Liquidity Management and Monetary Transmission: Empirical Analysis for India

Author: Vikas Charmal and Ashima Goyal

Title: Liquidity Management and Monetary Transmission: Empirical Analysis for India

Abstract: A change in monetary operating procedures provides a natural experiment we use to evaluate first, whether Indian monetary policy transmission is better when durable liquidity is in surplus or when it is in deficit; second is it better with interest rates as the policy instrument or quantity of money or a mixture of the two. After showing our period of analysis can be divided into two liquidity regimes, we estimate separate structural vector auto-regressions for the financial and real sector, as well as SVARs for the whole period with alternative operating instruments. Monetary transmission from the repo rate was better during the period the liquidity adjustment facility (LAF) was in surplus with the central bank in absorption mode denoting excess durable liquidity. Pass through was faster and the repo rate had a greater influence on other variables. The impact of the rate on output gap exceeds that on inflation. The weighted average call money rate was found to outperform others as the operating target. Monetary policy has evolved so that policy rates are more effective in transmission compared to money supply, but best results are when durable liquidity is also in surplus. The results suggest keeping the LAF in deficit mode over 2011-19 was not optimal.

Keywords: Monetary transmission; liquidity deficit and surplus; repo rate; instrument; operating target

JEL Code: E52; E58; E65