Nonlinear Reaction functions: Evidence from India

This paper uses time-series data from India and tests for asymmetries in policy preferences of the Reserve Bank of India (the Central Bank of India, hereafter RBI). The results show evidence in favour of preference asymmetries in monetary policy reaction function in India and hence nonlinearities in the Taylor-rule. Evidence of both recession avoidance preference (RAP) as well as inflation avoidance preference (IAP) is established. And it is found that RAP is dominant over IAP, thus confirming nonlinearities in reaction function which in the present case turns out to be concave in inflation and output gap. Further, the results indicate preference asymmetries in both the objectives. The coefficient weights to positive and negative inflation and output gap differ over long time horizons thus confirming asymmetric policy preferences. Specifically the RBI seems to be more averse to a negative output gap (contraction) as compared to an equal positive gap. In addition, the RBI appears to be more averse to a positive inflation gap as compared to an equal negative gap.