Reserve Bank I Intellectual Stirrings

20. Monetary policy in the past has been fashioned largely on the lines of specification of the desirable rate of expansion in broad money (M3) which is worked out on the basis of the response of demand for real money to income growth and the tolerable rate of inflation. Most studies in India have shown that money demand functions have so far been fairly stable. However, the financial innovations that have recently emerged in the economy provide some evidence that the dominant effect on the demand for money in the near future need not necessarily be real income, as in the past. Interest rates too seem to exercise some influence on the decisions to hold money.

21. It is not easy to evolve, in the present circumstances, a monetary conditions index or a clear-cut interest rate channel of transmission of effects of monetary policy. The information base required for such an exercise is substantial. In the absence of frequent data on output developments with minimal lags, and on turnovers in different markets, the information on rate movements alone would not give a full picture of the monetary conditions, and therefore, such information should be interpreted with circumspection. It can, however, be utilized in conjunction with other more reliable indicators for purposes of policy-making. As a first step to move in this direction, it is necessary to adopt a multiple indicator approach wherein interest rates or rates of return in different markets (money, capital and government securities markets) along with such data as on currency, credit extended by banks and financial institutions, fiscal position, trade, capital flows, inflation rate, exchange rate, refinancing and

transactions in foreign exchange available on high frequency basis are juxtaposed with output data for drawing policy perspectives. An exercise of this sort should help the Bank to evolve over time a model for estimating liquidity in the economy in the performance of its day-to-day operations.

The way I interpret this passage is as follows. Governor C Rangarajan was quite obdurate on one point. He had studied economics on the east coast. When he was growing up in that hive of intellect, a monetary history of the United States, written by Milton Friedman, was making waves. In that book Friedman showed that in the long run, there was amazingly close correlation between the nominal national income of the United States and money supply which implies close correlation between inflation and the excess of money supply growth over growth of real income. This harked back to the quantity theory that money supply was associated with the product of income growth and inflation. From which the conclusion could be drawn that the way to rein in inflation was to control money supply. This doctrine made a deep impression upon young Rangarajan; and when he became governor, he had a chance to put the grand theory to work.

Governor Jalan comes from a different stock: he is a Cambridge man. John Maynard Keynes, the most influential Cambridge economist, attacked the quantity theory with great vigour in his General Theory. In his view, the primary impact of a change in money supply was not in the market for goods and services, but in the market for financial securities. The stocks of money and of financial assets were fixed in the short run; their holders could not influence the supply. At the same time, no one had to hold financial assets he did not want to hold: he could always sell securities, and spend money. What stocks they wanted to hold had to be equal to the available stocks. Both were brought into equality by changes in the interest rate. If, for instance, the stock of money increased, then the interest rate went down and security prices went up. The rise in their prices persuaded some of their holders to sell them and hold money instead; the interest rate came down till asset holders changed their asset

preferences so as to accommodate the increased stock of money.

This did not mean that the market for goods and services was not affected by changes in money supply; but the effect came through the financial markets. If the interest rate went down, industrialists were induced to increase investment; higher investment increased production and incomes, and increased incomes were spent on goods and services. But the effect of changes in money supply on output and prices was indirect, and mediated through the financial markets.

Bimal Jalan remembered some of what he had learnt 35 years ago, and was not so thoroughly indoctrinated by Chicago monetarism as his predecessor. So he expressed doubts about the orthodoxy, and wondered whether demand for money was not interest-sensitive. When he disclosed these thoughts to his satraps in the Reserve Bank, they were a bit stuck.. Although they had heard of Keynes and Friedman, they had only a vague idea of what those people had said; and at their level it would have been infra dig to call a younger and brighter person and ask her what it was all about. They also felt some loyalty to Rangarajan, and felt they could not jettison monetarism simply because he was now governor of another kind. But they could not deflect Jalan from his obsession. So they concocted the above two paragraphs of gobbledygook.

Insofar as those paragraphs mean anything, whoever wrote it is thinking of what he once read about the Federal Reserve (quite possibly something I had written in 1996). The Federal Reserve has a powerful economic division. It monitors hundreds of series, and its chief feeds the Federal Reserve Board with sophisticated economic analysis. The satraps of the Reserve Bank also dreamed of building a vast new economic division which would collect hundreds of series and employ thousands. But they would like to build it up slowly, so that no results had to be delivered for as long as possible.

If this is what they had in mind, they are mistaken. The Federal Reserve Board has a very simple remit: it meets periodically to decide what the Treasury bill rate should be; based on its decision, the Federal Reserve varies its Treasury bills issues to achieve the target rate of interest. The Treasury bill rate is the base rate for all other interest rates, private and public, and thus determines the cost of borrowing; through this cost of borrowing, the Federal Reserve seeks to accelerate or decelerate investment and economic activity, precisely as Keynes said. It does not bother itself about money supply; in fact, some 40 per cent of US currency circulates abroad, and the more of it goes abroad, the better for the US government, which treats it as a perpetual interest-free borrowing. The US government does not interfere with the Federal Reserves decisions on the interest rate. It is inconceivable that the Government of India would ever be equally indifferent to what interest rate the RBI fixes. The US

model is quite inappropriate for India until public borrowing becomes insignificant here.