A monetary policy model for India

Abstract

A New Keynesian model estimated for India yields valuable insights. Aggregate demand reacts to interest rate changes with a lag of three quarters, while inflation takes four quarters to respond to demand conditions. Inflation thus responds to monetary policy actions with a lag of seven quarters. Inflation is inertial and persistent when it sets in, irrespective of the source. Exchange rate pass-through to domestic inflation is low. Inflation turns out to be the dominant focus of monetary policy, accompanied by a strong commitment to the stabilization of output.

Keywords:

• exchange rate pass-through
• India
• IS curve
• monetary policy
• monetary policy reaction function
• monetary transmission
• neutral interest rate
• new Keynesian model
• Phillips curve

Notes

1. Data on world GDP are available only from the first quarter of 2000 onwards in the IMF's World Economic Outlook and moreover, only growth rates are available. Hence, real world exports are used as a proxy for external demand.

2.  http://research.stlouisfed.org/fred2/.

3.  http://www.mospi.gov.in/mospi_press_releases.htm.

4. All estimations have been done in WinRATS (version 7.30) with standard errors corrected with Newey-West/Bartlett window and 2 lags in all cases (4 lags in specifications in columns 10–11 in Table 3).

5. All data used in the regressions are stationary based on augmented Dickey-Fuller tests with lag selection based on BIC criterion. These results are not reported to save space.

6. This is consistent with the cross-country evidence that finds the coefficient on expected inflation to be significantly below 0.50 (Berg et al., 2006). For the United States, Gali et al. (2005) estimate the coefficients on expected inflation to be higher at 0.65, but as discussed earlier, this could be reflecting omission of supply shocks (Mehra 2004).

7. Estimation of a policy reaction function formulation with contemporaneous arguments for the baseline specification shows that the coefficients on both inflation (GDP deflator) and output gap remain positive and significant, but the long-run coefficient on inflation turns out to be less than unity, whereas that on the output gap remains above unity (see Patra and Kapur 2010 for details).

8. Tests of weak instruments have been done using the modules ‘ivreg2’ and ‘rivtest‘ in the ‘Stata’ software.