Liquidity management and monetary transmission: empirical analysis for India

Purpose A change in monetary operating procedures provides a natural experiment which is used to evaluate, first, whether Indian monetary policy transmission is better when durable liquidity is in surplus or when it is in deficit; second whether it is better with interest rates as the policy instrument or quantity of money or a mixture of the two. Design/methodology/approach This study first shows that the period of analysis can be divided into two separate regimes one of liquidity surplus (2002-2010) and the other of deficit (2011-2019).This study then estimates separate structural vector auto-regressions (SVARs) for the financial and real sector, with relevant exogenous foreign, policy and other variables for each of the periods as well as SVARs for the whole period with alternative operating instruments. Findings Monetary transmission from the repo rate was better during the period the liquidity adjustment facility (LAF) was in surplus with the central bank in absorption mode denoting excess durable liquidity. Pass through was faster and the repo rate had a greater influence on other variables. The impact of the rate on output gap exceeds that on inflation. The weighted average call money rate was found to outperform others as the operating target. Monetary policy has evolved so that policy rates are more effective in transmission compared to money supply, but best results are when durable liquidity is also in surplus. Originality/value The results contribute to ongoing debates on the Indian monetary policy framework and give useful inputs for policy in emerging markets where research is scarce. They suggest keeping the LAF in deficit mode over 2011-19 was not optimal.