Monetary policy transmission

GS Paper III

News excerpt:

Surplus liquidity normalisation and robust credit growth bolstered monetary policy transmission in India.

More details on news:

  • The RBI shifted to a tightening mode in May 2022 due to inflationary pressures from the conflict in Ukraine, global commodity price rises, disruptions in supply chains, and volatility in the global financial market.
  • Between May 2022 and February 2023, the RBI raised the repo rate by 250 basis points (bps), signalling a significant shift in lending rates.
  • The introduction of the External Benchmark-Based Lending Rate (EBLR) system for loan pricing played a crucial role in strengthening monetary policy transmission.
  • Strong credit growth during the tightening phase, with the sustained robust credit demand and moderation in surplus liquidity in the banking system, bolsters the transmission of monetary policy.
  • The transmission to term deposit rates has been robust, while savings deposit rates have exhibited rigidity.

What is monetary policy transmission?

  • The transmission of monetary policy describes how changes made by the RBI to its monetary policy settings flow through to economic activity and inflation.

Monetary policy transmission mechanism

  • RBI uses tools like interest rates to influence the economy.
  • The official interest rate changes impact market rates, expectations, asset prices, and exchange rates.
  • Altered market rates affect borrowing costs, influencing credit demand and consumption.
  • Changes in asset prices and expectations influence wealth and confidence, impacting spending.
  • Ultimately, these factors affect inflation as the central bank aims to balance economic growth and price stability.

Significance of monetary policy transmission:

  • Influence credit growth: Monetary policy transmission is pivotal in shaping credit expansion and fostering investment.
  • Influence the exchange rate: The transmission mechanism can potentially influence the exchange rate of the Indian rupee.
  • Impact on consumer expenditure: Through its influence on interest rates and credit accessibility, monetary policy transmission has the capability to impact consumer expenditure.
  • Manage inflation: Managing inflation is facilitated by the transmission mechanism, which achieves this by shaping interest rates and regulating credit accessibility.
  • Effect on interest rates: Monetary policy transmission affects the economy's prevailing interest rates.

Role of the Reserve Bank of India (RBI) in monetary policy transmission:

  • The Reserve Bank of India (RBI) plays a pivotal role in monetary policy transmission by influencing the entire spectrum of interest rates through its monetary policy rate changes.
  • The effectiveness of this transmission mechanism is crucial for achieving the ultimate objectives of price stability and economic growth.
  • The RBI aims to achieve a target inflation rate by adjusting policy rates. Effective transmission mechanisms help align the inflation expectations of businesses and consumers with the targeted rate.
  • RBI has implemented various internal benchmarks, such as BPLR, base rate, and MCLR, to guide the pricing of loans by banks.
  • The recent shift to an external benchmark system reflects the evolving strategies to enhance transparency and improve the pass-through of monetary policy signals to lending interest rates, aiming to strengthen the overall effectiveness of monetary policy in India.

Conclusion: 

Thus, surplus liquidity normalisation, robust credit growth, and the External Benchmark-Based Lending Rate system strengthened monetary policy transmission. Despite improvement in transmission, the process is not yet complete, emphasising that efforts are still underway to ensure the effectiveness of policy rate actions on deposit and lending rates.

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