Regime-shifts in India’s monetary policy response function

Abstract

Objectives of monetary policy have always been debated intensively. This debate has resurfaced during past few years in some countries including India where formulation of monetary policy has undergone significant change during the last two decades and is increasingly responding to changing macroeconomic environment. Against this backdrop, this paper models the monetary policy response function for India, for the period April 1996–July 2015. Using 91-day Treasury bill rate as the policy rate, the study finds that monetary policy in India has been responsive to inflation rate, output gap and exchange rate volatility (proxied by the rate of depreciation of INR/USD) during this period. This paper finds evidence in favour of substantial time varying behavior in the reaction function. The regime shift tests show that the transition is governed by inflation gap as well as exchange rate volatility (depreciation rate). Highly complex dynamics of interest rate restricted estimation of multiple models, but the models which are estimated show that the response function responds to inflation gap as well as exchange rate volatility. Another important finding of the study is high degree of inertia in the policy rates.