inflation are significant in the estimates of reaction function over 1980-2008; the coefficient of output is more significant than inflation. Patra and Kapur (2012) estimate several different models using data for 1996-2011 and found that even though the quantitative results are specific to the estimated model, both inflation and the output gap are significant in the policy reaction functions.

Studies using longer time series data show the relative importance of inflation and the output gap in policy reaction function has evolved over time. Singh (2010) e.g. shows the output gap to have a larger influence on monetary policy until the 1980s, and the effect of inflation to be stronger in the following two decades. Mohanty (2013) also finds the impact of inflation to be stronger than that of the output gap (and the latter to be statistically insignificant) during a more recent period, 2000-01 to 2012-13.

How may concerns related to exchange rate or capital flows affect monetary policy in an emerging country? As discussed in Section 2, capital inflows usually cause exchange rate appreciation and capital outflows result in exchange rate depreciation. Central banks in order to resist these exchange rate movements, may lower the policy rates to deflect capital inflows and raise them to deter outflows. In addition, central banks may buy foreign exchange to build its reserve cover or to avoid exchange rate appreciation during capital inflows or sell them during outflows, but may choose not to sterilize them fully. Thus the monetary stance often becomes expansionary during capital inflows and contractionary during outflows.

Has monetary policy in India been affected by issues related to capital flows? The evidence is more tenuous on the impact of exchange rate or capital flows on monetary policy in India. Mohanty and Klau (2004) find changes in policy rates to be correlated with exchange rate in India as well as other emerging markets, highlighting the support for the “fear of floating” hypothesis. Additionally, they find the response of policy rates to the exchange rate to be larger than that to inflation or the output gap.<sup>22</sup> Hutchison et al. (2013) estimate the monetary policy rule in India at different times over the 1987–2008 period. They show that external considerations influenced RBI policy over the sample period— taking the form of responding to exchange rate depreciation (appreciation) by raising (lowering) the interest rate. Patra and Kapur (2012) find exchange rates to be broadly insignificant, and to only have a lagged impact on money supply, but not on policy rates.<sup>23</sup> In our own analysis we correlate reserve money supply (total reserve money supply as well as reserve money in circulation held by public), broad money supply (M3), and the

> 22 They also indicate an interesting asymmetry in some countries in that the central bank’s response to a negative inflation shock is weaker than to a positive shock.

> 23 Taking a different tack in a RBI working paper, Verma and Prakash (2011) find capital inflows to be unresponsive to the interest rate differential, and conclude that the policy rates may primarily focus on domestic inflation and growth objectives, and the response to the magnitude and composition of capital flows may well be through other instruments.

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