Monetary transmission mechanism in India: A structural analysis of interest rate and exchange rate channels

Abstract

The paper investigates the monetary transmission mechanism in India, focusing on the roles of the interest rate and exchange rate channels in influencing key macroeconomic variables such as GDP, inflation, money supply, and exchange rates. Using monthly data from January 1997 to January 2017, a Structural Vector Autoregression (SVAR) framework with non-recursive identification restrictions is employed to analyze the dynamics of monetary policy transmission. Impulse response functions (IRFs) reveal that interest rate shocks lead to a delayed but significant reduction in output and inflation, consistent with the interest rate channel, while exchange rate shocks immediately affect GDP and inflation through currency movements, underscoring the exchange rate channel's importance. Forecast error variance decomposition (FEVD) quantifies the relative contributions of these shocks, showing that the interest rate channel plays a growing role over time, while the exchange rate channel has a persistent influence, particularly in the short term. These findings highlight the dual importance of domestic monetary policy and external exchange rate dynamics in shaping India’s macroeconomic stability. The paper provides critical insights for policymakers, emphasizing the need for a balanced and proactive monetary policy framework to manage inflation and support sustainable economic growth in an open economy context.