rate of 4 per cent per annum as tolerable for india. 6. india is a moderate inflation country with the long - term average inflation rate remaining in a single digit of about 7. 5 per cent since 1970 – 71. over this 40 - year period, the average inflation rate, however, has decelerated to about 5. 5 per cent in the decade of 2000s. the medium term objective of monetary policy is to bring down the average inflation rate to around 3. 0 per cent consistent with india ’ s integration with the global economy. 1 7. while a low level of inflation is essential to sustain high levels of growth, it is not sufficient to maintain financial stability, as has been demonstrated by the recent global financial crisis. consequently, besides price stability, ensuring orderly conditions in the reserve bank of india ( 2010 ), third quarter review of monetary policy for the year 2009 – 10, reserve bank of india, january 29, 2010. financial markets has become a key policy concern. in this context, it may be indicated that financial stability had emerged as another important objective of monetary policy in india much before the crisis. thus, monetary policy in india has evolved to have multiple objectives of price stability, financial stability and growth. these objectives are not inherently contradictory, rather mutually reinforcing. price and financial stability are important for sustaining high levels of growth which is the ultimate objective of public policy. ii. evolution of monetary policy framework 8. in order to attain the objectives of policy it is necessary to have a consistent policy framework. at a theoretical level, the evolution of monetary framework could be traced to the desire to reduce inflationary bias in the economy through various refinements under the broader debate on “ rules ” versus “ discretion ” in policy making, and more recently, “ constrained discretion ” which believes that the doctrines of “ rules ” and “ discretion ” are not mutually exclusive 2. in practice, the nature of the framework is contingent upon two important considerations. first, the level of development of financial markets and institutions ; and second, the degree of openness of the economy to trade and capital flows. in india, like most other countries, the monetary policy framework has evolved in response to and in consequence of financial developments and shifts in the underlying transmission mechanism. how did monetary policy framework evolve globally? 9. in order to achieve the objectives of monetary policy which are not under the direct control of central banks, monetary authorities typically set “ intermediate targets ”, which bear a stable relationship

was, however, a flexible one allowing for various feedback effects. moreover, money supply target was relatively well understood by the public at large. 7 reserve bank of india ( 2005 ), report on currency and finance 2003 – 04, pp 53 – 79. but it took almost twelve years to fructify when automatic monetization through ad hoc treasury bills was abolished and a system of ways and means advances ( wma ) was introduced in 1997. technically, in a simple form, if expected real gdp growth is 6 per cent, the income elasticity of demand for money is 1. 5 and a tolerable level of inflation is 5 per cent, the broad money ( m3 ) expansion target can be set at 14 per cent ( m3 growth = 1. 5 x 6 + 5 = 14 % ). rangarajan, c. ( 1997 ), “ role of monetary policy ”, economic and political weekly, december 27. 15. with the pace of trade and financial liberalization gaining momentum following the initiation of structural reforms in the early 1990s, the efficacy of broad money as an intermediate target of monetary policy came under question. the reserve bank ’ s monetary and credit policy for the first half of 1998 – 99 observed that financial innovations emerging in the economy provided some evidence that the dominant effect on the demand for money in the near future need not necessarily be real income, as in the past. 16. since the mid - 1990s, apart from dealing with the usual supply shocks, monetary policy had to increasingly contend with external shocks emanating from swings in capital flows, volatility in the exchange rate and global business cycles. subsequently, increase in liquidity emanating from capital inflows raised the ratio of net foreign assets ( nfa ) to reserve money ( chart 1 ). this rendered the control of monetary aggregates more difficult. consequently, there was also increasing evidence of changes in the underlying transmission mechanism of monetary policy with interest rate and the exchange rate gaining importance vis - a - vis quantity variables. 8 bank credit to private sector as a per cent of gdp also started rising, though it still remains low as compared to advanced economies and many emes underscoring the potential for greater credit penetration ( table 1 ). these developments necessitated refinements in the conduct of monetary policy. reserve bank of india ( 1998 ), the working group on money supply : analytics and methodology of compilation ( chairman : dr. y. v. reddy ). 17. against this backdrop