What drives Indian inflation? Demand or supply

Ashima Goyal and Abhishek Kumar

Indira Gandhi Institute of Development Research, Mumbai Working Papers from Indira Gandhi Institute of Development Research, Mumbai, India

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 per cent of the forecast error variance of consumer price 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)
Pages: 75 pages
Date: 2022-09
New Economics Papers: this item is included in nep-ban, nep-cba, nep-dge and nep-mon
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Persistent link: https://EconPapers.repec.org/RePEc:ind:igiwpp:2022-013

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