Monetary Policy Reaction in an Interdependent Instrument Setting

Policy reaction equations are fitted for the statutory reserve deposit (SRD) and open-market instruments (OMO). The interest rate is treated exogenously. The policy regime envisaged accommodates interdependencies between the instruments. The study is based on quarterly data over the period 1961-74. The results demonstrate a marked difference in the form of the policy response for the two instruments: the SRD instrument responds strongly to the domestic targets, inflation and, unemployment; but shows little response to external factors. The OMO instrument reacts to external influences, but not to the domestic targets, a result consistent with the policymaker's desire to sterilize exogenous influences on the cash-base of the economy. The OMO instrument has a strong association with the interest rate reflecting its market orientation and the political costs of adjusting it. The interest rate proxy is not significant in the SRD equation. There is some evidence for a harmonious association between the SRD and OMO instruments. Finally, the form of the response in each case varies according to the policy intent: contraction and expansion. This reflects a change in the weights attaching to the policy targets as the policy-intention alters.