Dynamic interaction among macroeconomic fundamentals: evidence from India using the SVAR framework

Abstract

The present study aims to empirically examine the potential relationship among macroeconomic fundamentals in India, such as oil price, monetary aggregate, output, interest rate, exchange rate, and inflation. To this end, we use a structural vector autoregression (SVAR) framework to analyse the relationship using more recent data from 1996:Q2 to 2021:Q2. The results are concluded using impulse response functions, variance decomposition, and historical decomposition analyses. The study summarises the following observations: first, we find that the oil price has a considerable impact on Indian macroeconomic fundamentals. Second, monetary policy variable and the monetary aggregate respond to all shocks significantly. Third, despite adopting an inflation-targeting framework, India’s monetary transmission mechanism has remained weak, with monetary policy shocks having an insignificant impact on output and inflation. Lastly, the exchange rate is a very important variable for the Indian economy, significantly affecting the different macroeconomic fundamentals. These findings could have major policy implications. In the current flexible inflation-targeting framework, the use of the interest rate as an operating target and the broad money measure as one of the essential indicator variables may help anchor inflation within the targeted band.