This is a long thread on the analytical structure of the inflation targeting regime in India. The tweets below are based on the Quarterly Projection Model of the RBI. The aim is not to get into a debate on inflation targeting but correct some of the misconceptions on Twitter.
The QPM is one of the central pillars of inflation targeting in India. There are ten equations that have been used. I have attempted here to provide a simplified explanation of the structure of this analytical edifice.
1. Aggregate demand comes in the form of an IS equation that estimates the non-agricultural (NA) output gap. That is explained by the past NA output gap, expectations of the future NA output gap, global demand, credit conditions, the real lending rate and the real exchange rate.
2. Monetary transmission features in an equation on bank lending tightening conditions. This appears because the Indian financial system is dominated by banks. Lending conditions not only affect the output gap but are also affected by it.
3. Philips Curve for core inflation is influenced by several factors such as the domestic output gap, expected inflation, past inflation and also the gap between headline and core (a problem right now). Food prices are assumed to influence core inflation via expectations channel.
4. Inflation expectations are dependent on not only past and future inflations but also on the credibility of the central bank to deal with price pressures in the economy.
5. CB credibility is only built gradually over time. Also, it assumed that credibility changes in a non-linear fashion, which in effect means that monetary policy has to be aggressive to achieve initial disinflation. Policy responses can be milder once credibility is built up.
6. The RBI model parts ways with other CB models by having a separate equation for food inflation, given the high weight of food in the Indian CPI. Food inflation in the short run is driven by three shocks -- monsoons, minimum support prices, vegetable prices.
7. There is another separate equation for energy prices as well, and considers two types of energy prices -- market prices and administered prices. Market prices are determined by global entry prices and movements in the exchange rate.
8. There is a monetary policy function that is built around the inflation forecast. This reaction function contains both core inflation and headline inflation, so the RBI can look at only core, only headline or some combination of the two while decided its policy response.
9. The transmission from policy rates to the interest rates for private borrowing is modelled as dependent on the term structure of interest rates as well as the term premium.
10. The final equation is for the exchange rate, using uncovered interest parity adjusted for risk. Exchange rate expectations, domestic nominal interest rates, global nominal interest rates and a time-varying country risk premium enter this equation as independent variables.
How well does this analytical model work? That is an empirical question. The limited point of this series of tweets is to show that the analytical framework is richer than many assume. That does not mean it is perfect. Or that India should not seek a new inflation target in 2021.
I have obviously simplified some of the components of the analytical edifice, so read this as a tracing rather than the actual drawing.
