ISSN (Print) - 0012-9976 | ISSN (Online) - 2349-8846

M J Manohar RaoSubscribe to M J Manohar Rao

Science of Monetary Policy

This paper exposits the monetary policy design problem within the limits of an empirical framework for the Indian economy. Four main issues are examined. The paper first looks at a few of the theories that have been advanced to explain the stylised facts of economic fluctuations and then examines the main features of business cycles in the Indian economy over the past 50 years. In the process, it presents forecasts of aggregate economic activity for 2002-03 and 2003-04 besides obtaining quantitative estimates of the impact of the business cycle on the fiscal deficit. Second, it empirically measures the threshold rate of inflation within the framework of growth-inflation trade-offs and derives the optimal rate of monetary expansion needed to smooth out fluctuations and stabilise the inflation rate at its threshold level. Third, it specifies a theoretical model (linking growth, inflation, interest rates and money supply) capable of deriving an optimal fiscal deficit which maximises the real growth rate; and applies it within the Indian context to measure the desired amount of fiscal consolidation. Finally, it provides estimates of a comprehensive macroeconomic conditions index which can very effectively be incorporated into a simple Taylor-type interest rate rule (reaction function) for monetary policy.

Fiscal Deficits, Interest Rates and Inflation

The relationship between budget deficits, money creation and debt financing suggests that interest rate targeting and inflation control are both monetary and fiscal policy issues. The paper formalises these links within two analytical frameworks, static as well as dynamic, which by highlighting the concepts of the 'high interest trap' and the 'tight money paradox', respectively, suggests that, for any given deficit, there exists optimal levels of monetisation and market borrowings. The model is then applied to evaluate the implications of the union budget 2000-01 and the results indicate that unless government borrowings are reduced substantially, and about 40 per cent of the deficit is monetised, the inflation rate as well as the interest rate could be much higher than what they fundamentally ought to be.

Indian Macro-Economic Data Base in a Consistency Accounting Framework (1950-51 to 1997-98) - II

Despite certain minor problems of definitions and measurements left unresolved by the earlier exercise on Indian macro-economic data base consistency (reported in the previous issue of EPW), the resulting integration helped us to detect the structural changes that have occurred in the real and financial sectors of the Indian economy over the entire sample period, in general, and between the pre- and post-liberalisation phases, in particular. In such a context, we have identified many important empirical patterns and regularities, notably the existence of business cycles, the counter-cyclical nature of inflation, the twin deficits problem, the impact of absorption on reserves, the evolution of the debt-income ratio, the relationship between real interest rates and growth, the sustainability of the fiscal stance, amongst others, which could act as theoretical guideposts for the formulation of issues in the role and conduct of macro-economic stabilisation policy.

Indian Macro-Economic Data Base in a Consistency Accounting Framework (1950-51 to 1997-98) - I

This study presents for the first time in the Indian context a consistent set of annual macro-economic data from 1950-51 to 1997-98 by integrating the national accounts statistics of the CSO with the balance of payments and the monetary data of the RBI as well as with the fiscal data of the government of India. Despite certain minor problems of definitions and measurements left unresolved by this exercise, the resulting integration helped us to detect the structural changes that have occurred in the real and financial sectors of the Indian economy over the entire sample period, in general, and between the pre- and postliberalisation phases, in particular. In such a context, we have identified many important empirical patterns and regularities, notably the existence of business cycles, the counter-cyclical nature of inflation, the cyclical variations in income distribution, the twin deficits problem, the impact of absorption on reserves, the evolution of the debt-income ratio, the relationship between real interest rates and growth, the sustainability of the fiscal stance, amongst others, which could act as theoretical guideposts for the formulation of issues in the role and conduct of macro-economic stabilisation policy. In this first part, we use a consistency accounting matrix which specifies the linkages between sources and uses of funds as well as between institutional sector accounts. It is seen that the resulting framework ensures the numerical consistency of data drawn from different sources in such a way that both the sectoral budget constraints as well as the overall economywide budget constraints are simultaneously satisfied.

Financial Programming and Stabilisation Policy Options for Macro-Economic Adjustment

The paper initially discusses the real and monetary aspects of short-run structural adjustment using a flow-of-funds methodology. Based upon such a framework, it then specifies an analytical basis which is capable of integrating the financial programming model of the Fund with the financial requirements approach of the Bank in a manner which removes the existing dichotomies between the real and financial sectors of the economy. The merged model, which defines monetary, external, real and financial sector equilibrium, is then used to prescribe feasible stabilisation policy options for the Indian economy over the current fiscal year.

Interest Rate Targeting-Critical Role of Fiscal Stance

This paper examines the relationship between budget deficits, money creation and debt financing which suggests that interest rate targeting and inflation control are both monetary and fiscal policy issues. It then formalises these links within an analytical framework which, by highlighting the concept of the 'high-interest trap'. suggests that, for any given deficit, there exists optimal levels of monetisation and market borrowings. The model is then applied to evaluate the implications of the Union Budget 1998-99 and the results indicate that unless government borrowings are reduced substantially, the inflation rate would be much higher than what the fundamentals require it to be.

Optimising the Pace of Capital Account Convertibility

Optimising the Pace of Capital Account Convertibility M J Manohar Rao Balwant Singh The paper formalises the relationship between monetary and exchange rate policy during the process of financial opening; and shows that a rapid opening of the capital account could render an economy vulnerable to speculative attacks. The model is then applied in the current Indian context to determine the optimal pace of capital account convertibility (CAC). The results, obtained using control theory, indicate the urgent need for phasing in CAC gradually because any attempt at 'shock therapy' by exceeding this pace could, under the present circumstances, result in an economic stagnation characterised by low growth, high real rates of interest and overshooting exchange rates.

Macro-Economics of Capital Account-Convertibility

Macro-Economics of Capital Account Convertibility M J Manohar Rao Introduction THE authorities in many developing countries, including India, are currently implementing de jure liberalisation of the capital account of the balance of payments (BOP). At least two reasons can be identified for this interest in financial openness. First, there has been increasing de facto opening of the capital account: the effectiveness of capital controls has declined due to growing trade integration, financial innovations and financial opening elsewhere; and 15 years after the debt crisis, credit rationing by commercial banks is fading away while flight capital is being repatriated. Second, there is a proposal from the International Monetary Fund (IMF) to amend the articles of agreement to incorporate CAC as one of the obligations of Fund membership.

Financial Openness, Shadow Floating Exchange Rates and Speculative Attacks

Both the literature as welt as the evidence on speculative attacks in foreign exchange markets provide important lessons for managing an exchange rate regime. Balance of payments crises, rather than being exogenous shocks, could well be the equilibrium outcome of maximising behaviour by rational agents faced with a fundamental inconsistency between monetary and exchange rate policies. The longer the delay in bringing about such consistency between monetary, fiscal and exchange rate policies, the higher will be the potential costs of an eventual adjustment when ultimately faced with the inevitable regime collapse.
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