Aim of any monetary policy is to achieve growth with price and financial stability.
Monetary policy framework in India has undergone a major shift, particularly with the adoption of liquidity adjustment facility (LAF) as the operating procedure of monetary policy.
See more details on LAF framework in my blog article here (Click it)
As a result, since the beginning of the 2000s, change in policy interest rate has occupied the central role in signaling the stance of monetary policy. However its important how these signals are transmitted through the financial system and the economy and how businesses and households react.
Monetary policy transmissionis a process through which monetary policy decisions affect the economy in general and the price level in particular.
Major monetary policy transmission channels are:
> Interest Rate Channel
> Exchange Rate Channel
> Credit Channel
Other monetary transmission channels are asset price channel, base rate channel etc. .
With the short-term interest rates emerging as the predominant instrument of monetary signals worldwide, the interest rate channel is the key channel of monetary transmission.
1) Interest Rate Channel:
Policy rates of any Central bank targets the short term nominal interest rates. This then has cascading effect as follows:
short term nominal interest rate --> long term nominal interest rate --> long term real interest rates
Higher real interest rates affect spending and investment behaviour of individuals as well as firms. By reducing disposable income, higher real interest rates depress current consumption. At the same time, higher real interest rates encourage current savings.Similarly, an increase in interest rates reduces profits of the firms. This makes fresh investments less attractive. Overall, consumption and investment declines which contracts output. This, in turn, pulls prices downwards.
RBI has increasingly been using interest rate channel in its monetary policy.
(Note: This is the keynesian IS-LM curve theory )
2) Exchange Rate Channel
The transmission of monetary policy through interest rates has secondary impact on exchange rates. Higher interest rates make domestic financial assets attractive and this induces an appreciation of the domestic currency. This has both a direct and indirect effect on prices. Appreciation of the exchange rate lowers domestic prices of imports (the direct effect). At the same time, appreciation of the domestic currency adversely affects the external competitiveness of the economy. This leads to a reduction in net exports and, hence, in aggregate demand and output leading to a decline in prices (the indirect effect).
Both the direct and indirect effects work in the same direction, i.e., reduce prices (lowering inflation).
3) Credit Channel
Again, rise in interest rate lowers profitability of firms. This makes them more difficult to obtain credit, thereby lowering investment and ultimately aggregate demand of the economy.