INTRODUCTION History of RBI The Reserve Bank of India is the central bank of the country.

Central banks are a relatively recent innovation and most central banks, as we know them today, were established around the early twentieth century. The Reserve Bank of India was set up on the basis of the recommendations of the Hilton Young Commission. The Reserve Bank of India Act, 1934 (II of 1934) provides the statutory basis of the functioning of the Bank, which commenced operations on April 1, 1935. The Reserve Bank of India was nationalized with effect from 1st January, 1949 on the basis of the Reserve Bank of India

The Bank was constituted to
• • •

Regulate the issue of banknotes Maintain reserves with a view to securing monetary stability and To operate the credit and currency system of the country to its advantage.

The Bank began its operations by taking over from the Government the functions so far being performed by the Controller of Currency and from the Imperial Bank of India, the management of Government accounts and public debt. The existing currency offices at Calcutta, Bombay, Madras, Rangoon, Karachi, Lahore and Cawnpore (Kanpur) became branches of the Issue Department. Offices of the Banking Department were established in Calcutta, Bombay, Madras, Delhi and Rangoon. Burma (Myanmar) seceded from the Indian Union in 1937 but the Reserve Bank continued to act as the Central Bank for Burma till Japanese Occupation of Burma and later upto April, 1947. After the partition of India, the Reserve Bank served as the central bank of Pakistan upto June 1948 when the State Bank of Pakistan commenced operations. The Bank, which was originally set up as a shareholder's bank, was nationalized in 1949. An interesting feature of the Reserve Bank of India was that at its very inception, the Bank was seen as playing a special role in the context of development, especially Agriculture. When India commenced its plan endeavours, the development role of the Bank came into focus, especially in the sixties when the Reserve Bank, in many ways, pioneered the concept and practise of using finance to catalyse development. The Bank was also instrumental in institutional development and helped set up insitutions like the Deposit Insurance and Credit Guarantee Corporation of India, the Unit Trust of India, the Industrial Development Bank of India, the National Bank of Agriculture and Rural Development, the Discount and Finance House of India etc. to build the financial infrastructure of the country.

The openness of the economy. through which the Reserve Bank of India seeks to ensure price stability forth economy. which aims to achieve economic goals through taxation and government expenditure. interest rates and the inflation Definition of monitory policy Monetary policy is the management of a nation's money supply to achieve economic goals by a central bank or currency board. and Overseeing the Payments System and onto developing the financial markets. Monetary policy has responded continuously to changes in Domestics and international macro economic conditions. the Bank's focus has shifted back to core central banking functions like Monetary Policy. foreign currency Assets of the reserve bank of India(RBI) rose from USD 15. tends to curb inflation by contracting the money supply. These factors include . also called contractionary monetary policy. The RBI controls the money supply through open market operations. the current monetary operating framework has relied more on outright open market operations and daily repo and reserve repo operations than on the use of direct instruments. and also sets interest rates between banks and reserve requirements. Tight monetary policy.these changes have affected liquidity and Monetary management. as measured by the ratio of merchandise trade(exports Plus imports) to GDP. Monetary policy is contrasted with fiscal policy. external transactions as a proportion of GDP Rose from 25% to 40% during the same period. handles monetary policy in India. Including services trade plus invisibles.2005. cost and directions of credit flow in the economy.With liberalisation. Easy monetary . Monetary policy objectives can include control of inflation. capital inflows have increased even more sharply.1 billion in the march 1994 To over USD 140 billion by march 15. making interest rates the increasingly Dominant transmission channel of monetary policy in India. The Monetary and Credit Policy is the policy supply. in the 1980s. or even simply economic stability. Reforms during the 1990s enhanced the sensitivity of price Signals of price signals from the central bank. traditionally announced twice a year.monetary policy was geared towards controlling the quantum. Oversight Rate are now gradually emerging as the principal operating target. MONETORY POLICY Monetary policy in India underwent significant changes in the 1990s as the Indian Economy became increasing open and financial sector reforms were put in place. In this process. rose from about 18% in 1993-94 to about26%by 2003-04. Bank Supervision and Regulation. The Reserve Bank of India (RBI). the quantity variables dominated as the transmission Channel of monetary policy. control of exchange rates. Alongwith the increase in trade as a Percentage of GDP.

In many cases.14 The appropriate inflation threshold beyond which costs tend to exceed benefits. Notably. often sparked off by irregularities in the banking system and "irrational exhuberance" in ." The anti-inflationary stance of monetary policy during the 1990s was essentially framed against the backdrop of high inflation of the 1960s. fuelled by large-scale monetisation of fiscal deficits. the costs of getting there are large.. "……. Indeed. It is. that it brings large benefits with few if any costs. while the costs of the inflation itself will still be very small. The most important contribution of the financial system to an economy is its ability to augment savings and allocate resources more efficiently. rests not on evidence but on faith. attempt to bring down inflation rate from about 2 per cent to almost zero. financial crises. In a sharp contrast. Paul Krugman has recently argued that. A regime of rising prices. if not held in check." Prof. the domestic inflation rate also has a bearing on the exchange rate of the currency. Krugman's arguments do not seem relevant for developing economies because his criticism is aimed against those countries which seek 'absolute' price stability and (unlike most developing countries). Thus. The empirical evidence on the relationship between inflation and growth in cross-country framework is somewhat inconclusive.even deflation . The case of price stability as the prime objective of monetary policy rests on the assumption that volatility in prices creates uncertainty in economic decision making. Prof. inflation affects adversely the poorer sections of the society who have no hedges against inflation. Rising prices affect savings adversely while they make speculative investments more attractive. say 3-4 per cent. even moderate inflation levels are often perceived to be worrisome by the policy makers because. can lead to higher inflation and eventually affect growth. a critical question that arises in this context is at what level of inflation the adverse consequences begin to set in. Besides. the sample includes countries with inflation rates as low as only one to two per cent as well as countries with inflation rates going beyond 200 and 300 per cent.policy. The evidence actually points the other way: the benefits of price stability are elusive. the recent co-existence of low and stable inflation . clearly vitiates the atmosphere for promotion of savings and allocation of investment. inflationary pressures. there is a social dimension. This is evident from what he himself advocates: "….the belief that absolute price stability is a huge blessing.15 Nevertheless. In many cases. thus. While there is a growing consensus among the central bankers regarding the virtues of price stability. This is high enough to accommodate most of the real wage cuts that markets impose. Furthermore. the case against price stability is not without its protagonists. needs to be estimated for each country separately.adopt as a long run target fairly low but not zero inflation. particularly in developing economies. however. clear that growth rates tend to fall with high inflation. has naturally fostered a degree of revisionism. tends to encourage growth by expanding the money supply The key issue here is whether the attainment of price stability should be the dominant objective of monetary policy. and zero inflation may not be a good thing even in the long run.with low growth. also called expansionary monetary policy. thus.

a 1999 Bank of England21survey of monetary policy frameworks reveals the continuing diversity of central bank objectives. especially in response to financial market developments.16 Notwithstanding the extreme theoretical positions. who interpret the present situation as an aberration and those advocating the so-called "new view". output gaps and asset. Interestingly. adopted price stability as the sole goal of monetary policy during the 1990s. there is little evidence to suggest that inflation targeting on average improves performance as measured by the behavior of inflation. the objective of output stabilisation has. outside the fold.19 Constrained discretion seems to be the preferred rule for most central banks today. been prominently pursued by central banks all over the world.22 In the Indian context. which in turn. Combating the spiral of falling prices and output in a conventional monetary policy framework is especially difficult given the zero bound on nominal interest rates. there are 18 inflation targeters.20 This also implies there are many others. credit and financial markets (which are aggregated to construct an index of deflation vulnerability) so as to ward off the potential deflationary tendencies. the debate on "rules versus discretion" has engaged the attention of policy makers. markets. While price stability emerged as the main/ other important policy objective in 50 out of the 77 central banks. 2003). which could not be picked up by inflation indicators. in the face of a benign inflationary environment in the last few years. and give the scope for time-inconsistent behaviour and the associated inflation bias of central bankers. as many as 54 central banks reported exchange rate management to be the main/other important policy objective. This set off a process of deflation. fed back into the system by eroding collateral values. Several developing countries have also used monetary measures to defend the exchange rate. or interest rates. who urge a broader degree of central bank activism. There is no doubt that inflation targeters have been able to achieve a reasonable degree of price stability. particularly the Taylor-type rules. both in terms of preventing economic overheating and providing stimulus to faster recovery from recessions. output. At the same time. monetary policy has to stabilise swings in effective demand as well (Bernanke17. This has fostered a lively debate between the proponents of the so-called "continuity view". In this context. the broad objectives of monetary policy have been: · to maintain a reasonable degree of price stability. This is reinforced by the recent report of the IMF's Interdepartmental Task Force on Deflation. had adverse output effects. there has been a growing emphasis on policy rules. A number of central banks. including the US Federal Reserve. . which have potential output effects. thus.18 The Report suggests that central banks need to pay attention to a wide menu of macroeconomic indicators. most central banks tend to operate on the golden mean of constrained discretion which takes the pragmatic view that within the mandate of price stability. Despite a generalised recognition of price stability as the primary goal of monetary policy. beginning with New Zealand (1989). no less. including developments in aggregate prices. and · to help accelerate the rate of economic growth.

to be transparent and credible. the Chakravarty Committee (1985) had presumed precisely the same target of four per cent as "the acceptable rise in prices' purported to reflect 'changes in relative prices necessary to attract resources to growth sectors". during the first two years. In India. on an average.23 It may be noted. that there is a need to have an appropriate fix on the acceptable level of the inflation rate in India. however. in India also. as noted by Governor Jalan in the Monetary and Credit Policy Statement of April 2000: "Based on the experience of some industrialised countries. financed by primary money leads to an annual inflation rate of about 2. however. Subsequent research places estimates of threshold inflation in India in the range of 4-7 per cent. it was 8 per cent. A macro-econometric model of the Indian economy shows that a 10 per cent sustained hike in real public investment in the non-agriculture sector. there is still fiscal dominance and the debt management function gets inextricably linked . There are several operational constraints. monetary policy. No one in India is advocating absolute price stability or even the order of price stability that is being sought as an objective in the industrially advanced countries. Narasimham). The Advisory Group on Monetary and Financial Policies (Chairman: Shri M.7 per cent over this period. However. recommended that the Reserve Bank should be mandated a sole price stability objective. there is a view that. This implies that in the long run a sustained improvement in growth through monetisation of the fiscal deficit could involve a severe trade-off in terms of inflation as every one per cent additional output growth would entail nearly 6 to 6. inflation rate rises to about 17 per cent per annum while additional output growth slows down considerably to an average of 2. there are several constraints in the Indian context in pursuing a single objective. does have some implications for the exchange rate of the rupee. In the 1970s. the average inflation shot up to around 11. Monetary growth can be so moderated that meeting the objective of growth does not push inflation rate beyond this tolerable level on an average. This itself is much higher than what the industrial countries are aiming at and therefore. The crucial question that is being debated in India as elsewhere is whether the pursuit of the objective of price stability by monetary authorities undermines the ability of the economy to attain and sustain high growth. in the period between 1990 and 1995. the average annual inflation rate.The emphasis as between the two objectives has changed from year to year depending upon the prevailing conditions. In a span of 10 to 15 years. First.3 per cent during 1995-2002.0 per cent before decelerating to about 5.5 per cent increase in the inflation rate in the long-run.3 per cent and additional GDP growth of one per cent. depending on the period and methodology. In the 1980s. While technically this appears to be a sound proposition. should have an explicit narrowly defined objective like an inflation mandate or target. The objective of the policy has been to keep the inflation rate around 4 to 5 per cent. was 9 per cent. as measured by the Wholesale Price Index (WPI). A considerable part of the relevant research effort has been devoted to the trade-off between economic growth and price stability.

. the transmission channel of policy is rather weak and yet to evolve fully. Fluctuations in agricultural output have an important bearing on prices. the high frequency data requirements including those on a fully dependable inflation rate for targeting purposes are yet to be met " (December 2000). power. Fourth. · The rapidity of product innovations makes inter-temporal comparisons increasingly difficult. Besides. the comfortable stocks of foodgrains and foreign exchange reserves would facilitate better supply management in the unlikely event of price pressures in agricultural commodities. the prices of 'fuel. There are several issues involved here: · The vast range of the consumption basket often makes it difficult to create a comprehensive price index. First. The Wholesale Price Index (WPI) and the Consumer Price Index (CPI) occasionally diverge because of the problems of coverage and the weighting of commodities comprising the indices. As pointed out in the Reserve Bank's April 2001 Monetary and Credit Policy Statement.with the monetary management function while steering the interest rates…Secondly. Third. light and lubricants' so far have remained moderate in the absence of any renewed pressure on international oil prices. Second. both M3 and reserve money growth have remained subdued…". the good monsoon and expected recovery of agricultural production would have a favourable impact on prices of agricultural commodities. its power could have been upgraded from 266 MHz to 1000 MHz. particularly in the wake of reduction in geopolitical tensions in the Middle-East. · There is also the choice between wholesale and consumer prices. this divergence between retail and consumer prices is a reason why central banks need to monitor several indicators. while a baseline personal computer could cost the same in 1997 and 2003. which was recognised by the Working Group on the Index Numbers of Wholesale Price in India (1999). Illustratively. The measurement of services inflation. which remain still imperfect and segmented. in the absence of fully integrated financial markets. which is what inflation is all about. Reddy's Mid-Term Review of Monetary and Credit Policy of November 2003: "…The probability of emergence of any undue pressure on prices during this year appears to be low on current indications. Nevertheless. a continuous increase in prices. there is also the question of measuring inflation. cannot occur unless it is sustained by a continuing increase in money supply. for example. V. The control of money supply has thus an important role to play in any scheme aimed at controlling inflation. Thirdly. the issue of the merit of price stability as a central banking objective. is an important issue in the Indian context. The mix of monetary and non-monetary factors behind Indian inflation is reflected in Governor Y. It is true that developing economies like India are subject to greater supply shocks than developed economies. A question that is sometimes raised in this context is whether monetary policy by itself could be able to contain inflationary pressures particularly in developing economies like ours.

the monetary policy decisions of the Reserve Bank. the methodology of factoring in asset prices in the standard price indices is still not very firm. on balance. which is the part of inflation that emanates from demand side pressures. 2.specific. The theory as well as in practice . Net loans to central government (i. Besides. the difficulty is often that a measure of 'core' inflation could lose public credibility since a large part of the inflation is driven by a wide-range of regular supply shocks.and push. In case of emerging market economies such as India. Although the two objectives are mutually reinforcing in the long run. ceteris paribus.24 It is not clear. open market operations) Net purchase of foreign currency assets Change in cash reserve ratio Changes in repo rate and reverse repo rate Bank rate . 5. especially in case of structurally constrained economies. but as I look at the history of economic thought and changing fashions in economic policy making. Thus. It is in this context.· Individual consumption baskets have been rapidly expanding.25 There are several methodologies available . Instruments of monetary policy in India 1. are essentially environment. short-run trade-offs are often live and real. Thus. be worse-off because the list of items of consumption they perceive as a 'standard need' has expanded although their prices have not changed.e. several central banks. especially in emerging market economies.factors behind inflation. just as price stability is of prime importance. whether asset price changes should be viewed as a cause or a component of inflation as we understand it today. first of all. 3. · Another issue is the integration of asset prices in the standard price indices. Since the monetary authority is essentially concerned with the management of demand. individuals could. It is important to appreciate that. like those of most central banks. becomes even more relevant because of a large non-monetised and agricultural economy. and concentrate on a single target of inflation control with the use of a single instrument. which typically comprise commodities. 4. Governor Jalan has summed up the prevalent thinking: "…There is a growing consensus now .that Central Bank should have instrumental independence. It seems to me that a certain amount of target flexibility and balancing of conflicting objectives are unavoidable…" (December 2000). Canada. · There is a need to distinguish between the pull. is theoretically sound. such as oil.the most popular one being to exclude commodities whose prices are subject to supply shocks. such as Australia. one instrument" will survive the test of time…In developing countries this whole question of tradeoff .particularly at the margin -and during periods of external or domestic uncertainties. The recent literature has attempted to construct measures of "core" inflation. growth is equally a matter of policy concern. New Zealand and the UK monitor some variants of core inflation. I must confess to a sense of discomfort on whether the current dominant view on "one target. no doubt.

This market force cannot be counted by RBI for long periods of time. mutual funds and corporate with surplus cash are big investors in government securities. 24. any increase in CRR will require the banking system to contract credit by a large amount. which could cripple them. some of the investors can sell their holdings and the cash inflow would lead to credit creation of a large magnitude.f. Market intervention: Large balance of payment surpluses and build up of Forex reserves are bound to strengthen the rupee in the exchange market. it has another option of buying government securities.1.25% of demand and time deposits (w. by intervening in the market by offering to buy any amount of foreign currency at a particular rate. when RBI sells government securities at a higher rate than market rate. RBI absorbs funds and the banking system contracts credit by a large magnitude to reduce liquidity. banks are required to maintain the following reserves: • • Cash Reserve ratio: 8. Foreign Exchange Management Tweaking the basket of currencies: The exchange rate of rupee is calculated by RBI based on the exchange rates of basket of currencies of countries with which India has significant trade transactions. Open Market Operations: Banks as well as other financial institutions. Cash Reserve Ratio: Banks reserve liquidity through their power to create credit. RBI can prevent the sudden strengthening of rupee. RBI maintains confidentiality about the weightage given to each currency in the basket and when RBI wishes to manage the extent of volatility in the exchange rate of rupee. . RBI adjusts the weightages properly.05. Similarly. However. When RBI offers to buy the securities at a rate that is better than the rate prevailing in the market. This is known as open market operation. Presently in India. such as insurance companies. 3. RBI seeks to smoothen the movement of rates in either direction so than importers and exporters have time to adjust to the changing exchange rate scenario and are not caught by surprise by violent rate movements. When RBI wishes to inject liquidity into the market. 2.e.2008) Statutory Liquidity ratio: 25% of demand and time deposits Just as additional cash inflows enable the banking system to create credit.

In addition to ensuring that banks can fall back on the readily saleable government deposits in the event of a run on the bank. the statements include not only monetary policy stance or measures but also institutional and structural aspects. Bank rate: RBI provides refinance to banks against funds deployed by banks in specified sectors such as export finance portfolio of the banks.SLR (Statutory Liquidity ratio) is a requirement peculiar to India. but the rationale for such measures is given in the Press Release and also statements made by Governor and Deputy Governors unless a deliberate decision is taken not to do so on a . RBI uses repo and reverse repo to control liquidity on a day-to-day basis. A process of openness was initiated by Governor Rangarajan and has been widened. Changes in the bank rate are a signal to the market regarding the direction in which the RBI would like interest rates to move. Repo rate and Reverse Repo rate: Repo rate or repurchase rate is a swap deal involving the immediate sale of securities and simultaneous purchase of those securities at a future date. the process of monetary policy in India had been largely internal with only the end product of actions being made public. the bank rate used to be the primary interest rate tool of RBI. RBI’s MONETORY POLICY: Policy Making Process Traditionally. The stance of monetary policy and the rationale are communicated to the public in a variety of ways. The statements have become over time more analytical. rapid responses and being market savvy. It could also be an overnight deal with sale taking place on day one and repurchase on day two. at times introspective and a lot more elaborate. 4. it was a prescription to divert bank deposits to meet government investment expenditure. 5. at a designated price. The monetary measures are undertaken as and when the circumstances warrant. The repurchase price is adjusted for the interest payable for the use of funds for the period of contract. But over a period of time the repo rate has presently emerged as the primary interest rate tool and bank rate has lost much of its relevance. consultative and participative with external orientation. while the internal work processes have also been re-engineered to focus on technical analysis. horizontal management. deepened and intensified by Governor Jalan. Further. Reverse repo involves the immediate purchase and future sale of those same securities. the most important being the annual monetary policy statement of Governor Jalan in April and the mid-term review in October. coordination. The process has become relatively more articulate. In the past.

the RBI website has become a very effective medium of communication and it is rated by experts as one of the best among central bank websites in content. There are several other standing and adhoc committees or groups of the Board and Board for Financial Supervision plays a critical role in regard to institutional developments. Periodic consultations with the Government. economic and statistical analysis are reoriented to suit the changing needs.contemporaneous basis. financial conditions and advise or decide appropriately. In brief. market participants and financial intermediaries take place through Standing Committees and Adhoc Groups. presentation and timeliness. speeches and press releases. mainly with Ministry of Finance do ensure coordination. A Committee of the Board meets every week to review the monetary. Historically. inflation rates in India rarely touched double digit and when they did. A Financial Markets Committee focuses on a day-to-day market operations and tactics while a Monetary Policy Strategy Group analyses strategies on an ongoing basis. analytical. The relative emphasis between the objectives depends on the underlying economic conditions and is spelt out from time to time. in most cases. the major objectives of monetary policy in India have been those of maintaining price stability and ensuring adequate flow of credit to the productive sectors of the economy. Because of the reasonable stability of the money demand function. they were the result of supply shocks either in the form of increase in agricultural commodity prices or in the form of increase in international prices of crude oil. Transmission Mechanism The monetary policy framework in India from the mid-1980s till 1997-98 can. Several new institutional arrangements and work processes have been put in place to meet the needs of policy making in a complex and fast changing world. The Reserve Bank’s communications strategy and provision of information have facilitated conduct of policy in an increasingly market-oriented environment. Periodic consultations with academics. by and large. market information. in addition to mechanisms such as resource management discussions with banks. India has been able to maintain a moderate level of inflation. the supervisory data. Compared to many other developing economies. there are significant technical. The sources for appreciating the policy stance encompass several statutory and non-statutory publications. economic. Much of the data used by the Committee is available to the public with about a week’s lag. institutional and dynamic inputs that go into the process of making monetary policy. At the apex of policy process is Governor. the annual growth in broad money . Of late. be characterised as a monetary targeting framework on the lines recommended by Chakravarty Committee (1985). Objectives Although there has not been any explicit legislation for price stability. Within the Reserve Bank. assisted closely by Deputy Governors and guided by deliberations of a Board of Directors.

Strategies and Tactics There has been a shift in strategic objective. credit. the emerging evidences on transmission channel suggest that the rate channels are gradually gaining importance over the quantum channel. Monetary management involved working out a broad money growth through the money demand function that would be consistent with projected GDP growth and a tolerable level of inflation.monetary policy to achieve monetary objectives. The estimated income elasticity of demand for money which had exhibited a clearly decreasing trend in the earlier part of the reform period showed a sharp turning point in 1996-97 resulting in an increasing trend thereafter. the Reserve Bank had to resort to direct instruments like interest rate regulations. The econometric evidence produced by the Third Working Group on Money Supply (1998) indicated that output response to policy operating through the interest rate was gaining strength. fiscal position. In practice. In a way. . In this approach. These instruments were used intermittently to neutralise the monetary impact of the Government’s budgetary operations. information pertaining to other monetary and financial indicators should also be taken into account seriously while formulating monetary policy. Operating Procedures In the pre-reform period prior to 1991. selective credit control and the cash reserve ratio (CRR) as major monetary instruments. necessitated by deregulation and liberalisation of the financial markets combined with increasing openness of the economy. The demand for them was created through intermittent hikes in the Statutory Liquidity Ratio (SLR). exchange rate. such a shift was a logical outcome of measures taken over the reform period since the early 1990s. the monetary targeting approach was used in a flexible manner with a ‘feedback’ from the developments in the real sector. The administered interest rate regime during the earlier period kept the yield rate of the government securities artificially low. Similarly. The changing nature of the relationship highlights that while money is still an important indicator. refinancing and transactions in foreign exchange – available on high frequency basis – are juxtaposed with output data for drawing policy perspectives. especially in view of the sweeping changes in the financial sector in India in recent years. the impact of an expansionary monetary policy on inflation was found to be stronger through interest rates than the exchange rate. From the year 1998-99. given the relatively limited openness of the economy. therefore. interest rates or rates of return in different markets along with movements in currency. the Reserve Bank announced that henceforth it would follow a multiple indicator approach. however. trade. inflation rate. capital flows. given the command and control nature of the economy. While the monetary system in India is still evolving and the various inter-sectoral linkages in the economy are undergoing changes. The task before the Reserve Bank was.

0 per cent by December 2001.0 per cent in April 1997 to 6. The medium-term objective is to bring down the CRR to its statutory minimum level of develop the markets to prepare the ground for indirect operations. while signaling the stance of policy through changes in the Bank Rate. The use of these two instruments in conjunction with OMO enabled the Reserve Bank to keep the call rate within this informal corridor for most of the time.5 per cent in March 1991 to around 10. with a flexible corridor. Except savings deposit. Statutory Liquidity Ratio has been brought down from 38. Similarly. Another important and significant change introduced during the period is the reactivation of the Bank Rate by initially linking it to all other rates including the Reserve Bank’s refinance rates (April 1997).0 per cent in March 1991 to 5.0 per cent by October 1997. with the repo rate as floor and the Bank Rate as the ceiling. the interest rate structure was simultaneously rationalised and banks were given the freedom to determine their major rates. Gains from Reform It has been possible to reduce the statutory preemption on the banking system. yields on government securities were made market related. the Reserve Bank could use OMO as an effective instrument for liquidity management including to curb short-term volatilities in the foreign exchange market. It has also been possible to deregulate and rationalise the interest rate structure. while the Bank Rate was dormant and seldom used in 1991. the introduction of Liquidity Adjustment Facility (LAF) from June 2000 enabled the modulation of liquidity conditions on a daily basis and also short term interest rates through the LAF window. . which was the primary instrument of monetary policy. In terms of monetary policy signals.5 per cent to its statutory minimum of 25.5 per cent by December 2001. The Bank Rate has been brought down from 12. The commercial lending rates for prime borrowers of banks has fallen from a high of about 16. all other interest rate restrictions have been done away with and banks have been given full operational flexibility in determining their deposit and lending rates barring some restrictions on export credit and small borrowings. It is envisaged that the LAF rate would operate around the Bank Rate. As a result of these developments. it has been made operationally effective from 1997 and continues to remain the principal signaling instrument. Subsequently. the Reserve Bank helped create an array of other market related financial products. At the next stage. As a first step. The subsequent introduction of fixed rate repo (December 1997) helped in creating an informal corridor in the money market. has been brought down from 15.5 per cent by December 2001. At the same time. The Cash Reserve Ratio. as more active operative instrument for day-today liquidity management and steering short-term interest rates.0 per cent within a short period of time.

There are significant structural and procedural bottlenecks in the existing institutional set up for credit delivery. there has been secular decline in monetised deficit.A contrasting feature in the positions between 1991 and 2001 is India’s foreign exchange reserves. Such enlargement of the foreign currency assets. the limited reach of financial markets relative to the growing sectors. particularly in property rights and agriculture also impinge on the flow of credit in a deregulated environment. thus bringing the issue of financial stability to the fore. while reserves have been built in an atmosphere of liberalisation of both current account and to some extent capital account. and the overhang of institutional structure that tend to constrain the effectiveness of monetary policy in India. In view of comfortable foreign exchange reserves. capital flows and liberalisation of financial markets have increased the potential risks of institutions. while the twin objectives of monetary policy of maintaining price stability and ensuring availability of adequate credit to the productive sectors of the economy have remained unchanged.and medium-industry appears to be constrained causing concerns. The foreign currency assets of the Reserve Bank have increased from US $ 5. periodic oil price increases (for example in 1996-97. . on the other hand. draws attention to the delicate internal and external balance. completely altered the balance sheet of the Reserve Bank. external debt has been contained and short-term debt severely restricted. and in the process net foreign exchange assets of the Reserve Bank have become the principal contributor to reserve money expansion in the recent period. This has helped in reducing the government’s reliance on credit from the Reserve Bank. Tasks before the Reserve Bank These are impressive gains from reforms but there are emerging challenges to the conduct of monetary policy in our country. The pace of reforms in real sector. Over the period. Some of the immediate tasks before the Reserve Bank are presented to provoke debate and promote research. The monetary and credit policy for 1991-92 was formulated against the background of a difficult foreign exchange situation. Large capital inflows have been accommodated by the Reserve Bank while its monetary impact has been sterilised through OMO. with the combined deficit of the Central and State Governments continuing to be high. Consequently. Credit flow to agriculture and small. Thus.8 billion in March 1991 to US $ 48. 1999-00 and 2000-01) did not translate into Balance of Payment (BoP) crises as in the earlier occasions. The persistence of fiscal deficit. It is necessary to recognise the existence of the large informal sector.0 billion in December 2001. The road ahead would be demanding and the Reserve Bank would have to strive to meet the challenge of steering the structurally transforming economy from a transitional phase to a mature and vibrant system and increasingly deal with alternative phases of the business cycle. especially services.

such models are based on yearly data and hence these may not be very useful for guiding the short-term monetary policy actions of the Reserve Bank. Manohar Rao. It is well recognised that monetary policy decisions must be based on some idea of how decisions will affect the real world and this implies conduct of policy within the framework of a model. and in a globally interrelated financial world. data to monitor the economy are sometimes inadequate. there has been increasing awareness among the policy makers of the limitations of such models for several reasons. Though multi-sector macro-econometric models are available. Dilip Nachane. or delayed. “the model may be as simple as one unspecified equation kept in the head of the central bank Governor. The process of deregulation coupled with technological progress has led to increasing role for market prices and consequently more complexities for establishing relationships in an environment where everything happens very fast. Economics may not be a science. Vikas Chitre and Indira Rajaraman as external experts and a team from within the Reserve Bank were set up for developing such a model. but it should at least be conducted according to scientific principles recognising cause and effect”.Modeling Exercises In addressing a gathering of elite econometricians assembled here. it was felt that a short-term liquidity model may be developed in the Reserve Bank focusing on the interlinkages in the markets and then operationalise these linkages to other sectors of the economy. which will help the policy decision process. a mention should be made about developments in monetary modeling. It is felt that this is an appropriate time to explore more formally the relationship among different segments of the markets and sectors of the economy. but one must begin somewhere. With this objective in mind. and often revised. The Advisory Group met twice and after deliberations felt that a daily/ weekly/fortnightly model would give an idea about short. William White of Bank for International Settlements (BIS) mentioned in an address recently in RBI. which will help in understanding the transmission mechanism of the monetary policy in India. not only the future but even the past is uncertain. the Reserve Bank had already announced its intention to build an operational model. As Dr. due to significant revisions in data. Accordingly. While reliance on explicit modeling was rather heavy in some central banks. An Advisory Group with eminent academicians like Professors Mihir medium-term movements but . It is said that in regard to modern economies. It is difficult to arrive at a proper model for any economy with the degree of certainty that policy makers want especially in view of observed alterations in the private sector behaviour in response to official behaviour. Further. The model was initially conceived to focus on the short-term objective of different sources and components of the reserve money based on the recommendations of an internal technical group on Liquidity Analysis and Forecasting. particularly in the 1960 and 1970s. In brief. there is need to recognise the complexities in model building for monetary policies and approach it with great humility and a dose of skepticism but ample justification for such modeling work certainly persists.

models using annual data will also be useful to assess the implications of the monetary policy measures on the real economy. the interaction of the financial markets with weekly data focusing mainly on policy measures and different rates in the financial markets. It is expected that the draft of the proposed model would be put in public domain shortly. Accordingly. which states “The conduct of monetary policy in India would continue to involve the constant rebalancing of objectives in terms of the relative importance assigned. Inflation and the Conduct of Monetary Policy of the Report. Concluding Remarks The challenges ahead are aptly summarised in the concluding paragraph of the chapter on Growth. Observations in the operational framework of the model is limited as the LAF has been operationalised only a year ago. it has been decided to modify the approach. On the basis of the advice of eminent experts in the Advisory Group. The intention of the Reserve Bank is to expedite the technical work in this regard and seek the advice of individual members of Advisory Group on an ongoing basis both at formal and informal levels. The current thinking in the Reserve Bank is broadly on the following lines: the short-term liquidity model making use of high frequency data will be explored. The Reserve Bank would seek the active participation of the interested econometricians in the debate on the draft model and give benefit of advice to the Reserve Bank for finalising and adoption. the selection of instruments and operating frameworks. A crucial aspect in an exercise is the forecast of currency in circulation. . and a search for an improved understanding of the working of the economy and the channels through which monetary policy operates”.


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