Financial Econometrics

RELATION BETWEEN RETAIL INFLATION, CRUDE OIL

PRICES AND AVERAGE ANNUAL RAINFALL IN INDIA

Submitted by
Khushboo Goyal
Section- C (Finance)
19DM094
Introduction
”Inflation mean sustained rise in the general price level of the goods and services in an economy over
a period of time. When the general price level rises, each unit of currency buys fewer goods and
services, reflecting reduction in purchasing power per unit of money.”

“The common measure of inflation rate is usually the consumer price index (CPI). Inflation affects
economies in various positive and negative ways. The negative impact can be in the form increase in
the opportunity cost of holding money, fall in investment and savings etc. Positive impact includes
reduction in employment, encouraging loans and investments instead of money hoarding etc.”

“Today,most economists favor a low and steady rate of inflation. Low inflation reduces the severity
of economic recessions by enabling the labor market to adjust more quickly in a downturn, and
reduces the risk that a liquidity trap prevents monetary policy from stabilizing the economy.”

Literature review
“A number of studies report small or limited effect of oil price on inflation. Among them include
Hooker (2002) and Gregorio et al. (2007). More recently, Arango et al. (2014) applied a small open
macroeconomic model with optimal interest rate rule to study the relationship between commodity
prices shocks and inflation process. Their results is consistent with previous findings that pass-
through from oil prices to headline inflation has decreased. ”
”They interpreted the result as the outcome of the effectiveness of monetary policy that includes
commodity prices movements in the set of inflation expectations under inflation targeting regime.
Jiranyakul (2015) also fail to detect the long-run impact of oil price shocks on consumer prices in the
case of Thailand.”
“Later Hamilton (2000) reported clear evidence of nonlinearity-oil price increases is much more
important than oil price decreases. An alternative interpretation was proposed based on the
estimation of a linear functional form using exogenous disruptions in petroleum supplies as an
instrument. His study shows that oil shocks play a crucial role in determining macroeconomic
behavior because they disrupt spending by consumers and firms. ”

Types of Inflation
Open Inflation:” The rate at which cost increases due to economic trends of spending.”

Suppressed Inflation:” Existing inflation disguised by government price controls or other

interferences in the economy such as subsidies. Such suppression can only be temporary because no
governmental measure can completely control accelerating inflation in the long run. It is also called
Repressed Inflation.”

Galloping Inflation:” A rapid Inflation which is near to impossible to reduce. Creeping Inflation: It
occurs when the inflation of a nation increases progressively, but continuous and throughout. This is
the most common pattern in many countries. Although the increase is comparatively small in the
short-term it continues over time and hence the effect will become greater and greater.”

Hyper Inflation: Hyper Inflation is mainly caused due to excessive deficit spending by government
(financed by printing of more money).
Factor affecting Inflation
Although various factors like Demand side factors, Supply side Factors, Domestic Factor, and
External Factor affects the inflation, but for this report we will study Supply side Factors and
External Factors and their impact on inflation.

Factors affecting the Supply Side:” The supply side of inflation is a major ingredient for rise in
Inflation in India. The agricultural need creates a want resulting in a higher level of inflation.
Similarly, the high cost of labour will eventually increase the production cost which in turn will lead
to a higher price for that particular commodity. Some of the factors affecting the supply side of
inflation in India are as follows:”

 Rise in prices

 Erratic agriculture growth (especially due to erratic monsoon)

 Agricultural price policy

 Inadequate industrial growth

Erratic agriculture growth (especially due to erratic monsoon): A key driver for inflation is the
monsoon. A good monsoon results in better harvest thereby maintaining the supply of products
under balance with demand, keeping the prices under control. However, any rise or fall in the levels
of rainfall results in either floods or drought which impact the farm supply adversely and causes rise
in the price (inflation).
External Factors: The exchange rate is a key component for the increase in inflationary that rises in
India. Since our more than 80% of crude oil needs is fulfilled by the imports exchange rate affects the
oil prices significantly. Depreciation of Indian currency in relation to US$ increases our oil import
bills.

Oil is the major component in various industries

including aviation, automobile, manufacturing,
agriculture, any rise in the price of oil resulting in
increased cost of production/manufacturing
which is transferred from producer to consumer
in the form rise in the prices of goods and
services which result into inflationary situation in
the country.

Theories of Inflation

Theories of Inflation

Market- Power theory Conventional Demand- Structural Theory of

of Inflation Pull Inflation Inflation

Mark-up
Theory

Bottle-Neck
Inflation
There exist lots of theories which affects inflation but the theory which is applicable in this
model is MARK-UP theory of Inflation
According to mark up theory, there are two causes of rise in inflation, one is through demand pull
and the other is cost-push. The inflation is cumulative of both these reasons. And in the report, the
variables taken is inflation (dependent), rainfall and oil prices (independent). The inflation is
dependent on rainfall and oil prices that affects the supply of food products, thus validating the
mark-up theory i.e. retail inflation is pulled by cost-pull factors. For example: as we are facing the
current situation in the economy, rising prices of onions and the reason has been inadequate rainfall
that affected the supply of onions and therefore there was hike in the prices of onions.

Also considering another example, oil prices are the major input and cost determinant for the
aviation sector. Now we also know that when the oil prices rise, the cost of operation of aviation
industry and overall transportation cost increases, which leads to general rise in price level. Thus,
impacting the inflation rates of the economy.

a<-read.csv("fp.csv")

summary(a)

## X1 X2 Y
## Min. :-0.30783 Min. :-0.90354 Min. : 0.470
## 1st Qu.:-0.02422 1st Qu.:-0.05643 1st Qu.: 5.335
## Median : 0.11535 Median :-0.03865 Median : 6.530
## Mean : 0.11599 Mean : 0.31031 Mean : 7.480
## 3rd Qu.: 0.23346 3rd Qu.: 0.06993 3rd Qu.: 9.580
## Max. : 0.64731 Max. : 7.87993 Max. :15.320

Developing a hypothesis
Null hypothesis = crude oil prices and monsoon does not affect retail inflation.
Alternate hypothesis = Crude oil prices and monsoon affects retail inflation

Ordinary Least Square Method

In order to examine the theory and to find evidence to prove or disprove the hypothesis
stated previously. Multivariate regression has been applied to find the sensitivity of retail
inflation as affected by average annual rainfall and crude oil prices. Below are following
results of Multivariate Regression.
LM Test
b<-lm(Y~X1+X2,data=a)

summary(b)

##
## Call:
## lm(formula = Y ~ X1 + X2, data = a)
##
## Residuals:
## Min 1Q Median 3Q Max
## -5.0756 -2.6781 -0.3074 2.9682 4.5636
##
## Coefficients:
## Estimate Std. Error t value Pr(>|t|)
## (Intercept) 8.4712 0.7560 11.206 4.52e-10 ***
## X1 -8.9191 3.3531 -2.660 0.015 *
## X2 0.1383 0.4642 0.298 0.769
## ---
## Signif. codes: 0 '***' 0.001 '**' 0.01 '*' 0.05 '.' 0.1 ' ' 1
##
## Residual standard error: 3.22 on 20 degrees of freedom
## Multiple R-squared: 0.2896, Adjusted R-squared: 0.2186
## F-statistic: 4.076 on 2 and 20 DF,p-value: 0.03274

Regression equation so formed is

Retail Inflation = 8.4712 - 8.9191X1 + 0.1383X2
WHERE X1 is Crude Oil Price and X2 is Average Annual Rainfall in India
The multiple R-square value is 0.2896. It is also the coefficient of determination. It measures
the proportion/percentage of total variation in Y explained by the regression model. This
model says the Y value i.e. Retail Inflation is approximately 28.96 % better predicted due to
the presence of conditional variables like crude oil prices and average annual rainfall.
We can see that the model is significant. The p value is 0.03274 which is less than
alpha=0.05. We reject the null hypothesis and accept the alternative hypothesis.
residuals<-resid(b)

The difference between the observed value of the dependent variable and the predicted
value of dependent variable is called residual.
We apply the test “Resid” to check the pattern of residuals. If we see some set patterns for
residual that would mean that some of the predictor information is leaking in as error
implying we have to look for an explanatory variable to include in the model to account for
that leaked pattern.
To check whether the residual is random or not calculate mean of the residuals. If the mean
turn out to be zero the residual is random otherwise not.
mean(residuals)
## [1] 2.823451e-16

Here, mean of the residual is very close to zero or we can say is approximately zero, which
signifies that the residuals are random in nature
plot(residuals,col="dark blue",main="scatter plot of residuals of b")
A residual plot is graph that shows the residuals on the vertical axis and the independent
variables on horizontal axis. If the points in the residual plot are randomly dispersed around
the horizontal axis, the model is appropriate for the data, otherwise not. In the diagram
below the points are scatter without following any pattern signifies the randomness of the
model.

density(residuals)
## Call:
## density.default(x = residuals)
##
## Data: residuals (23 obs.); Bandwidth 'bw' = 1.476
##
## x y
## Min. :-9.504 Min. :0.0001754
## 1st Qu.:-4.880 1st Qu.:0.0106288
## Median :-0.256 Median :0.0650742
## Mean :-0.256 Mean :0.0540034
## 3rd Qu.: 4.368 3rd Qu.:0.0872406
## Max. : 8.992 Max. :0.1030743

d<-density(residuals)

plot(d)
hist(residuals,col="green")

library(tseries)

## Registered S3 method overwritten by 'quantmod':

## method from
## as.zoo.data.frame zoo
jarque.bera.test(residuals)

##
## Jarque Bera Test
##
## data: residuals
## X-squared = 1.5735, df = 2, p-value = 0.4553

Jarque-bera test check the whether residuals are normally distributed or not. For jarque-
bera test a hypothesis need to be develop which is a follows
Null hypothesis – Error terms are normally distributed
Alternative Hypothesis- Error terms are not normally distributed
If p-value >0.05 accept the null hypothesis and if p-value < 0.05 reject the null hypothesis
In the above test, p-value=0.4553 which is greater than 0.05 therefore we will accept the
null hypothesis i.e. Error terms are normally distributed.
library(lmtest)

## Loading required package: zoo

##
## Attaching package: 'zoo'

## The following objects are masked from 'package:base':

##
## as.Date, as.Date.numeric

library(sandwich)

bptest(b

##
## studentized Breusch-Pagan test
## data: b
## BP = 1.8593, df = 2, p-value = 0.3947

This test is done to see if the residuals are homoscedastic or hetero skedastic, ideally
residuals should be homoscedastic. To do this test the following hypothesis is created where
NULL HYPOTHESIS -The variance of the error terms is constant
ALTERNATIVE HYPOTHESIS -The variance of the error terms is not constant.
After doing the Breusch-Pagan test (bp) on the residuals it is seen p value is 0.3947, which is
greater than 0.05. So we accept the null hypothesis and reject the alternative hypothesis,
which concludes that the variance of the error terms is constant.
bgtest(b)

##
## Breusch-Godfrey test for serial correlation of order up to 1
##
## data: b
## LM test = 0.68989, df = 1, p-value = 0.4062

Null Hypothesis There is autocorrelation between the independent variables.

Alternative Hypothesis There is no autocorrelation between the independent variables
The above test is performed to test if the models suffers from the problem of
autocorrelation of the independent variables. P-value= 0.4062 which is greater than 0.05,
which means we reject the null hypothesis and accept the alternative hypothesis.

Conclusion
From the test done above it can be concluded that the model is significant enough to
generate some meaningful results. Later after applying the above mentioned test it appears
that the model satisfies all the test which means that the residuals are homoscedastic, non-
auto correlated and randomly distributed.

Reference
https://data.gov.in/catalog/all-india-area-weighted-monthly-seasonal-and-annual-rainfall-mm?
filters%5Bfield_catalog_reference%5D=85825&format=json&offset=0&limit=6&sort%5Bcreated
%5D=desc

https://www.statista.com/statistics/271322/inflation-rate-in-india/

https://www.moneycontrol.com/commodity/crudeoil-price.html