ISSN (Print) - 0012-9976 | ISSN (Online) - 2349-8846

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Science of Monetary Policy

This paper exposits the monetary policy design problem within the limits of an empirical framework for the Indian economy. Four main issues are examined. The paper first looks at a few of the theories that have been advanced to explain the stylised facts of economic fluctuations and then examines the main features of business cycles in the Indian economy over the past 50 years. In the process, it presents forecasts of aggregate economic activity for 2002-03 and 2003-04 besides obtaining quantitative estimates of the impact of the business cycle on the fiscal deficit. Second, it empirically measures the threshold rate of inflation within the framework of growth-inflation trade-offs and derives the optimal rate of monetary expansion needed to smooth out fluctuations and stabilise the inflation rate at its threshold level. Third, it specifies a theoretical model (linking growth, inflation, interest rates and money supply) capable of deriving an optimal fiscal deficit which maximises the real growth rate; and applies it within the Indian context to measure the desired amount of fiscal consolidation. Finally, it provides estimates of a comprehensive macroeconomic conditions index which can very effectively be incorporated into a simple Taylor-type interest rate rule (reaction function) for monetary policy.

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