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Adding heft to inflation targeting

LiveMint logoLiveMint 23-05-2017 Niranjan Rajadhyaksha

Indian monetary policy entered a new era more than a year ago. The Reserve Bank of India (RBI) now considers consumer price inflation as the nominal anchor of its policy.

One important question that deserves more public attention is whether the new flexible inflation targeting framework is being built on robust theory. In an article, “Monetary Policy: In Search Of A Theory”, published in this newspaper in September 2014, former RBI executive director A. Vasudevan had pointedly said: “It is not clear whether the RBI has any sharp theoretical premise behind the flexible inflation targeting that it has been advocating.”

An excellent new book edited by Chetan Ghate of the Indian Statistical Institute and Kenneth L. Kletzer of the University of California needs to be read against the backdrop of such valid questions on the theoretical bedrock of inflation targeting in India. (See: Monetary Policy In India: A Modern Macroeconomic Perspective, edited by Chetan Ghate and Kenneth M. Kletzer, Springer, 2016.) The contributors include some of the best macroeconomists doing work on India—Urjit Patel, Prachi Mishra, Rajeswari Sengupta, Viral Acharya, Rahul Anand, Michael Patra, Sajjid Chinoy, Muneesh Kapoor and several others. Many of them have been involved with the Indian central bank.

Monetary Policy In India: A Modern Macroeconomic Perspective is clearly infused with the spirit of the New Keynesian consensus that came to dominate macro-thinking over the past two decades—and which has also come under fire for its failures since the financial crisis. The Urjit Patel committee had unambiguously stated on page 12 of its report that it was influenced by the New Keynesian research programme.

The Patel committee had limited itself to the basic three-equation New Keynesian model—or what has interestingly been described as a monetary model without money. Such a basic model has little use in actual policy design or analysis. The volume edited by Ghate and Kletzer is perhaps the first attempt—at least in my reading—to bring together a richer set of New Keynesian analyses of the Indian economy. It should thus be read by policymakers, monetary policy analysts, academics and economics students.

Central banks had to change course after their traditional models built on behavioural equations fell prey to the powerful Lucas critique. What emerged as a replacement were dynamic stochastic general equilibrium (DSGE) models on the one hand and vector auto regression (VAR) models on the other. It is often said that the former seek theoretical coherence while the latter seek empirical coherence. Both are used intensively these days, but how one can build a bridge between them is still inadequately understood by monetary economists.

This chasm can be seen in the book as well. The papers that are focused on concrete policy challenges are dominated by VAR models while the section on theoretical challenges is all about DSGE models. Despite this analytical duality, there are excellent papers, some that have been previously published, on issues such as monetary transmission, liquidity management, the recent disinflation and the impact of capital flows.

It is no secret that DSGE models have come under fire since the financial crisis. These models explain the changes in an economy through the impact of fundamental shocks—though the lack of a financial system in these models meant that central banks depending on them were blindsided in 2008. There has also been intense criticism of core assumptions such as rational expectations or stationary time series data. Indian DSGE models will also have to take into account issues like a large informal sector (an important “friction”). Even economists such as Olivier Blanchard who pioneered the early DSGE models have accepted the need to reinforce them. More critical voices such as Paul Krugman believe they should be junked.

The emerging New Keynesian research programme in Indian macroeconomics is well represented in this book. The big question continues to be how it will eventually filter down into the practice of central banking in India. There are three important issues to be considered in this context.

First, does the RBI have a DSGE model that it is ready to use as the main tool to analyse the economy? The Indian central bank may eventually even consider sharing its model with the outside world, as some of its peers such as the New York Fed do.

Second, to what extent do the members of the monetary policy committee, especially its external members, use formal New Keynesian models to inform their voting? It is not clear from the minutes of their meetings that are published on the central bank website.

Third, the flexible inflation targeting policy framework is deeply dependent on unobserved variables such as the output gap and the equilibrium rate of interest, especially in the central bank response function. There is still too much ambiguity on the central bank estimates of these variables.

The shift to flexible inflation targeting is based on a deep theoretical shift in economic thinking. Whether one agrees with it or not, India has now embraced the new paradigm. The volume edited by Ghate and Kletzer is important, and needs to be read, because of its insights into how the RBI can give more empirical and theoretical heft to its policies in this new era.

Niranjan Rajadhyaksha is executive editor of  Mint. 

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Read Niranjan’s previous Mint columns at

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