The RBI also faces the challenge of simultaneously managing the exchange rate in the face of porous controls on international capital flows.
While the exchange rate has depreciated recently as capital inflows have cooled, the hot button issue just a few months ago was whether the exchange rate should be kept from appreciating. Some economists argued for preventing exchange rate appreciation, and managing the inflationary impact of capital inflows by selling government bonds, thus soaking up excess liquidity. Others favored an “export-competitive” exchange rate policy, but also argued that monetary policy was irrelevant as current inflationary symptoms were arising from temporary supply-side shocks. The “radical” position (at least by Indian policy standards) has been that the RBI should focus on fighting inflation, but give itself more room to do so by allowing the exchange rate to adjust to market conditions. One version of this stance is that raising the interest rate is less effective as an inflation-fighting policy than allowing the rupee to appreciate, as financial repression and underdeveloped financial markets keep interest rate changes from rippling through the economy strongly enough. What does the evidence tell us?
There are several empirical analyses of the “monetary transmission mechanism” in India. These suggest that the interest rate channel of monetary policy has strengthened since 1998, which should not come as a surprise since there has been considerable financial liberalization, accompanied by a revision of the RBI’s policy approach. This result comes out in an interesting fashion in a 2005 IMF study by A. Prasad and Saibal Ghosh, using firm-level data. The responses of firms to monetary tightening vary by size and, while greater in the period 1998-2003 versus the prior half-decade, seem to involve a reversal of initial cutbacks in corporate debt. Still, interest rates do affect firm borrowing behavior.
A better feel for the aggregate impacts of monetary policy comes from an economywide analysis. Kanhaiya Singh and K.P. Kalirajan (SK) have provided one of the most sophisticated and recent empirical exercises. They model responses of the economy to changes in RBI policy variables, and the RBI’s own reactions to changes in economic conditions such as the inflation rate and growth rate. In their model of the Indian economy, a positive shock to the interest rate results in a sharp decline of real broad money demand followed by an initial fall in output (growth), a fall in inflation, and a depreciation of the rupee. This suggests the interest rate is an effective inflation-fighting tool in India even though, as the authors say, “the financial market in India is not yet matured.”
The results even indicate that output recovers with a lag in the face of such interest rate increases. All this sounds quite good from the perspective of what policymakers are currently doing, though there is no modeling of inflation expectations in India that I am aware of, and that issue seems to also be driving monetary policy. In contrast to interest rate policy, in the SK time series estimations there is no long-run link between monetary aggregates and output, rendering such aggregates less reliable as targets or indicators for policymakers.
Some of the other results of the SK analysis are less intuitive and may raise concerns for policymaking. According to the estimates, increasing the cash reserve ratio reduces output, but initially increases inflation and depreciates the currency, possibly contrary to the expectations of the monetary authorities. The transmission mechanism for this effect is not clear to me, but if this has anything to do with what we are seeing in the short run in India, it would suggest that some policy decisions are actually being counterproductive. In the model, inflation eventually falls below its initial level, and the currency appreciates, but only after a sufficiently long period (more than six months). Aside from the timing of policy impacts, which seems to be guesswork now for policymakers (unless they have a secret model of the economy not available publicly), the SK model highlights the tension between managing inflation and managing the exchange rate in an open economy. The authors also imply this in pointing out that a low interest rate regime would be better for managing inflows and the exchange rate. Whatever tool RBI uses to fight inflation, it makes its other task of keeping the exchange rate from appreciating more difficult.
Ultimately, as a microeconomist, I am left a bit frustrated by my observations of the conduct of monetary policy in India. It seems to involve analysis of a lot of different data, but without a clear picture of behavioral responses to changes in policy variables. This is aside from the problem of managing the impossible trinity of independent monetary policy, the exchange rate level and international capital flows. I’d like to know what others think.