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An SVAR Approach to Evaluation of Monetary Policy in India: Solution to the Exchange Rate Puzzles in an Open Economy

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Abstract

Following the exchange-rate paper by Kim and Roubini (J Monet Econ 45(3):561–586, 2000), we revisit the questions on monetary policy, exchange rate delayed overshooting, the inflationary puzzle, and the weak monetary transmission mechanism; but we do so for the open Indian economy. We further incorporate a superior monetary measure, the aggregation-theoretic Divisia monetary aggregate. Our paper confirms the efficacy of the Kim and Roubini (J Monet Econ 45(3):561–586, 2000) contemporaneous restriction, customized for the Indian economy, especially when compared with recursive structure, which is damaged by the price puzzle and the exchange rate puzzle. The importance of incorporating correctly measured money into the exchange rate model is illustrated, when we compare models with no-money, simple-sum monetary measures, and Divisia monetary measures. Our results are confirmed in terms of impulse response, variance decomposition analysis, and out-of-sample forecasting. In addition, we do a flip-flop variance decomposition analysis, finding two important phenomena in the Indian economy: (i) the existence of a weak link between the nominal-policy variable and real-economic activity, and (ii) the use of inflation-targeting as a primary goal of the Indian monetary authority. These two main results are robust, holding across different time period, dissimilar monetary aggregates, and diverse exogenous model designs.

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Notes

  1. The velocity of M1, which had been stable since 1945, suddenly took a sharp downward trend after 1980 (Courtenay and Thornton (1987)). Leeper and Roush (2003) agree with Chrystal and McDonald that traditionally stable money demand functions were widely perceived to have become unstable.

  2. Nelson (2003) offers an alternative role for money. He argues that money demand depends on a long-term interest rate. Nelson’s resulting specification of the Federal Reserve’s interest rate rule is a dynamic generalization of the conventional monetary policy rules by Taylor (1999) Taylor rule, which excludes money. Money now has a direct effect that is independent of the short-term interest rate. Nelson concludes that the effect is consistent with U.S. data. Anderson and Kavajecz (1994) argued for the use of monetary aggregates as either indicators and/or targets of monetary policy. Several more recent studies, such as Nicoletti-Altimari (2001); Trecoci and Vega (2002); Jansen (2004), and Assenmacher-Wesche and Gerlach (2006), have found a useful leading indicator role for monetary and credit aggregates with respect to low-frequency trends in inflation.

  3. Differencing of variables does not provide gain in asymptotic efficiency and may cause loss of information regarding the co-movements, such as cointegrating relationships between variables. Hence, we use a VAR in levels.

  4. The Indian monetary aggregates are defined as follows: M2 = currency with the public + demand deposits with banks + other deposits with the Reserve Bank of India + savings deposits with banks + term deposits with contractual maturity of up to and including one year with banks + certificate of deposits issued by banks; M3 = M2 + term deposits with contractual maturity of over one year with banks + call borrowings from non-depository financial corporations by banks; and L1 = M3 + all deposits with the Post Office Savings Banks (excluding National Savings Certificates).

  5. The results with other models are available upon request.

  6. The result for other models are available upon request.

  7. The result for other models are available upon request.

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Correspondence to William A. Barnett.

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We would like to thank the anonymous reviewers for their constructive comments that helped us improve the manuscript. We also appreciate some of the excellent comments received during the Financial Market and Nonlinear Dynamics (FMND) workshop.

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Appendix

Table 5 Lag selection test

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Barnett, W.A., Bhadury, S.S. & Ghosh, T. An SVAR Approach to Evaluation of Monetary Policy in India: Solution to the Exchange Rate Puzzles in an Open Economy. Open Econ Rev 27, 871–893 (2016). https://doi.org/10.1007/s11079-016-9403-2

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