Monetary Policy Transmission in India: Interest Rate Puzzle

The interest rate transmission mechanism of monetary policy to real economic activity has been the center of interest of many researchers globally. The aim of this paper is to study the impact of the policy interest rate (both nominal and real interest rates) on the output gap in India for the period from May 2001 to March 2015 using monthly data, and explore whether the Reserve Bank's switching to inflation targeting has hampered the growth objective. The paper uses Autoregressive Distributed Lag (ARDL) cointegration approach to study the long-run and shortrun dynamics of the objective variables. It takes sufficient number of lags to handle the problem of endogeneity mostly present amongst macroeconomic variables. The study finds presence of interest rate puzzle, where the conventional negative relationship between output and interest rate is broken. It suggests the presence of some other factors such as business mood, investment uncertainty, presence of parallel economy or the time period which was dominated by global financial crisis and its aftermath as the possible reasons for the decline in growth rate.