Three essays in monetary economics

Abstract

This thesis studies the monetary economics of the Indian economy in the form of three related essays. Starting from Friedman's constant money growth rate prescription & Kydiand & Prescott's Noble winning work on time inconsistency problems associated with discretionary monetary policy, it is by now widely agreed that a central bank should limit its discretion and use "rules" - or what are also referred to as monetary policy reaction functions - in the conduct of monetary policy. The first essay of the study discusses the issues involved in operationalization of a class of such reaction functions and provides some results on the performance of the Taylor and the McCallum rules on the Indian data. For a central bank to be able to use "rules", however, in an informed manner, it must understand the monetary economics and the transmission channels operating in the economy. The second essay addresses some of those issues and tackles the problem of the optimal operating target for the Reserve Bank of India (RBI) in the light of the changing monetary environment Given that a central bank has a usable rule and understands the transmission mechanism, for it to act, it also needs information on what are called indicator variables-a kind of an early warning system". The third and final essay concerns itself with constructing one such indicator - the term structure of interest rates - for monetary policy analysis. 1. Operationalizing Taylor-type rules for the Indian Economy - Issues and Some Results (1992 Q3 - 2001 Q4) The first essay is methodological in nature in that it discusses the issues involved in operationalizing a monetary policy reaction function for a central bank. The study not only delineates the issues but also addresses them while attempting to formulate a reaction function for India. In particular, the performance of backward and forward looking Taylor and McCallum rules are compared for the period 1992Q3 - 2001Q4. It is found that backward-looking McCallum rule tracks the evolution of monetary base over the sample period reasonably closely. Recent declarations by RBI that reserve money is its operating target (Annual Reports, 2001-02 and 2002-03) lend credence to the findings of the study. Ability of the McCallum rule to track monetary base closely is also an indication that RBI's implicit final target for monetary policy could be nominal income. 2. On Selection of an Operating Target for Monetary Policy for RBI The theoretical evaluation of whether to use money stock or the short - term interest rate for monetary policy was first conducted by William Poole. Working under the assumption that the central bank can perfectly control either the money stock or the short - term interest rate, he analysed the shocks to the IS/LM curves in a 'simple stochastic macro model'. He concluded that the choice is largely empirical. The second essay, then, concerns itself largely with the empirics of monetary economics of India and tries to address the operating target selection problem for RBI. In particular, the second essay provides evidence on the long- run stability of the money multiplier, the stability of the money demand function, erogeneity of money, and the credit channel of monetary transmission in India for the period post-BoP crisis. Allowing for in - sample regime switching, it is found that M3 money multiplier can be characterized by a one-time regime shift around the beginning of 1997 - time when issuance of ad hoc on-tap T-Bills gave way to the system of Ways and Means advances. Results on the stability of Ml multiplier are found to be less clear and relationship, if it exists, is statistically weak. Money demand function comes across as stable in a multivariate VAR framework but money is found to be endogenous, precluding its choice as a potential intermediate target. Using alternative tests, monetary base is found to be exogenous to contemporaneous movements in call rate, thereby presenting itself as a variable of choice for studying monetary policy stocks. Employing a Bernanke and Blinder (1992) kind of set up it is found that loans, investments and deposits of commercial banking system respond significantly to a monetary policy shock. Results to a positive shock to monetary base are as expected. Investments respond almost immediately and then taper with time whereas deposits permanently settle at a higher level. Loans respond more slowly and are seen to move with output after a lag of around 8-12 months. Corroborating the findings of the first essay, monetary base appears to be the appropriate operating target for the conduct of monetary policy as reflected by a stable demand for money multiplier and long run demand for money, (weak) erogeneity to short-term interest rates, and a strong transmission effect on output and commercial banks' balance sheet variables. 3. Term Structure Modeling for Monetary Policy Analysis - Comparing Results from Alternative Specifications It is aptly established that while the term structure has almost no ability to forecast future inflation changes for short horizons, at horizons greater than a year the yield curve does contain a great deal of information regarding both future paths of inflation as well as future short rates. To analyze the information content of the term structure of interest rates regarding future short term interest rate changes and future inflation, however, one needs a reliable term structure model. The third and final essay compares the performance of three alternative specifications for the term structure from the point of view of monetary policy analysis. For the first time in the Indian context, two a theoretical (Nelson and Siegel, 1987 and Svensson, 1994) models are compared against empirical implications of a general equilibrium (Cox, Inger soll and Ross, 1985) model. While Svensson is seen to offer no improvement over Nelson Siegel, Cox lngersoll Ross comes out as marginally superior to both on the criteria of mean absolute pricing and yield errors (both in sample and out-of-sample), behaviour of the short and the long rates, stability of the parameters and behaviour of forward rates for maturities 1-8 years. This is encouraging because models like NelsonSiegel and Svensson are designed to fit the observed yield curves, while Coxlngersoll Ross is a theoretical model derived from intertemporal description of a competitive economy.