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The anti-inflationary monetary policy stance of RBI, as reflected in the high nominal policy interest rate since mid-2011, has been generally perceived as one of the factors contributing to the sustained sluggishness in GDP growth and investment activity over past several successive quarters. For a period of more than eighteen successive months since July 26, 2011, RBIís repo rate was maintained at or above 8%. While growth sacrifice as a means to contain inflationary pressures is context specific, depending on the drivers of inflation, it remains a debatable issue as to whether nominal or real interest rate matters for influencing growth and investment. Theoretical and empirical literature suggests that investment and growth could be sensitive to changes in both nominal and real interest rates.
While economic decisions relating to investment, consumption and saving may be generally based on assessment of nominal interest rates and inflation, effectively, it is the real interest rate which matters. Consultations with representatives of industry and commercial banks revealed that nominal interest rate is more relevant for firm level investment decisions, but inflation expectations and the inflation environment also matter, pointing thereby to the implicit role of real interest rate in influencing investment. A central bankís assessment of effectiveness of monetary policy generally takes into consideration the transmission of nominal policy rate changes through nominal market interest rates to ultimate goal variables, namely growth and inflation. However, given the argument that it is the real interest rate which matters for real variables like investment and growth, there is a view that nominal interest rate may not always reflect the correct stance of monetary policy. For example, if nominal policy rate is high, but both inflation and inflation expectations are also high, then despite a higher nominal policy rate, the implied real rate may suggest an expansionary, rather than an anti-inflationary stance of monetary policy.
If the level of the real interest rate is a better reflection of monetary policy stance, then how can a central bank influence the real interest rate? The review of literature presented in this paper suggests that a central bank can influence real rates