SYMBIOSIS COLLEGE OF ARTS AND COMMERCE

An Autonomous College under Savitribai Phule Pune University

Senapati Bapat Road, Pane 411004

DISSERTATION
PROJECT

IMPACT OF MONETARY POLICY EASING IN TIMES OF

PANDEMIC IN INDIA

DISSERTATION PROJECT

Submitted By

MARYAM ZAHRA (1614)

&
RAJAT MISHRA (1620)

CLASS: M.A. ECONOMICS

Under the Guidance of

DR. NEELOFAR RAINA

In partial
fulfillment of

M.A. (Economics)

MAY 2022
 SYMBIOSIS COLLEGE OF ARTS AND COMMERCE
An Autonomous College under Savitribai Phule Pune University
Senapati Bapat Road, Pane 411004

CERTIFICATE

This is to state that the work incorporated in the dissertation project on “Impact of Monetary

Policy Easing in Times of Pandemic in India”, submitted by Maryam Zahra (1614) & Rajat

Mishra (1620) for the M.A. (Economics), was carried out under the guidance and supervision

of Dr. Neelofar Raina. The material obtained from other sources has been duly acknowledged

in the project.

Name & Signature of the student_________________ Exam Seat No____________________________

MARYAM ZAHRA 1614

RAJAT MISHRA 1620

Date:

Place: Pune

Certified by:

DR. NEELOFAR RAINA

(Name & Signature of the Mentor)

 ACKNOWLEDGEMENT

We, Maryam Zahra and Rajat Mishra would like to express our heartfelt acknowledgment

to our mentor, Dr. Neelofar Raina, for her supervision and guidance in conducting this study.

This project would not have been delivered without her oversight and constant support.

We are also grateful to our parents and family members for their constant

encouragement and inspiration, which helped us conclude this work.

We would like to communicate our heartfelt gratitude to the coordinator and all Symbiosis

College of Arts and Commerce staff, particularly Dr. Jini Jacob, who assisted us in completing

all formalities of research work.

We would also like to convey our sincerest appreciation to our friend, Siddhi Dole for

her assistance in completing this study.

Date:
 INDEX

Sr. No. List of Contents Page No.

i. Index of Tables 2
ii. Index of Figures 3
iii. Index of Abbreviations 4

Abstract 6

Chapter Scheme
I Introduction 7
Monetary Policy Easing During the Covid-19 Pandemic and Transmission 8
Research Gap 18
Objectives 18
Need of the Study 18
Scope of the Study 19
Conceptual Framework 19
II Review of Literature
Monetary Policy: Conventional and Unconventional 21
Monetary Policy and Yield on Government Securities 22
Movement of Benchmark Indices 23
Capital Flows: What are they good for? 23
Exchange Rate Stabilisation 24
III Research Methodology
Model for the study: Rationale, Mathematical Framework, and Assumptions 27
Methodology 29
Tools for Analysis in Vector AutoRegression 31
Hypothesis 32
IV Analysis and Findings
Test for Stationarity, Lags Length Selection, and Cointegration 33
Granger Causality Test 41
Vector Autoregression Estimates 44
Impulse Response Function 48
Variance Decomposition 50
Hypothesis Testing 54
V Conclusion 55
VI Bibliography 56
 i. Index of Tables

Sr. No. List of Contents Page No.

1 Revision in Key Rates set by RBI 9
2 Labour market indicators for Urban sector (age: 15 & above) 11
3 Government Bond Yields 13
4 Augmented Dicky-Fuller Test 33
5 VAR Lag Order Selection Criteria 34
6 Johansen Cointegration Test 35
7 VAR Residual Serial Correlation LM Tests 36

8 VAR Residual Correlation Matrix 37

9 Roots of Characteristic Polynomial 39

10 VAR Granger Causality/Block Exogeneity Wald Tests 41

11 Vector AutoRegression Estimates 44

12 Vector AutoRegression Estimates: P Values 46

13 Variance Decomposition using Cholesky (d.f. adjusted factors) 50

2
 ii. Index of Figures

Sr. No. List of Contents Page No.

1 Liquidity Conditions 9
2 Trends in CPI-C headline, Core and food inflation 10
3 India 10-year Benchmark G-sec yield 13
4 Slope of the yield curve 14
5 Foreign Exchange Reserves 16
6 Movement of Indian Benchmark Indices 17

7 Variables used in the VAR model 30

8 Correlograms 38

9 Roots of Characteristic Polynomial 40

10 Impulse Response Functions 48

11 Variance Decomposition 52

3
 iii. Index of Abbreviations

Sr. No. Abbreviations Particulars

1 OMO Open Market Operations
2 RBI Reserve Bank of India
3 ADF Augmented Dickey–Fuller Unit Root Test
4 AIC Akaike Information Criterion
5 BONDYIELD 10-Year G-Sec Bond Yield
6 CFM Capital Flow Management

7 CPI-C Consumer Price Index- Combined

8 CRR Cash Reserve Ratio

9 D(REPO_RATE) Differenced Repo Rate

10 EME Emerging Market Economies

11 EXRATE Exchange Rate denoted by USD/INR

12 FAR Fully Accessible Route

13 FOREIGNRES Net Foreign Exchange Reserves

14 FY Financial Year

15 GDP Gross Domestic Product

16 G-Sec Government Securities

17 INF Inflation Rate

18 IPO Initial Public Offering

19 IRF Impulse Response Function

20 LAF Liquidity Adjustment Facility

21 LFPR Labour Force Participation Rate

22 MPC Monetary Policy Committee

23 MSF Marginal Standing Facility

24 NBFC Non-Banking Financial Companies

25 NSE National Stock Exchange

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26 OMO Open Market Operations

27 PLFS Periodic Labour Force Survey

28 QE Quantitative Easing

29 RBI Reserve Bank of India

30 REPO_RATE Repo Rate

31 SD Standard Deviation

32 SENSEX BSE Sensex Index

33 SLR Statutory Liquidity Ratio

34 TLTRO Targeted Long Term Repo Operations

35 UNEMP Unemployment Rate

36 VAR Vector AutoRegression

37 VRRR Variable Rate Reverse Repo

38 WPR Worker Population Ratio

39 YTM Yield to Maturity

5
 Abstract

Unprecedented Covid-19 hampered aggregate demand in the economy. Global

economic downturn, government- induced lockdown and supply chain disruptions caused the
economy to shrink by 23.9 percent in April-through-June quarter of Financial Year 2020-21.
In response, the Reserve Bank of India implemented monetary policy easing, which included
large-scale purchases of financial assets and low policy interest rates to provide liquidity and
support to the economy. The study aimed to critically evaluate the short-term effects of
monetary policy easing policies on the various macroeconomic indicators using Vector
AutoRegression analysis. These developments were examined for inflation, unemployment,
capital markets, money markets, exchange rates and net foreign exchange reserves where it
was found that repo rate has a negative relationship with unemployment rate, inflation rate,
sensex, bond yield and OMOs and a positive relationship with exchange rate, net foreign
exchange reserves. Similarly, the results suggested that the net open market operations have a
negative relationship with inflation, unemployment, sensex and net foreign exchange reserves
and a positive relationship with exchange rate and bond yield.

Key words: Monetary Policy, G-Sec, Inflation, Unemployment, Exchange Rate, Sensex,
Foreign Exchange Reserves

6
 Chapter I- Introduction

The global economy has struggled over the last two years due to the Covid-19
pandemic. Supply chains and production have been disrupted, which, all else being equal,
should have led prices to rise as raw materials and finished goods were more difficult to come
by, However, the pandemic has had a greater impact on demand, forcing future inflation and
interest rate expectations to fall even lower. The desire to invest has waned, and people all
across the world are now saving much of their income. When confronted with these issues, the
government of India's first response was a series of safety nets aimed to soften the impact on
vulnerable segments of society and the business sector. In March of 2020, the RBI took an
accommodative stance, which implied rate cuts to inject money into the financial system. The
objective was to lessen the impact of Covid-19 on the economy and keep inflation within the
target range of 4 percent with a bandwidth of 2 percent on either side.
Monetary policy refers to the policy of the Central Bank through which it aims to ensure
that money retains its value over time, normally achieved by influencing the supply of money
in the economy. This is done through a set of tools at the disposal of the Central Bank. The
purpose is to control macroeconomic factors, including inflation, consumption, economic
growth, and overall liquidity, and contribute to the stability of gross domestic product,
accomplish and maintain low unemployment, and stabilise currency exchange rates. Monetary
policy can be expansionary or contractionary. Expansionary policy enhances the money supply
by reducing short-term interest rates, conducting Open Market Operations (through large-scale
asset purchases), lowering reserve requirements, and clearly communicating further policy
measures. A contractionary monetary policy is intended to reduce the rate of monetary
expansion by soaking liquidity from the market to fight inflation.
The RBI unveiled plenty of initiatives from March 27, 2020, some conventional and
some unconventional, both system-wide and specific to sectors and institutions to handle
pandemic-induced distortions and restraints.

7
Monetary Policy Easing During the Covid-19 Pandemic
Measures taken by RBI
The repo rate (the rate at which the central bank loans money to commercial banks) has
been reduced by 115 basis points to 4% since March 2020. The reverse repo rate (the rate at
which commercial banks park their assets with the Reserve Bank of India) dropped to 3.35
percent. The cash reserve ratio, the Statutory Liquidity Ratio, and the bank rate were also
dropped marginally. A decline in all these policy rates led to commercial banks' bringing down
their lending rates. Hence, increasing the overall money supply in the economy.
The Reserve Bank also employed Term Repo, Variable Rate Reverse Repo, and
Marginal Standing Facility (MSF) under the Liquidity Adjustment Facility (LAF), and Open
Market Operations (OMOs) of simultaneous sale and purchase of G-Sec. The interest rate
corridor's floor and ceiling are formed by the fixed-rate reverse repo and the MSF rate,
respectively.
The RBI infused more than Rs. 2.7 lakh crore of liquidity through Open Market
Operation (OMO) purchases between February and December 2020. Rs. 1.13 lakh crore of
Targeted Long Term Repo Operations (TLTROs) of up to three years for investment in
corporate bonds, commercial papers, and non-convertible debentures were carried out. It
allowed banks to borrow money from the RBI at the repo rate to lend to companies and NBFCs.
Reduction of CRR requirements to 3 percent led to an increase of approximately Rs. 1.37 lakh
crore primary liquidity in the banking system. These three measures relating to TLTRO, CRR
and MSF injected a total liquidity of ₹ 3.74 lakh crore to the system. Since February 6, 2020,
liquidity boosting initiatives of Rs. 17.2 lakh crore (8.7% of nominal GDP for 2020-21) have
been announced. Under G-sec acquisition programme (G-SAP) 1.0, the RBI purchased
Government securities (G-sec) worth Rs. 1 lakh crore and Rs. 1.2 lakh crore under G-SAP 2.0
to enable “a stable and orderly evolution of the yield curve.”
These initiatives, which were backed by both traditional and unconventional liquidity
measures, boosted financial market sentiment while maintaining orderly market conditions.
Interest rates and bond yields fell across market segments, and spreads narrowed, indicating
that monetary transmission has improved.

8
 Table 1: Revision in Key Rates set by RBI

Figure 1: Liquidity Conditions

Monetary Policy Transmission

Inflation and Unemployment
The Reserve Bank of India (RBI) adopted inflation targeting as the official monetary
policy framework for the Indian economy in March 2015. Inflation targeting entails bringing
inflation to a desired level within a specified time frame. The centre decided to retain the
inflation target of 4 percent, with a bandwidth of 2 percent either side for the Monetary Policy
Committee of the RBI.
Maintaining an inflation target lowers the danger that an unexpectedly substantial
reduction in aggregate demand will push the economy into deflation territory, causing the
nominal interest rate to drop to zero. Of course, the advantages of having an inflation buffer
zone must be balanced against the drawbacks of allowing greater inflation rates in normal

9
times. (Bernanke, 2002)
The Consumer Price Index-Combined (CPI-C) measures overall inflation that excludes
'food and beverages' and 'fuel and light.' 'Fuel and light' in CPI-C does not include major fuel
items like 'petrol for vehicle' and 'diesel for a vehicle’ because of their large weights. As a
result, the traditional method of calculating retail core inflation includes volatile fuel items in
core inflation rather than excluding them. Because of this, the rise in fuel prices is affecting
core inflation.
Subdued economic activity in advanced economies, including the outbreak of Covid-
19 and the sharp fall in international crude oil prices, led to an inflationary environment in the
global economy.
Covid-19 pandemic-related supply-side shocks affected retail inflation, and food items
contributed the most to the overall rise in inflation on a domestic level. In December 2020, the
fall in food inflation resulting from easing supply-side restrictions reduced overall inflationary
pressure. From 6.6 percent in 2020-21 to 5.2 percent in 2021-22 (April-December), retail
inflation fell to 5.6 percent in December.
Long-term policies are more likely to help India's inflation because supply-side factors
predominate in the country's determination of inflation. For perishable goods and to reduce
wastage of horticulture, the focus should be on transportation and storage infrastructure
(supply-chain development). Better storage and supply chain management are required to
minimise seasonal price spikes for consumers and ensure availability during the lean season.
Amidst Russia's invasion of Ukraine, worldwide prices for imported goods, particularly
crude oil, natural gas, and edible oils, had skyrocketed. The Indian crude oil basket cost, which
had already been rising since January 2022, increased by 27.4 percent to USD 123.4 per barrel
between February 26, 2022, and March 12, 2022.

Figure 2: Trends in CPI-C headline, Core and food inflation

10
 Before the outbreak of Covid-19, the urban labour market had shown signs of
improvement in terms of Labour Force Participation Rate (LFPR), Worker population Ratio
(WPR) and Unemployment rates (UR). Late March 2020's nation-wide lockdown adversely
affected the nation’s labour market. 20.8 percent of urban workers were out of work in the first
quarter of 2020-21.
For up to March 2021, employment in the urban sector affected by the pandemic has nearly
returned to pre-pandemic levels, according to the quarterly Periodic Labour Force Survey
(PLFS). Urban unemployment rate rose to 9.3 percent in December 2021 from 8.2 percent in
the previous month while the rural unemployment rate was up 7.28 percent from 6.41 percent.
Overall unemployment rate stood at 7.91 percent in December 2021.

Table 2: Labour market indicators for Urban sector (age: 15 & above)

Advancements in the G-Sec Market

Government Securities (G-Secs) are government-issued securities issued by the central
or state governments. These securities represent the Centre's and/or individual States' market
borrowings. They are issued to finance the government's fiscal deficit and to manage the
government's occasional cash shortages.
A secondary market G-sec acquisition programme (G-SAP) announced earlier in the
year contributed to the period of surplus liquidity. G-SAP was India’s debut in Quantitative
easing and it entails an advance commitment to acquire a particular amount of government
securities to ensure “an orderly evolution of the yield curve”, which basically translates into
RBI providing a helping hand to support government borrowing cheaply. Under G-SAP 1.0,
RBI purchased G-secs worth Rs.1 lakh crore and Rs.1.2 lakh crore under G-SAP 2.0. RBI also
used Operation Twist to acquire long-term government bonds while selling short-term ones to
keep borrowing costs low.

11
 Specific designated categories of Central Government securities were fully opened up
to non-resident securities without any restrictions in 2020-21. As a result, a new channel, the
Fully Accessible Route (FAR), for non-residents to invest in government securities was
announced. From April 1, 2020, a list of existing securities was placed under FAR, and all new
issuances of government securities with 5-year, 10-year, and 30-year maturities from the fiscal
year 2020-21 were eligible under FAR. This proved to be an essential step toward including
India in global bond indices.
The 10-year benchmark G-sec yield traded with a softening tilt in the first half of 2020-
21, reflecting lower policy rates, lower crude oil prices, and surplus liquidity. The 10-year
benchmark G-sec rate fell to 5.73 percent in mid-May 2020, from about 6.4-6.5 percent in April
2020, allowing for record Government of India borrowing at the lowest weighted average yield.
It then climbed to 6.45 percent on December 31, 2021. The announcement of G-SAP
2.0, the RBI's decision to maintain its easy monetary policy stance, and the government's
determination not to borrow any more money in the second half of 2021-22 kept rates near 6
percent.
Yields began to grow at the start of the second quarter (Q2) of 2021-22. The
pronouncement of a staged rise in the scale of VRRR operations on August 6, 2021, and a
change in market confidence to factor in the probability of a shift in the interest rate cycle
sometime ahead also led to some hardening of yields up to 6.26 percent. The continuous
decrease in inflation, the incorporation of the 10-year benchmark paper in the G-SAP auctions,
all helped to keep yields under control.
The term spread (the difference between the 10-year and 1-year G sec yields) expanded
dramatically in 2020, then tightened modestly in 2021-22. However, it is still larger than it was
prior to the pandemic.

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 Figure 3: India 10-year Benchmark G-sec yield

Table 3: Government Bond Yields

Yield curve as a forecasting tool.

Bond yields and bond prices have an inverse relationship. The bond price falls when
the interest rate rises, and vice-versa. The yield to maturity (YTM) of a bond is typically used
to calculate its yield. The most important determinant in determining bond yields is the
economy's interest rate. When the RBI raises the repo rate, bond yields are expected to rise in
reaction, and vice-versa. The yield curve plays a role in the transmission of monetary policy
changes to a wide range of interest rates in the economy.
In the absence of a crystal ball, the yield curve is the next best thing for investors. In

13
general, shorter-term rates reflect what investors anticipate will occur with central bank policies
in the near future. Longer-dated maturities indicate investors' best judgement for inflation,
economic growth, and interest rates in the medium to long term.
Normal yield curve- The yield curve is said to have a 'normal' shape when short-term
rates are lower than long-term yields, resulting in an upward slope. It is because longer-term
bonds are more sensitive to the probability that interest rates or inflation will rise in the future.
Longer-term bonds carry a larger risk than the short-duration bonds. Hence, investors demand
a higher yield to hold longer-term bonds
Flat yield curve- The yield curve is flat when short-term and long-term yields are
similar. When the yield curve transitions between a normal and inverted shape or vice versa, a
flat curve is frequently observed. A flattening of the yield curve can indicate a recession,
especially if the curve becomes downward-sloping or inverted.
Steep yield curve- A steepening yield curve signals that investors anticipate inflation
and economic growth to strengthen. As a result, bond investors predict higher rates in the
future.
Inverted yield curve- In an "inverted" yield curve, short-term yields are greater than
long-term ones, so the curve slopes downward. An inverted yield curve may be observed when
investors believe it is more likely that the future policy interest rate will be lower than the
current policy interest rate. In some nations, such as the United States, an inverted yield curve
has been historically correlated with the onset of economic contraction. This is due to the fact
that central banks drop interest rates in response to slower economic growth and inflation,
which investors may foresee correctly.

Figure 4: Slope of the yield curve

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Impact on the Forex reserves and Exchange rate
At the end of March 2020, when India plunged and went into a sudden and
unprecedented lockdown, the Indian currency took a hit. In April, the rupee touched a record
low of 76.92 against a dollar. There was nervousness among global investors, which was also
evident in the stock markets that went into a near tailspin.
Several central banks around the world followed suit, which benefited India. Global
investors flocked to emerging economies as interest rates in other countries fell, flooding India
with liquidity. So, even while the Indian economy was in the midst of a downturn, foreign
investors continued to pour money into the country.
In the fiscal year 2020-21 (April-March), total foreign direct investments into India
increased by 10% year on year to an all-time high of $81.72 billion (Rs6.08 lakh crore). In the
first half of FY 22, net capital flows more than tripled to US$ 65.6 billion (4.5 percent of GDP)
over those in the corresponding period in FY 21.
This helped the Reserve Bank of India to accumulate foreign exchange reserves, which
reached $634 billion in December 2021. This amount exceeds the country's external debt and
is equivalent to 13.2 months of imports. India held the fourth highest foreign exchange reserves
in November 2021, behind China, Japan, and Switzerland. However, the import cover of India's
foreign exchange reserves decreased to 13.2 months at the end of December 2021, down from
17.4 months at the end of March 2021, as merchandise imports rose in tandem with domestic
economic growth.
In 2020-21, the Indian rupee fell 4.5% year on year against the US dollar. Although the
rupee fluctuated in both directions against the US dollar from April to December 2021, it fell
by 3.4% in December 2021 compared to March 2021. However, the rupee's decline was
moderate compared to other emerging market currencies.
With a 51 percent share of India's external debt at the end of September 2021, US dollar-
denominated debt remained the largest currency component of India's external debt, followed
by the Indian rupee. Over the years, external debt denominated in Indian rupees has increased
significantly due, among other factors, to a calibrated promotion of FPI investment into the
Indian debt market, in addition to the sustained enormous growth of the Non-Resident External
Rupee Account. As the second-largest component, after the US dollar, debt denominated in
Indian rupees provides significant protection against currency rate fluctuations.
The Indian rupee has been weakening against the US dollar ever since Russia launched
an attack on Ukraine. The domestic currency unit depreciated from Rs. 74.6 per US dollar on

15
February 23, 2022, to Rs. 76.1 per US dollar by March 11, 2022, thus making the landed cost
of imports dearer.

Figure 5: Foreign Exchange Reserves

The Trend of Benchmark Indices

There were some significant corrections due to Covid-19 induced uncertainty in the
beginning of this financial year, however both Nifty50 and S&P BSE Sensex index recovered
strongly afterwards. The S&P BSE Sensex, the benchmark index of BSE, rose by 68.9 % to
49,792.1 on January 20,2021, compared to 29,468 on March 31, 2020. During the same period,
Nifty 50 index of National Stock Exchange (NSE) gained by 70.3 percent from March 31, 2020
to January 20, 2021.
The capital markets have had an amazing year 2021-22. Many new-age companies/tech
start-ups/unicorns raised money through initial public offerings (IPOs). Between April and
November 2021, 75 initial public offerings (IPOs) raised Rs. 89,066 crores, far more than in
any previous year.
On October 18, 2021, the Sensex and Nifty reached their all-time highs of 61,766 and
18,477, respectively. It fell after that but started to rise again and stood at 61,223 and 18,256
respectively as on 14th January 2022.

16
 Figure 6: Movement of Indian Benchmark Indices

Relationship between Stock market and interest rates

The relationship between interest rates and the stock market is reasonably indirect, the
two tend to move in opposite directions. Historically, whenever the RBI has reduced the
interest rates, a strong increasing trend has been observed in the Indian Stock Market Indices.
Be it the 2008 financial crisis after which the interest rates were sharply cut or the recent 2020
Covid-19 pandemic when Shaktikanta Das slashed interest rates through its Q2 Monetary
Policy release. As a general rule of thumb, when the RBI cuts interest rates, it causes the stock
market to go up; when the RBI raises interest rates, it causes the stock market to go down. In
every instance, a strong up trend has been observed in the Indian Stock Market simultaneously.
Income-oriented investors tend to hold their money in fixed deposits or fixed return
assets when interest rates are high. When interest rates are lowered, holding newly issued
securities won't be as profitable. Decrease in interest rates induces investors to move from bond
market to equity market.
Since interest rate and inflation are inversely related, theoretically, equities should be a
natural hedge against inflation since business revenue and profits rise at the same rate as prices
of goods rise. However, there is no assurance about how the market will react to any given
interest rate change.
There is a strong inverse relationship between expected inflation and anticipated real
GDP growth. If markets expect higher inflation, they expect lower growth, and stocks start to
decline. As a result, the inverse relationship between stock prices and inflation is effectively a
proxy for the positive relationship between stock returns and future GDP growth.

17
Research Gap
There is a large literature available that discusses the impact of sudden halt on the
economy that indicates the relevance of monetary policy easing in augmenting money supply
in the economy during times of crisis. However, the effectiveness of monetary policy easing
on reducing pandemic consequences is modest. Thus, the goal of this research is to critically
evaluate the consequences of monetary policy easing on various macroeconomic indicators in
the economy in the light of Covid-19 pandemic.
There has been an increase in the number of research focusing on the transmission
mechanism of monetary policy easing in the contexts of the United States, the G7 non-United
States, and the Eurozone area. During the pandemic, however, quantitative studies of the effect
of monetary policy shocks on macroeconomic variables in an Indian environment are restricted
and otherwise inadequate.
A review of previous empirical works finds that no study has used a VAR framework
to evaluate the influence of foreign and domestic monetary policy shocks on macroeconomic
variables in the Indian setting during the pandemic.

Research Objectives
The objectives of the study will be the following:
● To examine the impact of RBI’s monetary policy easing on various macroeconomic
indicators during Covid-19.
● To substantiate the constructive impact of monetary easing policies on economic
stability.

Need of the study

Monetary policy has the potential to mitigate the pandemic's harmful effects by
boosting consumption and investment patterns. As a result, the current study examines the
impact of the monetary policy rate on the above-mentioned variables during Covid-19. Vector
AutoRegression is used to conduct the research.
The study examines macroeconomic variables and financial aspects in India in order to
assess the role of monetary policy in mitigating pandemic effects and assisting the economy's
recovery. The study looks at factors that may be used to quantify economic activity, such as

18
the Inflation Rate, Unemployment Rate, 10-Year Government Bond Yields, Exchange Rates
denoted by INR/USD, Net Foreign Exchange Reserves and Stock Market Index denoted by
BSE Sensex.

Scope of the study

This research seeks to determine the monetary policy indicators that best describe the
transmission of Indian monetary policy during the pandemic times. This study also examines
how monetary policy shocks affect these domestic macroeconomic variables. The research
study is examined on the secondary monthly data from May 2017 to March 2022.
The major motivation is to examine the mechanism of Indian monetary policy easing
transmission. Another reason for this analysis is that there are no clear relationships between
India's key economic indicators. In some scenarios, economic indicators move as expected in
response to the employment of monetary policy tools, whereas in others, they move in
directions that contradict traditional theory. This was the impetus for researching the impulse
reactions of major macroeconomic indicators to monetary policy shocks, especially during the
pandemic.
This study will help further the study of transmission of monetary policy easing and
will help the future research to forecast the impact of monetary policy easing on various
macroeconomic indicators.

Conceptual Framework
Monetary Policy Framework in India over the years
The monetary policy framework in India has varied in its focus depending on both
context (domestic and external factors) and instruments available to RBI. At the
commencement of the planning period, the policy could be best described as “controlled
expansion” of the money supply. It was significantly influenced by fiscal policy at the time.
The goal of Reserve Bank of India (RBI) was to minimise the downsides of effects of
monetization. India switched to a monetary targeting framework in the mid-1980s. During this
period, the two main objectives of monetary policy were preserving price stability and ensuring
supply of adequate credit to the productive sectors of the economy (Mishra and Mishra 2012).
The intermediate target shifted to monetary targeting with annual growth in money
supply. Instruments such as Gradual interest rate deregulation; Direct instruments (selective
credit control, SLR, CRR) were used. Selective credit control operations had been eliminated
by 1994. Current account and partial capital account liberalisation were followed by a gradual

19
move towards more flexible exchange rates.
The sequencing of the entire process was well thought out and executed. While controls
continued on domestic portfolios and debt inflows, equity inflows were liberalised as there is
repayment burden linked to equity. On foreign debt, the sequence of relaxation favoured
commercial credit and longer-term debt. Major reforms were undertaken towards development
of equity, forex money and government securities markets. Although low by developing
country standards, Indian inflation was higher than world rates.
The accumulation of enormous public debt rendered the previous fiscal-monetary
combination untenable. The automatic monetization of the government deficit was halted, and
auction-based market borrowing was implemented to cover fiscal deficits. The repressive
financial regime fell apart, interest rates became more market-driven, and the government
began to borrow at market rates. From 1998-99 to till about 2014, most of the focus has been
on inflation and growth with multiple intermediate targets. The RBI has used a host of Direct
(CRR, SLR) and indirect instruments (Repo operations under LAF and OMOs) to achieve its
mandate (Mohan, 2008).
On February 20, 2015, the Reserve Bank of India and the Government of India signed
the Monetary Policy Framework Agreement, which gave RBI an obligation for inflation
targeting and price stability. As per the Official Gazette, the four percent CPI target is fixed
with a tolerance band of +- two percent and on March 31, 2021, the target was retained.
Following that, the Reserve Bank of India (RBI) Act, 1934 was revised to provide the
previously stated Monetary Policy Framework Agreement formal backing and to establish a
Monetary Policy Committee (MPC). Despite the fact that the central bank already had a
monetary framework and was implementing monetary policy, the newly created legislative
framework would require the RBI to provide an explanation to the Central Government in the
form of a report if it failed to meet the defined inflation targets. The report must include the
reasons for the failure, corrective actions, and an estimate of when the inflation target will be
met. Furthermore, the RBI is required to issue a Monetary Policy Report every six months,
outlining the drivers of inflation as well as inflation estimates for the next six to eighteen
months (Ghosh et al. 2021).

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 Chapter II- Review of Literature

Monetary Policy: Conventional and Unconventional

As noted by (Bernanke et al.,2004), the traditional instrument of monetary policy in
most major economies, in support of quantitative easing, is used as an anti-deflationary tool,
as historically, money growth and inflation have tended to be strongly associated. Central
bankers can lower long-term rates and give the economy a boost by convincing the public that
the policy rate will stay low for longer than expected, even if the short-term rate is close to
zero.
When the policy interest rate reaches the lower bound, standard monetary policy tools
are no longer helpful in stimulating growth. At the zero lower bound, monetary policy loses
the ability to facilitate growth. However, it is still possible to add stimulus by operating on
longer-term interest rates and other asset prices and yields in those circumstances.
A study by Rajan (2017) probes why unconventional monetary policies are used,
whether they work, their long-term implications on the economy, and what happens while
phasing them out. The central bank sought to affect the prices of long-term instruments, hoping
it would spread across different asset classes. Deeming it necessary at a time when policy rates
had reached the zero lower bound. When central banks intervene in the securities market to
lower the yield curve, it simply seems to work as the central bank puts its weight behind the
market. Regarding long-term effects, easy monetary conditions have driven a search for yield,
which has lowered risk premia for all types of assets. Central bank balance sheets grow
excessively large and wind up taking much of the liquidity management away from the private
sector. Capital flows to emerging markets as investors search for high yields during the phase-
in. While phasing out, capital flows out. The taper tantrum was catastrophic for some of these
markets because of their inability to cope with the large, sudden capital outflows they
experienced. Overall, these policy measures appear to impact the markets positively.
Bernanke (2020) reviewed new monetary policy instruments' experience and future
potential. He stated that the new monetary tools, including QE and forward guidance, can
materially affect financial conditions much like traditional monetary policies do when rates are
away from the lower bound. Other than QE and forward guidance, new measures such as
negative policy rates and yield curve control may also be helpful in particular circumstances.
(i) central bank purchases of longer-term financial assets (often referred to as
quantitative easing, or QE); and (ii) monetary policymakers' communicating their economic
forecasts and policy goals (forward guidance). Forward guidance can help inform financial

21
markets of policymakers' likely reactions to economic developments and enables them to
commit to future policy actions. These policies could help pull the economy out of recession.
The money supply affects the price level and not output or employment and high
inflation will take a toll on the allocation of resources and long term growth. The monetary
policy has important changing effects on real variables like unemployment and output and it
affects the inflationary rates with a delay in duration and magnitude. Hence the Inflation
Targeted approach can streamline the whole monetary policy process and refine the design and
performance and increase transparency. (Masson et al. 1998)
Although the advanced economies' unconventional policies were intended to support
their domestic economies, the ultra-low interest rates and quantitative easing in advanced
economies resulted in a significant expansion of global liquidity and spillover effects in the
form of debt and equity flows for emerging market economies (EMEs) like India. (Fratzscher
et al.,2018; Lim and Mohapotra, 2016)

Monetary Policy and Yield on Government Securities

Given the importance of sovereign bond yields in monetary policy transmission, this
paper seeks to objectively examine several factors affecting G-Sec yields across the maturity
spectrum in the Indian context. (Kapur et al. 2018).
Domestic government bond yields are influenced by the size of the central government's
borrowing programme, foreign portfolio investments in the domestic bond market, and
international bond yields, albeit these factors vary by maturity. If the government's deficit
grows, it may need to borrow more money from the market to cover it. More borrowings would
increase the supply of bonds on the market, lowering bond prices and raising rates (as bond
prices and yields are inversely related).
The policy rate was found to be a primary driver of short-term government bond yields,
although its significance diminishes as bond maturities increase. The weak link between the
policy rate and longer-term government bond yields has already been documented and
nicknamed "conundrum" (Thornton, 2012).
When long-term bond yields rise faster than short-term bond yields, the yield curve is
said to be "steepening". This usually means that future growth will be stronger. The yield curve,
on the other hand, is said to be "flattening" when short-term bond yields rise faster than long-
term bond yields. This normally means that growth will slow down in the future. When short-
term bond yields rise above long-term bond yields, the yield curve can become "inverted" on
rare occasions. This means that a recession is likely (Krishna & Nag, 2022).

22
 The predominance of monetary policy among macroeconomic factors in explaining the
shape of the yield curve, according to Sensarma and Bhattacharyya (2017), suggests that, given
the persistence of large market borrowing programmes over time, the Indian bond market
remains substantially responsive to policy signals.

Movement of Benchmark Indices

The gap in volume between the equity and bond markets is striking. In each market, the
investor profile and investment motivation are different. During periods of expansion, the
Indian bond and stock markets trade inversely. When the stock market is strong, investors will
book profits by selling short and diverting the money received from the stock market to bonds,
lowering bond rates. As they compete for capital, Bonds and stocks trade inversely. (Sharma
& Saxena, 2020)
Short-term interest rate declines induced by policy should increase demand for higher-
yielding assets like equities and longer-term bonds. Higher asset prices, in turn, can provide
wealth effects, boosting investment and, eventually, growth.

Capital Flows: What are they Good for?

Since investment spending is needed to support growth, the availability of external
financing should in principle help countries grow, because it allows the public and private
sector in an economy to spend more than they earn. This doesn’t always translate into economic
growth as borrowing for consumption doesn’t have the same effect as borrowing to finance
investment. (IMF, 2012)
Brauning and Ivashina (2017) found significant effects of monetary policy on cross-
border bank flows because loans are short maturity and flow back promptly as policy tightens.
Since the Global Financial Crisis, some economists have linked the shifts in foreign
capital flows to EMEs primarily to the monetary stimulus by the Fed and other advanced-
economy central banks. Some claim that the effects of US monetary policy on global risk
sentiment influence capital flows, with looser policy contributing to a more positive mood in
markets and tighter policy lowering sentiment. (Powell, 2018)
Firstly, countries were not well equipped to self insure themselves with the volatility of
capital flows. Second, if the expansionary policy of the US pushed money into EMES,
tightening of the monetary policy syphoned the money out of EMEs as real interest rates in the
US were more lucrative for the investors. Third, exchange rate depreciation resulted from
sudden reversals destabilising developing countries as they tend to be international debtors with

23
foreign currency-denominated debt, making them prone to exchange rate induced debt crises.
The United States became the “primary beneficiary” of capital account liberalisation in other
countries. And its banks were, too. (Jongwanich, 2010)
Cross-border gross banking flows, currency rate appreciation, stock market
appreciation, and asset price and credit booms in capital-receiving countries are all effects of
easy global liquidity circumstances. (Rajan, 2013)
Rodrik's empirical analysis found no link between the opening of countries' capital
accounts and the size of their investments or their growth rate. It concluded that the benefits of
an open capital account, if any, are not obvious, but the costs are clearly evident in the form of
recurring crises in emerging markets. (Rodrik, 1998)
Bhagwati argued that, until the Asian crisis impelled the public to the fact that capital
movements could often trigger crises, many assumed that the free mobility of capital between
all nations, like the free trade of their goods and services, was a phenomenon of profit. Just as
protectionism, capital control was seen as a hindrance to economic activity. (Bhagwati, 1998)
Thus, the 2000s, for the most part, saw policymakers in the developing world relying
less on the fixing of exchange rates and more on the accumulation of foreign exchange reserves
as a form of self-insurance. Accumulation of foreign reserves helped countries to insure
themselves against the volatile flows. Paradoxically, this effort at self-insurance helped make
developing countries more attractive than ever before in the eyes of international finance.
(David Lubin, 2017)
Although it requires good governance to attract FDI, it is to be preferred over portfolio
investment. FDI has risk-sharing characteristics as it doesn’t exit the country quickly and its
return tends to be paid to investors only when the economy is booming. The risk attached to
foreign savings is that they can be suddenly withdrawn. (Soto, 2001)
Economists and policymakers have been more supportive of "capital-flow
management" (CFM) methods to mitigate the negative consequences of large and erratic capital
flows over the last few years. Limiting exchange rate appreciation, reducing portfolio inflows,
increasing monetary policy independence, lowering inflation, lowering volatility, and/or
lowering specific measures of financial fragility (such as bank leverage, credit growth, asset
bubbles, foreign currency exposure, or short-term liabilities) are all stated goals of these recent
CFM changes. (Forbes et al., 2014)

Exchange Rate Stabilisation

The impacts of monetary policy easing, including how it affects the currency rate, have

24
been studied extensively. Indeed, the exchange rate has dominated scholarly and policy
discussions on the effectiveness of monetary policy easing, transmission channels, and
spillovers (e.g. Rajan 2013, Bernanke 2015, Powell 2018).
Many EMEs have significantly strengthened their fiscal and monetary policy
frameworks while implementing more flexible exchange rates, a policy that, according to
Jerome H. Powell’s research, provides superior protection against external financial shocks.
(Powell 2018)

Lessons to be Learnt
(Eichengreen and Gupta, 2014; Mishra et al. 2014) analysing short-run financial market
reactions to the Fed’s tapering announcements in 2013-14 found out that In the episode of
emerging market volatility after the Fed started discussing taper in May 2013, countries that
allowed the real exchange rate to appreciate the most and their current account deficits to widen
during the prior period of quantitative easing suffered the most significant adverse impact on
debt-market conditions, although they find no such evidence for equity markets.
In 2013, the same was true for India. The country’s fiscal deficit had increased, and
inflation remained persistently high, around 10 percent. Between May 22, 2013, and the end
of August 2013, the rupee fell by 18 percent, and stock prices, foreign exchange reserves, and
portfolio flows all declined. These macroeconomic weaknesses have surfaced amid a sharp
growth slowdown. The reaction was sufficiently pronounced for the press to warn that India
might be heading toward a financial crisis. In these circumstances, exchange rate flexibility in
recipient countries sometimes exacerbates booms rather than equilibrates them.
A study by Basu et al., (2014) argues that once a country is damaged by an external
shock, resulting in a restructuring of global portfolios, there are no clear choices. Running
against big budget deficits, maintaining a sustainable current account, managing capital flows
to attract foreign direct investment, and encouraging reasonably steady longer-term flows while
discouraging erratic short-term flows should be done. Avoidance of excessive exchange rate
appreciation through reserve management and macroprudential regulation, stockpiling more
forex reserves, and preparing banks and corporations to deal with increased exchange rate
volatility is strongly advocated.
As a result, actual exchange rate appreciation has been restrained or avoided this time
more successfully. In reaction to the 2020 decrease in output, central banks were allowed to
cut their policy rates, something they had not been able to do in previous periods of economic
weakness and catastrophe. This reflects that emerging market monetary policy frameworks are

25
now more robust. In addition, current account balances as a percentage of GDP are presently
higher than those in 2010-12. Since 2013, emerging markets, such as India, have improved
their external economic and financial standing. (Eichengreen et at. 2022)

26
 Chapter III: Research Methodology

Model for the study

Rationale for Vector Auto-Regression (VAR) Analysis
Multilinear regression analysis is normally used to understand the relationship between
the various variables, namely a dependent variable with more than one independent variable.
It is not possible to conduct the same analysis as there are more than one dependent variable.
This is where the VAR model is useful. It is a time series model that is mostly used for
macroeconomic or forecasting study. It is made up of a collection of multivariate linear
autoregressive equations that describe the joint dynamics of economic factors. In this model,
the residuals are combinations of the underlying structural economic shocks, which are
believed to be dynamic in character. The model includes less constraints to provide a better
understanding of the overlap and play between the many variables utilised in the study, which
aids in understanding economic shocks.
The impulse response function is made up of the coefficients in the equations. They
depict the dynamic reaction of the variables to the shocks in which two or more variables
influence each other. This makes the model bi-directional, which provides a better
understanding of the economic situation because it provides perspectives from both directions
rather than just one. Normally, predictors influence the Y variable and not vice-versa unlike
this model.
Another significant feature of VAR is that each variable is modelled as a function of
previous values. This introduces us to lags (delayed time values), or simply put, the prior year's
data from various time series is utilised as a foundation for making forecasts in the system. The
predictions are for the present as well as the future.
Mathematical framework of VAR
The standard formula for a basic autoregressive model is:
Yt = a + β1Yt-1 + β2Yt-2 + ……+ βpYt-p + εt
Where,
a is the intercept
β1, β2, βp – are the coefficients of the lags
Y- Time series variable

27
t – time
p – order of Y lags
ε – error
The preceding formula explains how the past values of the time series Y can be utilised
to forecast the current and future values till p.
Each time series in the VAR framework is described as a linear combination of its own
historical values as well as the values of other variables in the framework. As a result, each
time series gets its own equation, turning the model into a system of equations.
Thus, in this study there will have a set of 8 equations as there are 8 variables-
Variable Y1, Y2, Y3, Y4, Y5, Y6, Y7, Y8
So the equations will be as follows:

And the same applies for Y3, Y4, Y5, Y6, Y7, Y8
Where Y[1,t-1] and Y[2,t-1] are the first lag of the two time series Y1 and Y2
respectively.
The reason for using VAR for this study lies in the fact that it is a bi-directional study.
Unlike the traditional regression analysis where there is a dependent variable (y) which is the
effect and an independent variable (x) which is the cause, in VAR since all (y) terms are
interrelated, the (y) terms are considered as endogenous variables rather than exogenous
predictors.
So as the number of time series in a model is increased, larger will be the set of
equations in the framework.
The use of VAR for this study stems from the fact that it is a bi-directional investigation.
Unlike classical regression analysis, which has a dependent variable (y) that is the effect and
an independent variable (x) that is the cause, all (y) terms in VAR are considered endogenous
variables rather than exogenous predictors because they are interconnected.
Assumptions in VAR Analysis
Below are the assumptions involved in VAR:
The error term has a conditional mean of zero.
The variables in the model are stationary.

28
Large outliers are unlikely.
No perfect multicollinearity.

Methodology
The research study focuses on the secondary monthly data from May 2017 to March
2022 has been employed from the RBI Handbook of Statistics on Indian Economy, RBI’s
Database on Indian Economy and the Economic Survey of India. Data from 2017-2019 is used
to show the pre-pandemic levels as the period between 2020- 2021 has been unprecedented
and volatile and 2022 is the endemic period. This justifies the choice of the dates of the sample.
The variables used in the Vector AutoRegression (VAR) are defined as follows:
Repo Rate (REPO_RATE)
Repo Rate is used to represent the conventional monetary policy measure
Net OMOs (OMO)
Net Liquidity injected or absorbed through the Open Market Operations is an
unconventional monetary policy measure where + indicates injection and - indicates
absorption.
Inflation Rate (INF)
Year-on-Year Inflation rate has been taken in place of Consumer Price Index (CPI) as
CPI doesn’t satisfy the stability criteria in the VAR model. Price stability is the main goal of
monetary policy.
Unemployment Rate (UNEMP)
One of the functions of monetary policy is to reduce unemployment rate to support
growth and development
10-Year G-Sec Bond Yield (BONDYIELD)
Monetary policy and the bond market are inextricably linked because interest rates have
an immediate impact on bond prices in turn affecting bond yields.
Exchange Rate (EXRATE)
Low interest rates typically contribute to currency depreciation as foreign investors seek
higher returns and reduce their demand for the currency.
Net Foreign Exchange Reserves (FOREIGNRES)
These reserves are utilised to back up liabilities and influence monetary policy and to

29
secure monetary stability.
BSE Sensex Index (SENSEX)
Reduction in monetary policy rates leads to reduction in the cost of debt which
ultimately brings down the cost of equity and stock values are positively impacted. Stock
values, on the other hand, tend to fall when the RBI signals higher interest rates.

Graphical Representation of Variables

The time series are plotted in Figure 7. All of the variables display a possibly non-
stationary behaviour.

Figure 7: Variables used in the VAR model

30
Tools for Analysis in Vector AutoRegression

Test for Stationarity

The Augmented Dickey–Fuller (ADF) unit root test is used to ensure that the data series
has the property of stationarity. When selecting how many lags to include in a series to test for
the unit root, we assume that there is no autocorrelation among the error components. Several
publications, however, have provided methods for testing the null hypothesis of a unit root
against a stationary time series with breaks or nonlinearities. These studies demonstrate how
to eliminate bias in the commonly used unit root test by endogenously estimating the time of
structural breaks or nonlinearities. However, the unit root test that is utilised here is not resistant
to the vulnerabilities listed above.
The following is the hypothesis for the test:
Null Hypothesis (H0) = Time series has a unit root
Alternative hypothesis (H1) = Time series does not have a unit root
Lags Length Selection
The model used to estimate the causal link between variables is extremely sensitive to
the lag length. This indicates how many lag values should be inserted into the equation system.
The Akaike information criterion was used to determine the optimum amount of delays for the
calculated VAR model (AIC).
Cointegration
To check that the VAR is stable, Johansen's cointegration test is used to confirm that
the series are neither cointegrated or cointegrated with a "N" relationship. A residual correlation
test is also used to detect whether or not the residuals are correlated.
Residual Correlation Test
A residual correlation test is undertaken to ensure that the residuals are serially
uncorrelated, so that the VAR model can be used and correlograms are constructed to check
serial autocorrelation with approximate 2 standard error bounds. Roots of Characteristic
Polynomial is also plotted and tabulated.
Granger Causality Test
Looking into the Granger causality between several pairings of variables allows us to
investigate whether a variable's joint lags can improve the overall estimation result. As our
focus is to explore the possible impact of monetary policy variables on macroeconomic
indicators, we assess whether the various components of monetary policy are able to Granger
cause relevant macroeconomic indicators.

31
 Toda and Yamamoto (1995) methodology is applied here, which is appropriate
wherein variables may probably be integrated.
Impulse Response Function
The time path of the variables in the model to a unit increase in the present value of one
of the VAR faults is traced using impulse response functions. The Cholesky Decomposition is
used to identify impulse responses. The order of the variables play a key role as the restrictions
on the matrix implies some shocks have no contemporaneous effects on some of the variables
in the system.
The impulse response function (IRF) calculates the effect of a single shock in one
parameter on the current and future values of other variables. It should be noted that the AR
roots are located within the unit circle, which is an important diagnostic for the stability and
validity of IRF.
Variance Decomposition
The variance decomposition displays the percentage of the error made during
forecasting a variable over time due to specific shock. In other words, how much of the
variability in the dependent variable is explained by its “own shocks” vs the “shocks in the
other variables in the system”. The Cholesky Decomposition is used to identify variance
decomposition here as well.
The variance decomposition is a useful technique for understanding the quantum, speed
of adjustment, and persistence of the system as a result of stochastic innovation.

Hypothesis
The following is the hypothesis for our study:
H0: There does not exist a significant relationship between monetary policy variables (Repo
Rate and Open Market Operations) and Macroeconomic indicators (Inflation Rate,
Unemployment Rate, Bond Yield, Exchange Rate, Net Foreign Exchange Reserves, and
Sensex)
H1: There exists a significant relationship between monetary policy variables (Repo Rate and
Open Market Operations) and Macroeconomic Indicators (Inflation Rate, Unemployment Rate,
Bond Yield, Exchange Rate, Net Foreign Exchange Reserves, and Sensex)

32
 Chapter IV: Analysis and Findings

The chapter deconstructs the findings generated from data processing based on the
study's objectives. It provides a statistical and graphical summary of the study's findings by
demonstrating the relationship between the monetary policy rates and various macroeconomic
indicators.

Test for Stationarity, Lags Length Selection and Cointegration

Table 4: Augmented Dicky-Fuller Test

The results of the ADF Unit root test showed that all the variables are non-stationary.
(Table 4).
The ADF test affirms that only one variable—namely, the unemployment rate
(UNEMP) —had no unit root in level, whereas all the other variables were integrated in order
one. That is, all the variables except the UNEMP become stationary at the 5% significance
level, only after the first difference.

33
 Table 5: VAR Lag Order Selection Criteria

The AIC selection criteria chose four lags as an optimal lag, while the likelihood ratio
statistics recommended one lag only. Therefore, four lags are used to estimate the parameters
of the VAR and 10 lags for the impulse responses function and variance decomposition, as one
lag is inadequate in capturing the dynamic system of the model. (Table 5)

34
 Table 6: Johansen Cointegration Test

Because the Johansen cointegration test detects six cointegrating links within the
model, it is also viable to assess a model with a long-term identification constraint (Table 6).
However, we are only focusing on the short-term relationships between these variables.

35
Table 7: VAR Residual Serial Correlation LM Tests

36
 Table 8: VAR Residual Correlation Matrix

The residuals were found not to be highly correlated using residual correlation tests
when including four lags in the model. (Table 7 and Table 8)

37
 Figure 8: Correlograms
Correlograms were also constructed up to lag four depicted that there was no

38
autocorrelation up to lag four as evident from the graphs. (Figure 8)
Table 9: Roots of Characteristic Polynomial

39
 Figure 9: Roots of Characteristic Polynomial

In order for the VAR model to satisfy the stability condition, Roots of Characteristic
Polynomial were tabulated and plotted in (Table 9) and (Figure 9) respectively and there was
no root lying outside the unit circle.

40
Granger Causality Test
Table 10: VAR Granger Causality/Block Exogeneity Wald Tests

41
 The results of the Granger Causality reveal some cases wherein the impact of monetary
policy variables is statistically significant (Table 10).
First, Inflation Rate, Net OMOs and exchange rate seem to have forecasting

42
information for Repo Rate. Secondly, Net OMOs seem to be driven by Inflation Rate and Bond
Yield. Thirdly, the repo rate granger causes Inflation and unemployment. Lastly, Inflation
Granger causes changes in net foreign exchange reserves.
Bond yield and exchange rate seem to be driven by none of the variables in the model.
The repo rate is not granger causing bond yield, exchange rate, net foreign reserves and sensex.

43
Vector Autoregression Estimates
Table 11: Vector AutoRegression Estimates

44
 A total of 264 coefficients were used for the analysis. The box corresponding to
D(REPO_RATE) lag 1 and D(REPO_RATE) shows the coefficient, standard error in the
parentheses followed by the t- statistic. The standard deviation describes the deviations that
occur while precisely forecasting the slope coefficients. Divide the coefficients by their
standard errors to get the T-statistics.

45
 Table 12: Vector AutoRegression Estimates: P Values

However, due to the lack of p values, we cannot infer the statistical significance of the
standard errors from Table 11. Table 12 depicts the p values of the respective T-statistics from
which statistical significance of the coefficients can be inferred.
The VAR results (Table 11 and Table 12) indicate that the Net OMOs have a significant
and negative relationship with Repo rate and positive relationship with net foreign exchange
reserves. This implies that Open market operations have an indirect impact on repo rates.
OMOs enable a central bank to control an economy's money supply. Under a contractionary

46
policy, a central bank sells securities on the open market, absorbing liquidity, reducing the
amount of money in circulation and causing the repo rate to rise. Expansionary monetary policy
involves the acquisition of securities, an increase in the money supply, and the injection of
liquidity, which results in a fall in the repo rate.
Exchange Rate has a statistically significant positive relationship with Repo Rate. The
RBI can boost the repo rate, causing interest rates, bond yields, and return on debt papers to
rise, attracting more investor money to chase greater returns if they are low in other markets.
Higher interest rates, on the other hand, reduce money circulation in the economy, putting more
money in the hands of the RBI to control the currency demand-supply imbalance.
The net foreign exchange reserves have a statistically significant positive relationship
with the exchange rate. This infers that the change of reserves is very closely related to
exchange rate policy adjustments.
The inflation rate has a statistically strong and inverse relationship with Repo rate and
Net OMOs. Under a contractionary policy, a central bank raises the repo rate, absorbing
liquidity, reducing the inflation. Expansionary monetary policy involves a fall in the repo rate
which leads to increase in inflation. It also has a statistically significant positive relationship
with Net Foreign Exchange Reserves.
Repo Rate has a statistically significant negative relationship with unemployment with
a lag of one but statistically significant positive relationship with lags of three and four. A fall
in the repo rate has no direct relationship with unemployment. But , on the other hand, it
initiates a cycle of economic activity that may result in an increase in employment in an
economy.
BSE Sensex seems to be driving a statistically significant but weak negative impact on
exchange rate. Although, no direct relationship is there, the main assumption is that as the
domestic stock market rises, investors gain confidence that the country's economy is also rising,
resulting in increasing interest from overseas investors and demand for the domestic currency.
If the stock market underperforms, confidence falls and international investors return their
funds to their home currencies.

47
Impulse Response Function

Figure 10: Impulse Response Functions

48
 Similar to the outcome from VAR, from Figure 10, it is seen that a unit standard
deviation (SD) positive shock of repo rate leads to a decline in inflation rate, which is
statistically significant in short and long term. This is in tune with the theory where the repo
rate and inflation are inversely related. Inflation falls when the repo rate is raised. Inflation
rises when the repo rate falls. Controlling the repo rate is one of the most important strategies
that central banks use to control inflation.
A unit standard deviation positive repo shock causes no response in Net OMOs in the
short and long run, but a unit standard deviation positive Net OMOs shock causes a fall in repo
rate in the near term. Net OMOs have an inverse relationship with repo rates as evident from
the theory that the central bank uses a contractionary policy to sell securities on the open
market, absorbing liquidity, reducing the amount of money in circulation, and raising the repo
rate and vice versa.
The repo rate positive shock causes a statistically significant decrease in the
unemployment rate in both the short and long run.
The same positive repo rate shock causes an increase in the exchange rate and net
foreign exchange reserves that is statistically significant in the short and long run, as well as a
decrease in the sensex in the short term.
But, the positive shock of Net OMOs causes inflation to decline in the short run, and
unemployment to decline both in the short and long run, causes no response to bond yield,
leads to increase in net foreign exchange reserves and sensex in the short run.

49
Variance Decomposition
Table 13: Variance Decomposition using Cholesky (d.f. adjusted factors)

50
51
 Figure 11: Variance Decomposition

(Table 13) and (Figure 11) depict the variance decomposition results.
Repo Rate
The variance decomposition results for Repo Rate show that with respect to the first
month, 100% of the forecast error variance is explained by the variable itself. In the long-run
however, this starts to mitigate and by the 10th month, 33.81% of the variance is explained by
its own variable. Net OMOs account for only 10.64% of the shock in the second month but it
increases upto 26.56% in the sixth month and starts to decline and is 24.05% in the long-run.
Inflation was found to be significant in the short-term but gradually declines in the long-
run. Unemployment rate shock and sensex shock have miniscule contribution in explaining the
repo rate shock and the bond yield shock is more or less constant over time. The exchange rate
shock accounts for 8.42% of the repo rate shock in the second month but increases up to 13.73%

52
in the fourth month from which it declines till 10.86% in the 10th month.
The shock of foreign reserve is negligible in the short-term but increases up to 9.30%
in the long-run.
Open Market Operations
In the short run, 99.28% of the forecast error variance of Net OMOs is explained by the
variable itself. While the influence did decrease from 99.28% in the short run to 54.35% in the
long run, the influence was still strong indicating string endogeneity.
The influence of shocks of Repo rate, inflation, unemployment, exchange rate, net
foreign exchange reserves and sensex is negligible although an increasing trend is depicted.
The shock of bond yield stays approximately constant over time.
Inflation Rate
In the short run, 94.62% of the forecast error variance of Inflation rate is explained by
the variable itself. This trend however starts degrading in the long run displaying strong
endogeneity in the short run. The shock of repo rate however, is negligible is the first month
but increases to 15.49% in the long-run. The variance error percentage of Net OMOs is at
4.77% in the first month which is then enhanced till 8.73% by the 10th month.
The shocks of unemployment rate, bond yield, exchange rate, net foreign exchange
reserves and sensex are minute.
Unemployment Rate
The Variance decomposition showed that 87.70% of the shocks in the unemployment
rate were due to shocks in the unemployment rate itself in the first month, This sharply declines
to 46.35% in the second month and stands at meagre 19.75% by the 10th month. The forecast
error variances of Repo Rate, Net OMOs, Inflation, bond yield and exchange rate are negligible
in the short term but go on increasing in the long run. Net Foreign exchange reserves and
Sensex shocks are insignificant.
Bond Yield
The results show that only 57.49% of variation in Bond Yield is explained by the
variable itself and 36.18% is explained by variation in Inflation and both gradually decline over
time. Repo Rate shocks show an increasing course and the shocks of Net OMOs,
unemployment rate, exchange rate, net foreign exchange reserves and Sensex are trivial.
Exchange Rate
70.81% of the shocks in the exchange rate is explained by the variable itself and shows
a decreasing path. Repo rate shocks are significant in explaining the shocks of exchange rate
by 22.96% in the first month which decreases to 15.17% in the long run. Net OMOs,

53
unemployment rate, Inflation, Bond yield, net foreign exchange reserves and sensex shocks
show an escalating trend but are largely inconsequential.
Net Foreign Exchange Reserves
Net Foreign Exchange reserves shocks strongly influence their own self by 77.05% in
the short run which shows a dwindling trend. Repo rate, Net OMOs and Bond Yield are trivial
in the short run but somewhat significant in the long run. Exchange rate stays constant and
inflation, unemployment rate and Sensex are miniscule.
Sensex
The results depict that 54.72% of the shocks in sensex are explained by repo rate which
slightly declines in the longer run. Only 29.66% of the shocks are explained by its own variable.
Foreign reserves are trivial in the short run but influence sensex in the long run by 10%. Net
OMOs and inflation show a rising course and unemployment, bond yield and exchange rate
shocks stay approximately constant over time.

Hypothesis Testing

Since there exists a significant relationship between monetary policy variables (Repo
Rate and Open Market Operations) and Macroeconomic Indicators (Inflation Rate,
Unemployment Rate, Bond Yield, Exchange Rate, Net Foreign Exchange Reserves and
Sensex) as evident from the above tests, therefore, we reject our null hypothesis.

54
 Chapter V: Conclusion

The discussion in the paper highlights how monetary easing policies implemented by
the RBI can impact various macroeconomic indicators. These include conventional policy
interest rate changes and unconventional measures involving large-scale asset purchases. Such
effects can take the form of greater volatility in capital inflows, changes in equity valuations,
and exchange rate movements.
India's macroeconomic sustainability indicators are strong and significantly improved,
in comparison to what they were during the global financial crisis or the taper event of 2013.
The import cover and foreign exchange reserves, for example, have more than doubled in
recent years. Compared to 2010-12, cumulative portfolio inflows relative to GDP are lower.
External financing requirements are limited and lower than GDP than they were in 2010-12. In
2022-23, substantial foreign exchange reserves, continuing foreign direct investment, and
expanding export earnings will be a good buffer against any liquidity tightening/tapering or
monetary policy normalisation.
India should continue to encourage stable longer-term capital inflows while
discouraging volatile short-term flows, hold a larger stock of forex reserves, avoid excessive
exchange rate appreciation through reserves and macroprudential policy interventions, and
prepare banks and firms to deal with greater exchange rate volatility. India's policymakers must
reduce reliance on "hot money" inflows.
The findings of the study suggest that Repo Rate has a negative relationship with
unemployment rate, inflation rate, sensex, bond yield and OMOs and a positive relationship
with exchange rate, net foreign exchange reserves. Similarly, the results suggest that the net
open market operations have a negative relationship with inflation, unemployment, sensex and
net foreign exchange reserves and a positive relationship with exchange rate and bond yield.
All of the findings are in line with previous literature and the working of the economy.
Thus, concluding that monetary policy variables like repo rate and OMOs do play a significant
role in stabilising economic activity.
The financial system is always a possible area of stress during turbulent times.
However, the Indian financial system, has done exceptionally well. Domestic financial markets
have moved broadly in sync with the accommodative monetary policy stance.

55
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