Flexible Inflation Targeting and Exchange Rate Passthrough in India: A Markov Switching Analysis

Sayar Ahmad Shah

Emerging Markets Finance and Trade, 2025, vol. 61, issue 7, 1978-2000

Abstract: This study investigates the exchange rate passthrough during the pre and post-inflationary targeting period. The study employs a regime-switching Markov approach to examine the dynamics of exchange rate and inflation in India. The findings provide that exchange rate passthrough follows a nonlinear pattern with high exchange rate variations bringing small changes in inflation and vice-versa. This contrasts with the existing literature, which confirms the linear relationship between the exchange rate and domestic prices. The nonlinear behavior of ERPT reflects that with changes in the exchange rate, domestic price levels are asymmetrically affected due to the kind of monetary policy in vogue. Further, the asymmetric behavior of exchange rate passthrough with a switching effect underscores the role of multitude of domestic and external factors that prevent the complete transmission of exchange rate changes to domestic inflation. The policy implications of the present study assert that to enhance exchange rate passthrough and to ensure the price parity in an inflationary targeting monetary policy regime, it is imperative to consider the role of the exchange rate in the monetary policy given its shock-absorbing feature.

Date: 2025
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DOI: 10.1080/1540496X.2024.2439464

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