Impact of financial market developments on monetary transmission mechanism

Abstract

The monetary transmission mechanism is the process through which any changes in the short term interest rate made by the central bank of the country propagate into changes in the interest rates all across the economy, thereby affecting the output and inflation. The changes in policy rates first impacts the financial and assets markets which in turn induces changes in the spending behavior of the consumers which ends up impacting the GDP and inflation. The effectiveness of the monetary transmission mechanism largely decides the amount of the control that the Central Bank exercises on the economy of a country. The effectiveness and efficiency of Monetary Transmission Mechanism in a country depends on the state of development of its financial markets which are central to the conduct of monetary policy. The monetary policy is implemented largely through operations in these markets. The penetration of the transmission of monetary policy in the real economy hinges crucially on a set of parameters that are affected by the structure of the financial system; that is, the existence and degree of development of financial markets, and changes in these markets that affect their functioning. Research shows that in India, the monetary policy transmission is largely dysfunctional because the interest rate pass through from policy rate to deposit and lending rates is not only incomplete but also suffers from huge lags as well. Because monetary transmission is weak, if a certain reduction in inflation is called for, very large changes in the policy rate have to be made by RBI. Central banks in mature market economies on the other hand are able to control inflation through small changes in the interest rate. The aim of this project is to examine the monetary transmission mechanism in India and make specific recommendations on the financial market reforms that are needed to make the monetary policy more impactful by making the transmission mechanism effective. We start with a literature review of various monetary transmission channels and how each of them react to the changes in policy rate. The next section discusses the current state of monetary transmission channels in India and examines its strength. Thereafter, we take a look at the monetary transmission mechanism from a financial markets perspective and introduce the concept of BCD Nexus. Proper functioning of this interlinked set of markets is critical for having an efficient monetary policy transmission. We then discuss the role of BCD Nexus in monetary transmission mechanism and finally close with recommendations on the kind of financial market developments that are needed in India to make the monetary transmission mechanism more effective.