Monetary policy transmission improves if friction in the financial system diminishes, according to the findings of a study by the Development Research Group (DRG) of the Reserve Bank of India (RBI).
This is possible with greater financial inclusion in terms of depositors’ base and easing of the collateral constraints of the households, the DRG said in its report. “Easier norms for collateral are likely to enable households to increase their borrowings which, in turn, may improve the transmission,” it added.
The DRG is constituted by the apex bank in its Department of Economic and Policy Research to carry out quick policy-oriented research on subjects of current interest.
Study model
The DRG study — ‘Role of financial frictions in monetary policy transmission in India’ — developed a New Keynesian Dynamic Stochastic General Equilibrium (NK-DSGE) model with an imperfectly competitive banking sector and examined the role of various financial frictions in monetary policy transmission (MPT) in India.
The credit channel-based explanation of MPT attributes weak transmission of monetary policy in emerging market and developing economies to the predominance of financial market frictions.
Credit market friction
“Presence of information asymmetries, limited enforceability of contracts and heterogeneity among the economic agents give rise to frictions in the financial market transactions, which play a crucial role in determining the degree of pass-through and speed of adjustments in the MPT mechanism,” the DRG said.
Focusing on the credit market friction parameters, the study undertook counter-factual experiments and evaluated the responsiveness of MPT using the accumulated effects over a time horizon of eight quarters. The study findings show MPT improved as friction in the financial system diminished.
The study also undertook simulation experiments with respect to a set of alternative policy rules.
“Adjusting the policy interest rate to smooth out the credit cycle exacerbates volatility of inflation and output,” the DRG said. It suggested that inflation stabilisation was the most desirable policy option for the RBI as it minimised the welfare loss irrespective of policy rules. “Overall, it appears that targeting financial stability through monetary policy rule may not be appropriate for the purpose of economic stabilisation.”
