Exploring Correlations between Aggregate Demand and Supply Shocks in India

Author: Ashima Goyal and Sritama Ray

Title: Exploring Correlations between Aggregate Demand and Supply Shocks in India

Abstract: We explore the relative contributions of demand and supply shocks on inflation and output in India when correlation is allowed between shocks. Our SVAR model is estimated with quarterly GDP, WPI and CPI data covering the period between 1997Q2 and 2020Q1. The Keynesian case is of demand leading to a shift in supply as firms with excess capacity respond, while the case of supply affecting demand could be due to policy reactions to supply shocks. We estimate the correlations and slopes under different identifying assumptions. We find a positive correlation between shocks in all cases. Overall, a Horizontal Supply Curve (HSC) identification is supported, an asymmetry expected for a populous emerging market in transition. The short-run output cost of disinflationary policy is, therefore, large. Moreover, a policy demand contraction following a negative supply shock turns out to have perverse effects when the HSC holds, further aggravated when headline CPI is the target variable. This was the Indian experience of slowdown and inflation persistence after 2011 following demand tightening under food price shocks. Policy should ideally sustain demand, which can induce output expansion, and moderate the impact of shocks making the impact of demand and supply shocks more even. India’s inflation targeting framework can therefore work better by aiding supply side improvements and anchoring inflation expectations.

Keywords: Correlated demand and supply shocks; asymmetry; monetary policy; horizontal and vertical supply curves; India; structural VAR

JEL Code: C51; C52; E52; E58

Weblink: http://www.igidr.ac.in/pdf/publication/WP-2022-004.pdf