Issues in the Choice of a Monetary Regime for India

Warwick J. McKibbin

&

Kanhaiya Singh

Summary – Current Issues in Monetary Policy in India– The Theory of Monetary Regime Design

• Instrument Choice Problem• Intermediate Target Problem• Simple versus Optimal Rules

– The MSG2 Multi Country Model– Implementing Alternative Regimes in the model– Results for Alternative Regimes for India– Conclusion

Current Debate in India

• Money Targeting in place since the mid 1980s;

• Substantial reform of the financial markets in the 1990s with greater reliance on prices rather than quantitative restrictions in implementing monetary policy;

• Should India move to an inflation target?

Theory of Regime Design

• A monetary regime is a set of instruments, intermediate targets and ultimate targets (goals) in which a relationship is specified between instruments and intermediate targets in order to minimize a loss function in terms of ultimate goals.

Theory of Regime Design

• Many issues– which instruments?– which intermediate targets?– rules versus discretion

• credibility and time consistency important

– arbitrary simple rules versus optimal simple rules versus fully optimal rules

• Ultimately many of the issues are empirical

The Modeling framework

• The McKibbin-Sachs Global Model (version 44m)

The MSG2 Model

• Dynamic, Intertemporal, General Equilibrium

• Multi-Country

• Macroeconomic

• Keynesian short run with unemployment

• Mix of forward looking & rule of thumb behavior

See WWW.MSGPL.COM.AU

The MSG2 Model– Countries

– United States

– Japan

– Germany

– France

– Canada

– United Kingdom

– Italy

– Rest of Euro Zone

– Mexico

– Rest of OECD

– India

– OPEC

– Eastern Europe and former Soviet Union

– Other developing countries

Agents and Markets

• AGENTS MARKETS Households Goods & Services Firms Factors of Production Governments Money

Bond Equity

Foreign Exchange

Key dynamic features

• annual frequency

• physical capital is accumulation is endogenous but subject to adjustment costs

• forward looking agents in goods, factor and financial markets

• full accounting of stock flow relations

• combination of intertemporal optimization by agents plus liquidity constraints

• sticky nominal wages

Some Important Issues

• Trade, capital flows and adjustments in domestic financial markets are central to global adjustment to shocks;

• Agents arbitrage between different assets within countries and across countries - taking into account the adjustment costs of changing the physical capital stock in each sector.

3 regimes

• Money targeting

• Inflation targeting

• Nominal income targeting (nominal GDP)

5 shocks (in 2000)

• Persistent rise in aggregate demand

• Temporary rise in aggregate demand

• Persistent rise in labour productivity

• Temporary rise in labour productivity

• Permanent rise in the risk of holding Indian assets

Some results

Note that all results are deviation from what otherwise would have occurred (zero is no deviation)

Figure-1

Real GDP Under a Permanent Domestic Demand Shock

-0.1

0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

% d

evia

tio

n f

rom

bas

elin

e

Money Target

Inflation Target

Nominal Income Target

Figure-2

Inflation Under a Permanent Domestic Demand Shock

-0.8

-0.7

-0.6

-0.5

-0.4

-0.3

-0.2

-0.1

0

0.1

0.2

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

% p

oin

t d

evia

tio

n f

rom

baseli

ne

Money Target

Inflation Target

Nominal Income Target

Figure-3

$US/Rupee Exchange Rate Under a Permanent Domestic Demand Shock

0

1

2

3

4

5

6

7

8

9

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

% d

evia

tio

n f

rom

baseli

ne

Money Target

Inflation Target

Nominal Income Target

Figure-4

Interest Rate Under a Permanent Domestic Demand Shock

-0.2

0

0.2

0.4

0.6

0.8

1

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

% p

oin

t d

evia

tio

n f

rom

baseli

ne

Money Target

Inflation Target

Nominal Income Target

Figure-5

Trade Balance Under a Permanent Domestic Demand Shock

-0.9

-0.8

-0.7

-0.6

-0.5

-0.4

-0.3

-0.2

-0.1

01999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

% G

DP

de

via

tio

n f

rom

ba

se

line Money Target

Inflation Target

Nominal Income Target

Figure-6

Stock Market Value Under a Permanent Domestic Demand Shock

-3

-2.5

-2

-1.5

-1

-0.5

01999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

% d

evia

tio

n f

rom

baseli

ne

Money Target

Inflation Target

Nominal Income Target

Figure-7

Real GDP Under a Temporary Domestic Demand Shock

-0.4

-0.2

0

0.2

0.4

0.6

0.8

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

% d

evia

tio

n f

rom

baseli

ne

Money Target

Inflation Target

Nominal Income Target

Figure-8

Inflation Under a Temporary Domestic Demand Shock

-0.4

-0.3

-0.2

-0.1

0

0.1

0.2

0.3

0.4

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

% p

oin

t d

evia

tio

n f

rom

bas

elin

e

Money Target

Inflation Target

Nominal Income Target

Figure-13

Real GDP Under a Permanent Domestic Supply Shock

0

0.2

0.4

0.6

0.8

1

1.2

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

% d

evia

tio

n f

rom

baseli

ne

Money Target

Inflation Target

Nominal Income Target

Figure-14

Inflation Under a Permanent Domestic Supply Shock

-0.45

-0.4

-0.35

-0.3

-0.25

-0.2

-0.15

-0.1

-0.05

0

0.05

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

% p

oin

t d

evia

tio

n f

rom

baseli

ne

Money Target

Inflation Target

Nominal Income Target

Figure-15

$US/Rupee Exchange Rate Under a Permanent Domestic Supply Shock

-3.5

-3

-2.5

-2

-1.5

-1

-0.5

01999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

% d

evia

tio

n f

rom

baseli

ne

Money Target

Inflation Target

Nominal Income Target

Figure-16

Interest Rate Under a Permanent Domestic Supply Shock

-0.6

-0.5

-0.4

-0.3

-0.2

-0.1

0

0.1

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

% p

oin

t d

evia

tio

n f

rom

baseli

ne

Money Target

Inflation Target

Nominal Income Target

Figure-17

Trade Balance Under a Permanent Domestic Supply Shock

0

0.05

0.1

0.15

0.2

0.25

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

% G

DP

devia

tio

n f

rom

baseli

ne

Money Target

Inflation Target

Nominal Income Target

Figure-18

Stock Market Value Under a Permanent Domestic Supply Shock

0

0.5

1

1.5

2

2.5

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

% d

evia

tio

n f

rom

baseli

ne

Money Target

Inflation Target

Nominal Income Target

Figure-19

Real GDP Under a Temporary Domestic Supply Shock

-0.4

-0.2

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

% d

evia

tio

n f

rom

baseli

ne

Money Target

Inflation Target

Nominal Income Target

Figure-20

Inflation Under a Temporary Domestic Supply Shock

-0.8

-0.6

-0.4

-0.2

0

0.2

0.4

0.6

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

% p

oin

t d

evia

tio

n f

rom

baseli

ne

Money Target

Inflation Target

Nominal Income Target

Figure-25

Real GDP Under a Permanent Increase in Risk Premium on Indian Assets

-1.6

-1.4

-1.2

-1

-0.8

-0.6

-0.4

-0.2

01999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

% d

evia

tio

n f

rom

bas

elin

e

Money Target

Inflation Target

Nominal Income Target

Figure-26

Inflation Under a Permanent Increase in Risk Premium on Indian Assets

-0.2

0

0.2

0.4

0.6

0.8

1

1.2

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

% p

oin

t d

evia

tio

n f

rom

baseli

ne

Money Target

Inflation Target

Nominal Income Target

$US/Rupee Exchange Rate Under a Permanent Increase in Risk Premium on Indian Assets

-14

-12

-10

-8

-6

-4

-2

01999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

% d

ev

iati

on

fro

m b

as

eli

ne

Money Target

Inflation Target

Nominal Income Target

Figure-28

In terest Rate Under a Perm anent Inc rease in R isk Prem iu m on IndianAssets

-0.8

-0.6

-0.4

-0.2

0

0.2

0.4

0.6

0.8

1

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

%pointdev iationfrombaseline

M oney Target

In fla tion Target

Nom inal Incom e Target

Figure-29

Trade Balance Under a Permanent Increase in Risk Premium on Indian Assets

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

% G

DP

dev

iati

on

fro

m b

asel

ine

Money Target

Inflation Target

Nominal Income Target

Figure-30

Stock Market Value Under a Permanent Increase in Risk Premium on Indian Assets

-8

-7

-6

-5

-4

-3

-2

-1

01999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

% d

evia

tio

n f

rom

baseli

ne

Money Target

Inflation Target

Nominal Income Target

Summary of Results

• Inflation targeting increases output volatility under supply shocks and shocks to risk perceptions

• Money targeting increase volatility of output for temporary aggregate demand shocks (and money demand shocks)

• Nominal income targeting appears to work well but there are issues to be resolved in practical implementation

Summary of Results• Inflation targeting is likely to dominate

money targeting in a period of financial reform but a pure form of inflation targeting is problematic for the types of shocks likely to occur in India during a period of structural reform (productivity and confidence shocks)

Summary of Results• A nominal income target is likely to be

better for India in terms of handling shocks and just as good as inflation targeting for credibility

• The Australian Reserve Bank approach of inflation targeting over the cycle is really an imprecisely defined nominal income target

• More research is needed on how to implement nominal income targeting in India.