Interest rates

The Reserve Bank of India should take into consideration longer term liquidity management for smooth monetary transmission. It must clearly define “durable liquidity” in the form of some quantitative variable and set its desired path for one year or so. This will anchor expectations on future interest rate and liquidity premium, and certainly improve the link between the interest rates in various terms to maturity. Moreover, the desired target for durable liquidity can also serve to improve overall monetary policy effectiveness.

While the rationale for raising the interest rate to defend an exchange rate under speculative attack is well grounded in economic and financial theories, empirical validation of the effectiveness of such a policy stance has generally been difficult and is shrouded with conflicting findings. In India, besides forex market interventions and use of several administrative measures, the Reserve Bank of India has occasionally resorted to the high interest rate option during major episodes of significant pressures on the external value of the rupee. An empirical assessment suggests that one standard deviation shock to the call rate leads to rupee appreciation in the very second month. Similarly, for one standard deviation shock to net interventions, the exchange rate appreciates gradually by a few paise over five months. The impulse response also suggests that in response to one standard deviation shock the exchange rate appreciates by about 8 paise in the second month, but subsequently the exchange rate depreciates gradually, more than offsetting the initial impact of the hike in interest rate.

This paper recommends an inflation adjustment formula for setting the interest rate on all Small Savings and Provident Funds and discusses the rationale for the suggested formula.

Deena Khatkhate and Dan Villanueva’s (henceforth KV) rejoinder (EPW, May 12) to my piece ‘On Fiscal Deficits and Real Interest Rates’ (EPW, April 14) is rather intriguing: after castigating me for my position they reach a conclusion which is in conformity with it. I had argued in my paper that the fiscal deficit has no direct bearing (i e, other than through a general equilibrium system, of which IS-LM is the simplest possible example) on the level of the interest rate, and that therefore the proposition that the fiscal deficit must be cut in order to lower the interest rate, lacks theoretical justification. They conclude: “The factual evidence also shows that interest rates can remain higher with a fiscal surplus, depending on other economic variables, than in a situation with a fiscal deficit”. Their conclusion appears to be in conformity with my argument, though not necessarily identical with it (since I was arguing on a ceteris paribus basis, i e, ruling out other simultaneous parametric changes). From their conclusion too the question should follow: what theoretical justification is there for the current official position that the fiscal deficit must be cut for lowering the real interest rate?