The empirical estimates suggest that short end of the financial market, particularly the call money rate, exhibits a significant and contemporaneous (instantaneous) pass-through of 75 - 80 basis points in response to a percentage point change in the monetary policy rates under deficit liquidity conditions and phases of relatively tight monetary policy. The state of liquidity in financial markets is found to play an important role in conditioning the pass-through of policy rate changes to short end of financial market. A significant asymmetry is observed in the transmission of policy rate changes between the surplus and deficit liquidity conditions, particularly at the short end of financial market, suggesting that maintaining suitable liquidity environment is critical to yielding improved pass-through. There is also considerable asymmetry evident in the transmission of monetary policy to financial markets depending on the tight or easy cycles of monetary policy, which suggests the criticality of attaining a threshold level for the policy rate under each cycle to have desired pass-through. Medium to long term rates such as bank deposit and lending rates also exhibit asymmetrical response to policy rate changes under varied market conditions. The results from the VAR model reiterate that it is the strong presence of transmission lags that leads to higher degree of pass-through to financial markets, thus, underscoring the importance of a forward-looking approach. JEL classification : E52, G1
Keywords : Monetary policy, financial markets; transmission channels Introduction
Notwithstanding a rich theoretical foundation and large body of empirical literature on monetary policy transmission, policy makers continue to face considerable uncertainty about the impact of policy changes given the lack of direct interface of monetary policy actions with real economic activity, existence of complexities in financial * Author is Executive Assistant to Deputy Governor and Director in the Department of Economic and Policy Research of the Reserve Bank of India, Mumbai. Views expressed in the paper are the sole responsibility of the author. The initial findings of the paper were presented in a seminar at the School of Communication and Management Studies at Cochin on October 21, 2011. The author was immensely benefitted from the comments offered by the participants and discussants at the Annual Research Conference of the Department of Economic and Policy Research of the Reserve Bank of India held at Mumbai on November 25, 2011. Author would also like to thank anonymous referees of the paper for providing technical comments which helped in further improving the paper. Author has also benefitted from technical comments offered by Dr. B. K. Bhoi, Adviser and Dr. Harendra Behera, Research Officer of the Monetary Policy Department of the Reserve Bank of India. Author’s correspondence email is bhupal@ rbi.org.in.
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markets and presence of transmission lags. The presence of long transmission lags also make it challenging to disentangle the impact of monetary policy shocks from other exogenous shocks that may occur in the interregnum. This lack of certainty in actual magnitude and the timing of impact of policy changes on financial and real variables build in considerable caution in policy decisions. Bernanke and Gertler (1995), while raising the concern about the lack of understanding about the transmission mechanism observed that “the same research that has established that changes in monetary policy are eventually followed by changes in output is largely silent about what happens in the interim. To a great extent, empirical analysis of the effects of monetary policy has treated the monetary transmission mechanism itself as a ‘black box’.” Although this may not be true for many advanced economies where there are less imperfections in asset, labour and goods markets, many developing economies...
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