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Inflation Targeting, Monetary Policy Surprises, and Capital Misallocation

Author

Listed:
  • Vidhya Soundararajan

    (Centre for Advanced Financial Research and Learning (CAFRAL))

  • Vaibhav Nainwal

    (Centre for Advanced Financial Research and Learning (CAFRAL))

  • Rajeswari Sengupta

    (Indira Gandhi Institute of Development Research (IGIDR))

Abstract

We examine whether a more predictable monetary policy framework improves the allocation of capital across firms. Using firm-level data from the Indian manufacturing sector for 2005-2024, we study this in the context of India's adoption of flexible inflation targeting (FIT) in 2015. We find that firms with high pre-FIT average revenue per unit of capital (ARPK) subsequently accumulate more capital and experience a relative decline in ARPK, consistent with capital being reallocated toward previously under-capitalized firms. Event-study estimates show that these changes emerge after the reform. To further examine the role of monetary policy predictability in capital allocation, we use high-frequency measures of monetary policy surprises. We document a decline in the volatility of these surprises following FIT and show that larger surprises are associated with higher ARPK and lower capital accumulation, particularly among firms with high ex-ante ARPK. Together, these findings are consistent with greater monetary policy predictability contributing to improved capital allocation following FIT.

Suggested Citation

  • Vidhya Soundararajan & Vaibhav Nainwal & Rajeswari Sengupta, 2026. "Inflation Targeting, Monetary Policy Surprises, and Capital Misallocation," Working Papers 023676, Centre for Advanced Financial Research and Learning (CAFRAL).
    • Handle: RePEc:ris:cafral:023676
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    Keywords

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    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
    • E22 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Investment; Capital; Intangible Capital; Capacity
    • D24 - Microeconomics - - Production and Organizations - - - Production; Cost; Capital; Capital, Total Factor, and Multifactor Productivity; Capacity
    • O16 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Financial Markets; Saving and Capital Investment; Corporate Finance and Governance

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