Introduction

The primary objective of monetary policy is to maintain price stability while keeping in mind the
objective of growth. To achieve the goals of broad economic policy, the Reserve Bank of India
(RBI) uses monetary policy to control inflation, interest rates, supply of money and credit
availability. In order to facilitate this, the RBI has a government-constituted Monetary Policy
Committee (MPC) which is tasked with framing monetary policy using tools like the repo rate,
reverse repo rate, bank rate, cash reserve ratio (CRR). The Monetary Policy Committee is
assigned with the task of fixing the benchmark policy rate (repo rate) required to contain inflation
within the specified target level. A Committee-based approach for determining the Monetary
Policywas aimed at adding a lot of value and transparency to monetary policy decisions. The
meetings of the Monetary Policy Committee are held at least 4 times a year and its decisions are
published after each such meeting. All members are required to be involved in the voting on the
policy decision. Besides the MPC itself, the RBI’s monetary policy department also contributes to
the process. Views of key stakeholders are also accounted for while deciding the repo rate.

Generally central bank autonomy is viewed in terms of the extent to which the bank is independent
of fiscal pressure in the conduct of monetary policy. However, political independence is determined
by the institutional relationship between the central bank and the government. Monetary policy
generally aims at targeting the growth rate of money supply however defined, or pegging the
interest rate at some desired level by manipulating policy instruments. Hence, better monetary
management implies the actual growth of money supply or interest rates converg- ing to their
target levels. The RBI has begun active money supply targeting since 1990-91, though the practice
of money supply targeting had formally come into existence in the mid-1980s. Reflecting the
recommendation of the committee to re- view the working of the Indian monetary system, the
proposed target level for money supply growth is generally fixed on the basis of an expected
increase in real output and an acceptable rate of inflation. Secondly, the autonomy of the RBI has
been constrained by the unique feature of the Indian financial system that the govern- ment mostly
owns it. The directives of the government to the commercial banks as owner and supervisory
norms imposed by RBI as monetary authority were often in conflict, which partly contributed to the
deterioration in the quality of the loan assets of the nationalised commercial banks. The flexibility of
monetary policy, particularly in transition economies, is con- strained by a larger fiscal deficit, economi-
cally weak state enterprises, domestic coalitions that petition the government to cut budget deficits arising
out of politically motivated subsidies and alarming growth of non-developmental expenditure. For instance,
monetary policy in transition economies is driven by politically moti- vated fiscal policy. The managers of
the economically weak state-owned firms maintain their influence to obtain provisions of subsidised loans,
which become a major source of inflation. An indepen- dent central bank that is free of political pressure can
cut down inefficiency in credit allocation and hence reduce inflation. Monetisation of government's fiscal
deficit through seignorage is another impor- tant source of inflation in transition econo- mies. An
independent central bank is believed to resist giving cheap deficit financing and hence put pressure on
government to limit the size of the deficit or to invent non-inflationary sources of fiscal financi

RBI also intervenes in the foreign exchange market to provide a stable corridor for the exchange
rate. Whenever the rupee comes under pressure the RBI follows the practice of selling the dollar in
the spot and forward markets and con- comitantly rising interest rates and reserve ratios. Similarly,
when the rupee appreciates thanks to larger inflow of foreign capital RBI sells dollars in the spot
and for- ward markets. For instance, the RBI was a net seller of foreign exchange to the tune of US
$ 1,627 million in June 1998 whereas the RBI was a net buyer by an amount of US $ 1,420 million
in March 1999.

Monitoring of price stability and money multiplier

Even if the amount of reserve money is under control there is no assurance of successful money
supply targeting. It is striking to notice that the growth of M3 has increased from 13.66 per cent in
1995- 96 to 15.23 in 1996-97 in contrast to the drastic fall of reserve money from 14.87 to 2.84 per
cent during the same period (Table 2). The reason is that the money multiplier has increased,
mostly reflecting the 4 percentage point reduction in reserve requirements during the year. Indeed
money multiplier is a behavioural coefficient determined by the complex financial transactions
carried out by the RBI, the government, commercial banks and the public. The RBI influences mul-
tiplier by changing the CRR whereas commercial banks and the public influence the multiplier by
adjusting their asset portfolio. The policy impact on the multiplier can therefore be eliminated by
adjusting the high powered money for CRR changes. It is evident from Table 1 that the adjusted
money multiplier (m*) is rising. This rise can be attributed partly to the fall in currency to deposit
ratio and partly to commercial banks' reserve to deposit ratio. This indicates that the fall in CRR
results in a one-shot rise in excess reserve which will be utilised in the credit creation process over
a period of time, depending upon the rise in the demand for bank credit. However, it fell to 0.28 per
cent in 1998-99, reflecting readjustment of portfolio by commercial banks. These stylised facts
indicate that the behaviour of the money multiplier during the last five years was largely influenced
by frequent changes in CRR, and changes in portfolio choices of the public and commercial banks.
Rath (1999) has con- cluded from an empirical study using time series data that the money
multiplier re- sponded to financial liberalisation wit- nessed since the late 1980s and supported a
paradigm of mixed portfolio-loan de- mand model for money supply process in the Indian context.
In this context, RBI has mentioned that "while the money demand is a fairly stable function of
income, the rising significance of interest rate seems to have imparted some degree of endogenity
to money supply price. This assertion however needs further scrutiny. A close examination of the
data in Table 2 points to a different cause for money supply endogenity. If it is interest ratesthat
turned out to be very significant in recent times then one would expect, on theoretical grounds, a
positive association between the multiplier and velocity, given a stable income elasticity of demand
for money. On the one hand, when there is a rise in the interest rate, both commercial banks and
the public tend to economise their cash holdings. This will bring down the two ratios and hence,
increase the money multiplier. On the other hand, velocity tends to rise in response to an increase
in interest rates as it is inversely related to the demand for money function.

The data reveals that there is a consistent inverse association between these two ratios, indicating
that the income elasticity of the demand for money in general and deposits in particular might have
increased in recent years. If we consider the opportunity cost of holding money, it is not the rise in
the real interest rates, but the fall in the expected rate of inflation whose impact is likely to have a
pronounced.

Table 1: Multiplier and velocity behaviour

Table 2: Selected Monetary Ratios and Growth Rates

Some examples can also be refererred to the scenario during the year 2005 is also in conformity
with the above ob- servations. The year-on year growth of M3 supply at 16.6 per cent as on
January 14, 20005 against -0.1 per cent growth of reserve money is well above the projected
growth rate. The fall in the growth of reserve money mainly comes out of a drastic fall in net RBI
credit to the government, registering -29.0 per cent to the state gov- ernments and 2.8 per cent to
the central government. This is attributed to the suc- cessful open market operation conducted by
RBI during the year. "The net sale of dated securities and treasury bills by RBI through its OMO
window as at the end [of] December 1999 amounted to Rs 27,206 crore, which exceeded the
corresponding amount at Rs 18,391 crore in the corre- sponding period of the previous financial
year" (Economnic Survey 1999-2000, para 4.34). This has reflected the RBI's strategy of off-
loading the securities to the market, which were earlier accepted on private placement. What
accounted for this successful OMO and what is the state of the liquidity in the system during the
year? The amount of liquidity during the year has been enhanced by a number of factors. The CRR
has been reduced by 0.5 percentage point to 10 per cent with effect from the fortnight begin- ning
May 8, 1999 and further to 9 per cent in two phases of half-a-percentage point each with effect
from November 6, 1999 and November 20, 1999 respectively. The incremental CRR of 10 per cent
on in- crease in liabilities under the FCNR(B) scheme was also withdrawn with effect from
November 6, 1999 (Economic Sur- vey 1999-2000, para 3.6). Following the recommendation of the
Narasimham Com- mittee (1999), an interim liquidity adjust- ment facility has been put in place with
effect from April 21, 1999. The net foreign exchange asset of the RBI has increased by 10.7 per
cent. Time deposits of com- mercial banks registered a lower growth rate of 14 per cent till January
14, 2000 as compared with last year's growth of 17 per cent. But 14 per cent growth is not
insignificant, as it is higher than the growth rate of 13.7 per cent during the correspond- ing period
of the previous financial year, given the high base of the previous year. The comfortable liquidity
position of the commercial banks can further be indicated by the fact that the credit offtake of com-
mercial banks from RBI has declined to -31.3 per cent till January 14, 2000 as compared with the
corresponding period of the previous year. The call money rates have ruled around 8 per cent
since mid- November 1999. The growth in non-food credit, which was negative during the first
quarter of the year, picked up in the second quarter, and registered a growth rate of 10.6 per cent
till January 14, 2000 against 7.2 per cent in the corresponding period of the previous year. Thus,
the comfortable liquidity situation has sup- ported the OMOs of the RBI and as a result, there is a
corresponding decline in the monetisation of the central government's fiscal deficit. However, lower
growth of reserve money due to a sharp decline in the growth of RBI credit to commercial banks,
commercial sectorand the downfall in the monetisation of the fiscal deficit failed to ensure any
reduction in M3 growth, because of a rise in the money multiplier (4.2). This is indicative of the fact
that money supply responds to demand, and reserve money based monetary targeting has
become more complicated. We drive the point home by arguing that fiscal correction must precede
the discussion of RBI autonomy, as the efficacy of monetary policy is significantly affected by fiscal
pressure, in one way or the other, irrespective of whether the policy aims at targeting money supply
or interest rates.

Monetary policy and Inflation

In the past few years, the growth-inflation trade-off and the subsequent role of monetary policy in
India has provoked prolonged debates among Indian policymakers and academics (Mohanty
2013), as high inflation and low growth have coexisted. This is contrary to conventional economic
theory, which suggests that low inflation helps accelerate the real growth of the economy by
stimulating overall consumption and investment. It is also important to note that high growth leads
to high inflation, following the Phillips curve (Phillips 1958), which depicts a short-term direct
relationship between growth and inflation (i.e., high growth in the short-run gives rise to inflationary
pressures). As a result, there has been a wide consensus among economic thinkers that monetary
policy should have the single objective of low and stable inflation, so that by anchoring inflation
expectations in the desired way, monetary policy can create an environment conducive to growth
(Rajan and Prasad 2008). However, in the recent past it has been observed that the several
attempts by the Reserve Bank of India (RBI) to contain inflation through tight money policy have
failed, and eventually ended up slowing the growth process. Thus, the persistently high inflation in
India along with low growth has become a puzzle for the monetary authorities (Mohanty 2013).
Needless to say, this inflation inflicts a real cost on the economy as its major burden is borne by
the poor, which eventually leads to distributional inequalities (Mohanty 2013, 2014). Also,
persistently high inflation beyond a particular threshold level could pose serious challenges to
growth in the long-run (Mohaddes and Raissi 2014). The Phillips curve also implies a positive link
between output gap and inflation. It is important to note that both the level of and changes in the
output gap affect inflation. Monetary policy decisions are based on different indicators that provide
vital information on future inflation and output growth. In monetary policy the output gap can be
used as one of the indicators of inflation. Therefore the important task for policymakers is to study
the link between output gap and inflation and thereby ensure the required changes in policy rates.
Against this backdrop, the present study uses the Granger Causality in the frequency domain
approach developed by Lemmens et al. (2008) to first test the impact of monetary policy on output
and inflation, and to then analyse the relationship between output gap and inflation in India, thus
providing essential information regarding the prevailing output gap and inflation dynamics. Also,
Structural Vector Auto-Regression (SVAR) is used to discover the structural relationships between monetary
policy rate, inflation, and output in India. All these factors are required to be studied with great detail which
will be covered and explained further.