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On Monetary Economics

Parag Waknis (parag@aud.ac.in) teaches at Ambedkar University Delhi, New Delhi.

Monetary Policy in India: A Modern Macroeconomic Perspective edited by Chetan Ghate and Kenneth M Kletzer, Springer, 2016; pp xiii+652, price not indicated.

 

The volume under review put together by Chetan Ghate and Kenneth M Kletzer is an important addition to the literature on monetary policy in India. First, it offers a collection of carefully crafted essays on the different structural aspects of the Indian economy that one needs to consider while thinking about its monetary policy. Unlike most developed countries, a typical developing economy like India experiences a substantial degree of segmentation in goods as well as financial markets limiting the efficacy of monetary policy. Moreover, the spillover effects of fiscal policy practised by developing country governments, often coupled with financial repression, make inflation a much harder phenomenon to understand and influence.

Second, by framing the issues related to monetary policy of India in a class of microfounded models, the book brings the analysis closer to contemporary macroeconomic thinking. Third, it is a timely publication considering that a formal institutional framework underlying formulation and implementation of a monetary policy has only been put in place recently with the adoption of an inflation targeting framework in March 2015.

Ghate and Kletzer (p 3) introduce the collection of essays by highlighting their relevance and contribution in the context of current issues in monetary economics in India. These issues include the experience of relatively higher inflation rates between 2006 and 2013 that lead to unhinged inflation expectations, weak monetary transmission, and substantial segmentation of goods and financial markets in terms of formal–informal markets, credit rationing, and regulation of financial intermediation.

Monetary Transmission

The papers in the first section address the issues related to effective monetary policy transmission. Prachi Mishra, Peter Montiel and Rajeswari Sengupta (p 59) look at monetary transmission evidence from India and how it compares with the experiences of other developing countries. M S Mohanty and Kumar Rishabh (p 111) take a look at the effect of the financial crisis of 2008 on financial intermediation and monetary transmission in emerging market economies in general.

To analyse the effects of institutional constraints imposed by statutory liquidity ratio (SLR) and priority sector lending on monetary policy, Amartya Lahiri and Urjit R Patel (p 31) build a small open economy model with households, firms, government, and the banking sector as players in the economy. Banks lend to the private sector and the government. They show that if the SLR requirement is binding, then a policy rate cut may have exactly the opposite effect than intended. Under a binding SLR constraint in their model, banks hold private and government assets in fixed proportions. This reduces their ability to optimise their loan portfolio and, therefore, a policy rate cut makes banks reduce both private and government bonds, leading to a reduction output and aggregate demand. In addition to this opposite effect of a policy rate, a binding SLR may also lead to an equilibrium where an increase in policy rate is associated with higher inflation. Also, a binding SLR may require changing the SLR to get the conventional outcome, rather than changing the policy rate.

These stark conclusions may be the result of a simpler model, but it does illustrate the way in which SLR requirements could interact with monetary policy changes stipulated by an interest rate rule to produce diametrically opposite effects. The paper also tackles some confounding evidence where banks, both private and public, hold excess reserves in government than stipulated by the SLR. The authors highlight the increased non-performing assets since 2009 as a plausible reason driving this behaviour.

Another interesting paper in this section is by Rahul Anand, Sonali Das and Purva Khera (p 151). It analyses monetary policy transmission in the presence of labour market frictions. These frictions are the result of several regulations that create barriers to entry and competition and make hiring and firing workers costly, generating reluctance for expansion on the part of firms. These regulations are one of the important factors contributing to the substantial informal sector in the Indian economy. The authors look at the effects of reducing these frictions on monetary policy transmission. They build a small open economy model with formal and informal sectors, endogenous entry of firms, and monopolistic completion. Their formal sector also experiences price and wage stickiness. They find that monetary policy is less effective in a high-friction environment and that the trade-off between inflation and output improves.

Financial Structure

The section on liquidity management and financial structure of the Indian economy has an interesting line-up of articles on financial markets and investment finance by Rajesh Chakrabarti (p 173); the relative health of public versus private sector banks by Viral Acharya and Krishnamurthy V Subramanian (p 195); the term structure of interest rates in India by Rajnish Mehra and Arunima Sinha (p 231); and liquidity management and monetary policy by Michael Debabrata Patra et al (p 257).

Financial markets form an essential channel of monetary policy transmission. From this perspective, Chakrabarti’s article gives a good overview of the theory and empirics of linkages between monetary policy and financial markets. A well-functioning debt market is one of the important precursors for efficient monetary policy implementation. The debt market in India only started developing post 1992 following a series of reforms undertaken by the Reserve Bank of India (RBI). In the context of the nascent Indian debt market, Mehra and Sinha provide a brief overview of evolution of debt markets in India and then proceed to investigate rationalisation of the yield curve based on the expectations hypothesis. They also explore the information content in the term structure of the interest rates of government securities and its implications for monetary policy.

While the analysis using Campbell–Shiller coefficients on Indian data provides results similar to the United States, the only recent introduction of inflation-indexed bonds in the Indian market means that not much can be inferred about inflation expectations from the term structure. The authors also find that mapping of short-term to long-term nominal yields is not stable suggesting considerable challenges in implementing monetary policy in India.

Patra et al give a good overview of the development of RBI’s liquidity management framework, mainly focusing on the first leg of monetary transmission: from the policy rate or operational target.

Constraints in Banking

The third section has papers that look at various constraints on normal central banking in India. The issues covered include capital flows, exchange rate management, and inflation persistence. While Atish R Ghosh et al (p 299) look at the capital flows and capital controls in India, Poonam Gupta (p 385) explores how the RBI has managed to conduct its monetary policy in the face of exchange rate spillovers caused by capital flows. Sajjid Z Chinoy et al talk about India’s sharp disinflation between 2013 and 2015 and show that “it can be attributed to the moderation of historical dynamics of inflation which influence contemporaneous inflation” (p 450). According to them, the softening of backward-looking wage expectations and institutional processes of wage and minimum support prices settings could be these factors. Vipul Bhatt and N Kundan Kishor (p 335) argue that trend inflation and inflation persistence are the key to understanding long-run inflation dynamics in India. They provide a measure of both that seem to be performing well in tracking inflation changes in recent times.

Being a theoretical monetary economist, the most interesting section for me in this book was “Towards a Theoretical Framework for Monetary Policy of India.” The three papers in this section present a variant of the new Keynesian model each to look at a particular issue at hand. Vasco Gabriel, Paul Levine and Bo Yang (p 455) present a small open economy new Keynesian model with financial frictions. Jagjit S Chadha and Young-Kwan Kang (p 507) present an open economy new Keynesian model with two interest rates and an explicit banking sector. They conclude that

relative to the standard interest rate reaction function, the modeling of financial frictions implies that more sophisticated monetary policy actions may be required than a standard active interest rate rule. (pp 537–38)

Shesadri Banerjee and Parantap Basu (p 549) build a model with new Keynesian features and incomplete financial markets and consider several frictions such as habit formation, staggered pricing of intermediate goods firms, investment adjustment costs, etc. Using the model, they evaluate the behaviour of the Indian economy in the context of quantitative easing.

In the last section, “Future Challenges,” Klaus Schmidt-Hebbel and Martín Carrasco (p 583) document the experience of countries that have adopted an inflation targeting framework, and bring out the prerequisites for its successful implementation based on these experiences. Barry Eichengreen (p 623) highlights the challenges faced by emerging market economies in the era of international policy coordination or actually the lack thereof.

Overall, the volume presents a substantive treatment of issues concerning the design of effective monetary policymaking in India. The editors, Ghate and Kletzer, have managed to bring together an impressive list of contributors and contributions. However, I do see some areas or modelling traditions that could have been included but were not.

Conclusions

Though the issues handled by the models in the theoretical framework section are substantive and extremely relevant for the Indian economy, I would have liked to see some papers that use some theoretical frameworks other than just the new Keynesian model. While being microfounded in the tradition of the real business cycle models, new Keynesian models are not microfounded on their monetary side and, combined with Taylor type rules, suffer from multiplicity of equilibria, including one with a liquidity trap (Benhabib et al 2001; Cochrane 2017). Second, as Wallace (2001) suggests, a model for monetary policy analysis should give rise to the demand for money endogenously. Keeping in line with this, I would have liked to see some analysis using money search models based on Lagos and Wright (2005) and summarised well in Nosal and Rocheteau (2017), or one based on an overlapping generations framework.

With a couple of exceptions, there is also much less emphasis on design of monetary policy in the presence of informal goods, labour, and financial markets. Given that such extensive informality severely limits the ability of the government to tax, there is a need to explore the nature of optimal monetary policy under tax evasion.

In spite of these points, the volume successfully manages to present a detailed analysis of issues concerning monetary policy design in an emerging market economy like India based on contemporary macroeconomic theory. It certainly should become an essential reader for everyone interested in the macroeconomic policy of India: students, teachers, and policymakers alike.

References

Benhabib, J et al (2001): “The Perils of Taylor Rules,” Journal of Economic Theory, Vol 96, Nos 1–2, pp 40–69.

Cochrane, J H (2017): “The New-Keynesian Liquidity Trap,” Journal of Monetary EconomicsVol 92, pp 47–63.

Lagos, R and R Wright (2005): “A Unified Framework for Monetary Theory and Policy Analysis,” Journal of Political Economy, Vol 113, No 3, pp 463–84.

Nosal, E and G Rocheteu (2017): Money, Payments, and Liquidity, MIT Press.

Wallace, N (2001): “Whither Monetary Economics?” International Economic Review, Vol 42, No 4, pp 847–69.

Updated On : 18th Jul, 2018

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