One of the oldest debates in monetary economics concerns the appropriate target of monetary policy. The target problem arises because monetary instruments cannot directly and immediately influence the ultimate objectives like price stability or output growth.
The economic literature widely accepts that while monetary policy is effective in stabilising output and prices in the short run, there is a consensus on the long-run neutrality of money.
Effective policy design requires accurate knowledge of timing effects on the economy and assumes that both the economic structure is known and the goal variables are observable.
In reality, policymakers face uncertainty due to competing hypotheses about the structure and due to the fact that many key endogenous and exogenous variables are observable only after a time lag. These challenges justify the need for using an intermediate target.
Traditionally, the conduct of monetary policy in India has used intermediate targets — variables that the central bank can influence directly and that closely correlate with the ultimate objectives of monetary policy.
The actual means through which the central bank intervenes in the economy is called the operating instrument. Meanwhile, some macroeconomic variables, though not directly targetable, serve as information indicators that help inform the policy stance.
First, since the exact structure of the economy is unknown, policy outcomes cannot be precisely predicted. However, some relationships — for instance, between certain observable endogenous variables and goal variables — are well understood. These reliable variables can thus serve as target variables to help guide policy decisions.
Second, goal variables like price stability and output growth are typically observable only after a significant lag. During this lag period, exogenous changes may occur that distort the original policy intention. A target variable helps mitigate this risk by allowing adjustments to be made based on more timely feedback.
By using target variables, policymakers can reduce the uncertainty associated with delayed feedback from the goal variables. This allows for more effective and responsive monetary intervention.
The target variables are endogenous variables that the monetary authority attempts to control or influence in order to impact the goal variables in a desired way. For a variable to serve effectively as a target, it should meet the following four qualifications:
1) It should be closely related to goal variables, and this relationship must be well understood and reliably estimable.
2) It should respond quickly to policy instruments.
3) It should be influenced more by policy than by non-policy factors.
4) It should be readily observable with little or no time lag.
A monetary policy target, whether intermediate or final, provides important signals to the market, conveys the policy stance unambiguously, and helps anchor inflation expectations. In the West, many countries have shifted from intermediate targets to final inflation targets due to instability in the demand for money, which weakened the link between monetary aggregates and inflation rates.
However, in India, intermediate targets remain relevant due to a relatively stable demand function for money.
Traditionally, three variables have served as major monetary policy targets in India:
1) Money Supply
2) Bank Credit
3) Interest Rate in the securities market
Money supply functions both as an economic variable—determined by the portfolio behavior of the public and banks—and a policy-controlled variable, whose size is influenced by the monetary authority’s assessment of the appropriate levels of primary and secondary money.
The Reserve Bank of India (RBI) sets a broad money (M3) expansion target in line with the projected GDP growth rate and a tolerable level of inflation. This target determines the desirable expansion of reserve money.
The level of reserve money expansion must align with expected fiscal conditions and external payments positions, since its primary sources include Net RBI credit to the government and net foreign exchange assets.
The RBI’s broad money target is announced publicly through the Governor’s monetary and credit policy statement. This target is further supported by other indicators like interest rates, exchange rates, and credit availability to the productive sectors of the economy.
At the macro level, India’s monetary policy primarily targets the control of reserve money due to the relative stability of the money multiplier over the medium term, whether for narrow money or broad money.
The Chakravarthy Committee Report (1985) emphasized that reserve money represents the liabilities of the central bank and the government deemed eligible to serve as reserves for banks in a fractional reserve system.
Accordingly, reserve money in India consists of:
Currency with the Reserve Bank
Currency with the public
Bankers' deposits with the RBI
These are considered liabilities of the RBI to the non-bank sector and are equivalent to currency with the public. The main sources of reserve money are assets acquired by the RBI and government currency liabilities to the public.
The formula for Reserve Money is as follows:
Reserve Money = Net RBI Credit to Government + RBI Credit to Banks + RBI Credit to Commercial Sector + Net Foreign Exchange Assets of RBI + Government’s Currency Liabilities to the Public – Net Non-Monetary Liabilities of RBI
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