A VAR Model of Monetary Policy and Hypothetical Case of Inflation Targeting in India
AbstractThe empirical VAR 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 without giving rise to any empirical anomalies. We use a VAR approach with recursive contemporaneous restrictions and identify monetary policy shocks by modelling the reaction function of the central bank and structure of the 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 looking at the current values of inflation only. This is in contrast with the â€žmultiple indicator approachâ€Ÿ currently followed by Reserve Bank of India. This hypothetical scenario of inflation targeting suggests a sharper response of the interest rate (monetary policy instrument) to shocks and strengthening of the exchange rate channel in transmission of interest rate impulses. This study also provides some useful implications on the type of theoretical framework which can be used to model the evolution of monetary policy for a developing economy like India.
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Bibliographic InfoPaper provided by Monash University, Department of Economics in its series Monash Economics Working Papers with number 15-10.
Length: 42 pages
Date of creation: May 2010
Date of revision:
Contact details of provider:
Postal: Department of Economics, Monash University, Victoria 3800, Australia
Web page: http://www.buseco.monash.edu.au/eco/
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Find related papers by JEL classification:
- E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
- E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
- E47 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Forecasting and Simulation: Models and Applications
This paper has been announced in the following NEP Reports:
- NEP-ALL-2010-09-18 (All new papers)
- NEP-CBA-2010-09-18 (Central Banking)
- NEP-MAC-2010-09-18 (Macroeconomics)
- NEP-MON-2010-09-18 (Monetary Economics)
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