Indian Economy: Empirical Analysis On Monetary And Financial Issues In India

Empirical Analysis on Monetary and Financial Issues in India

Takeshi Inoue, Shigeyuki Hamori

• Publisher: WSPC
• Year: 2014
• ISBN:
  9789814571920
• Topic: Biological Sciences
• Subtopic: Science General
• Index: Biological Sciences

India's financial sector has undergone significant changes following the start of the economic liberalization in the early 1990s. In addition to providing important information on monetary and financial issues in India, this book also provides examples to analyze a developing economy by using macro-financial data. The book also focuses on three main topics, that is, monetary policy, financial markets and finance-poverty nexus, and provides new insights into these issues by applying some recently developed quantitative techniques. Contents:

• Introduction
• Monetary Policy in India
  • An Empirical Analysis of the Money Demand Function in India
  • Financial Variables as Policy Indicators: Empirical Evidence from India
  • Is India Ready to Adopt a Policy Framework Targeting Inflation?
• Financial Markets in India:
  • Causal Relationships in Mean and Variance between Stock Returns and Foreign Institutional Investment in India
  • Market Efficiency of Commodity Futures in India
  • What are the Sources of Real and Nominal Exchange Rate Fluctuations? Evidence from SVAR Analysis for India
• Financial Development and Poverty Alleviation in India:
  • How Has Financial Deepening Affected Poverty Reduction in India?
  • Financial Inclusion and Poverty Alleviation in India
  • Concluding Remarks: Monetary Policy and Financial Sector for Sustainable Economic Growth and Poverty Reduction

Readership: Graduate students and researchers who are interested in understanding monetary and financial issues in India, from a macroeconomic viewpoint. Key Features:

• Application of econometric methods to analyze a developing economy
• Key information on monetary and financial issues in India
• Suggestions to alleviate poverty in the country

Part 1

Monetary Policy in India

Chapter 1

An Empirical Analysis of the Money Demand
Function in India

1.1 Introduction

India’s financial sector was first deregulated in the mid-1980s, when measures, such as introducing 182-day treasury bills, lifting the call money interest-rate ceiling, and establishing certificates of deposits and commercial paper, were taken in order to increase the efficiency of the government securities market as well as that of the money market (Sen and Vaidya, 1997). Furthermore, in the wake of the balance of payments crisis in 1991, there began an intermittent series of more systematic financial sector reforms that continues today. For example, the reform of the Indian interestrate structure, which had previously been strictly managed by the Reserve Bank of India (RBI), began with the April 1992 deregulation of deposit rates, and this has progressed to the point where commercial banks are now permitted to freely set all rupee lending rates and their deposit rates above Rs. 1 lakh.^1,2 The above are just a few examples of how interest-rate structure deregulation and the introduction of new financial products have progressed in India over the past 20 years.

Moreover, before the reforms, the RBI had long been constrained by the government’s fiscal management practices. For instance, governmental budget deficits were mainly financed by the central bank through the issuance of 91-day ad hoc Treasury bills as well as the pre-emption of commercial banks’ resources under the statutory liquidity ratio (SLR) requirement. Additionally, monetary expansion that emanated from deficit financing was accommodated by an increase in the cash reserve ratio (CRR) requirement.³ As a part of the financial reforms, however, in September 1994, the RBI agreed to limit the issuance of 91-day bills, which were finally eliminated in April 1997. At the same time, the CRR and SLR have also gradually been reduced, with the former now used as a complementary operating instrument. As a result, the RBI has reined in the automatic monetization of budget deficits and has successfully increased its operational independence in monetary policy management matters.

Theoretical research and empirical analyses, primarily using data on developed countries, have shown that the money demand function can become unstable as a result of such financial innovations and financial sector reforms. Partly because of instability in the money demand function, many central banks have in recent years switched from money supply targeting, which is focused on monetary aggregates as the intermediate target, to inflation targeting, which seeks to stabilize prices by adjusting interest rates based on inflation forecasts. In 1998, the RBI abandoned its flexible monetary targeting approach in favor of the multiple indicator approach (MIA), ending the use of money supply as the intermediate target, but retaining it as an important indicator of future prices. Consequently, examining the characteristics of the money demand function of India’s financial sector, which has undergone significant changes since the 1980s, should offer significant implications for the RBI’s present and future monetary policy. This study, therefore, uses annual data for the period 1976–2007 and monthly data for the period January 1980–December 2007 in order to estimate and describe India’s money demand function, which is derived from real money balances, interest rates, and output.

The remainder of this chapter is organized as follows. We begin by reviewing the relevant research and discussing the unique contributions of our study. In Section 1.3, the models are presented and in Section 1.4, variables are defined, sources are provided, and data characteristics are explained. In Section 1.5, we perform cointegration tests using both monthly and annual data, examine the long-term stability of the money demand function, and use the dynamic ordinary least squares (DOLS) (Saikkonen, 1992; Stock and Watson, 1993) method to examine the sign conditions and significance of output and interest-rate coefficients. Lastly, the analytical results are presented to discuss the characteristics of India’s money demand function and implications for its monetary policy.

1.2 Literature Review

India’s money demand function has been the subject of numerous quantitative research efforts. The first study to explicitly consider the stationarity of, and cointegration relationships among, the variables of the money demand function was presented by Moosa (1992), which used three types of money supply — cash, M1, and M2 — to perform cointegration tests on real money balances, short-term interest rates, and industrial production from 1972 to 1990. Moosa’s (1992) results indicated that for all three types of money supply, money balance had a cointegrating relationship with output and interest rates. However, greater numbers of cointegrating vectors were detected for cash and M1 than for M2, leading the author to state that narrower definitions of money supply are preferable for pursuing monetary policy.

Bhattacharya (1995), like Moosa (1992), considered three types of money supply — M1, M2, and M3 — and used annual data from 1950 to 1980 to analyze India’s money demand function. By performing cointegration tests for real money balances, real gross national product, and long-term and short-term interest rates, the author detected a cointegrating relationship among variables only when money supply was defined as M1 and clearly showed that long-term interest rates are more sensitive to money demand than are short-term interest rates. In addition, Bhattacharya (1995), after estimating an error correction model based on the cointegration test results, found that the error correction term is significant and negative in the case of M1 and that monetary policy is stable in the long term when money supply is narrowly defined.

In the same vein, Bahmani-Oskooee and Rehman (2005) analyzed the money demand functions for India and six other Asian countries during 1972–2000. Using the autoregressive distributed lag approach described in Pesaran et al. (2001), they performed cointegration tests on real money supplies, industrial production, inflation rates, and exchange rates (versus the US dollar). For India, cointegrating relationships were detected for M1, but not for M2, leading them to conclude that M1 is the appropriate money supply definition to use when setting monetary policy.

In contrast to the above, some previous research has used a broad definition of money supply to hold that India’s money demand function is stable. In one example, Pradhan and Subramanian (1997) employed cointegration tests and an error correction model, and using annual data for 1960 to 1994, detected relationships among real money balances, real gross domestic product (GDP), and nominal interest rates. By estimating an error correction model using M1 and M3 as money supply definitions, they found the error correction term to be significant and negative, thereby confirming that the money demand function is stable for both M1 and M3.

Das and Mandal (2000) considered only the M3 money supply in stating that India’s money demand function is stable. They used monthly data between April 1981 and March 1998 to perform cointegration tests and detected cointegrating vectors among money balances, industrial production, short-term interest rates, wholesale prices, share prices, and real effective exchange rates. Their position, therefore, was that long-term money demand relevant to M3 is stable. Similarly, Ramachandran (2004) also considered only the M3 money supply in using annual data for the period of FY 1951 to FY 2000 to perform cointegration tests on nominal money supply, output, and price levels. Because stable relationships were discovered among these three variables, the author stated that an increase in M3 in the long-term can be used as a latent indicator of future price movements.

The...

Table of contents

• Cover
• Halftitle
• Title
• Copyright
• Contents
• About the Authors
• List of Figures
• List of Tables
• List of Abbreviations
• List of First Appearances
• Introduction
• Part 1 Monetary Policy in India
• Part 2 Financial Markets in India
• Part 3 Financial Development and Poverty Alleviation in India
• Index