MONETARY

POLICY
TRANSMISSION
Group 4:
Shorya Chaplot (344), Shubham Gupta
(346)
Sisir V (347), Soumya Barman (348)
Sourabh Kumar (349), Suraj Tripathi (350)

INTEREST RATE CHANNEL

Monetary Policy

Real Interest rates

Business Investment
decisions
Investment decisions
Consumer Investment
decisions

RELEVANCE & EFFECTIVENESS

Advanced Economies- works by
impacting the cost of capital and is
effective
Emerging Economies- proves to be
weak if capital markets for debt and
equities are not well functioning; and
real estate markets are fragmented and
illiquid
Interest rate channel is strengthening in
many EMEs, including India
This is attributed to reduced fiscal
dominance, more flexible exchange

Asset Prices

Stock Market effect on Investment

Money
supply =>
Stock prices =>
Stock
Market
Price
Toblin Q => Investments => GDP

Firm balance sheet Effect

Money supply => Stock prices => Net
Worth => Lending => I => GDP
Household Liquidity and Wealth
Money supply => Stock prices =>
Decrease in financial stress =>
expenditure => GDP

Indian context:
In India capital market is not yet developed
and the transmission through them in not
significant
It is efficient in developed countries

Real Estate Price

Direct Effects on Housing Expenditure

Money supply => House price => H
investment => GDP
Housing Wealth Effect
Money Supply => House price =>
Wealth => C => GDP
Bank Balance sheet
Money supply => House price => Net
Worth bank => Lending =>
Investment => GDP

Exchange rate
Repo rate

Money supply
GDP

Net export

Depreciate Rupee
Net imports

Effectiveness in Indian
economy
Depends on openness of
economy
Heavily pegged and
managed exchange rate
Real exchange effective rate, to be managed between 5% of rate by RBI
Frequent intervention by RBI weakens the exchange rate channel
Large size of Indian domestic market as compare to exports and imports makes the
channel ineffective
Weak response of exchange rate on change of monetary policy reduces the
transmission via this channel

Based on information asymmetry Credit View

Bank Lending Channel

Balance Sheet
Channel

Only source of credit

Low net worth

Adverse selection
Moral hazard

Operation:

Operation:

Expansionary monetary
policy Bank deposits

Expansionary
Monetary policy
Stock prices

Banks play special role

Bank Loans
Investment

GDP

Adverse selection
Moral Hazard

Lending

Investment
GDP

GDP dependence on Credit

35%

2500000

30%

2000000

25%
20%

1500000

15%

1000000

10%

500000

5%
0%

1991 1995 2000 2001 2002 2003 2004 2005 2006

End-March

Total Credit Outstanding

Annual Growth

RBI Report 2006

Recommendations
The Indian economy is a bank-based economy.
Banks play an important role in financial intermediation and that the nonfinancial sector lacks alternative sources of funding.
Our analysis support the importance of the bank lending channel in the
transmission of monetary policy shocks to the real sector.
The lower market capitalization of listed companies in India as compared to
developed countries suggests that the capital markets in India are not sufficiently
developed.
Massive interventions by the Reserve Bank of India in the foreign exchange
market to stabilize the exchange rate weaken the exchange rate channel.
Banks play an important role in financial intermediation in the Indian economy,
and their strong representation reflects the lack of alternative sources of funding
for the private sector.