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What Drives Indian Inflation? Demand or Supply

Author

Listed:
  • Ashima Goyal

    (Indira Gandhi Institute of Development Research)

  • Abhishek Kumar

    (University of Southampton)

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.

Suggested Citation

  • Ashima Goyal & Abhishek Kumar, 2024. "What Drives Indian Inflation? Demand or Supply," India Studies in Business and Economics,, Springer.
    • Handle: RePEc:spr:isbchp:978-981-97-6753-3_6
    DOI: 10.1007/978-981-97-6753-3_6
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    More about this item

    Keywords

    Inflation; India; SVAR; FEV; Supply shock; Demand shock;
    All these keywords.

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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