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Testing for the Effectiveness of Inflation Targeting in India: A Factor Augmented Vector Autoregression (FAVAR) Approach

Author

Listed:
  • Jithin P

    (Department of Humanities and Social Sciences, Indian Institute of Technology Madras, Chennai, India)

  • Suresh Babu M

    (Department of Humanities and Social Sciences, Indian Institute of Technology Madras, Chennai, India)

Abstract

Employing Factor Augmented Vector Autoregression (FAVAR) model where factors are obtained using the principal component analysis (PCA) and the parameters of the model are estimated using Vector Autoregression framework, we analyse how changes in monetary policy variables impact inflation, output, money supply, and the financial sector in India. Our results for the period 2001:04 to 2016:03 show that the benchmark FAVAR model showed more reliable results than baseline VAR model. Benchmark FAVAR model shows the existence of weak ‘liquidity puzzle’ in India. The impulse responses from the FAVAR approach reveal that monetary policy is more efficient in explaining the variations in inflation rather than stimulating output indicating its effectiveness in attaining the objective of price stability.

Suggested Citation

  • Jithin P & Suresh Babu M, 2020. "Testing for the Effectiveness of Inflation Targeting in India: A Factor Augmented Vector Autoregression (FAVAR) Approach," Journal of Central Banking Theory and Practice, Central bank of Montenegro, vol. 9(3), pages 163-182.
    • Handle: RePEc:cbk:journl:v:9:y:2020:i:3:p:163-182
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    References listed on IDEAS

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    More about this item

    Keywords

    Factor Augmented VAR; Monetary policy; Economic growth; Inflation;
    All these keywords.

    JEL classification:

    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • O47 - Economic Development, Innovation, Technological Change, and Growth - - Economic Growth and Aggregate Productivity - - - Empirical Studies of Economic Growth; Aggregate Productivity; Cross-Country Output Convergence
    • E3 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles

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