Dynamics of Inflation in India: Bounds Testing Approach

Abstract

High inflation is widely believed to hamper economic growth and is harmful to social justice, thereby lending credence to emergence of low and stable inflation as a key objective of economic policy. India witnesses a rise in inflation during 1970s and 1980s due to various demand and supply side factors. Since then inflation has always remained a debateable issue among researchers and policy makers regarding its causes and management. Thus, the Present study provides an empirical analysis of the factors accounting for inflation dynamics and examine the nature of longrun and shortrun relationship among the variables in India for the period 1970-2015. To this end, the study applies auto-regressive distributive lag (ARDL) bounds testing approach to cointegration and Vector Error Correction Model to determine the direction of causality between the variables. The bounds test results indicate that there is a meaningful longrun relationship among the variables when inflation is considered as dependent variable. We find that money supply, interest rate, exchange rate and real output has a significant impact on the inflationary process in India both in the shortrun and longrun. The error correction term is found to be negative and significant which reinforces the long run equilibrium relationship among the variables. The paper concludes that inflation in India is explained by a combination of structural and monetary factors and consequently, study comes out with some important policy implications.