Analyze the Trade-Offs between Inflation Control, Exchange rate Stability, and Ensuring Adequate Access to Credit for Businesses and Households
 
Saumya Rajvanshi1*, Dr Gaurav Singhal2
1 Research Scholar, Sunrise University, Alwar Rajasthan, India
Email:  saumyaa26@gmail.com
2 Professor, Dept.of Economics, Sunrise University, Alwar Rajasthan, India
Abstract –
Introduction: Monetary policy, as a component of macroeconomic policy, has an influence on both economic growth and financial stability.
Aim of the study: the main aim of the study is to Analyze the Trade-Offs Between Inflation Control, Exchange Rate Stability, And Ensuring Adequate Access To Credit For Businesses And Households
Material and method: The data used in this research has been obtained from the Reserve Bank of India, Government of India - Ministry of Statistics and Program Implementation (MoSPI), Ministry of Labour and Employment (MoL&E), and Ministry of Finance (MoF) for the purpose of empirical analysis.
Conclusion: The research aimed to analyze the response of macroeconomic variables to monetary policy and get a deeper understanding of the transmission mechanism that drives them.
Keywords - Financial, Business, Inflation, Growth, Macroeconomic, Transmission
INTRODUCTION
Monetary policy, as a component of macroeconomic policy, has an influence on both economic growth and financial stability. The Reserve Bank of India (RBI) uses interest rates as a tool to directly influence inflation and economic development, hence implementing monetary policy. The impact of monetary policy intervention on the real economy has been a focal point in academic research and public policy discussions. Interest rates, as a crucial metric for financial markets, have a significant influence on the economy. Policy-makers and scholars confront a hard problem in identifying the transmission mechanism of monetary policy, which operates via interest rates, on economic growth. The interest rate is a distinct tool that has a significant influence on several industries. An elevated interest rate may discourage investment while simultaneously luring the essential influx of money for economic expansion, resulting in an appreciation of the currency rate and negatively affecting exports. In a financially limited nation, the cost of borrowing often increases when interest rates rise. This, in turn, hampers economic development by reducing investment in both the public and private sectors. Investments may exhibit significant responsiveness to fluctuations in interest rates, but it can be said that other factors, such as uncertainty, also influence investment choices. In recent years, there has been an increased dependence on monetary policy tools to provide stability in production levels and manage inflation rates, particularly after 2008. This phenomenon has been notably evident in the majority of developed countries, where there has been a persistent lack of inflation (often below the desired objective). Despite implementing expansive monetary policies for a prolonged time, many economies nevertheless encounter low levels of inflation. An problem that has been discussed in recent research is to the efficacy of unconventional monetary policy since 2008, when interest rates have remained consistently low, frequently reaching zero or even negative values. Due to the Covid-19 pandemic, unconventional monetary measures are once again being used. Nevertheless, it is premature to evaluate its transmission and influence on factors such as GDP, investment, inflation, and so on.
Monetary policy and financial stability in EMEs
EMEs and AEs vary in several aspects, many of which contribute to the complexity of their policy trade-offs. While certain emerging market economies (EMEs) had a period of moderate macroeconomic and financial stability in the late 1990s and early 2000s, most of them have recently faced debt and currency crises, as well as times of elevated inflation. This gives rise to a multitude of extra challenges for the formulation of policies. Price stability being a relatively recent occurrence means that inflation expectations in emerging market economies (EMEs) are more likely to fluctuate, making it more challenging for monetary policy to achieve low inflation compared to advanced economies (AEs). Furthermore, the relatively recent emergence of currency stability suggests that in some emerging market economies (EMEs), the public may have less faith in the robustness of their own currency. Therefore, these nations have a higher prevalence of currency mismatches, leading to increased macrofinancial risks. The existence of these mismatches means that currency depreciations might have adverse repercussions on balance sheets.
EMEs vary from AEs in their greater dependence on foreign credit and capital flows. The significance of capital flows for the expansion of credit and the stability of the financial system in emerging market economies (EMEs) was first recorded in the literature on currency crises. Based on this literature, it is suggested that emerging market economies (EMEs) experience significant inflows of capital for an extended period of time, which can be attributed to global factors like reduced global risk aversion or loose monetary conditions in global financial centers, as well as domestic factors like a more stable macroeconomic environment. This influx of capital leads to the accumulation of macrofinancial imbalances, such as excessive credit growth, in EMEs. Nevertheless, this process eventually reaches a conclusion, and an abrupt cessation results in a reversal of capital flow. This compels the authorities, within the framework of a fixed exchange rate system, to safeguard the peg until reserves are utilized. Consequently, this depletes the availability of credit, leading to a devaluation and potentially instigating a financial crisis.
LITERATURE REVIEW
Topic-Pavkovic, Branka & Šoja, Tijana (2023) The primary and essential goal of the currency board system is to ensure and preserve monetary stability, particularly in the aftermath of political and economic upheavals like the one saw in the Balkans during the 1990s. The central bank's very restricted mandate has effectively regulated financial institutions and governments, although it is not conducive to sustainable economic development and employment. This strategy establishes a fixed exchange rate between the home currency and the 'peg' currency, resulting in inflationary tendencies in the nation whose currency is used as the 'peg'. The current high inflation rates are attributable to both the pandemic problem and the conflict in Ukraine. This research examines the factors contributing to inflation in Bosnia and Herzegovina and Bulgaria, both of which have implemented currency boards. The findings indicate that inflation in these two nations is a consequence of 'imported inflation' stemming from two factors: the monetary policies implemented by the European Central Bank and the inflationary patterns seen in the European Monetary Union. However, the primary cause may be attributed to the Ukraine conflict, which subsequently led to an oil and food crisis.
Pratiwik, Erida & Prajanti, Sucihatiningsih (2023) The recurrent implementation of policy dynamics regarding Quantitative Easing (QE) and interest rates by The Federal Reserve can induce swings in the currency rate, even inside Indonesia. Hence, the objective of this research is to examine the causes and consequences of currency fluctuations. The variables utilized to assess the factors influencing the Exchange Rate (NT) using Auto Regressive Distributed Lag (ARDL) were Inflation (INF), Money Supply (LJUB), Open Market Operations (OPT), Foreign Exchange Reserves (LCD), Expected Inflation (LEHU), and Interest Rates (SB). The analysis of the effect of NT shocks was conducted using Vector Auto Regressive (VAR) models, including the LEHU, Residential Property Price Index (PIHPR), Stock Transactions (LTRANS), and Banking Credit Volume (VK) variables. The inclusion of the Expected Inflation variable and the use of ARDL-VAR methodology are innovative aspects of this research. The ARDL findings for the time series data from January 2014 to September 2022 indicate that both INF and LJUB have a favorable impact on NT in both the long and short term. Conversely, OPT, LCD, and SB have a negative impact. The LEHU had an adverse impact in the near term, but a beneficial impact in the long term. The model exhibited a monthly speed of adjustment of 49.86%. The influence of NT shock was felt by VK for a duration of 15 months, whereas PIHPR had an impact at 7 months, LTRANS at 10 months, and LEHU at 14 months. These findings suggest that the monetary authority should prioritize maintaining stability of the NT, particularly via INF and LJUB transmission. Furthermore, it is crucial to address the repercussions of shock, particularly on VK. This study only focuses on the monetary sector, whereas future research will include other macroeconomic factors for greater precision.
Juhro, Solikin & Rummel, Ole (2022) This section provides an analysis of monetary policy, including fundamental ideas and concepts, monetary policy frameworks, and the progression of monetary policy from the pre-1997/98 Asian financial crisis era to the post-2008/09 global financial crisis (GFC) era. The ITF remains a dependable monetary policy approach, all things considered. Nevertheless, as a result of past issues, particularly those that arose following the global financial crisis of 2008/09, several central banks must enhance their monetary policy framework by implementing a flexible Inflation Targeting Framework (ITF). This approach aims to collectively stabilize both inflation and the real economy in the near term.
Jacob, Tom & Raphael, Rincy (2021) Exports have been more vital in India's economic performance since liberalization. This research study aims to analyze the factors that influence exports in India, specifically focusing on inflation and currency rates, given the significant role of exports in the Indian economy. The primary data for the research is gathered from the RBI Database 2020 over a period of 25 years (1995 to 2020). The research used econometric approaches such as the Augmented Dickey Fuller (ADF) Test, Johansen's Co-integration Maximum Likelihood Test, and Vector Error Correction Model (VECM). To analyze the stability of the variables, examine the long-term link between macroeconomic factors and exports, and understand the dynamic interactions between the model's variables. The findings of this research indicate that all factors have a statistically significant influence on export performance. Specifically, it is seen that both the exchange rate and inflation have a favorable effect on export performance in India. These results indicate that there are policy implications for controlling inflation and the exchange rate system in order to boost exports in India and achieve overall economic development.
Guzman, Martin & Ocampo, José & Stiglitz, Joseph (2018) This article examines the impact of real exchange rate (RER) policies on fostering economic growth. Markets provide an insufficient level of investment in industries that are defined by the transfer of knowledge and skills. We demonstrate that implementing a stable and competitive Real Effective Exchange Rate (RER) policy may effectively address this externality as well as other market failures that are interconnected. The resultant expansion of these industries contributes to a more rapid overall economic growth. A multi-tiered exchange rate system is necessary when there are variations in spillovers across various sectors engaged in international trade. The effectiveness of RER policies is enhanced when they are accompanied with conventional industrial policies that improve the flexibility of the overall supply in response to changes in the RER. Interventions in the foreign currency market and management of capital flows are necessary mechanisms for achieving a stable and competitive Real Effective currency Rate (RER). We also analyze the compromises linked to different stable and competitive Real Effective Exchange Rate (RER) strategies, as well as the correlation between the implementation of exchange rate policies for macroeconomic stability and for economic progress.
METHODOLOGY
The data used in this research has been obtained from the Reserve Bank of India, Government of India - Ministry of Statistics and Program Implementation (MoSPI), Ministry of Labour and Employment (MoL&E), and Ministry of Finance (MoF) for the purpose of empirical analysis.
Variables and Data Sources
The research used quarterly data spanning from Q1 1998 to Q4 2018-19. The quarterly data pertains to macroeconomic variables in India, such as Gross Domestic Product, Inflation, Money Supply, Repo Rate, Index of Industrial Production, Government Final Consumption Expenditure, Private Final Consumption Expenditure, Gross Capital Formation, Exports, Imports, Exchange Rate, BSE-Sensex, NSE-Nifty, Public Investment, Private Corporate Investment, and Household Investment. These variables are used to analyze the various channels of monetary transmission in the country.
RESULTS
The selection of variables for the modeling exercise is determined by doing a thorough study, considering the time-series plots shown previously. In addition, the cross-correlation matrix was analyzed (Table 4.1). The correlation coefficients of the Repo rate with other macroeconomic indicators over four different time periods indicate varied outcomes. Subsequently, after the examination for unit roots, we proceeded to calculate pair-wise granger causality tests for each individual variable. Nevertheless, it is important to acknowledge that statistical exercises, like the estimation of Granger causality, have inherent limitations in establishing causality between two variables at a specific moment in time. These limitations are often influenced by various external and internal shocks that operate on a dynamic basis. Hence, in accordance with macroeconomic reasoning, certain factors that may not exhibit statistical causality but are recognized to have a causal connection based on theory have also been taken into account. Although not demonstrating causation, Repo Rate, WACR, CPI, and NFC have been taken into account in the analysis.
Table 1: Correlation coefficient between the repo rate and other macroeconomic factors
Analyzing the dynamic response of instrument specific variables
The unit-roots test is conducted to analyze the time series features of the variables. Following that, the impact of a shock to the Repo rate on certain variables, namely NSE (asset prices), ZRGDP (Real Sector Output), WPI (Price variable), and 5GSEC and 5YCB (markets), is explored. The selection of these variables is based on their signaling features, namely ZRGDP, NSE, 5GSEC, 5YCB, and WPI. The variable GDP represents the actual production of goods and services, which reflects the capacity to create wealth and the potential for excessive economic growth. The logarithmic series of the National Stock Exchange index (NSE) has been used to analyze the capital markets. This series reflects any interruptions in liquidity, which might affect the market's capacity to effectively allocate excess money to investment opportunities in the economy. The 5-year G-Sec Yields (5GSEC) and high-quality, triple A rated market corporate bond rates (5YCB) are used as a measure to gauge the investment mood in the economy. Wholesale pricing index (WPI) is now regarded as a reliable indicator of inflation or price stability.
Table 2: Composite SVAR Matrix
The composite SVAR Matrix (Table 4.2) shows that the first row represents the coefficient values for the influence of the shock on the Repo rate, which considerably affects the NSE. Specifically, the NSE is affected at a 5% level of significance, with a coefficient value of 0.93. Additionally, the policy rate has a substantial influence on the growth rate of Gross Domestic Product (ZRGDP), as well as on the yields of 5-year Corporate Bonds (5YCB) and 5 Year Government Security (5GSEC), with respective magnitudes of 0.71, 0.86, and 0.82. Nevertheless, the coefficient of the Wholesale Price Index (WPI) lacks statistical significance. The Stock Market is most affected by a policy rate shock, followed by the Five Year Corporate Bond, 5 Year Government Security, and Gross Domestic Product. The second row of the composite SVAR Matrix indicates that there is a considerable impact of a shock in the 91-days Treasury Bill on the NSE, as well as growth in real GDP, 5YCB, and 5GSEC. The magnitudes of these impacts are 1.65, 0.50, 1.33, and 1.32, respectively. The impact of the 91 Days Treasury Bill on the Wholesale Price Index (WPI) is not substantial. The Stock Market has the greatest effect from a shock in the 91 Days Treasury Bill, followed by business bonds, Government securities, and GDP.
Interpretation of the Variance Decomposition Results
The forecast error decomposition refers to the proportion of the error variance in predicting a variable that may be attributed to a particular shock at a certain time horizon. Therefore, the forecast error decomposition may be likened to a partial R2 that explains the variance of the prediction error based on the forecast horizon. The findings obtained from variance decomposition analysis elucidate the future unpredictability of a given time series as a consequence of future disturbances affecting other time series. Here, it aids in comprehending the influence of future shock on policy variables being examined, both in the long term and short term, and determining whether it is caused by its own delay or by another variable that contributes to variability.
Table 3: Forecast Error Variance Decomposition
In summary, the results of this first study indicate that the variables' reaction to the shock in Repo rate (REPO) has been considerable, with the exception of the WPI inflation. When there was a sudden change in the call money rate, the variable related to price stability did not have a significant reaction, although the other variables exhibited significant outcomes. The stock market variable (NSE) saw the most effect from a sudden change in the call money rate. Ultimately, the reaction of the price variable to a shock in the 91-day T-bills rate was shown to be inconsequential. The stock market variable, namely the NSE, had the greatest influence in terms of size. The significant response of variables other than price stability indicates that the transmission of interest rates has been effective, particularly in addressing changes in liquidity within the economy. This can enhance the market's ability to efficiently direct surplus funds to potential investors. The NSE has the greatest level of responsiveness to shock in all three policy variables, emphasizing the same point. There is little danger of overheating or significant impact on the potential to create wealth owing to sudden changes in policy factors affecting real production. The private business sector and the government securities have shown a strong reaction to changes in policy interest rates, which aligns with the idea that increases in interest rates lead to higher bond yields.
CONCLUSION
The research aimed to analyze the response of macroeconomic variables to monetary policy and get a deeper understanding of the transmission mechanism that drives them. The monetary policy has undergone changes throughout time in line with the goals of monetary policy. Originally, the primary aim of monetary policy was to guarantee price stability. However, after 2008, the goals of monetary policy have expanded to include the maintenance of financial stability. The Reserve Bank of India (RBI) has been actively working towards the development of financial markets in India since 1992, with the aim of achieving improved integration of these markets. In 1998, after the Asian crisis, the RBI implemented a multiple indicator strategy that included inflation as one of the indicators, along with other factors from the fiscal, financial, and external sectors. In 2016, India officially embraced inflation targeting as a goal of its monetary policy. Therefore, there was a shift from using many indicators, such as wholesale pricing, to a specific emphasis on consumer prices during this time period.
The transmission channels of monetary policy include interest rates, bank lending, asset prices, and currency rates. Extensive empirical research has been conducted to estimate the transmission mechanism of monetary policy across these channels. Nevertheless, the Reserve Bank of India (RBI) has consistently noted that the policy signals have not effectively reached the market, particularly via the banking sector. As a result, the RBI has been implementing policy measures to guarantee a prompt and effective transmission, particularly in relation to changes in the lending rates of banks.
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