Monetary Policy Transmission in Financial Markets: Evidence from India

Edwin Prabu (of RBI) and Prof Partha Ray  in this EPW paper:

In the Indian context, a key question is addressed: What has been the influence of monetary policy on different segments of the financial markets? Constructing a structural vector autoregressive model with the monetary policy rate, the pattern of monetary transmission to financial markets is examined over three distinct periods of regime changes in the Indian monetary policy and liquidity management framework. The empirical evidence indicates that there is sufficient period-specific transmission of monetary policy across the different segments of the financial markets. While the transmission of monetary policy to the money and bond markets is found to be fast and efficient, the impact of the policy rates on the forex and stock markets is limited.

Policy implications:

Monetary transmission is often implicitly seen to be a two-stage process whereby in the first stage monetary policy affects the different segments of the financial markets, and in the second stage, the impact of the financial markets gets transmitted to the real sector of the economy. The present paper looks into the first stage of this process.

Our results indicate that the impact not only varies across different segments of the financial markets, but it is also sensitive to the operating procedure of the monetary policy. Expectedly, our results find the primacy of the call rate in the money markets and are in consonance with the official RBI stance of treating the weighted average of overnight call money rate as the operating target of monetary policy. In particular, there is differentiation in the monetary policy transmission to the financial markets in India, being faster and persistent for the call and bond markets, to the least impactful for the forex and stock markets.

As far as the periodicity the transmission is concerned, in the first period (April 2005 to April 2011), the positive shock to the repo rate did not have any impact on the call money, while in both the second (May 2011 to June 2016, when the liquidity framework was fine-tuned with a clear operating target and introduction of term repo) and the third (July 2016 to December 2018, following the introduction of flexible inflation targeting) periods it was found to be quite high.

As already indicated, these impacts are the first stage impacts of monetary policy on financial markets. As is well known, monetary policy works through the Wall Street but wants to influence the Main Street ultimately. How can we link this story of financial markets to the real sector? This question remains unanswered in this paper and constitutes the agenda for further research.



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