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

Barnett, William A. and Bhadury, Soumya and Ghosh, Taniya (2015): An SVAR Approach to Evaluation of Monetary Policy in India: Solution to the Exchange Rate Puzzles in an Open Economy.

Abstract

Following the exchange-rate paper by Kim and Roubini (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 (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.

• Item Type: MPRA Paper
• Language: English
• Keywords: Monetary Policy; Monetary Aggregates; Divisia monetary aggregates; Structural VAR; Exchange Rate Overshooting; Liquidity Puzzle; Price Puzzle; Exchange Rate Puzzle; Forward Discount Bias Puzzle.
• Subjects: C - Mathematical and Quantitative Methods > C3 - Multiple or Simultaneous Equation Models ; Multiple Variables > C32 - Time-Series Models ; Dynamic Quantile Regressions ; Dynamic Treatment Effect Models ; Diffusion Processes ; State Space Models; E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E51 - Money Supply ; Credit ; Money Multipliers; E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E52 - Monetary Policy; F - International Economics > F3 - International Finance; F - International Economics > F4 - Macroeconomic Aspects of International Trade and Finance > F41 - Open Economy Macroeconomics

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