Aggregate demand management, policy errors and optimal monetary policy in India

Barendra Kumar Bhoi (), Abhishek Kumar () and Prashant Mehul Parab ()
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Barendra Kumar Bhoi: Indira Gandhi Institute of Development Research
Abhishek Kumar: Indira Gandhi Institute of Development Research
Prashant Mehul Parab: Indira Gandhi Institute of Development Research

Indira Gandhi Institute of Development Research, Mumbai Working Papers from Indira Gandhi Institute of Development Research, Mumbai, India

Abstract: This paper evaluates the rule-based interest rate policy for India since 2000 Q1, which has become more relevant in the flexible inflation targeting (FIT) regime. Based on results of the reduced form Taylor-rule, we observed two episodes of possible policy errors since 2001. First, in the aftermath of the global financial crisis, RBI brought down repo rate much below the level warranted by the Taylor rule that fueled inflation. Moreover, monetary policy tightening, followed thereafter, during March 2009 to June 2011 was insufficient in controlling prices. Second, despite favorable supply shocks, repo rate was above the rule-based policy rate during June 2013 to March 2016, leading to very high real interest rate. In the post-crisis period, we observed significant increase in the interest rate persistence, which could be attributed to RBI's reluctance to cut policy rate despite softening of inflation, leading to growth slowdown. Our results suggest that the optimal policy rate ranges from 4 to 5 for the last quarter of 2018. Actual repo rate at 6.5 in December 2018 was 150 to 250 basis points above the optimal rate. RBI has reduced repo rate by a cumulative 110 basis points since December 2018. As the negative output gap has widened and inflation remains subdued, there is scope to cut the repo rate further.

Keywords: Optimal Monetary Policy; Flexible Inflation Targeting; Taylor Rule; Growth Slowdown (search for similar items in EconPapers)
JEL-codes: E47 E52 E58 (search for similar items in EconPapers)
Pages: 29 pages
New Economics Papers: this item is included in nep-mac and nep-mon
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Persistent link: https://EconPapers.repec.org/RePEc:ind:igiwpp:2019-029

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