Monetary policy and the behaviour of inflation in India: Is there a need for institutional reform?

Inflation rates in a number of developed countries follow a common trend over the past five decades: inflation starts out low in the 1950s, rises for a time before peaking in the 1970s, and then falls back to initial levels. Interestingly the behaviour of trend inflation in India broadly exhibits such a pattern. This similarity in the behaviour suggests that any explanation of inflation ought to apply across countries. To this end we construct a reduced-form inflation model for India that encompasses various well-known policy mistake theories as special cases. The restriction imposed by each of these theories on the behaviour of inflation is tested empirically. Reduced-form estimates lend support to all these theories. Although the reason for the inflation bias differs from one theory to the other, the mechanism at the heart of these theories are in fact quite similar. They all lay responsibility for inflation with the nature of monetary institutions. We use these results to interpret India's inflation experience over the past five decades and discuss the implications for institutional reform.