Lags in the transmission process of monetary policy in India

Abstract

Monetary policy has been a major instrument of economic stabilization. Reliance on monetary policy for this purpose involves two main assumptions. a. That monetary policy is effective in influence the operation of economy b. That monetary policy effects the economy with a comparatively short-lag Recognition of the lags in the effect of monetary policy is important because such policy could prove to be ineffective due to problem of timing. In studying the operation of monetary policy in India, the specific objectives are: i. To estimate the various lags – inside, intermediate and outside – involved in the operation of monetary policy. The “inside” lags is defined as the time elapsed between the appearance of a need for policy action, and the taking of action. The “intermediate” lag is the time-period corresponding to that interval between the central bank’s taking action and the instant at which bankers begin to face altered condition. Finally, the “outside” lag is the time taken for a change in bank credit to effect the real sector significantly. II. To estimate the differential impact of credit changes on real industrial output and the price level, and the lags involved therein. III. Finally, depending on the nature of the lag structure estimated, we plan to provide policy prescriptions for the operation of monetary In estimating the lag structure, it is assumed that the predominant channel through which monetary policy affects the Indian economy is “availablity of credit”. This is mainly because, unlike in the West, the interest rates (cost of credit) are fixed independently by the Reserve Bank; and do not change with changes in monetary policy. Moreover, “distributed lag” models have been used to arrive at lag estimates. The major findings of the study are: 1. The “total” lag in the effect of monetary policy is of the order of five quarters (i. e., 15 months); a. The first component of the “total” lag – the “inside” lag is of the order of three quarters (i.e., 9 months). b. The “intermediate” lag was found to be almost non-existent. In other words, banks adjust almost immediately to autonomous changes in their reserves. But, a survey important finding in the study of the “intermediate” lag is that borrowing from the Reserve Bank act as the most significant variable in determining credit expansion. c. Finally, the “outside” lag was estimated at 1½ to 2 2 quarters (i.e., 4-6 months). 2. The major effect of monetary policy changes is on the price level, as compared to real output. The dissertation outlines certain policy implications based on the findings: 1. Since the major contributor to the “total” lag, the Reserve Bank should improve its business forecasts; as also take faster decisions as to the line of action required. By shortening the “inside’ lag, monetary policy could be used very effectively as a discretionary weapon. 2. Given that the major impact of credit changes is on the price level; a very detailed and rigorous plan for credit allocation should be formulated keeping in mind the input-supply constraints. 3. Finally, the Reserve Bank ought to monitor its leading to commercial banks very carefully. It has been shown borrowing from the most important basis for credit expansion. There is no point in following a tight credit policy based on detailed credit planning, and then allowing unnecessary expansion in credit through liberal advances to commercial banks.