What has happened?
Monetary policy transmission improves if friction in the financial system diminishes, according to the findings of a study by the Development Research Group (DRG) of the Reserve Bank of India (RBI).
The DRG is constituted by the apex bank in its Department of Economic and Policy Research to carry out quick policy-oriented research on subjects of current interest.
The DRG study — ‘Role of financial frictions in monetary policy transmission in India’ — developed a New Keynesian Dynamic Stochastic General Equilibrium (NK-DSGE) model with an imperfectly competitive banking sector and examined the role of various financial frictions in monetary policy transmission (MPT) in India.
Financial market frictions
The credit channel-based explanation of MPT attributes weak transmission of monetary policy in emerging market and developing economies to the predominance of financial market frictions.
Findings of the study
The study findings show MPT improved as friction in the financial system diminished.
Adjusting the policy interest rate to smooth out the credit cycle exacerbates volatility of inflation and output
Inflation stabilization, a desirable policy
It suggested that inflation stabilization was the most desirable policy option for the RBI as it minimized the welfare loss irrespective of policy rules
Overall, it appears that targeting financial stability through monetary policy rule may not be appropriate for the purpose of economic stabilization.