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Inflation targeting in India: A comparison with the multiple indicator approach

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  • Mishra, Ankita
  • Mishra, Vinod

Abstract

The empirical literature on identification and measurement of the impact of monetary policy shocks on the real side of the economy is fairly comprehensive for developed economies, but very limited for emerging and transition economies. In this study, we propose an identification scheme for a developing economy (taking India as a case study), which is able to capture the monetary transmission mechanism for that economy without giving rise to empirical anomalies. Using a VAR approach with recursive contemporaneous restrictions, we identify monetary policy shocks by modelling the reaction function of the central bank and structure of that economy. The effect of monetary policy shocks on the exchange rate and other macroeconomic variables is consistent with the predictions of a broad set of theoretical models. This set-up is used to build a hypothetical case of inflation targeting where the monetary policy instrument is set after assessing the current values of inflation only. This is in contrast with the ‘multiple indicator approach’ currently followed by the Reserve Bank of India (RBI). The results in this study suggest that the demand effects of interest rate are stronger than the exchange rate effects. There is also evidence of the mitigation of potential conflict between exchange rate and interest rate, one of main monetary policy dilemmas of the RBI in inflation targeting.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Asian Economics.

Volume (Year): 23 (2012)
Issue (Month): 1 ()
Pages: 86-98

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Handle: RePEc:eee:asieco:v:23:y:2012:i:1:p:86-98

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Web page: http://www.elsevier.com/locate/asieco

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Keywords: India; Inflation targeting; Monetary policy; VAR;

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  1. Sims, Christopher A, 1980. "Macroeconomics and Reality," Econometrica, Econometric Society, vol. 48(1), pages 1-48, January.
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  14. Ankita Mishra & Vinod Mishra, 2009. "Pre-Conditions For Inflation Targeting In An Emerging Economy - The Case Of India," Development Research Unit Working Paper Series 08-09, Monash University, Department of Economics.
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