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Vinson Kurian

The differential elasticity, in conjunction with differing industry mixes across States, may account for differential sub-national effects of monetary policy.

Thiruvananthapuram , Sept. 15

AN analysis of monetary policy effects on State economies has revealed that the nature of a State's response is positively related to the share of manufacturing in the Net State Domestic Product (NSDP), which may be viewed as evidence favouring an "interest rate channel".

The analysis, done by Mr D.M. Nachane, Mr Partha Ray and Mr Saibal Ghosh, also supports the fact that certain States with a relatively larger concentration of smaller firms tend to be more responsive to monetary policy shocks than States with a smaller concentration of the same, which, in essence, is testimony to the existence of a "broad credit channel".

In their paper on `Does monetary policy have differential State-level effects?', the authors observe that the prevailing paradigm of monetary policy predicates a uniform undifferentiated effect of such policy on the national economy. But this view ignores the fact that in reality, any nation is composed of diverse albeit interlinked regions, which might respond differently to identical macroeconomic stimuli.

For example, the effect of a change in the price of foodgrains might be quite different for a region, which is a dominant producer of that commodity vis-à-vis a region that is an important consumer. Likewise, a rise in the energy price (for example, fuel) might impact different regions unevenly, in view of differential importance of fuel in the consumption basket of various regions. The idea that monetary policy can likewise have varied effects across regions is a "short and logical next step".

In large federal structures such as the US, Canada and India, an additional dimension is introduced by the existence of component federal states with own Governments, and some policy autonomy. While the concept of an economic region is logically quite distinct from that of a federal state, the latter provides a convenient anchor for studying regional dimensions of macroeconomic policy. This is so because in most countries, data is organised State-wise rather than according to economic regions.

Also, over a historical period, States develop distinct economic characteristics (partly due to inherent geographical and environmental features and partly owing to differing economic policies pursued).

The literature on the monetary transmission mechanism lists several reasons as to why the actions of the authorities might have differential State-level effects. These include, among others, (1) State-wise differences in the mix of interest sensitive industries, (2) differences in the mixture of large versus small firms across States, and (3) the differential financial deepening across States.

It is acknowledged that the interest rate elasticity of credit demand differs across industries. The differential elasti- city, in conjunction with differing industry mixes across States, may account for differential sub-national effects of monetary policy. It is also a stylised fact that industry is more credit-dependent than either agriculture or services and, therefore, relatively industrialised States are likely to be more affected by monetary policy shocks than their less industrialised counterparts.

State-level differences in the composition and concentration of industry and sources of credit available to each could also lead to dissimilar responses to monetary policy. One view of monetary policy contends that monetary policy affects banks by directly affecting their ability to provide loans. Moreover, information costs and transaction costs require small firms to deal with financial intermediaries, primarily banks, to meet their credit needs. In contrast, large firms usually have greater and varies access to external, non-bank sources of funds. Consequently, activity in a State that has a high concentration of small firms could be especially sensitive to the policy of the monetary authorities.

Recent theoretical work on possible credit channels for the transmission of monetary policy actions to economic activity suggests that the mix of large versus small firms and large versus small banks is a crucial determinant of responses to monetary policy. Kashyap and Stein have pointed out that monetary policy is likely to have a relatively larger impact on countries having comparatively "bank-dependent" firms and a relatively large percentage of small banks.

In the Indian context, the process of financial deepening has not been uniform across States.

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