Exchange Rate and Pass‐Through Under Alternative Monetary Policies: Evidence From India

This article examines the role of alternative monetary policy rules in shaping exchange rate pass‐through and macroeconomic dynamics in a small open economy. To this end, we develop and estimate a Bayesian dynamic stochastic general equilibrium model featuring a conventional monetary policy rule and an exchange rate‐augmented monetary policy rule. The results show that incorporating exchange rate movements into the monetary policy rule lowers exchange rate pass‐through and weakens the transmission of external shocks to domestic inflation. Results from impulse response and conditional variance decomposition analyses reveal that the exchange rate‐augmented monetary policy rule enhances the economy's resilience to external disturbances. In addition, recursive forecasting shows comparable predictive performance under both policy rules, albeit modest improvements in interest rate forecasts under the exchange rate‐augmented monetary policy rule. Counterfactual analysis further complements the empirical relevance of the exchange rate‐augmented monetary policy rule. Policy‐wise incorporating exchange rate considerations into monetary policy can strengthen macroeconomic stability and policy transmission in small open economies such as India.