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

William Barnett (), Soumya Suvra Bhadury and Taniya Ghosh ()
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Soumya Suvra Bhadury: University of Kansas

Open Economies Review, 2016, vol. 27, issue 5, 871-893

Abstract: 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.

Keywords: Monetary policy; Monetary aggregates; Divisia monetary aggregates; Structural VAR; Exchange rate overshooting; Liquidity puzzle; Price puzzle; Exchange rate puzzle; Forward discount bias puzzle (search for similar items in EconPapers)
JEL-codes: C32 E51 E52 F31 F41 (search for similar items in EconPapers)
Date: 2016
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Working Paper: An SVAR Approach to Evaluation of Monetary Policy in India: Solution to the Exchange Rate Puzzles in an Open Economy (2015) Downloads
Working Paper: An SVAR Approach to Evaluation of Monetary Policy in India: Solution to the Exchange Rate Puzzles in an Open Economy (2015) Downloads
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