Evaluating inflation targeting as a monetary policy objective for India

Abstract

This study formulates a small open economy model for India with exchange rate as a prominent channel of monetary policy. The model is estimated using the Instrumental Variable-Generalized Methods of Moments (IV-GMM) estimator and evaluated through simulations. This study compares different cases of domestic and CPI inflation targeting, strict and flexible inflation targeting, and simple Taylor type rules. The analysis highlights the unsuitability of simple Taylor-type monetary rules in stabilizing the Indian economy and suggests that discretionary optimization works better in stabilizing this economy. There seems to be a trade-off between output gap stabilization and exchange rate stabilization in flexible domestic inflation targeting and CPI inflation targeting respectively. However, flexible domestic inflation targeting seems a better alternative from an overall macro stabilization perspective in India where financial markets are still not sufficiently integrated to ensure quick transmission of interest rate impulses and existence of rigidities in the economy.