India has just completed a decade of inflation targeting (IT) as a formal policy framework of the Reserve Bank of India (RBI). Under this framework, the RBI is supposed to contain inflation at 4% within a band of (+/-) 2 percentage points. In this piece, we explain the theory behind inflation targeting and test it against the Indian experience.

The RBI seeks to control inflation through two channels: controlling demand and influencing the public’s inflationary expectations. The RBI increases its policy rate of interest (the repo rate) when inflation kicks in. This pushes commercial banks’ lending rates up.