Monetary transmission refers to the process by which a central bank rsquo s monetary policy decision...........

Economic Affairs Money Supply and Monetary Policy

Monetary transmission refers to the process by which a central bank’s monetary policy decisions are passed on to the financial markets. Monetary transmission remains weak in India due to

1. High volume of government borrowing through the SLR route

2. High level of NPAs of banks

3. A number of Interest rate subvention schemes

Select the correct answer using the codes below.

1 only

2 only

2 and 3 only

1, 2 and 3

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Explanation:

It is essentially the process through which the policy action of the central bank is transmitted to the ultimate objective of stable inflation and growth. The policy action consists typically of changing the interest rate at which it borrows or lends “reserves” (in our case, Rupees) on an overnight basis with commercial banks. The transmission mechanism hinges crucially on how monetary policy changes influence households’ and firms’ behavior. This change can take place through several channels. Studying these channels is a vast subject in finance and economics literature. Changes in the central bank’s policy rate impact the economy with lags through a variety of channels, the primary ones being (i) interest rate channel, (ii) credit channel, (iii) exchange rate channel, and (iv) asset price channel. How these channels function in a given economy depends on the stage of development of the economy and its underlying financial structure.

Statement 1: A large part of bank’s deposits are lent to the government through the SLR route at a certain interest rate, which is not responsive to the general interest policy in the economy.

Statement 2: The implicit assumption here is that bank balance sheets are strong and in a position to step-up quickly the supply of credit in response to lower funding cost and higher demand for credit – the bank lending or the credit channel of transmission. Cross-country evidence indicates that monetary transmission is greatly hindered if bank balance sheets are weak in that they do not have much loss-absorption capacity to deal squarely with their problem.

Statement 3: If major schemes keep sub venting interest rates, even if the banks change the interest rate, it will not elicit a response from the public because they are anyways borrowing funds at a lower interest rate (due to the interest subvention).

Also, monetary transmission also remains weak in India due to following reasons:

Practice of yearly resetting of administered interest rates on small savings (including public provident fund) linked to G-sec yields Sticky bank rates