Regime Switching Monetary and Fiscal Policy Rules and Interaction there-in: An Indian Case Study

Abstract

Recession following the sub-prime crisis has rekindled the international interest in the field of monetary and fiscal policy interactions. However, very little is done to appropriately estimate these dynamic policies. This paper estimates monetary and fiscal policy rules after allowing for changes in their regimes with strong emphasis on mis-specification testing. We apply Markov regime switching model to Indian monetary and fiscal policy rules to highlight the changing stance of Indian macro-policy for the period 1951-2008; and investigate the behaviour of important macroeconomic variables under various policy regimes. Results suggest that fiscal policy was largely active except for a few periods of restraint. Monetary policy, in spite of achieving greater autonomy post 1990s, is still largely accommodating fiscal policy. Whenever monetary policy became active, fiscal policy undermined its effectiveness by not accommodating accordingly. We argue for a more aggressive monetary policy and a constrained fiscal policy.