Academic journal article Academy of Accounting and Financial Studies Journal

A Partial Least Square Modeling Involving Interest Rates and Other Macroeconomic Variables in India

Academic journal article Academy of Accounting and Financial Studies Journal

A Partial Least Square Modeling Involving Interest Rates and Other Macroeconomic Variables in India

Article excerpt


The monetary and credit policy in India is a multi-directed; it attempts to provide adequate liquidity for meeting reasonable credit requirements and support investment demand in the economy while keeping the price level within limits. Thus, the emphasis of state interventions keeps on changing depending on immediate economic concerns.

One of the benefits of the Indian political system is that the high level of inflation is not politically acceptable, and the government is forced to take several populist measures to keep the inflation rate down. Further, the relationship between inflation and GDP growth in India are not established, and political leaders are right in demanding low inflation and high GDP growth. Generally, inflation rates in India fluctuate around the 5% level and rarely allowed to touch double-digit. Whenever inflation increases, the single emphasis of the government turns into taming inflation. Many policy analysts have criticized RBI's monetary policy in recent times and found it to be inconsistent. The RBI often remains very elusive as to what they are trying to target and how the target is being achieved. Instead, the RBI often resorts to rather an ad hoc combination of foreign exchange intervention, interest rate changes, and a nonmarket mechanism like hikes in the Cash Reserve Ratio (CRR), among others.

Singh (2010) examined the monitory policy of India and found that the variations in the short-term interest rates are primarily influenced by the inflation gap than the output gap. They used a historical sample covering 1950-51 to 2008-09 and noticed an obvious bias in the conduct of monetary policy regarding stronger reaction to the output gap than to deviations in inflation. However, the results from 1988 onwards suggest that the monetary policy reacts relatively strongly to inflation deviations than in the output gap. The estimated coefficients of inflation gap in the Taylor rule equation are relatively large as compared to the coefficients of the output gap, suggesting more than the proportional reaction of monetary policy to inflation deviations. They also noted that the current exchange rate fluctuations also influence monetary policy decisions about the interest rate. In the study, we tried to examine the relationship between various measures of Interest rate, Output gap, foreign trade, and exchange rate using partial least squares.


Taylor (1993) established a linear relationship among the inflation gap (the difference between current inflation and targeted inflation) and output gap (the difference between actual output and targeted output) with the targeted interest rate. The relationships involving the current output gap and the current rate of inflation were expressed as follows:

(ProQuest: ... denotes formula omitted.)

Where, rt is the targeted federal funds rate, (y-yt·) is a measure of the output gap, and pt is the current rate of inflation. The response coefficients were fixed in the generic Taylor rule formulation as the target interest rate was kept at 2%. However, the original rule can be adapted to suit the requirements of other places. For example, the numerical constants of the equation can be replaced by parameter estimates using regression analysis.

Taylor remarked in his paper that even though his rule was targeted for the US, it is possible to extend the same to other developed economies. Several studies involving other developing nations observed that policymakers often try to achieve some explicitly or implicitly inflation target by adjusting interest rates.

With 25% of global GDP, the US economy is the prime mover of global economic trends, and the Taylor Rule works well for it. It was observed that inclusion of exchange rate and other macroeconomic variables in the benchmark policy rule could improve macroeconomic performance in a small open economy model.

Prior to the reform process initiated in the early 1990's, the Indian economy was practically a closed one, and prices of a large number of commodities were administered. …

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