Asymmetries in the monetary policy reaction function: evidence from India

This paper analyzes the reaction function of monetary authority in India from 1997Q 1 to 2019Q 4 using nonlinear Taylor rule. It has been found that monetary policy reaction function (MPRF) in India is asymmetric and is influenced by the state of the economy, determined by the lagged interest rate. To capture such asymmetry, we have used a set of nonlinear models including smooth transition regression (STR) model, threshold regression (TR) model and Markov-switching regression (MSR) model along with the instrumental variable estimation technique. The analysis discloses that the behaviour of the Reserve Bank of India (RBI) is asymmetric, reacts aggressively to output gap in general and particularly during periods of high interest rate. Furthermore, the RBI reacts more to inflation and output gap during low volatile regimes in MSR models compared to high volatile regimes. We also found that there is a high degree of inertia in the policy rates of the RBI. The study concludes that nonlinear models may not only help in understanding the behaviour of the RBI but also prevent from making incorrect and misleading conclusions in Indian context.

Monetary Policy Reaction Function in Positive and Normative Approaches: Evidence from ASEAN-3

A notable feature in many mainstream economic theories and empirical works of literature has been emphasized the conventional development in the domestic economic factors in dealing with monetary policy in both positive and normative approaches. However, external economic factors consist of potentially valuable information, such as the exchange rate and terms of trade, that cannot simply be ignored. To address this limitation, this study examines the monetary policy reaction function in an open economic model in both positive and normative approaches that encompasses the domestic and external factors, namely the inflation, the output gap, the exchange rate and the terms of trade. The empirical validity is obtained by using a sample of ASEAN-3 countries. Both the positive and normative approaches adopt the generalized method of moments and the grid search method, respectively. The findings deliver some policy implications; monetary policy via interest rate remains an important strategy in absorbing shocks from domestic and external factors, and the central bank should include important factors, namely the inflation, the output gap, the exchange rate and the terms of trade, in its monetary policy decision making that eventually help to attain the best economic outcomes.

FINANCIAL STABILITY AND MONETARY POLICY REACTION FUNCTION FOR SOUTH ASIAN COUNTRIES: AN ECONOMETRIC APPROACH

This study empirically investigates a monetary policy reaction function for South Asian economies by incorporating financial stability as an additional policy objective in the central bank’s loss function. Empirical results are estimated by applying auto-regressive distributed lag (ARDL) approach to cointegration and vector autoregressive (VAR) approach using time-series data of five South Asian countries, namely, Pakistan, India, Bangladesh, Nepal and Sri Lanka. Estimated results indicate that monetary policy significantly reacts to the level of financial stability in all countries. The result further suggests that central banks would tighten monetary policy if output gap widens and exchange rate depreciate. In addition, central banks of Pakistan and India do not respond significantly to inflation gap.