saving schemes weaken monetary transmission through infrequent resets and
substitution of bank deposits
▪ Interest rate subventions & loan waivers also attenuate monetary transmission
▪ On occasions tax distortions debilitates monetary policy

42. What Impedes Monetary Transmission in India?...(2)
42
Presence of Large Informal Sector and non-institutional lending
▪ Informal sector as defined by ILO in 1972 covers tiny units, engaged in production, whose
activities are not recognized, recorded, protected or regulated by the public authorities.
ILO redefined it in 1993 as units engaged in production, primarily for generating
employment and incomes to the persons concerned either as own account enterprises or as
informal employers.
▪ Share of informal/ unorganized sector in India’s GVA is currently ~52%. Its share in
employment is around 86%
▪ While the share in GVA is fairly stable in recent years; its employment share had declined
from 93% in 2003-04 to 86.8% in 2017-18
▪ According to NSSO 77h Round (AIDIS), 2021, the share of non-institutional credit in
outstanding cash debt of rural households was 34% at end-June 2018 in 2013. Though this
weakens monetary transmission, its declining share from 93% in 1951 has helped in
improving the interest rate channel of monetary transmission
▪ Rate of interest charged by MFIs ranged between 18-36% before new MFI regulations
have somewhat lowered it; rural money lenders often charge more and indulge in usurious
practices that have little relationship with interest rates in institutional credit markets.
However, with increased reliance of MFIs for bank borrowings, the interest rate
transmission is improving.

43. What Impedes Monetary Transmission in India?...(3)
43
Bank behavior amid Financial & Credit market frictions
▪ Banks costs of funds change slowly in response to a policy rate change, especially as term deposits
constitute 55% of total deposits (as of March 2022) and take time to be re-priced. But this share has
been declining over the years and was 64.5% in 2013, thus improving the transmission over the years.
▪ Banking sector is not sufficiently competitive with public sector banks accounting for ~60% of assets.
Banks are reluctant to pass on rate changes, especially in lowering lending rates as they tend to protect
their NIMs. However, the share of these state-owned banks was ~74% a decade ago and more
heterogenous banking sector on the back financial market development has improved competitiveness
and efficiency of the banking system.
▪ Corporate lending rates respond faster and such loans get re-priced, but deposit rates and household/
consumer loans do not get re-priced quickly as even floating rates have reset costs
▪ Even long-run pass-through of policy rate changes was found to be incomplete in earlier period of base
rate pricing of loans
▪ Transmission of policy rate changes to deposit and lending rates are conditioned by liquidity changes.
Transmission is stronger and faster in deficit liquidity conditions than surplus liquidity conditions.
▪ MCLR system introduced in April 2016 has helped improved monetary transmission considerably.
Under MCLR banks use one of the acceptable benchmark external to the bank, such as the RBI repo
rate, 91-day or 182-day T-bill yield, or any other benchmark market interest rate as developed by the
Financial Benchmarks India Pvt. Ltd (FIBIL). Transmission through these market rates is more potent

44. What Impedes Monetary Transmission in India?...(4)
44
Some Other bottlenecks to Transmission
▪ High inflation debilitates monetary policy efficacy as with negative real returns
on deposits financial disintermediation occurs and gold & real estate become
preferred saving instruments. Such financial repression returned during the
pandemic period as immediate priority was to avert scarring and job losses in
the pandemic period, but policy rates now being raised ro make real rates
positive
▪ Increasing share of NBFIs weakens the monetary policy contractionary
impulses (via Gurley-Shaw hypothesis)
▪ Unlimited liquidity under LAF provided by RBI in the past had weakened
transmission and capping liquidity under LAF at fixed rates and developing
term repos at variable rates has helped improve transmission

45. 45
RBI monetary policy October 2023
▪ MPC at its October 2023 policy
unanimously decided to keep
policy repo rate unchanged at
6.5%
▪ It kept the stance of the monetary
policy unchanged: “The MPC also
decided to remain focused on
withdrawal of accommodation to
ensure that inflation progressively
aligns with the target, while
supporting growth.”
▪ It kept its FY24 growth projection
unchanged at 6.5%
▪ It also kept its average inflation
projection for FY24 at 5.4

46. RBI continue to use policy interest rate (repo rate) to target inflation at
4±2% under a flexible inflation targeting (FIT) MPF
46
India gained from developing interest rate
operating target framework even under the
FIT regime that was introduced in 2016
▪ The transition to Inflation Targeting as MPF was
smooth as India was already communicating
monetary policy through short-term interest rate as
operating target
▪ FIT was introduced after large GFC stimuluses were
not winded back in time with recovery in real
activity leading to high inflation where various CPI
inflation measures showed that average inflation
was running at ~10% for six years. This loss of
nominal anchor prompted RBI to shift to IT
▪ IT clearly delivered disinflation gains as FIT period
delivered average inflation at 4% target without
much output sacrifice, It did not cause interest rates
to rise and other macro-parameters remained under
control
▪ Only during pandemic period has the inflation
breached inflation targets and this was conscious
decision to avert deep scarring and job losses during
the unprecedented COVID-19 shock
▪ RBI now has raised policy rates by 140 bps in the
current tightening cycle to fight inflation in
accordance with the inflation targeting framework