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In economic literature, the main alternative to monetary targeting is the use of the interest rate as the policy instrument. This approach is more suitable when different segments of the financial markets are well integrated and interest rates in various markets influence each other effectively.
In India, such financial market integration has not yet fully occurred, although there have been some signs of convergence in recent years.
Given this context, it is more appropriate for monetary authorities to target money supply rather than interest rates, while still monitoring interest rate movements across different markets and intervening as necessary.
The form of monetary targeting practiced in India is flexible and adaptive, taking into account various feedback mechanisms and economic developments.
In the Indian context, using monetary aggregates as intermediate targets is considered appropriate due to the following reasons:
1) The money demand function in India has remained stable over time, enabling reasonably accurate predictions of price movements.
2) The money stock target is widely understood by the public. It allows for a clear communication of the monetary policy stance and provides unambiguous signals to market participants.
Recently, monetary authorities have also started to closely monitor a wider range of indicators in addition to relying on intermediate targets like broad money (M3).
To aim at an intermediate target such as broad money, the overarching operational target becomes reserve money, particularly bank reserves.
The supplementary operating target in this framework is the short-term interest rate, typically represented by overnight call money rates.
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