Abstract:
As markets deepen and interest elasticities increase it is optimal for emerging markets to shift towards
an interest rate instrument since continuing monetization of the economy implies money demand shocks
are large. In an extension of the classic instrument choice problem to the case of frequent supply shocks,
it is shown the variance of output is lower with the interest rate rather than a monetary aggregate as
instrument, if the interest elasticity of aggregate demand is negative, and the interest elasticity of money
demand is high or low. It is necessary to design an appropriate monetary policy response to supply
shocks. An evaluation of India’s monetary policy procedures and of the recent fine-tuning of the
liquidity adjustment facility finds them to be in tune with these first principles and in the direction of
international best practices. But a survey of country experiences and procedures, and some aspects of
the Indian context suggest further improvements.
