Estimating Taylor Type Rule for India's Monetary Policy using ARDL Approach to Co-integration

Abstract

In an open economic environment, economies generally experienced economic instability emerging out of internal and external factors. Like other central banks ’apparently following discretionary policy rule corresponding to fluctuations in the economy, Reserve Bank of India has also been not less than anyone in responding frequently to different economic situations by changing key interest rates those it has under its privilege. Using Autoregressive Distributed Lag (ARDL) model of co-integration, this paper decisively estimates exchange rate augmented Taylor Type rule for India's monetary policy and examined its short-run and long-run behaviour with respect to the output gap, inflation gap and exchange rate over the period from 2001Q1 to 2012Q4. Estimation results revealed that output gap, inflation gap and exchange rate are the important determinants of monetary policy in India. Amongst these three, inflation and output gap found to be matter more for RBI than exchange rate in short-run, but the situation is vice-versa in long-run. The study also asserts that Exchange Rate Augmented Taylor Type rule sufficiently explains the behaviour of RBI's monetary policy.