Abstract
Abstract Employing Factor Augmented Vector Autoregression (FAVAR) model where factors are obtained using the principal component analysis (PCA) and the parameters of the model are estimated using Vector Autoregression framework, we analyse how changes in monetary policy variables impact inflation, output, money supply, and the financial sector in India. Our results for the period 2001:04 to 2016:03 show that the benchmark FAVAR model showed more reliable results than baseline VAR model. Benchmark FAVAR model shows the existence of weak ‘liquidity puzzle’ in India. The impulse responses from the FAVAR approach reveal that monetary policy is more efficient in explaining the variations in inflation rather than stimulating output indicating its effectiveness in attaining the objective of price stability.
Highlights
The effectiveness of monetary policy in combating inflation has always been an important question in emerging economies, including India, as inflationary pressures have augmented recently
The Factor Augmented Vector Autoregression (FAVAR) model which we specify in eq (2) will become a standard Vector Autoregressions (VARs) model if we assume that all Φ (L) = 0 in Eq (2) which relates Yt to Ft
We use a FAVAR model where the factors are estimated using principal component analysis and the parameters of the model with the help of vector autoregression framework to examine the impacts of monetary policy on output, level of inflation, and money
Summary
The effectiveness of monetary policy in combating inflation has always been an important question in emerging economies, including India, as inflationary pressures have augmented recently. Sims explained this phenomenon as the aftereffects of asymmetric information or imperfectly controlling for information of the central bank about the future For overcoming this problem Bernanke and Boivin (2003) and Bernanke, Bolivin, & Eliasz (2005) extended the VAR model by incorporating a larger number of information using factor analysis to evaluate the implications of monetary policy on economic activity in a data rich environment. Bernanke and Boivin (2003) find that the estimated factors can provide more reliable results in the estimation of the impacts of Fed’s policy reaction function Given these empirical developments, this paper seeks to examine the impacts of monetary policy on macroeconomic activity (output, prices and money) in India using the FAVAR methodology proposed by Bernanke, Bolivin, & Eliasz (2005), as such an attempt is conspicuously absent in the Indian context.
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