Disentangling India's Monetary Transmission Mechanism: A Channel-Specific Structural VAR Analysis of Interest Rate, Exchange Rate, and Asset Price Dynamics

Abstract

This study empirically investigates the transmission mechanism of India’s domestic monetary policy across key macroeconomic and financial variables using a Structural Vector Autoregression (SVAR) framework with non-recursive identification. Utilizing monthly data from January 1997 to January 2020, the analysis focuses on three distinct transmission channels—interest rate, exchange rate, and asset price—to assess how policy-induced shocks affect industrial output, inflation, money supply, exchange rate, and equity markets. The choice of the 1-year Treasury yield as the primary policy rate, based on Principal Component Analysis (PCA), reflects India's evolving monetary regime over the study period and ensures methodological consistency. The empirical findings suggest that monetary policy tightening exerts contractionary effects on output and asset prices, induces rupee appreciation, and affects inflation with a lag. Notably, the interest rate channel displays more persistent effects on long-term yields and inflation expectations, while the exchange rate and asset price channels respond more rapidly but with shorter-lived impacts. The study further incorporates control variables—including global oil prices, global GDP, and the Leo-Krippner Shadow Short Rate—and accounts for structural shifts through dummy variables for key financial crises. Robustness is validated via Granger causality tests and post-estimation diagnostics. This chapter offers a novel contribution by refining India's domestic transmission architecture using a non-recursive SVAR model, addressing heterogeneity in monetary regimes and advancing context-specific policy insights.

JEL Classification: E52 (Monetary Policy), E44 (Financial Markets and the Macroeconomy), C32 (Time-Series Models), E31 (Inflation), F41 (Open Economy Macroeconomics