An Empirical Analysis of Monetary Transmission in India in the Post-Reform Period: Relevance of the Banking Channel

Empirical evidences on the transmission mechanism by which monetary policy affects the economy, particularly general prices and real activity, are essential, both for effective policy making and understanding the alternate macroeconomic theories. A consensus has largely been established on the influence of monetary policy on the economy through its impact on the spending decisions on consumption and investment. Banks play a central role in monetary transmission as monetary policy impulses through bank credit affect consumption and investment decisions of the individuals and thus affect the aggregate demand, which in turn transmits the impact to the final objectives of price and output stabilization. The present study attempts to empirically examine the nature and strength of monetary policy influence on inflation and real activity in India, with special emphasis on the role of banking channel in the transmission process. Considering the fact that the Reserve Bank of India adopted multiple indicator approach in the conduct of monetary policy since April 1998, the present paper uses a Monetary Policy Indicator (MPI) to capture the policy stance appropriately. The empirical evidences reiterated monetary policy influence on inflation and real activity. The lag effect of monetary policy on inflation (about 18 months) was found to be longer as compared to real activity (about a year), implying the impact of policy shocks being realized initially in aggregate demand subsequently gets transmitted to prices. Monetary policy shocks were observed to have desired influence on interest rates and bank investments, while the effect on bank credit was observed with a lag of around one year. The empirical evidences revealed high importance of bank investment in the monetary transmission process, which seems plausible given the relevance and size of bank investment portfolio in the Indian context.