Pluralism in monetary policy framework: 

Pluralism in monetary policy framework: 

Context:

In spite of having sophisticated model at its disposal, the RBI’s performance on accurate inflation forecasting leaves much to be desired.

Background:

• India formally adopted “flexible-inflation targeting” (FIT) in June last year. A key feature of FIT is that monetary policy has an explicit inflation target in the long-term but medium-term inflation “projections” become the intermediate target. The success of FIT depends on the accuracy of medium-term inflation forecasts.
• The Reserve Bank of India (RBI) introduced models called the forecasting and policy analysis system (FPAS).
• Central to the FPAS is the quarterly projection model (QPM), a forward-looking model to assess the medium term path of the economy.
• The model consists of four equations related to the key endogenous variable like the IS curve (output gap), the Phillips curve (inflation), smoothed Taylor rule (short-term interest rate), and uncovered interest rate parity (exchange rate).
• In December 2016, RBI’s monetary policy committee (MPC) forecast that headline inflation in India in January-March would average 5% with an upside bias.
• The actual inflation turned out to be 3.6%, a massive 140 basis points lower than the forecast and the highest percentage forecasting error in RBI’s history.
• CPI (Consumer Price Index) inflation in June eased to 1.54%, a record low, while the RBI continues to forecast an average of 2.75% for the first half of FY18.

Criticisms:

The model has been criticized for relying on rational expectations, assuming complete markets, ignoring the financial sector and for creating models which are “money-neutral’.

Solutions:

•  Improve the DSGE framework by relaxing unrealistic assumptions and incorporating more features of the Indian economy, such as a large informal sector and an all-pervading shadow economy.
•  Explore alternative approaches which make realistic assumptions and incorporate the complexity of the real world.
•  The Economic Complexity Index developed using this approach is a more accurate predictor of GDP per capita than many competing growth theories.
•  RBIs highly capable economists can develop parallel models by applying alternative approaches to the Indian context.

Conclusion:

Pluralism is critical for all social sciences and economics is no exception. Exploring multiple schools of thought can only improve the framework’s accuracy and effectiveness of India’s monetary policy framework.