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Monetary policy refers to the use of techniques of monetary control at the disposal of
the central bank of the country for achieving certain objectives (Bhole, 2004). Prior to the
financial sector reforms, the Indian economy was characterized by fiscal dominance, where
monetary policy played a subservient role and the main impetus to growth was provided by fiscal
policy. Post reforms, however, monetary policy has played a more proactive role (Bhattacharya
and Ray, 2007). This may be because it was realized that monetary policy instruments can
be rapidly and flexibly deployed to alter the price and volume of credit on account of
relatively short `inside lag' (Rangarajan, 1995).
As a result, there has been a marked shift in the conduct of monetary policy in India.
With growing financial integration (domestic and international), increase in capital flows,
deregulation of interest rates, deregulation of credit, etc., the monetary policy makers are posed with
serious challenges. Though the objectives of the monetary policy continue to be price stability,
full employment and growth, the operating instruments of monetary policy have undergone
changes. So also the intermediate targets, which transmit the policy to the final goals, have changed.
A number of financial innovations, such as Liquidity Adjustment Facility (LAF),
Market Stabilization Scheme (MSS), Certificates of Deposits (CD), and Commercial Papers
(CP), have been introduced to improve the speed and efficiency of monetary policy. The
present study, therefore, purports to analyze the efficacy of monetary policy in India, after the
introduction of the LAF, i.e., for the period 1999-2007, on a monthly basis, by constructing a
narrative measure of monetary policy and using the same as a stance of monetary policy.
A considerable body of literature on monetary policy focuses on the channels of
monetary policy transmission mechanism, and uses the short-term money market rate (e.g., Fed rate
and Call rate) or money supply as the stance of monetary policy (Bernanke, 1986; Bernanke
and Blinder 1988; Bernanke and Blinder, 1990;
Mauskopf, 1990; Kashyap et al., 1993; Gertler
and Gilchrist, 1994; Ray et al., 1998; and
Reddy, 2000). These studies are empirical in nature
and analyze the efficacy of the channels and,
therefore, the efficacy of monetary policy.
However, these standard empirical research
measures, i.e., the short-term money market rate or the
money supply, are prone to fluctuations even without the impact of monetary policy
(Romer and Romer, 2003; and Bhattacharya and Ray, 2007). |
