Monetary Policy Transmission in the Presence of Product and Labor Market Frictions: The Case of India

Abstract

Tightly regulated product and labor markets in India have resulted in a lack of competition in product markets and the development of a large informal sector. This paper studies the effect of frictions in product and labor markets on the effectiveness of monetary policy, using a small open-economy DSGE model with informal and formal sectors, monopolistic competition, price and wage stickiness, and endogenous firm entry. Product market regulation affects firm entry costs and the degree of competition, and labor market regulation affects hiring costs and worker bargaining power. We show that monetary policy is less effective under tight regulations: monetary policy shocks have a smaller effect on inflation, compared to a situation with lower hiring costs or lower entry costs.