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

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)

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.