Indian Monetary Policy in the Time of Inflation Targeting and Demonetization

• Published date: 01 January 2019
• DOI: http://doi.org/10.1111/aepr.12242
• Author: Partha Ray,Rakesh Mohan
• Date: 01 January 2019

Indian Monetary Policy in the Time of

Inflation Targeting and Demonetization

Rakesh MOHAN

1

†and Partha RAY

2

1

Yale University and Brookings India and

2

Indian Institute of Management Calcutta

This paper provides a narrative of Indian monetary policy since the North Atlantic Financial

Crisis (NAFC) in the mid-2008 till the current period. The period 2009–2013 was dominated by

the joint monetary and fiscal stimuli of the Indian authorities prompted by the NAFC. These,

along with some structural shocks and a hands-off attitude in forex market intervention, could

have had their role in rising inflation and external account instability (leading up to the taper

tantrum episode). In such a backdrop, after considerable discussion during 2013–2014, a Mone-

tary Policy Framework Agreement was signed between the Government of India and the Reserve

Bank of India on February 20, 2015 that formally adopted flexible inflation targeting (IT) in

India. While the IT regime so far has coincided with significant reduction in inflation in India,

the atmosphere has been benign. Now that fuel prices have started moving in the north-east

direction, the government has proposed a revised framework for the minimum support price in

the Union Budget for 2018–2019 and fiscal slippages have started happening, it remains to be

seen whether IT can wither more rough weather in the days to come. Finally, in recent years,

Indian monetary policy has been dominated by two significant events: the emergence of signifi-

cant deterioration of Indian public sector balance sheets, and the demonetization episode in

November 2016. Monetary policy in both of these periods wrestled with fashioning an appropri-

ate strategy for managing the impossible trinity.

Key words: capital inflows, demonetization, India, inflation targeting, monetary policy

JEL codes: E52, E58, O53

Accepted: 27 June 2018

1. Introduction

The story of Indian monetary policy and financial sector reforms from the early 1990s

to 2009 has been chronicled in some detail by both the authors.

1

During this period, a

financially repressed economy, characterized by high statutory pre-emption, sectoral

This is a revised version of the paper presented to the 27th Asian Economic Policy Review Con-

ference in Tokyo on April 7, 2018. We are indebted to the participants of the conference and in

particular to Takatoshi Ito, Chalongphob Sussangkarn, and Colin McKenzie for their insightful

comments on the paper. The authors are also grateful to Y.V. Reddy for his comments on an

earlier version of the paper.

†Correspondence: Rakesh Mohan, Jackson Institute for Global Affairs, Yale University, New

Haven, CT 06520-826, USA. Email: rakesh.mohan@yale.edu

© 2018 Japan Center for Economic Research 67

doi: 10.1111/aepr.12242 Asian Economic Policy Review (2019) 14, 67–92

credit targets, administered interest rates, and fiscal dominance, traversed a sea change

in its financial sector structure, conduct and performance through a comprehensive

reform process. As financial repression was progressively dismantled, interest rates

deregulated, the banking sector liberalized, financial and money markets developed,

and fiscal dominance reduced, the Indian financial sector emerged as a modern market

oriented system by the mid-2000s.

Monetary policy reform was a key element of this process. Till about the mid-

1980s, monetary policy in India was more appropriately characterized as “credit

planning,”whereby the main objective was to channel credit at cheap administered

rates for the developmental needs of the economy with public sector banks acting as

the key intermediaries. Inflation was dominated by structural shocks like flood,

drought, or changes in oil prices. The first break in monetary policy formulation came

about in the mid-1980s when monetary targeting was adopted, wherein the targeted

path of monetary expansion was designed to fund the “desired growth of gross domes-

tic product (GDP) in nominal terms,”that is, growth after accounting for tolerable

inflation. Though the Reserve Bank of India (RBI) had introduced a number of money

market instruments in the late 1980s, together with some deregulation of interest rates

on existing money market instruments, these were mostly at the periphery. Thus, in

the absence of a well-functioning money market and predominance of RBI credit to

the central government, the primary tool of monetary policy was the traditional cash

reserve ratio (CRR) that aimed at controlling overall money supply to contain infla-

tionary pressures while also keeping in mind the objective of providing bank credit to

the commercial sector. Besides, fiscal dominance through significant automatic moneti-

zation of budget deficits deprived the RBI of operational autonomy. However, the RBI

muted this expansionary impact by mandating a certain proportion of bank assets to

be invested in government securities through varying rates of the “statutory liquidity

ratio”(SLR).

Monetary policy started to become operationally independent when the practice of

automatic monetisation through creation of ad hoc treasury bills was completely elimi-

nated in April 1997.

2

Just as monetary targeting had lost favor in advanced economies

(AE), its effectiveness in India began to be questioned in the mid-1990s. Consequently,

the RBI announced in April 1998 that it would switch to a “multiple indicators

approach,”wherein “besides broad money, which remains as an information variable,

a host of macroeconomic indicators including interest rates or rates of return in differ-

ent markets (money, capital, and government securities markets) along with such data

as on currency, credit extended by banks and financial institutions, fiscal position,

trade, capital flows, inflation rate, exchange rate, refinancing, and transactions in for-

eign exchange available on high frequency basis are juxtaposed with output data for

drawing policy perspectives in the process of monetary policy formulation”(Mohan,

2008). Its broad objectives have consistently focused on the maintenance of price sta-

bility along with economic growth and financial stability. With the use of multiple

indicators, the RBI has also used multiple instruments including both price and quan-

tity instruments.

Indian Monetary Policy Rakesh Mohan and Partha Ray

68 © 2018 Japan Center for Economic Research