I have been thinking about monetary policy for a while now- primarily as a part of my dissertation research and also because that is one of the things that interest me about macroeconomics. What should central banks do as a part of their regular functioning? Maintaining low inflation seems like a good task at hand. Of course, central banks like the Reserve bank of India (RBI), have a little more than that on their plate as managing the forex markets gets added to their usual functions. In addition to this there is also managing a substantial government borrowing program, making inflation targeting a bit more ominous of a job.
James Bullard convincingly argues here for inflation targeting by proposing to interpret the recent financial crisis as primarily a persistent wealth shock. I think Federal Reserve will do good to abide by it and be flexible on its current stance of maintaining a near zero interest rate. How does his advice bear on the RBI? If RBI decides to target inflation with managing the exchange rate and government borrowing along with it, the only thing it can actually do is to just keep on playing with the interest rate. This may or may not have the desired effect given a significant informal economy outside the purview of the formal banking sector. This is because the informal sector makes the transmission mechanism for monetary policy changes significantly complex than in an economy dominated by formal banking and financial sector. To figure out the transmission mechanism in presence of a informal sector, one has to have a model in mind of how the formal and informal sector interact in reaction to the given policy changes. Also, most of the inflation in the Indian economy is caused by persistent food price inflation which, seems to be not under the direct influence of RBI and may require some fundamental changes in the way the Government of India manages the food procurement and distribution system. For more on this check this post.
Good food for thought-any suggestions!