Transmission Mechanism of Monetary Policy: Case Study of Interest Rate Channel in India

Abstract

In India, prior to 1991, the tightly controlled interest rates caused impediments in the functioning of the interest rate channel of monetary policy transmission while after 1991, the RBI undertook various measures to strengthen the market-determination of interest rates. This paper has examined the evolution of the interest channel in India across the period 1985 to 2014 firstly by studying the interest rate pass-through using the Correlation matrix and the OLS technique and secondly, by studying the transmission of policy rates to the real economy using the reduced VAR model. The results show that the transmission of interest rates pass-through from policy rates to market interest rates (both - short-term as well as long-term) has strengthened while desired impact of long term market interest rates on industrial production and inflation appears to be weak.