Issues in the Choice of a Monetary Regime for India

Economic liberalization and financial sector reforms in India commenced in 1990. An important
issue currently facing India and the focus of a lively debate, is the question of the appropriate
regime for conducting monetary policy in an economy undergoing structural reforms. To add to
this important debate, this paper summarizes the state of the current policy debate on selecting a
monetary regime for India and presents estimates of the impact of alternative monetary regimes in
the face of a variety of shocks to the Indian economy. The impacts of shocks to aggregate
demand, productivity growth and risk perceptions are considered under the three policy regimes
of money targeting, inflation targeting and nominal income targeting. It is concluded that a
monetary target performs worst among the three regimes while the results of income targeting are
most encouraging. Inflation targeting only performs well for demand shocks but causes greater
volatility in real output under both productivity shocks and risk reassessment shocks. As there is a
general trend towards inflation targeting in industrialized economies, this particular results should
give some caution to Indian monetary authorities in following the industrialized world in their
choice of an inflation-targeting regime. The most likely shocks to face India in a period of
structural reform are different to those facing industrialized economies and are less well handled
under an inflation target regime compared to a nominal income-targeting regime.