Monetary Policy in India During Crisis:Impact on Inflation

Objectives: The study aims to compare the effectiveness of monetary policy in controlling inflation in India during pre and post global financial crisis by analysing the long term and short-term relationship between inflation gap, output gap, fiscal deficit, nominal exchange rate, money supply and interest rate. Methods/Statistical analysis: The study employs Auto Regressive Distributed Lag (ARDL) to co-integration. It is an advanced technique since it allows the flexibility to use variables of different order of integration (I(0) and I(1)) as compared to other methods such as VAR or VECM, which work on differenced variables and therefore led to loss of data. It also takes sufficient number of lags to avoid the problem of endogeneity in the models.Findings: The ARDL co-integration results suggest that interest rate isan effective tool of monetary policy in controlling inflation in India. The effectiveness however does reduce in the post-crisis period. It implies fiscal dominance of the monetary policy, where fiscal deficit per se does not cause inflation; still it can impact the latter through its transmission to the monetary policy, as was the case in the post global financial crisis period. The co-integration results also suggest that output gap, foreign exchange rate and money supply all have a significant impact on inflation gap, with no change in the behaviour of former two on inflation gap in the pre-and post-crisis period. While the money supply variable becomes less effective in the latter period. Crude oil price is found to be insignificant during the pre-crisis period but becomes significant during post crisis, while fiscal deficit remains insignificant in both the periods. Application/Improvements: This study supports the use of interest rate as a monetary policy tool, which is extremely relevant in wake of the shift of Indian monetary policy to inflation targeting. It highlights the need to control fiscal deficit for controlling inflation.