Financial Development and Monetary Policy Transmission Across Financial Markets: What Do Daily Data Tell for India?

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W P S (DEPR): 04 / 2013

RBI WORKING PAPER SERIES

Financial Development and Monetary Policy Transmission Across Financial Markets: What Do Daily Data tell for India?

Partha Ray and Edwin Prabu

DEPARTMENT OF ECONOMIC AND POLICY RESEARCH

APRIL 2013

The Reserve Bank of India (RBI) introduced the RBI Working Papers series in March 2011. These papers present research in progress of the staff members of RBI and are disseminated to elicit comments and further debate. The views expressed in these papers are those of authors and not that of RBI. Comments and observations may please be forwarded to authors. Citation and use of such papers should take into account its provisional character.

Copyright: Reserve Bank of India 2013

Financial Development and Monetary Policy Transmission Across Financial Markets: What Do Daily Data tell for India?1 Partha Ray 2 and Edwin Prabu 3 This paper seeks to address two questions In Indian context. First, what is the nature of integration among different segments of Indian financial markets? Second, what has been the influence of monetary policy on different segments of financial markets? As far as domestic financial integration is concerned, the study finds that the money market segment is fairly integrated. At the next level, among the constituents of the domestic financial markets, G-sec and corporate bond market are somewhat integrated. There is, however, limited evidence of integration between the money market and stock market. Using daily data over January 2005 – November 2012, the paper constructs a structural Vector autoregression (SVAR) model and studies the financial markets microstructure and monetary policy transmission in India related to four key segments, viz., money, bonds (GSec and corporate debt), forex and stock market. While the transmission of monetary policy to money market is found to be fast and efficient and the effects on bond and forex market are on expected lines, the impact of monetary policy to stock market is limited. The nature of monetary policy transmission, however, tends to vary, depending on the extent of liquidity (i.e., whether there is surplus or deficit liquidity).

JEL Classification: C32, E52, F41 Keywords: Monetary Policy, Structural Vector autoregression, impulse responses

                                                             1 The authors are indebted to Shri Deepak Mohanty, Shri K U B Rao, Dr. Himanshu Joshi and Shri Anand Shankar for their comments on an earlier draft of the paper. The authors are also indebted for the comments of the participants of an internal seminar at the Department of Economic and Policy Research on November 30, 2012 where they have had the privilege to present an earlier version of the paper. Usual disclaimer applies. The paper reflects personal views of the authors and not necessarily of the institution(s) to which they belong. 2 Director, Department of Economic and Policy Research, currently on sabbatical to Indian Institute of Management, Calcutta as Professor of Economics; email. 3  Assistant Adviser, Department of Economic and Policy Research; email:   1   

Introduction The process of financial development in any emerging economy would invlove the intimately interlinked developments of both financial institutions as well as financial markets. It is well-known that transmission of monetary policy, to begin with, takes place via financial markets. Financial market developments and extent of market integration across various segments of domestic financial markets play a key role in this context. The more integrated financial markets are, in all likelihood the more would be the strength of monetary transmission across financial markets. Empirically, however, the locomotion from microstructure to macro behaviour is essentially couched in terms of some aggregation. Two issues are important her e. First, the level of aggregation could dictate the nature of market. Illustratively, when the...
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