What Drives Indian Inflation? Demand or Supply

Ashima Goyal () and Abhishek Kumar ()
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Ashima Goyal: Indira Gandhi Institute of Development Research
Abhishek Kumar: University of Southampton

A chapter in Practical Economic Analysis and Computation, 2024, pp 91-140 from Springer

Abstract: Abstract Understanding the drivers of inflation is an important issue in business cycle research and has been a matter of debate. In this paper, using data from a large emerging economy, we identify a structural shock (inflation shock) that explains the maximum forecast error variance of consumer prices. The inflation shock explains more than 80% of the forecast error variance of consumer prices up to 40 quarters. This shock increases prices and decreases output, implying that it is a supply shock. We also show that the food inflation shock is the primitive shock, which makes the inflation shock a supply shock and also feeds into non-food inflation. A large interest rate reaction to this shock leads to a prolonged decline in credit, investment and output. Using the shocks obtained from a medium-scale new Keynesian model, we provide additional evidence that most of the variance of estimated inflation and food inflation shocks is explained by model-based supply shocks. These results suggest that central banks in emerging economies need to be more pragmatic in implementing inflation targeting policies.

Keywords: Inflation; India; SVAR; FEV; Supply shock; Demand shock (search for similar items in EconPapers)
JEL-codes: E43 E44 E52 (search for similar items in EconPapers)
Date: 2024
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Persistent link: https://EconPapers.repec.org/RePEc:spr:isbchp:978-981-97-6753-3_6

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DOI: 10.1007/978-981-97-6753-3_6

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