Inflation Targeting for India?: The Implications of Limited Asset Market Participation

This paper analyzes whether liquidity constraints matter for optimal monetary policy choices in an open economy. Asset market participation is limited as some agents lack financial capacity and behave in a hand-to-mouth fashion. I evaluate consumer welfare using a micro-founded welfare criterion derived through perturbation techniques, and find that the presence of liquidity constraints requires re-thinking conventional monetary policy design. Simple rules are ranked. While consumer price index (CPI) inflation targeting is appropriate in a fully Ricardian economy, a nominal exchange rate peg is shown to be least suboptimal when financial participation is low. The analysis is applied to the Indian context where monetary policy has recently been overhauled and a new CPI inflation targeting regime is being implemented.

Tara Iyer
Jul 2015