Effectiveness of multiple indicator approach in formulating monetary policy of India (2004-2016)

Abstract

Objectives of monetary policy majorly revolve around maintaining price stability and ensuring credit flow across various sectors of economy. With the liberalisation, globalisation and privatisation of Indian economy, maintaining orderly conditions also became an additional objective that the monetary policy is expected to achieve. Monetary policy tries to achieve the triangular equilibrium between price stability, financial stability and growth. Evolution of Monetary policy in India can be divided in 3 phases. From mid 1980s to 1997-98, monetary policy was based on monetary targeting. M3 (broad money indicator) was used as the target given its reasonable stability. Real GDP growth was used a feedback for the M3 variable. Post that, there was a transition to Multiple indicator approach which used both quantity and rate variables. High frequency, medium frequency and low frequency data were used for drawing policy perspectives. Finally, the multiple indicator approach paved for inflation targeting. Amendments were made to the Reserve Bank of India Act, 1934 through Finance Act 2016 of May 2016. Price stability was stated to be the primary objective of India’s monetary policy. CPI was adopted as the anchor for framing the monetary policy with the formation of Monetary Policy Committee (MPC) to achieve the inflation objective. Government set an inflation target of 4% with 6% and 2% as the upper and lower tolerance limits. Government and RBI constituted the 6 member MPC team. We divide our study from 2004-2016 into 2 halves: one studying the causality impacts during 2004- 2008 and the other determining the causality during 2008-2016. 2004-2008 was a period of moderate inflation and strong growth. Monetary policy reversed its stance to tightening post 2005. Also, there was steady capital inflow which induced appreciation of currency. RBI intervened from time to time in this period using sterilisation (market stabilisation scheme) in order to keep the currency under check. In the second half we look at the post crisis scenario which was hampered by negative sentiments. In the first half till 2013, there was high inflation (2008-13) but slowly and gradually disinflation became a mainstay during the second half (post 2013).