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Effect of Quantitative Easing on the Indian Economy: A Dynamic Stochastic General Equilibrium Perspective

Parantap Basu and Shesadri Banerjee ()

No 2015_03, CEGAP Working Papers from Durham University Business School

Abstract: The effect of external Quantitative Easing (QE) on a small open economy such as India is analyzed using a dynamic stochastic general equilibrium (DSGE) model. The modelling is motivated by some broad empirical regularities of the Indian economy during the pre and post QE periods. QE is modelled as a negative foreign interest rate shock with a mean reverting pattern. The mean reversion reflects the phasing out of the QE operation. In addition, we analyze the "news" effect of the tapering out phase of QE. Our model has standard frictions which include limited asset market participation of agents, home bias in consumption and nominal frictions in terms of staggered price settings. Monetary policy is modelled by the forward looking inflation targeting Taylor rule. The model explores a novel transmission channel of QE via the terms of trade measured by the ratio of import to export prices. We show that the impact and news effects of QE work through the terms of trade via the uncovered interest parity condition. Our model reproduces two prominent features of the Indian data: (i) initial decline of the terms of trade followed by a sharp reversal, and (ii) divergent behaviour of foreign and domestic interest rates. The model is broadly consistent with other empirical regularities including a deflationary spell in the Indian economy after 2012

Keywords: Quantitative Easing; India. (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-dge and nep-mon
Date: 2015-03
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