IGIDR Publication: What Drives Indian Inflation? Demand or Supply

NO : WP-2022-013

AUTHOR : Ashima Goyal and Abhishek Kumar

TITLE :  What Drives Indian Inflation? Demand or Supply


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;

JEL Code: E43; E44; E52

Weblink: http://www.igidr.ac.in/pdf/publication/WP-2022-013.pdf