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wp1084

wp1084

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WP/10/84
Inflation Expectations and Monetary Policy in India: An Empirical Exploration
 
 Michael Debabrata Patra and Partha Ray
 
 
© 2010 International Monetary Fund WP/
10/84
 
IMF Working Paper
Office of the Executive Director
Inflation Expectations and Monetary Policy in India: An Empirical Exploration Prepared by Michael Debabrata Patra and Partha Ray
1
 
Authorized for distribution by Arvind Virmani March 2010
Abstract
JEL Classification Numbers: E 31, E 52 Keywords: Inflation, Inflation Expectation, India, Monetary Policy Author 
s E-Mail Address:
mpatra@imf.org ; pray@imf.org
 
1
 The authors are indebted to Dr. Duvvuri Subbarao for his valuable reactions to an earlier draft of the paper. They are also grateful to Christopher Crowe, Roberto Guimaraes and Kalpana Kochhar for their comments. The views expressed in the paper are attributable to the authors only; all other usual disclaimers apply.
This Working Paper should not be reported as representing the views of the IMF.
 
The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate.
This paper pursues a computationally intensive approach to generate future inflation, followed by an exploration of the determinants of inflation expectations by estimating a new Keynesian type Phillips curve that takes into account country-specific characteristics, the stance of monetary and fiscal policies, marginal costs and exogenous supply shocks. The empirical results indicate that high and climbing inflation could easily seep into people’s anticipation of future inflation and linger. There is a reputational bonus for monetary policy to act against inflation now rather than going for cold turkey when societal compulsions reach a critical mass.
 
 2 Contents Page I.
 
The Context………………………………………………………………........ 3 II.
 
Recent Inflation Dynamics in India ………………………………………….. 4 Tracking Inflation Expectations: The State of Play ……………………….. 7 III. Methodological Issues ………………………………………………………... 8 Measurement of Inflation Expectations in India: A Pragmatic Approach 9 Drivers of Inflation Expectations ………………………………………….. 10 IV. Estimation Results …………………………………………………………….. 13 Time Series Properties of the Variables …………………………………….. 15 Determinants of Inflation Expectations …………………………………….. 16 Is it a Cointegrating Equation? …………………………………………........19 V. Conclusion ……………………………………………………………………... 19 Tables 1. Inflation Expectations Equation …………………………………………………... 13 2. Descriptive Statistics of Model Performance ………………………………...........14 3. Tests for Unit Roots and Order of Integration…………………………………….. 15 4. Redundant Variable Test with Model-based Inflation Expectations ……………... 18 5. Redundant Variable Test with Consensus Expectations ………………………….. 18 6. Results for Engle-Granger Procedure …………………………………………….. 19 7. Determinants of Inflationary Expectations (Model-based Forecasts) …………21 8. Determinants of Inflationary Expectations (based on Consensus Expectations) …. 22 9. Cointegration LR Test Based on Maximal Eigenvalue of the Stochastic Matrix…. 23 10. Cointegration LR Test Based on Trace of the Stochastic Matrix ………………... 23 11. Estimated Cointegrated Vectors in Johansen Estimation ……………………....... 24 Charts 1. Consumer Price Inflation………………………………………………................... 5 2. Movements in WPI and CPI Inflation ……………………………………...............6 3. Actual and Simulated Inflation …………………………………………................. 14 4. Consensus Inflation Forecasts and Actual (Monthly) Inflation ..………………….. 15 5. Impulse Response to a Change in Real Interest Rate …………………………....... 17 Annexes I. Determinants of Inflation Expectations .…………………..……………………… 21 II. Cointegrating Vectors for Inflation Expectations and Determinants……………... 23 References ……………………………………………………………………………. 25

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