1.1 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.
1.2 In India, structural reforms were initiated in the early
1990s. 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 Report undertakes a detailed discussion
of all these issues. While the focus of the Report is on the evolution of monetary
policy in India and the challenges facing it, different Chapters present these
developments against the recent theoretical developments in the field of monetary
economics and the accumulated cross-country empirical evidence.
1.3 As a prelude to the substantive theme based discussions,
Chapter II of the Report titled 'Recent Economic Developments' provides
an analytical account of macroeconomic developments in the Indian economy during
the year 2004-05 so far.
1.4 In the theme-based discussions, Chapter III titled 'Monetary
Policy Framework: An Analytical Overview' covers issues relating to objectives,
intermediate targets and operating procedures of monetary policy. It explores
the rationale for price stability objective of monetary policy and discusses
the trade-offs between inflation and growth that a central bank faces. The role
of institutional developments - central bank independence and fiscal rules -
in contributing to monetary stability is also addressed. It is followed by a
discussion on strategies and tactics of monetary policy, with a focus on key
changes during the 1980s and 1990s in the intermediate targets, instruments
and operating procedures to meet the evolving challenges. Issues in liquidity
management to ensure stable conditions in money markets are also covered. The
Chapter also revisits issues related to stability of money demand.
1.5 Chapter IV of the Report – 'Monetary Policy in
an Open Economy' - focuses on the challenges that external openness imposes
upon the conduct of monetary policy. The Chapter presents stylised facts on
key aspects of globalisation and its implications on the conduct of monetary
policy. During the 1990s, capital flows to emerging markets have exhibited a
highly volatile behaviour – witnessing a sharp rise in the quantum till the
Asian crisis followed by massive reversals in the aftermath of the Asian crisis
and a recovery in recent period. Implications of the volatility in capital flows
and its impact on exchange rate and monetary management are addressed. It examines
factors that have led emerging economies in the recent years to become net exporters
of capital to the mature economies. A cross-country survey of policy responses
to manage capital flows is presented to draw policy lessons for India. In view
of the threat posed by existing global macroeconomic imbalances, a key feature
is the recognition that increased financial openness requires monetary policy
to pursue orderly conditions in financial markets. An attempt is made to measure
synchronicity of business cycles in India with its trading partners to examine
temporal changes in co-movement. The need to manage the quantum of capital flows
and its associated volatility and to innovate constantly in terms of instruments,
as borne out by the Indian experience, is also highlighted.
1.6 Chapter V entitled 'Monetary Policy and Inflation'
undertakes an assessment of monetary policy in achieving its primary objective,
viz., inflation. It examines the global inflation record of the last
half- century. This is followed by an assessment of various factors that led
to the initial build-up of inflation during the 1960s and 1970s and its subsequent
containment in the 1980s and 1990s. The experience with inflation targeting
framework is critically analysed and its relevance for an emerging economy like
India is assessed. The need for fiscal prudence in maintaining price stability
is highlighted. Issues such as the conduct of monetary policy in a low inflation
environment, exchange-rate pass-through to domestic prices and the impact of
oil shocks on economic activity are also addressed. The Chapter also attempts
to model inflation process in India and provides estimates of the degree of
pass-through of exchange rate to domestic inflation.
1.7 Bank credit is an important source of finance for growth,
especially in developing and emerging economies. At the same time, bank credit
is an impor tant channel of monetary transmission. Fur thermore, excessive increases
in credit aggregates are believed to contain lead information on future financial
vulnerability. These set of issues are discussed in Chapter VI entitled 'Bank
Credit'. With a shift away from directed credit towards a market-oriented
system of credit allocation, high information and transaction costs can have
an adverse effect on credit availability for key sectors of the economy. In
this context, the Chapter dwells upon the various measures taken by the Reserve
Bank to improve the credit delivery mechanism in the Indian financial sector.
An assessment of these efforts in augmenting the flow of credit to various sectors
of the economy in the post-reforms period is undertaken. The issue of banks’
preference for investment in Government securities, despite reductions in statutory
preemptions, is also addressed.
1.8 Monetary policy is known to operate with long and variable
lags. Chapter VII - 'Monetary Transmission Mechanism' - undertakes
a discussion of issues related to monetary transmission. A brief theoretical
overview of various channels through which monetary policy influences output
and prices is followed by a cross-country empirical evidence on transmission
lags and pass-through from policy rates to market rates. The Chapter also covers
various policy efforts initiated in India with a view to impart flexibility
to the interest rate structure as well as movements in real interest rates.
Finally, the Chapter undertakes empirical exercises to explore the monetary
transmission channels in India including estimates of interest rate pass-through.
1.9 Given the increasing concerns on financial instability,
Chapter VIII focussed on 'Financial Stability' undertakes a discussion
of key issues in regard to financial stability. The Chapter starts with a discussion
as to why price stability is not sufficient for financial stability. The role
of monetary policy per se in contributing to financial stability – in
particular, responding to asset price misalignments – is critically analysed.
Given the limitations of the traditional monetary instruments in achieving financial
stability, the Chapter discusses other policies - regulation, supervision, payments
and settlement systems, accounting and governance norms and lender of last resort
facility – that are needed to curb excessive volatility in the financial markets
and to maintain financial stability through building strong institutions. The
Indian approach to ensuring financial stability is highlighted. 1.10 The final
Chapter of the Report - 'Assessment of Monetary Policy' - presents
an overall assessment on the key issues and challenges in the conduct of monetary
policy, with special reference to India.