New monetary transmission channels - Role of interest rates and exchange rate in conduct of Indian monetary policy

This paper explores new dimensions in the monetary transmission mechanism in the environment of liberalisation initiated in the early 1990s and in the context of growing integration of financial markets. An examination of the Chakravarty Committee paradigm in this changed milieu motivated us to see the role of two key variables in the conduct of monetary policy, viz, interest rates and exchange rates. The long-run relationship between money, prices, output, and exchange rate is examined and the impact of money market disequilibrium on interest rats is traced by testing the joins significance of the lags of disequilibrium errors. We also conduct weak and block exogenity rests for exchange rates. Interest rates and exchange rates are seen to be endogenously determined in the liberalised regime beginning 1992-93, raising the possibility of the change in transmission mechanism following the advent of financial reforms. The recent shifts in the operating procedure of monetary policy are in consonance with our findings.