Inflation Targeting, Monetary Policy Surprises, and Capital Misallocation

Vidhya Soundararajan, Vaibhav Nainwal and Rajeswari Sengupta
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Rajeswari Sengupta: Indira Gandhi Institute of Development Research (IGIDR)

Working Papers from Centre for Advanced Financial Research and Learning (CAFRAL)

Abstract: We examine whether a more predictable monetary policy framework improves the allocation of capital across firms. Using firm-level data from the Indian manufacturing sector for 2005-2024, we study this in the context of India's adoption of flexible inflation targeting (FIT) in 2015. We find that firms with high pre-FIT average revenue per unit of capital (ARPK) subsequently accumulate more capital and experience a relative decline in ARPK, consistent with capital being reallocated toward previously under-capitalized firms. Event-study estimates show that these changes emerge after the reform. To further examine the role of monetary policy predictability in capital allocation, we use high-frequency measures of monetary policy surprises. We document a decline in the volatility of these surprises following FIT and show that larger surprises are associated with higher ARPK and lower capital accumulation, particularly among firms with high ex-ante ARPK. Together, these findings are consistent with greater monetary policy predictability contributing to improved capital allocation following FIT.

Keywords: Flexible Inflation Targeting; Monetary Policy; Capital Misallocation; Firm Investment; Monetary Policy Surprises (search for similar items in EconPapers)
JEL-codes: D24 E22 E52 E58 O16 (search for similar items in EconPapers)
Pages: 26
Date: 2026-09-30
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Persistent link: https://EconPapers.repec.org/RePEc:ris:cafral:023676

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