As an open economy, the Indian economy is vulnerable to the exogenous shocks from external events. Therefore, its Central Bank (RBI) has to consider the impact of the external shocks on the domestic economy in formulating its monetary policy. This study examines how effective is domestic monetary policy in mitigating the negative effects of external shocks (for example, oil price, foreign monetary policy, and foreign income shocks) on domestic economic activity. This information is pivotal for the monetary authority in order to evaluate what would happen to the domestic economy if it does not react to the external shocks. In order to estimate the effectiveness of monetary policy in mitigating the negative impact from external variables, the study uses ‘Shutdown Methodology’. The findings suggest that monetary policy plays an important role in stabilizing the domestic output and inflation from the adverse global supply shocks (an increase in world oil price growth), while its role in shielding domestic output from adverse effects of increase in federal rate is only marginal. This is an important finding as it shows that despite the partial pass-through of global oil price changes to domestic economy, some impact which is felt on domestic GDP and inflation can me ameliorated by the Central Bank’s prudent policy measures.

KEYWORDS: Monetary policy, Structural VAR, External factors