The first question that needs to be addressed relates to the objective or objectives of monetary policy. A recurring question is whether monetary policy should be concerned with all the goals of economic policy. The issue of ‘objective’ has become important because of the need to provide a clear guidance to monetary policy makers. Indeed, this aspect has assumed added significance in the context of the increasing stress on the autonomy of Central Banks. Autonomy goes with accountability and accountability in turn requires a clear enunciation of the goals.

Since the inception of development planning, the broad objectives of India’s economic policy have been to achieve a faster rate of growth, ensure reasonable degree of price stability and promote distributive justice. Working of monetary policy in India over the past several decades would reveal that monetary policy has emphasised these broad objectives of our economic policy. In one of my earlier articles, I had said:

In a broad sense the objectives of monetary policy can be no different from the over all objectives of economic policy. The broad objectives of monetary policy in India have been: (1) to maintain a reasonable degree of price stability and (2) to help accelerate the rate of economic growth. The emphasis as between the two objectives has changed from year to year, depending upon the conditions prevailing in that year and in the previous year.

The question of a dominant objective arises essentially because of the multiplicity of objectives and the inherent conflict among such objectives. Jan Tinbergen had argued decades ago that there should be as many instruments as there are objectives, if all objectives are to be fulfilled. Faced with multiple objectives that are equally relevant and desirable, there is always the problem of assigning to each instrument the most appropriate objective. This ‘assignment rule’ favours monetary policy as the most appropriate instrument to achieve the objective of price stability. It is this line of reasoning which has led to the single objective approach.

The crucial question that is being debated in India as elsewhere is whether the pursuit of the objective of price stability by monetary authorities undermines the ability of the economy to attain and sustain high growth. A considerable part of the relevant research effort has been devoted to the trade-off between economic growth and price stability. Empirical evidence on the relationship between growth and inflation in a cross country framework is somewhat inconclusive because such studies include countries with an inflation rate as low as one to two per cent to those with inflation rates going beyond 200 to 300 per cent. These studies, however, clearly establish that growth rates become increasingly negative at higher rates of inflation.

The case of price stability as the objective of monetary policy rests on the assumption that volatility in prices creates uncertainty in decision-making. Rising prices adversely affect savings while they make speculative investments more attractive. The most important contribution of the financial system to an economy is its ability to augment savings and allocate resources more efficiently. A regime of rising prices vitiates the atmosphere for promotion of savings and allocation of investment. Apart from all these, there is a social dimension particularly in developing countries. Inflation adversely affects those who have no hedges against it and that includes all the poorer sections of the community. The fiscal consolidation also becomes easier in an environment of reasonable degree of price stability. In a period of rising prices, the gap between revenues and expenditures widens. Expenditures tend to grow at a faster rate than revenues because many components of expenditures such as employees’ compensation are closely linked to variations in prices.

The question that recurs very often in the minds of the policy makers is whether in the short run, there is a trade-off between inflation and growth which can be exploited. In the industrial countries, a solution is sought through the adoption of Taylor’s rule which prescribes that the signal interest rate be fixed taking into account the deviations of inflation rate from the target and actual output from its potential. In this rule, the coefficient of inflation deviation term is fixed at a level higher than unity. While the rule is intuitively appealing, there are serious problems in determining the value of the coefficients. In this context, the critical question to raise is: At what level of inflation, do adverse consequences begin to set in? It is this inflation threshold which will provide some guidance to the policy makers. Below and around this threshold level of inflation, there is greater maneuverability for the policy makers to take into account other considerations. Interest­ingly, the Chakravarty Committee regarded the acceptable rise in prices as 4 per cent. This, according to the Committee, will reflect changes in relative prices necessary to attract resources to growth sectors. I have myself indicated that in the Indian context, inflation rate in the range of 5 to 6 per cent may be acceptable. There is some amount of judgment involved in this, as econometric models are not in a position to capture all the costs of inflation. This approach provides some guidance as to when policy has to become tight or to be loosened. It is also necessary for the policy makers to note that this order of inflation is higher than what the industrial countries are aiming at. This will have some implications for the exchange rate of the currency. While the open economy helps to overcome domestic supply shocks, it also imposes the burden to keep the inflation rate in alignment with other countries.

The second issue relates to the intermediate target. In India since the mid Eighties the target chosen has been broad money. The Chakaravarty Committee recommended a system of flexible monetary targeting. It is true that central banks in several countries in the industrial world have abandoned intermediate targets and have focussed on the final target such as inflation control. While this has the advantage of specifying the ultimate objective in clear and precise terms, it must be admitted that there is some uncertainty regarding the route through which this will be achieved. One of the reasons for the abandonment of intermediate targets in these countries has been the breakdown of the relationship between monetary aggregates and the inflation rate. The demand function for money has been found to be unstable. However, in India, studies show that the money demand function is a stable function of select variables and it can be used to reasonably predict inflation. Several statistical functions of the demand for money estimated by using the equilibrium and disequilibrium analysis provide overwhelming evidence on the long run stability of the money demand function. Perhaps some of the factors that have contributed to the instability of the demand function for money in the industrially advanced countries such as financial innovations and large movements of funds across the border are yet to have the same impact in India. In the demand function for money in India, income emerges as the most dominant variable. Such a function enables the authorities to estimate the appropriate growth in money supply, given the expected increase in real output and the acceptable level in price increase. With the freeing of the interest rate structure, interest rate may also emerge as an appropriate intermediate variable in the coming years. In fact, with the inflation rate coming down and remaining in a narrow range, it will be possible to focus on interest rate along with overall monetary aggregates. However, as of now, money supply seems to be an appropriate target. Such a target is relatively well understood by the public and provides unambiguously the stance of monetary policy.

The literature on monetary economics talks of four distinct monetary transmission channels. They are (1) Quantum Channel, especially relating to money supply and credit, (2) Interest Rate Channel, (3) The Exchange Rate Channel and (4) The Asset Prices Channel. While the emphasis in India so far has been on the quantum channel, with the development of financial markets and closer integration of such markets, the interest rate channel will assume importance. It must be noted that at the equilibrium both quantity and price are determined. Changes in interest rates cannot be ordained. The appropriate quantitative changes in money will have to be brought about even though the signal for change may be given by the price variable like interest rate.

Another question of importance that has arisen relates to the appropriate level of interest rate. The nominal interest rate comprises of three elements: (1) the real rate of interest; (2) inflation expectations; and (3) a discount factor for uncertainties. The effectiveness of monetary policy to bring down the nominal interest rate will depend on the impact that this policy will have on inflation expectations and on the perception of uncertainty in the economy. A monetary policy that is geared to maintain reasonable price stability, if it is successful, can help to bring down the interest rate in sympathy with the downward drift in inflation. Inflationary expectations can be broken, if the monetary authority enjoys high credibility. However, this leaves the real rate of interest to be determined. The real interest rate is not an observed variable. The real interest rate is influenced by several long-term factors such as saving and investment balance in the economy and the rate of return on capital. Theory tells us that on an economy-wide basis, this rate should not exceed the real rate of growth. In fast growing economies the real rate of interest will be higher. In South Korea during the years of very rapid economic growth the real rate of interest was around six to seven per cent in several years. The real rate of interest is thus related to the rate of growth of the economy. In the early 1990s in India, the real rate of interest was low because the inflation rate was in the range of 8 to 10 per cent. However, with the break in the inflation rate beginning 1996–97, the real rate of interest has gone up. As mentioned earlier, the inflation rate on an average has remained at less than five per cent since 1996–97. However, it must be kept in mind that the real rate of interest will have to be relatively higher in developing economies which seek to maintain a high savings rate and which aim at growing at more than six to seven per cent per annum. This is typically the situation in India. A situation of high real rate of interest accompanied by high growth rate must be distinguished from other situations when real rates of interest may remain high. In this context, it is worth noting that the high level of nominal interest rate in developing economies may also be due to high intermediation costs. Improved efficiency can reduce the spread between the deposit rate and lending rate and bring the lending rate in closer alignment with fundamental factors.

The role of monetary authority in exchange rate management came into focus in the 1990s. Since 1975, the exchange rate of the rupee was deter­mined with reference to the daily exchange rate movements of a selected number of currencies of the countries which were India’s major trading partners. The Reserve Bank of India was required to maintain the exchange rate within a band on either side of a base ‘basket’ value. This allowed the achievement of a medium-term real effective exchange rate (REER) objective through changes in the NEER. Such a regime could be maintained only with the support of extensive exchange controls and import controls. The reform measures introduced in 1991 included significant changes in the foreign trade regime and exchange rate management. The devaluation of the rupee in mid 1991 was followed by a system of dual exchange rate system in March 1992. A year later, the dual system was abolished and the country moved towards a unified market determined exchange rate system. The monetary authority does not intervene in the market process of rate determination as long as orderly conditions prevail in the exchange market and the exchange rate reflects macro economic fundamentals.

The approach to exchange rate by the monetary authorities in the developed world generally has been to let the market determine the rate. However, there have been several exceptions. There have been occasions when central banks in these countries have intervened, some times in a concerted way, when exchange markets became volatile. The Indian experience with market determined exchange rate system is that there have been several occasions when the RBI had to intervene strongly to prevent volatility. This happened in 1995 and 1996 and later in 1997 and 1998 at the time of the East Asian crisis. The impact of the East Asian crisis on the Indian market was minimal. This was partly due to the reason that while India subscribed to current account convertibility under Clause VIII of the IMF agreement, the capital account liberalisation was undertaken cautiously. Besides, India’s current account deficit during this period was low. In fact, in 1991, a High Level Committee on Balance of Payments had made specific recommendations regarding the level of current account deficit, the size and composition of capital flows, the management of external debt including short-term debt and the quantum of foreign exchange reserves. Implementation of these recommendations stood India in good stead at the time of the East Asian crisis.

In narrow under developed markets like in India, there is a tendency for the herd instinct which amplifies the fluctuations. This can cause volatile and destabilising movements in the exchange rate which may go beyond any correction, required by the fundamentals. Even in developed markets there is a tendency for the market to ‘overshoot’, when a critical mass in terms of the perception of overvaluation in the exchange rate is reached. With narrow markets, the danger is greater. On such occasions, the monetary authority has to step in to ensure orderly market conditions. The monetary authority must, however, recognise that integration of markets is inevitable and therefore action must be spread across the markets to achieve results.

In developing economies like India, trade flows both visible and invisible, dominate the balance of payments. That is why for the exchange rate regime in India, continuous monitoring of the real exchange rate with an appropriate base becomes important. It provides valuable information to the authorities on the behaviour of the current account to which it is intrinsically linked. A monetary policy geared to domestic price stability in this situation helps to avoid disruptive adjustments in the exchange rate. In that sense monetary policy and exchange rate management become intertwined.

Increasingly macroeconomic stability as an objective of central banking is closely linked to financial stability. It is easy to see how the two are inter linked. Financial stability broadly implies the stability of the important institutions and markets forming part of the financial system. Financial stability requires that the key institutions in the financial system are stable, in that, there is a high degree of confidence about meeting contractual obligations without interruption or outside assistance. While the complementarity between the objectives of macro stability and financial stability is easily recognised, the one question that needs to be addressed is whether there can be a conflict between the two objectives. It is not inconceivable to have situations in which the price stability objective might call for a restrictive policy, while the financial market conditions may demand a somewhat liberal policy to provide relief. The Reserve Bank of India was extremely conscious of this dilemma. Banking sector reforms were in full swing in the 1990s which necessarily put the banking system under strain. While facilitating the smooth transition, RBI took care that there was no dilution of the basic objectives of monetary policy. However, viewed as part of overall economic stability, financial stability need not run at cross-purpose with other dimensions of macro economic stability. Normally, price stability should provide an environment favourable to financial stability. If on occasions dealing directly with financial stability becomes necessary, it must be done as in the case of intervention in the foreign exchange markets. Actions to maintain financial stability in those circumstances may be in the long run interest of economic stability.

Autonomy of central banks has become an article of faith in the industrial countries. It has been written into the constitution setting up the European Central Bank. The literature on this subject is growing. There is a general consensus to give instrument independence to central banks among countries that have decided that the single objective of monetary policy is inflation control. Autonomy implies discretion to central banks to decide on the timing and nature of monetary policy intervention. It also calls for transparency in relation to both objectives and strategies. The increased use of explicit targets by central banks is part of the broader move to build credibility through transparency. It is quite true that in India, monetary policy has been very much conditioned by the stance of fiscal policy. The system of the scheme of ad hoc Treasury Bills facilitated monetisation of the fiscal deficit without limit and without prior approval.

The 1990s saw the phasing out of the system and the introduction of the scheme of Ways and Means Advance. This was a major step towards the achievement of greater discretion. The Fiscal Responsibility Bill that is now before the Indian Parliament takes this to its logical conclusion. When enacted this would be a great step forward not only in fiscal but monetary management. Two associated comments may be made in this context.

First, an autonomous central bank does not mean lack of coordination with the Government. Nor does it imply lack of harmony. In fact, harmony in the sense in which it is used in classical symphonic music will be achieved. In a symphony, different artistes play different notes simul­taneously but in effect create a blend that produces the best of music. However, the stances of monetary policy and fiscal policy cannot run at cross-purposes. For example, a lax fiscal policy accompanied by a tight monetary policy can lead to a sharp increase in interest rate. On the other hand, an accommodative monetary policy in a period of lax fiscal policy can lead to explosive increase in prices. While monetary and fiscal coordination is desirable, it is important at the same time that the monetary authority which has its own specific agenda must have the institutional autonomy and should not be burdened with functions which may come in conflict with its own special objective. It is in this context that the Reserve Bank of India and Government of India are examining the issue whether the management of public debt can be delinked from RBI.

Second, the emergence of an autonomous central bank does not mean that the ‘state of bliss’ has arrived. It only enables the central bank to pursue a consistent monetary policy over a long time. Then the onus of responsibility for the conduct of monetary policy will rest on the shoulders of the Reserve Bank, where it should logically rest. In an open economy, the task of the central bank will be rendered more difficult if it does not have the autonomy and discretion to make changes quickly in response to external shocks.

There was a time when it was said that central banking was neither a science nor an art but a craft. This is at best a half-truth. Central banking has never been a case of applying well known remedies to well known problems. ‘Rules versus discretion’ has been a subject of long-standing debate in monetary policy. Rigid rules such as those implicit in gold standard will give to central banks no room for maneuverability. On the other hand, total discretion with respect to objectives and instruments will make monetary policy indeterminate. That is why the new phrase ‘constrained discretion’. This will require the central banks to be transparent and explicit with respect to objectives and strategies, while leaving the freedom to them to choose the timing and nature of their actions. This is the type of autonomy towards which every central bank should move.