Monday, November 25, 2019

5 December 2019: The Impact of Monetary Policy in a Dual Economy

Varsha S. Kulkarni
Harvard University

Organised by
The Centre for Development Economics and Department of Economics, Delhi School of Economics

There is a line of research in macroeconomics that believes that if the expectations are rational then the activist monetary policies would do little to raise the output and instead may increase or even destabilize the inflation. In accordance with the New Keynesian Philips Curve (NKPC), when the traders are able to anticipate changes in policies, they’re able to make accurate estimations of inflation and hence the output would remain mostly unchanged (at full employment). This absence of an appreciable long-run tradeoff between inflation and output also strengthens the case for inflation targeting. However, in practice both the long-run neutrality of money and unchanging output have been increasingly questioned. The impact of policies is known to be substantial for increasing output. Further, one of the main drawbacks of NKPC is identified as not being able to explain the widely prevalent inflation persistence. In keeping with all this, a hybrid expectations model is often suggested as an improvement, one which would incorporate both backward-looking and forward-looking inflation components. While researchers are constantly trying to study different sources of market imperfections to explain the findings, there is a lot of variation across countries in terms of the behavior of traders and the formation of expectations. It is of interest to see how the policies like inflation targeting would unfold in the midst of uncertainties and aggregate demand shocks experienced commonly by the developing economies. We explore one such scenario for an economy like India which functions dually between the well-regulated and informed formal sector on the one hand and the relatively unregulated and uninformed informal sector on the other. We identify the informal sector as an important source of imperfection and expectation heterogeneity. We study the heterogeneous expectations in terms of their reactions to inflation target both theoretically and empirically. In this paper, the heterogeneity in expectations together with the response to an inflation target gives rise to a non-constant velocity and, therefore, aggregate demand, even when money supply is fixed. We find that the presence of informal sector makes it difficult to control the fluctuations in output and therefore poses a challenge to effective policy making. We study empirically the impact of demonetization shock. Finally, the paper incorporates this heterogeneity as two different kinds of firms reacting differently to new information or policies. It derives a variant of the sticky information Phillips curve developed earlier. In this talk, I will present the computational, empirical as well as theoretical results and discuss the implications.

Date: December 5, 2019
Time: 03:05 P.M.

Amex Room (Second Floor)
Department of Economics,
Delhi School of Economics,
New Delhi-110007(INDIA)


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