Inflation Targeting in India: Issues and Prospects

Abstract:     
Inflation targeting (henceforth IT) has emerged as a significant monetary policy framework in both developed and transition economies. It has been in place for a decade or more in a number of countries - with around 20 central banks adopting it as their basic monetary policy framework. Some authors have argued that for transition economies undergoing sustained financial liberalization and integration in world financial markets IT is an attractive monetary policy framework. Consequently there is some pressure for such economies to adopt IT as a core element in their monetary policy frameworks.

The present paper evaluates the case for IT in India. It begins with stating, almost from first principles, the objectives of monetary policy in India. I argue that inflation control cannot be an exclusive concern of monetary policy in a country such as India with a substantial poverty problem. The rationales for IT is then spelt out as are some nuances of the practical implementation of IT. The paper provides some evidence on the effects of IT in developed and transition economies and argues that although IT may have been responsible for maintaining a low inflation regime it has not brought down the inflation rate itself substantially. Further, the volatility of exchange rate and output movements in transition countries adopting IT has been higher than in developed market economies. The paper then discusses India's experience with using rules-based policy measures (nominal targets) and elaborates on the reasons (as espoused in the extant literature) why India is not ready for IT. It is further shown that even if the Reserve Bank of India wanted to, it could not pursue IT since the short-term interest rate (the principal policy tool used to affect inflation in countries working with IT) does not have significant effects on the rate of inflation. The paper concludes by listing monetary policy options for India at the current time.

Number of Pages in PDF File: 50

Keywords: India, Inflation Targeting, VAR Model

JEL Classification: E42, E45, E47

working papers series