Active monetary policy and the slowdown: Evidence from DSGE based Indian aggregate demand and supply

Abstract

We explore reasons for the strongly asymmetric Indian monetary transmission and response to other shocks, compared to those of the United States, obtained in a standard New Keynesian Dynamic Stochastic General Equilibrium (DSGE) model. While counterfactual analysis moderates other impulse responses, it suggests large cost shocks remain a primitive cause of inflation, and the strong transmission comes from large interest rate changes. Reducing the variance of the interest rate shock can significantly moderate the large output cost. Asymmetric excess volatility due to preference and technology shocks is reduced on introducing regime switching between multiple steady-states. The estimated model including multiple regimes is therefore used to obtain aggregate demand and aggregate supply schedules, which incorporate the policy reaction function, and to identify their shifts during the Indian slowdown. The correlation between factors shifting aggregate demand and supply is estimated. Since it is negative it aggravates the shocks. The post 2011 slowdown is explained by severe demand contraction in response to adverse supply shocks. Habit persistence in consumption changes the slope of both aggregate demand and supply curves significantly.