Inflation in India: Empirical analysis using VAR Approach

Abstract

Central Banks across the countries are moving away from single indicator to multiple indicator approach towards conducting monetary policy. Further, diagnosis of the headline inflation alone could be misleading for policy purpose because inflation
increases due to transitory factors also. To deal with such situations the concept of core inflation helps in determining the underlying trend in the headline inflation in formulating credible monetary policy to attain the price stability objective. In this context, this study explores the determinants of headline and core inflation for the period 2004 to December 2012 in Indian economy by employing Vector Autoregressive method It is found that both core and headline inflation variables have co-integrating relationship with the Index of Industrial Production, Reserve Money, Broad Money, Gold Prices, and Crude oil Prices. The granger causality results suggest that Index of Industrial Production causes headline inflation and core inflation (WPI excluding fuel and power). Broad Money causes core inflation2 (WPI excluding fuel and power), whereas crude oil price causes all three indicators of inflation (headline, core inflation1: WPI excluding food articles and core inflation2: WPI excluding fuel and power). It has been found that both crude oil price and index of industrial production are most important variables in explaining the variation in inflation. Thus the most significant impact on inflation comes via crude oil price and index of industrial production.