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This paper examines the transmission mechanism of monetary policy in India. Considering the external constraints on monetary policy, it estimates a series of vector autoregression models to examine the effects of an unanticipated monetary policy tightening on the real sector. The empirical results suggest that the lending rate initially increases in response to a monetary tightening. Banks play an important role in the transmission of monetary policy shocks to the real sector.

Monetary policy affects the real sector at least in the short run, and monetary policy decisions are transmitted to the real sector through different mechanisms. These mechanisms differ from one country to another depending upon their legal and financial structures. Since the beginning of the 1990s, analysis of monetary transmission mechanisms in emerging economies has gained substantial importance due to structural and economic reforms and subsequent transitions to new policy regimes. However, these economies have specific characteristics that differ from those of industrialized countries. Monetary policies in emerging economies are constrained by the world's major central banks, i.e., the Federal Reserve Bank, the European Central Bank and the Bank of Japan. Hence, the analysis of monetary transmission mechanisms in emerging economies requires a model specification different from that of developed countries. A model misspecification may bias the results. The so-called price-puzzle is one of the consequences of model misspecification (Sims, 1992). Previous empirical studies concerning monetary transmission mechanisms in emerging countries have established the importance of the bank lending channel. However, it is possible that the entire change in aggregate demand after a monetary policy shock occurs via the traditional money channel. Whether the effects of monetary tightening pass through the bank lending channel and not through the traditional money channel remains to be shown. Central banks in emerging economies stabilize exchange rates.1 A flexible exchange rate regime in these economies resembles a de facto peg. Since these economies are characterized by underdeveloped financial markets, their central banks intervene in foreign exchange markets to stabilize exchange rates. This phenomenon is often explained by the hypothesis of “fear of floating” (Calvo & Reinhart, 2000). Given this specific behavior of central banks in emerging economies, a better understanding of monetary transmission mechanisms requires an analysis of not only the response of aggregate demand, but also the response of the exchange rate to a monetary policy shock. In the post-reform period, the Reserve Bank of India has adopted market-oriented monetary policy instruments and operating procedures. In the new monetary policy framework, issues related to monetary transmission mechanisms have gained much importance. Some studies have examined specific transmission channels of monetary policy in India.2 Since these studies suffer from the above-mentioned flaws, by taking into account these observations and providing a comprehensive empirical analysis of monetary transmission mechanisms in India, we hope that our work will have important implications for an emerging economy. In this paper, we examine three channels of monetary transmission in India: the bank lending channel, the asset price channel and the exchange rate channel. The paper proceeds as follows. In Section 2, we review the previous work on monetary transmission mechanisms. In Section 3, we propose a benchmark vector autoregression (VAR) model in order to estimate the dynamic responses of GDP, prices and interest rates to an unanticipated monetary policy tightening. In Section 4, we augment the benchmark VAR model to examine the transmission channels of monetary policy and examine the robustness of our results. We conclude in Section 5.

The existence of external constraints on monetary policy in emerging economies requires a model specification different from that of developed countries. This paper provides a comprehensive empirical analysis of the monetary transmission mechanism in India. We estimated a series of VAR models to examine three transmission channels of monetary policy. The benchmark VAR model is composed of a vector of endogenous domestic variables and a vector of exogenous foreign variables. We imposed restrictions on the contemporaneous effects of endogenous variables to have an exact identification of the benchmark VAR model. The results of the benchmark VAR model suggest that an unanticipated monetary policy shock has transitory effects on the overnight call money rate. The price-puzzle vanished after the inclusion of the vector of exogenous foreign variables. Prices and GDP decline after an unanticipated positive overnight call money rate shock. Moreover, prices start declining after a decline in GDP. The Indian economy is a bank-based economy. Since 2005, bank credit to the commercial sector has accounted for more than 70% of total domestic credit. The currency to deposit ratio has declined continuously since 1999. These facts suggest that the banks play an important role in financial intermediation and that the non-financial sector lacks alternative sources of funding. Our empirical results support the importance of the bank lending channel in the transmission of monetary policy shocks to the real sector. The lower market capitalization of listed companies in India as compared to developed countries suggests that the capital markets in India are not sufficiently developed. Empirical estimates in the augmented VAR model suggest that the asset price channel is not important in the transmission of monetary policy shocks to the real sector in India. Central banks in emerging economies stabilize exchange rates even though they announce that they do not do so. Massive interventions by the Reserve Bank of India in the foreign exchange market to stabilize the exchange rate weaken the exchange rate channel. The short-lived response of the real effective exchange rate to an unanticipated monetary policy tightening suggests that the exchange rate channel is not important in the transmission of monetary policy shocks in India. This analysis provides some important theoretical and policy implications. First, Indian monetary policy is constrained by the Fed's monetary policy. Hence, an analysis of Indian monetary policy requires the inclusion of the federal funds rate in the information set of the Reserve Bank of India. A proper model specification, considering the external constraints on monetary policy and controlling for international economic events, reduces the bias. Second, the Reserve Bank of India intervenes massively in the foreign exchange market to stabilize the exchange rate. The Indian rupee seems to be pegged to the US dollar. Hence, a proper comprehension of the monetary transmission mechanism in India requires the analysis not only of the response of GDP, but also of the response of the exchange rate to a monetary policy shock. Third, banks play an important role in financial intermediation in the Indian economy, and their strong representation reflects the lack of alternative sources of funding for the private sector.