New issues in Indian macro policy.

in fluctuations of inventory and investment. An interesting feature of this business cycle
lies in the increasing synchronisation with the world business cycle.

As a consequence, for the first time, macroeconomic policy in India now needs to identify
ways through which the policy framework can stabilise this conventional business cycle, as
is done in market economies around the world.

3.2.1 Monetary policy

Before the ways and means agreement was signed between the Ministry of Finance and
RBI, the lever of monetary policy was ‘used up’ for doing deficit financing. With the ways
and means agreement in place, and after a significant fiscal consolidation has come about,
monetary policy could have occupied the centre stage in stabilisation.

However, in the eary 1990s, currency flexibility went down sharply. This was accom-
panied by a rapid transition to de facto convertibility. As a consequence, the lever of
monetary policy was ‘used up’ for achieving currency targets. Thus, by the early 2000s,
just when India was experiencing a conventional business cycle, where monetary policy
could have come into its own in stabilising this business cycle, monetary policy autonomy
was lost through a combination of convertibility accompanied by exchange rate rigidity.

This combination of the existing fiscal policy framework and the existing monetary
policy framework leaves India without a macro policy framework for stabilisation. This
suggests that Indian GDP growth volatility will be high in coming years, higher than is
found in other continental-sized economies which have achieved a stabilising monetary
policy.

The ‘Taylor principle’ asserts that for monetary policy to be stabilising, the response
of the central bank to a shock in expected inflation has to be greater than one-for-one.¹³
The inflation coefficient in estimated Taylor rules has to be greater than one. Present
estimates in India (Mohanty and Klau, 2004; Virmani, 2004) yield values well below 0.5.
This suggests that monetary policy in India violates the Taylor principle, that monetary
policy in India is destabilising. This is, of course, consistent with the picture of a monetary
policy regime that is driven by exchange rate pegging. In an open economy, a central bank
that runs a pegged exchange rate cannot control inflation or contribute to stabilising the
business cycle.

Reorienting monetary policy to the task of stabilisation requires changes in institutional
arrangements.

With an open capital account, exchange rate pegging clearly induces a loss of monetary
policy autonomy. However, a floating exchange rate is not a monetary regime. A mere
switch from a pegged exchange rate to a floating rate, without fully thinking through the
implications for monetary economics, would be a mistake. Countries that have lacked a
nominal anchor, such as Argentina, Brazil, Israel, Mexico and Chile, are known to have
suffered prolonged episodes of high and variable inflation. With increasing INR/USD
volatility in recent months (Figure 7), India runs the risk of entering a period of high and

¹³See Was a rate hike required in Business Standard, at http://www.mayin.org/ajayshah/MEDIA/
2006/ratehike.html on the web.

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