ISSN (Print) - 0012-9976 | ISSN (Online) - 2349-8846

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Monetary Policy in the Midst of Cost-push Inflation

The Reserve Bank of India adopted inflation-targeting monetary policy based on the New Keynesian 3-equation model. How realistic are the assumptions, and how effective have monetary policy instruments been in controlling the inflation rate? Given India’s structural specificities, what are the implications of cost-push inflation for policy rate and output gap? This paper addresses these questions by identifying alternative theoretical possibilities within a simple 3-equation model and locating the Indian specificity by estimating the Phillips curve and monetary policy rule equation. The analysis points towards the constraints of monetary policy in India due to presence of a flat Phillips curve and indicates the possibility of adverse effect on output gap due to presence of Taylor’s rule.

There are broadly three distinct routes through which the inflation rate has been sought to be controlled in macroeconomic theory. The first route pertains to price control, where the state is perceived to control the inflation rate by imposing constraints on the mark-up of firms. The second route involves the fiscal policy, where fiscal instruments are sought to be used to adjust aggregate demand or relax structural bottlenecks. The third route pertains to monetary policy. The distinguishing feature of the New Consensus macroeconomic policy framework is that it puts the burden of controlling the inflation rate exclusively on monetary policy. With fiscal policy being largely used to meet the deficit or debt targets set by the fiscal policy rule, the monetary policy seeks to control the inflation rate by adjusting demand and output.1

India’s present macroeconomic framework is guided by the New Consensus theory. Following the implementation of the Urjit Patel Committee Report (2014), the Reserve Bank of India (RBI) explicitly pursues inflation-targeting monetary policy. The theoretical foundation for this policy framework is provided by the New Keynesian 3-equation model. The recent episode of cost-push inflation in India and across the world has posed new challenges for the RBI. How effective is monetary policy in mitigating inflationary pressure? What are the implications of cost-push inflation for policy rate and output gap?

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Updated On : 5th Jun, 2023
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