The contribution of food subsidy policy to monetary policy in India

Food price volatility is a major threat for welfare, economic prosperity and political stability. The monetary authority is generally viewed in the literature as the only institution responsible for price stability, however this approach overlooks the importance of food price stabilization policies using fiscal instruments. We develop and estimate a Bayesian DSGE model that incorporates monetary and fiscal policy tailored to India, replicating food demand and food supply subsidies. We find that following a world food price shock, CPI and therefore interest rate volatility would be 21% higher in the absence of food subsidies. Putting this effect aside would lead to overestimating the effectiveness of inflation targeting by the central bank. Accordingly, we find that the subsidy policy has large heterogeneous distributional welfare effects: while farmers benefit from all subsidies, the inclusion of urban households into the demand subsidy program is required to offset supply subsidy welfare cost.

Automated summary

Food price volatility poses a major threat to welfare, economic prosperity, and political stability. In addition to the monetary authority, food price stabilization policies using fiscal instruments are also important for controlling inflation. This study develops a Bayesian DSGE model tailored to India and incorporates both monetary and fiscal policies, specifically focusing on food demand and supply subsidies. The findings show that the absence of food subsidies would lead to a 21% increase in CPI and interest rate volatility following a global food price shock. Ignoring this effect would result in an overestimation of the effectiveness of inflation targeting by the central bank. The subsidy policy has significant heterogeneous distributional welfare effects, with farmers benefiting from all subsidies and the inclusion of urban households in the demand subsidy program being necessary to offset the welfare cost of supply subsidies.