Policy errors and business cycle fluctuations: Evidence from an emerging economy

In the immediate aftermath of the global financial crisis, the monetary policy in India became accommodative as in other major economies, but the policy subsequently turned highly contractionary despite falling inflation, which we characterize as policy errors. Government expenditure also had similar pattern. This paper therefore estimates a medium scale New Keynesian model (with earnings and assets based collateral constraint) to explore the impact of such policy errors on Indian business cycles, capturing the prevailing narrative on both monetary and fiscal policies along with the actual inflation scenario. Our smoothed estimates of mark-up, productivity, interest rate and government expenditure shocks mimic the actual transition of the economy, with both policy shocks moving together in a similar pattern in the post crisis period. We find that the interest rate policy was highly contractionary during 2013-2016 which led to significantly lower output. We rationalize that if supply side shocks (adverse productivity or mark-up) dominate, such policy errors tend to occur, suggesting that policy makers need to pay attention to the sources of inflation in a developing economy while setting demand-management policies. Given the current pandemic as more of a adverse supply shock, similar policy errors are likely to occur if interest rate responds to this type of inflationary shocks.