An Analysis on the Effect of Inflation on the Country’s Economy and Its Aftermath

Abstract

There is an estimation of an augmented Phillips curve to examine the effects of supply shocks on inflation in India. The results suggest that supply shocks have only a transitory effect on headline and core inflation rates. The evidence is robust to various respecifications and measures of core inflation. A possible explanation for this is that monetary policy has not provided the basis for a permanent change in the inflationary process by accommodating supply shocks, i.e. the expansion of the money supply in response to negative supply shocks. Thus, monetary authorities have implicitly targeted the core measure of inflation by discounting price movements that are expected to reverse in the short term. In short, it is not supply shocks per se that are decisive in determining inflation, but how policymakers respond to these shocks.

This paper examines the drivers of headline inflation and its component, food inflation in India, using monthly data from April 1996 to March 2017. The analysis includes measures of both WPI and CPI-IW inflation along with their food inflation component. The study uses a cointegration approach to identify the determinants of inflation in India. Empirical estimates of the study show that there is a long-run relationship between inflation and its determinants, which include expected inflation, output gap, growth rate of money supply, exchange rate, interest rate, fiscal deficit, minimum support prices, international oil discounts and food prices.