The Reserve Bank of India (RBI) reviewed inflation to better capture fiscal and monetary policy interactions with the real economy.

Economists at the RBI describe the framework as a forward-looking, calibrated, new-Keynesian gap model.

The Reserve Bank of India said it has revised its inflation-forecasting model to better capture how financial and monetary policy interact with real-economy elements. The Reserve Bank of India, in its latest bi-annual monetary policy report published on Wednesday, stated that the adjustments include fiscal-monetary dynamics, India’s unique and often chaotic fuel pricing regime, and their impact on exchange rate fluctuations and balance of payments. Is included.

Dubbed as the quarterly projection model 2.0, RBI economists describe the framework as a forward-looking, open-economy, calibrated, new-Keynesian gap model. The previous version was often criticized for over-estimating the risk for inflation.

The amendments came just days after the RBI approved the government to maintain its 2 percent -6 percent inflation target range for the next five years. It did not offer a comparison between the rates of inflation predicted under the previous model and the new one, but said its instruments helped keep inflation around the average 4 percent midpoint in the last five years.

RBI said that the new model is divided into three sections:

  • The first, or fiscal block, reduces the government’s primary deficit in structural and cyclical components. A blow to inflation through prior demand and major risks to the country; For example, a structural increase in losses would create a positive output gap and high debt makes borrowing expensive and depreciating the currency, leading to higher inflation. A cyclic jerk is insignificant
  • The second, or fuel block, takes into account India’s complex system of pricing. Commodities such as gasoline and diesel are priced based on international oil prices, exchange rates, and local taxes, while liquefied petroleum gas and kerosene prices are market determined but with a backward pass. The cost of electricity is administered by the state governments. The RBI said that headline inflation rises by 25 basis points in response to the fuel tax hike of Rs 10 (13 cents) per liter.
  • The balance of payment blocks identifies the costs associated with exchange rate volatility. In the case of a capital outflow shock of 1 percent of GDP, and the RBI intervenes and sterilizes 70 percent of this outflow, reserves will fall below 0.7 percent of GDP and the exchange rate will fall, prompting inflationary pressures

Shailesh J. at IIT, Mumbai. “This is an attempt to align the RBI’s inflation forecast model to the country’s exchange rate regime,” said Rohan Chinchwadkar, an assistant professor of finance at the Mehta School of Management. A twitter post

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