WP/14/178

Food Inflation in India: The Role for Monetary

Policy
Rahul Anand, Ding Ding, and Volodymyr Tulin

 2014 International Monetary Fund

WP/14/178

IMF Working Paper

Asia and Pacific Department
Food Inflation in India: The Role for Monetary Policy
Prepared by Rahul Anand, Ding Ding and Volodymyr Tulin1
Authorized for distribution by Paul Cashin
September 2014
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.
Abstract
Indian food and fuel inflation has remained high for several years, and second-round effects
on core inflation are estimated to be large. This paper estimates the size of second-round
effects using an estimated reduced-form general equilibrium model of the Indian economy,
which incorporates pass-through from headline inflation to core inflation. The results indicate
that India's inflation is highly inertial and persistent. Due to second-round effects, the gap
between headline inflation and core inflation decreases by about three fourths within one
year as core inflation catches up with headline inflation. Large second-round effects stem
from several factors, such as the high share of food in household expenditure and the role of
food inflation in informing inflation expectations and wage setting. Analysis suggests that in
order to durably reduce the current high inflation, the monetary policy stance needs to remain
tight for a considerable length of time. In addition, progress on structural reforms to raise
potential growth is critical to reduce the burden on monetary policy.
JEL Classification Numbers: E52, E58, F47, O23
Keywords: Monetary policy, forecasting, food inflation, India.
Authors E-Mail Addresses: [email protected]; [email protected]; [email protected]

We are grateful to Paul Cashin, Nigel Chalk, Roberto Garcia-Saltos, Chetan Ghate, Laura Papi, Rafael Portillo,
Thomas Richardson, and our colleagues in the Asia and Pacific Department for helpful comments and discussions.
We benefited from the feedback received from seminar participants at the Reserve Bank of India (November,
2013), at the NIPFP-DEA Annual Research Program (February, 2014), and at the Indian Statistical Institute, New
Delhi (April, 2014).

2
Contents

Page

I. Introduction ..........................................................................................................................3
II. Background ..........................................................................................................................4
A. The Recent Inflation Dynamics in India: Some Facts ...................................................4
B. Why Monetary Policy Should Pay Attention to Food Inflation in India .......................5
C. Food and Fuel Inflation Pass-Through: Quantifying the Importance ...........................6
III. The Model ............................................................................................................................8
IV. Estimation ..........................................................................................................................10
A. Parameter Values for India ..........................................................................................10
B. Steady State Values......................................................................................................11
C. Bayesian Estimation.....................................................................................................11
D. Data ..............................................................................................................................13
E. Prior Distribution of Estimated Parameters .................................................................13
V. Results and Discussion........................................................................................................13
A. Estimation Results .......................................................................................................13
B. Shock Scenarios and Policy Implications ....................................................................16
VI. Conclusions........................................................................................................................20

Figures
1. Inflation in India ..................................................................................................................4
2. Role of Food Inflation in India ............................................................................................4
3. Impulse Response to an Interest Rate Shock .....................................................................17
4. Impulse Response to a Demand Shock ..............................................................................18
5. Impulse Response to Food and Fuel Price Shock ..............................................................18
6. Interest Rates: Predicted vs. Actual ...................................................................................19
Tables
1. Share of Food Expenditure in Total Household Expenditure ..............................................5
2. Regression Analysis of Non-core Inflation Pass-Through ..................................................7
References ................................................................................................................................21

3
I. INTRODUCTION
Drawing from a wider mandate, monetary policy in India has evolved to have multiple
objectives of price stability, financial stability and growth. The Reserve Bank of Indias
approach recognizes that price and financial stability are important for sustaining high levels
of growth which is the ultimate objective of public policy (Mohanty, 2012). The appropriate
monetary policy stance depends on inflation dynamics, the distribution of exogenous shocks
affecting the economy, and the monetary transmission mechanism. India as a small economy
(compared to the global economy) and an importer of fuel faces internal shocks as well as
external shocks from the rest of the world.
Persistent and elevated food inflation has presented challenges for monetary management in
India. While it is a widely held view that central banks should only respond to changes in the
underlying core inflation and second-round effects on core inflation of commodity price
shocks, there is growing evidence that the dynamics of food price inflation can be very
different in emerging economies. Therefore, ignoring food inflation in monetary policy
action may lead to policy mistakes. As pointed out by D. Subbarao, the then Reserve Bank of
India (RBI) Governor, If food inflation is higher, as is typically the case in many low
income countries including India, then we would be underestimating inflationary pressures
on a systemic basis. That would mislead policy prescriptions.
The purpose of this paper is to estimate the second-round effects of food price inflation and
investigate their importance for monetary policy formulation in India. In order to do that, we
first document why second-round effects may have non-trivial consequences for monetary
policy formation in emerging market economies. Second, we carry out econometric analysis
investigating the importance of such second-round effects in India. Lastly, we develop and
estimate a suitable dynamic stochastic general equilibrium model that builds on a stylized
gap model (each variable is expressed in terms of its deviation from equilibrium, in other
words in gap terms)2, tailored to Indias fundamentals to study various aspects of monetary
policy transmission in India.
To address these questions, we estimate a New Keynesian Phillips Curve (NKPC) in a
dynamic small open economy model, and analyze the effect of the output gap, lagged
inflation, exchange rate and inflation expectation on current inflation. To estimate the
second-round effects, we modify the model to capture the pass-through from headline to core
inflation. While this model is simple and abstracts from many important features of the
economy, such specifications have long been the workhorse of monetary policy analysis at
the International Monetary Fund. In addition to effectively capturing the key channels of
monetary policy transmission, this framework has the virtues of clarity and tractability.

See for example, Berg, Karam, and Laxton (2006a, 2006b).

4
The paper is organized as follows. In Section II, we examine the inflation dynamics in India
and present some empirical facts to further motivate the analysis. In Section III, we develop a
small New Keynesian macroeconomic model with rational expectations taking into
account India specific factors. Section IV briefly describes the data and the estimation
methodology before we present the results of the estimation in Section V. Section VI
concludes.
II. BACKGROUND
A. THE RECENT INFLATION DYNAMICS IN INDIA: SOME FACTS
High and persistent inflation is a key macroeconomic challenge facing India (see IMF 2014a,
2014b). Elevated inflation has also coincided
Figure 1. Inflation in India
22
with the growth slowdown, which has
(In percent, y/y)
Headline CPI-Combined
20
distinguished India from other major emerging
Core Inflation
18
market economies in the recent years. A
Food Inflation
16
14
number of factors have caused high inflation,
12
including: food inflation feeding quickly into
10
8
wages and core inflation; entrenched inflation
6
expectations; cost-push shocks from binding
4
sector-specific supply constraints (particularly
2
0
in agriculture, energy and transportation); pass2007
2008
2009
2010
2011
2012
2013
2014
through from a weaker rupee; and ongoing
Sources: Haver Analytics; and IMF staff calculations.
energy price increases.3
High food inflation and its prominence in shaping wage setting and inflation expectations
formation are key features of Indian inflation
Figure 2. Role of food inflation in India
22
(Figure 2). The importance of food inflation in
(In percent, y/y)
20
shaping inflation dynamics in India is due to the 18
following factors:
16
(i)
the share of food expenditure in total
household expenditure is high;
(ii)
inflation expectations are anchored by
food inflation;

20
18
16
14
12
10
8
6
4
2
0

22
20
18
16

14

14

12

12

10

10
8

6
Food Inflation
Wage growth (non-agro unskilled labor)
inflation expectations: 12-month ahead

4
2
0
2007

2008

2009

2010

2011

2012

2013

4
2
0
2014

Sources: CEIC; Haver Analytics; and IMF staff calculations.

3

22

The Urjit Patel Committee Report (RBI, 2014) also reflects on the role of these factors arguing for the need to
pay attention to food and fuel inflation: High inflation in food and energy items is generally reflected in
elevated inflation expectations. With a lag, this gets manifested in the inflation of other items, particularly
services. Shocks to food inflation and fuel inflation also have a much larger and more persistent impact on
inflation expectations than shocks to non-food non-fuel inflation.

5
(iii)

consumer price inflation, in which food has a large weight, directly feeds into wages.

B. WHY MONETARY POLICY SHOULD PAY ATTENTION TO FOOD INFLATION IN INDIA

India is not unique, amongst emerging economies, where food price shocks play a non-trivial
role in shaping inflation dynamics. Unlike in advanced economies, food price shocks in
emerging market economies are more volatile and persistent, and are propagated strongly
into nonfood inflation (Walsh, 2011). Also, they tend to have stronger and longer-lasting
effects on inflation in economies with high food shares in the consumption basket and in
economies with less firmly anchored expectations (IMF, 2011a).
Accordingly, excluding commodity-price inflation in economies where food and fuel
represent a large share of household expenditure, and where commodity price changes affect
core inflation through second-round effects may not be appropriate (Cato and Chang, 2010;
Walsh, 2011). Anand and Prasad (2010) also conclude that in an environment of creditconstrained consumers, which is a common feature of emerging market economies, a narrow
policy focus on nonfood inflation can lead to suboptimal outcomes. In sum, ignoring food
inflation in monetary policy formulation may lead to policy mistakes.
In India, like other emerging market economies, the share of food expenditure in total
household expenditure is much higher relative to advanced economies (Table 1).
Correspondingly, the weight on food in CPI basket is also high. In CPI-Combined measure of
inflation, the weight on food, beverages and tobacco is 49.7 percent.
Table 1. Share of Food Expenditure in Total Household Expenditure
(In percent)
Emerging Markets

Advanced Economies

Indonesia

53.0

Japan

Vietnam

49.8

Germany

11.5

India

45.1

Australia

10.8

China

36.7

Canada

9.3
8.8

Russia

33.2

United Kingdom

Malaysia

28.0

USA

Average

41.6

Average

14.7

5.7
10.1

Sources: Household Surveys, CEIC, International Food Consumption Patterns Dataset,

Economic Research Service, USDA and authors calculations.
Notes: Data for emerging markets are for 2005 while for advanced economies it is for 2006.
Expenditure on food includes expenditure on food consumed at home only and does not
include expenditure on beverages and tobacco. For India, estimates based on 2011/12
household survey (NSSO's 68th round). For rural India, average share of spending on food
estimated at 48.3 percent, while for urban India it was 37.3 percent.

Also, food inflation appears to play a pivotal role in informing inflation expectations. The
RBIs inflation expectations survey of households suggests that general price expectations
are more consistently aligned with food price expectations than with any other product

6
groups. The fraction of households expecting headline CPI inflation to move in coherence
with food inflation has averaged about 90 percent in the recent years. For example, in
December 2012, more than 95 percent of the respondents appeared to have been influenced
by expected changes in food prices for arriving at general price expectations, suggesting that
respondents consider food prices to be very important when they think about price dynamics.
Wage growth has accelerated in recent years. Both agricultural and non-agricultural wages
have been on sustained growth trajectories since the mid-2000s. As well, real wage growth
has been significantly positive. Admittedly, several factors have contributed to sustained real
wage growth in recent years. Of them, the MGNREGA4 scheme stands out. While the
scheme has undoubtedly benefited inclusiveness and enhanced socio-economic position of
Indias rural population, it has likely also buttressed inflation pressures in recent years.
MGNREGA has not only set a floor on many rural wages and strengthened the bargaining
position of rural labor force, but has also tied up wage growth indexation to retail inflation
thus reinforcing the nexus between prices and wages. Furthermore, India food inflation
underpinned by wage and input cost inflation was further reinforced by wage increases
buttressing demand. As econometric analysis in Mohanty (2014) suggests, both the costs of
material inputs and wages have sharp positive impact on food inflation in India. However,
wage growth affects food inflation gradually, and is more persistent than the impact of
increase in costs of material inputs.
To sum up, the established conventional wisdom for the monetary policy is to look through
the transitory supply shocks, in particular to food and fuel prices. Persistent supply shocks,
however, require monetary policy action aimed at mitigating their second-round effects on
generalized inflation and keeping in check inflation process by anchoring inflation
expectations.
C. FOOD AND FUEL INFLATION PASS-THROUGH: QUANTIFYING THE IMPORTANCE
To formalize the relationship between food and fuel inflation and its pass-through to core
inflation, we assess the dynamics of headline inflation with respect to core inflation in India.
We follow Cecchetti and Moessner (2008) and Clark (2001) to answer the following
questions:
1. Does headline inflation revert to core inflation?
If headline inflation reverts quickly to core inflation, then the impact of food and fuel price
shocks is temporary, and second-round effects are probably limited. On the other hand, if
4

Mahatma Gandhi National Rural Employment Guarantee Act (MGNREGA).

7
headline inflation does not revert to core, either the shocks are persistent or the second-round
effects are large due to higher inflation expectations and accelerating wages. Empirically, the
issue is addressed here by examining the following regression estimated on monthly inflation
data for 19962013:

2. Does core inflation revert to headline inflation?

If core inflation reverts to headline inflation, it would indicate that shocks to headline
inflation, such as those caused by commodity-price spikes, feed into inflation expectations
and price setting, driving core inflation to catch up with headline inflation. Empirically, the
issue is addressed here by examining the following regression estimated on monthly inflation
data for 19962013:

Where
respectively.

and

denote headline and core year-over-year CPI inflation,

Table 2. Regression analysis of non-core inflation pass-through

Dependent variable:
-0.31
(0.27)

Constant

0.136
(0.59)

-0.68 ***
(0.21)
-0.11
(0.49)

Sample: 1997-2013
Source: IMF staff estimates.
Note: Robust standard errors in parenthesis.
Note: ***,**, * indicates 1,5, 10 percent statistical significance.

The empirical results suggest that second-round effects are indeed statistically significant
(Table 2). Specifically, if headline reverts to core, the coefficient is expected to be
negative. The results, however, suggest that the null of
0 cant be rejected, which
implies that headline inflation does not revert to core inflation. At the same time, individually
both the hypothesis that
1 and that
1 and
0, i.e. that headline fully reverts
to core within a year, are rejected. Therefore, it can be concluded that headline does not
revert to core, suggesting that either food shocks are persistent or second-round effects are
large. On the other hand, the estimate of is -0.68, which is highly statistically significant,
suggests that core inflation reverts to headline inflation. At the same time, the null hypothesis

8
of
0, which corresponds to a situation where core does not revert to headline, is rejected.
Moreover, both the hypothesis that
1 and that
1 and
0 cannot be rejected.
This suggests that core inflation catches up with headline inflation and reverts to headline
quickly. Therefore, large second-round effects are present.5
III. THE MODEL
As discussed above, incorporating the second-round effects of food price inflation is essential
for monetary policy formulation in India. To provide a more complete account of the
importance of the second round effects of food and fuel inflation in India, we bring in the
elements of pass-through into a general equilibrium setting.
Analysis of inflation dynamics suggest that second-round effects are potentially large, and
policymakers need to pay a close attention to food price shocks. Therefore, to understand
inflation dynamics and monetary transmission in India, estimating the size of these secondround effects is important. We estimate these effects using a variant of small New
Keynesian macroeconomic model with rational expectations developed by Berg, Karam,
and Laxton (2006a, 2006b).We modify the model to capture the pass-through from headline
to core inflation.
The model features a small open economy with forward-looking aggregate supply and
demand with micro foundations, and stylized monetary transmission channels. Output
developments in the rest of the world feed directly into the small economy, as they
characterize foreign demand for Indian products. Changes in foreign inflation and/or interest
rates affect the exchange rate and, subsequently, demand and inflation in the Indian
economy. The model is set up in gap terms (i.e. deviations of variables from their respective
steady state values). In order to estimate the second-round effects, we add an equation to
capture the pass-through from headline to core inflation.
The baseline model has five behavioral equations: (1) an aggregate demand or IS curve that
relates the level of real activity to expected and past real activity, the real interest rate, the
real exchange rate, and the foreign output gap; (2) a price setting or Phillips curve equation
that relates core CPI inflation to past and expected inflation, the output gap, and the exchange
rate, as well as the pass-through from the headline to core inflation; (3) a food inflation
equation that relates food inflation to past and expected inflation, the output gap, the
exchange rate; (4) an uncovered interest parity condition for the exchange rate, with some
allowance for backward looking expectations; and (5) a rule for setting the policy interest
rate as a function of the output gap and expected inflation.
5

The estimates reported correspond to CPI-IW inflation. Conclusions remain the same if WPI or CPI-combined
(spliced using CPI-IW) inflation is used instead.

The output gap dynamics is described by the following equation:

ygapt ld ygapt 1 lag ygapt 1 RRgap RRgapt 1 Zgap zgapt 1 RWygap ygaptRW tygap
where ygap is the output gap, RRgap the real interest rate gap, zgap the gap of real exchange
rate, ygapRW the output gap in the rest of the world, a series of parameters attached to
those variable, and ygap an error term, which captures other temporary exogenous effects.6
The headline inflation equation is given as the aggregation of the core and food and fuel
inflation:

t 1 tc tff
where tc is core inflation rate, c,fft is non-core (food and fuel) inflation rate, and is the
weight on non-core inflation.
We then have two pricing equations: one for core inflation and one for food and fuel
inflation. They have a very similar structure except for an additional term in the former to
capture the pass-through from headline to core inflation, or the second-round effects.
tc c ,ld 4 tc 4 (1 c ,ld ) 4 tc1 c , ygap ygap t 1 c , z ( z t z t 1 ) c , ( 4 t 1 4 c ,t 1 ) t ,c
t ff ff ,ld 4 tff 4 (1 ff ,ld ) 4 tc1 ff , ygap ygap t 1 ff , z ( z t z t 1 ) t , ff

where tc 4 t 4 and t ff 4 t 4 are the four-quarter ahead year-over-year core and food and fuel
inflation rates, respectively7, tc 4 t 1 and t ff 4 t 1 are their one quarter lagged year-over-year
inflation rates, ygap the output gap, zt zt 1 the real depreciation, c a series of parameters,
and t ,c and t , ff are error terms. The addition term ( 4 t 1 4 c ,t 1 ) in the core inflation
equation captures the extent of pass-through from non-core to core inflation. Expected
inflation enters the equation due to the assumption of staggered price-setting (Calvo, 1983)
while indexation schemes can rationalize the backward-looking inflation component. The real
exchange rate z reflects the effect of imported goods prices on inflation in an open
economy.8

We use the U.S. output gap as the proxy for the output gap of the rest of the world.
Core CPI are compiled by staff by stripping out food and energy items from the CPI basket.
8
An increase in the real exchange rate (z) corresponds here to a real depreciation.
7

10
The real exchange rate dynamics is described by the following equation:
z t z z t 1 (1 z ) z t 1 ( RRt RRtRW * ) / 4 tz

where z t is the real exchange rate (an increase represents a depreciation), RRt the real
interest rate, RRtRW the real interest rate in the US, * the equilibrium risk premium on the
domestic currency, z parameters, and tz an error term. A residual captures other temporary
exogenous effects.
Finally, the monetary policy rule is described by the following equation:

RS t RSlag RS t 1 (1 RSlag ) * [ RRt* 4 t ( 4 t 4 t* 4 ) ygap ygapt ] tRS

where RSt is the nominal interest rate, RR* the equilibrium real interest rate, * the inflation
objective, parameters, and tRS an error term.
The model is a two-country model where the home country is small and open, whereas, the
foreign countrythe home countrys main trading partneris relatively large and closed,
and in effect exogenous to the home country. Thus, the foreign country enters the home
country equations through (i) the impact of its activity on the home country demand and (ii)
the impact of its real interest rate on the bilateral exchange rate. Conversely, the home
country does not impact the foreign country, which implies that the output gap of the foreign
country does not depend on the bilateral exchange rate or the home country activity; and
foreign country inflation does not depend on the bilateral exchange rate. Hence, the
uncovered interest rate parity condition is irrelevant for the foreign country model. So the
model has three additional behavioral equations that describe the foreign sector: an output
gap equation, an inflation equation and a policy reaction function similar to the ones
specified above with the exception that no rest of the world (RW) variables appear, and there
is no pass-through term in the inflation equation.
IV. ESTIMATION
A. Parameter Values for India
The parameter values are chosen based on the modeling experience of other country models,
but adapted to our knowledge about the characteristics of the Indian economy and policymaking. The model is estimated as an open economy, where the United States is treated as
the relevant foreign sector for India. For the United States, we use the prior distributions used
in Berg, Karam, and Laxton (2006b).

11
B. Steady State Values
The long-term steady-state values for key parametersthe inflation objective, real exchange
rate, and real interest rateare chosen to match the historical average of these variables. Rest
of the world equilibrium real interest rate is set at 1.5 percent, and the inflation rate at
2.4 percent. We set Indias long-term headline CPI inflation rate at 6.5 percent and the
equilibrium real interest rate at 1.5 percent. These two imply an equilibrium nominal shortterm interest rate of about 8 percent. Furthermore, as we use de-trended real exchange rate
series, which removes average real appreciation of about 1 percent per annum, we make a
technical assumption of zero equilibrium risk premium. All gaps that measure deviations of
actual variables from their long-run equilibrium are by definition zero.
C. Bayesian Estimation
The model is estimated using Bayesian techniques based on prior distributions for the
parameters from previous empirical studies. Advancement in both computing power and
software has made Bayesian estimation of structural rational expectations models more
feasible.9 Bayesian estimation provides a middle ground between classical estimation and the
calibration of macro models. The use of classical estimation in a situation of a relatively
small sample size (which is almost always the case for macro time series data) often gives
macro model results that are inconsistent and faced with simultaneity challenges. Models
with calibrated parameters avoid this problem, but are often criticized as representing no
more than the modelers judgment, which may or may not be consistent with the data. We
estimate the model using the Bayesian estimation module in DYNARE (Juillard, 2001).
Bayesian inference has a number of benefits. First, it formalizes the use of prior empirical or
theoretical knowledge about the parameters of interest. Use of prior distributions makes the
highly nonlinear optimization algorithm considerably more stable, making it feasible to apply
the technique when sample periods are short. This is a particularly important aspect for India
where quarterly National Accounts data only start in 1996Q1. In addition, the estimation
procedure also allows for measurement errors in the data. For India this is also extremely
important given data quality and measurement issues, of the national accounts and CPI
inflation in particular. Some of the excess volatility in the data is thus allocated to
measurement error which does not enter into the stochastic simulations. Second, Bayesian
inference provides a natural framework for parameterizing and evaluating simple
macroeconomic models that are likely to be fundamentally mis-specified. Thus, as pointed
out by Fernandez-Villaverde and Rubio-Ramirez (2004) and Schorfheide (2000), the
inference problem is not to determine whether the model is `true' or the `true' value of a
9

For a detailed description of the Bayesian estimation technique see Schorfheide (2000) and Geweke
(1999). Details on the software for estimation can be found in Juillard (2004).

12
particular parameter, but rather to determine which set of parameter values maximize the
ability of the model to summarize the regular features of the data. Finally, Bayesian inference
provides a simple method for comparing and choosing between different mis-specified
models that may not be nested on the basis of the marginal likelihood or the posterior
probability of the model. In particular, Geweke (1998) shows that the marginal likelihood is
directly related to the predictive performance of the model which provides a natural
benchmark for assessing the usefulness of economic models for policy analysis and
forecasting.
Bayesian estimation requires construction of the posterior density of the parameters of
interest given the data. If we denote the set of parameters to be estimated as using
observations on a set of variables X, the posterior density can be written as p | X . The
posterior density is thus the probability distribution of , conditional on having observed the
data X. It forms the basis for inference in the Bayesian framework. Following Bayes law, the
posterior density is proportional to the product of the prior density of the parameters p
and the distribution of the data given the parameter set f X | :
p | X

p f X |
f X

where f X is the marginal distribution of the data. The conditional distribution function of

the data given the parameter set f X | is equivalent to the likelihood function of the set of

parameters given the data L | X .The likelihood function can be calculated from the statespace representation of the model using the Kalman filter (see Ljungqvist and Sargent (2004)
for details). Bayesian inference therefore requires (i) the choice of prior densities for the
parameters of interest, and (ii) construction of the posterior from the prior densities and the
likelihood function. The remainder of this section discusses briefly how to construct the
posterior distribution. The choice of prior is discussed later, together with the estimation
results.
Given the likelihood function and a set of prior distributions, an approximation to the
posterior mode of the parameters of interest can be calculated using a Laplace approximation.
The posterior mode obtained in this way is used as the starting value for the MetropolisHastings algorithm (see Bauwens, Lubrano, and Richard (1999) for details). This algorithm
allows us to generate draws from the posterior density p | X . At each iteration, a proposal
density (a normal distribution with mean equal to the previously accepted draw) is used to
generate a new draw which is accepted as a draw from the posterior density p | X with
probability p. The probability p depends on the value of the posterior and the proposal
density at the candidate draw, relative to the previously accepted draw. We generate 100000
draws in 4 chains in this manner, discarding the first 50000 draws to reduce the importance
of the starting values.

13
D. Data
To estimate the model, we use key macroeconomic variables for India from 1996Q1 to 2013
Q4. Three-month Treasury bill rate is used as a proxy for nominal interest rate, and real
exchange rate (CPI-based) is used as a proxy for real exchange rate. For Indias inflation, we
use a backcasted CPI-Combined based on CPI-IW. We use GDP, inflation, and interest rate
data of the United States for the rest of the world in the model. Variables are seasonally
adjusted using X12 filter.
E. Prior Distribution of Estimated Parameters
Our choice of prior distributions for the estimated parameters is guided both by theoretical
considerations and empirical evidence. Given the lack of significant empirical evidence,
however, we choose relatively diffuse priors that cover a wide range of parameter values. For
the structural parameters, we choose either gamma distributions or beta distributions in the
case when a parameter such as the autoregressive shock processesis restricted by
theoretical considerations to lie between zero and one. Finally, as in much of the literature
the inverted gamma distribution is used for the standard errors of the shock processes. This
distribution guarantees a positive variance but with a large domain.
V. RESULTS AND DISCUSSION
A. Estimation Results
Estimated aggregate demand equation:
Coefficient estimates for the output gap equation are reported in a table below:

ygapt ld ygapt 1 lag ygapt 1 RRgap RRgapt 1 Zgap zgapt 1 RWygap ygaptRW tygap
Parameter

ld

lag
RRgap
Zgap
RWygap

Prior mean
0.40
0.60
0.05
0.05
0.15

Posterior mean
0.19
0.59
0.04
0.04
0.10

The parameters in the output gap equation depend to a large extent on the degree of inertia
in the economy, the effectiveness of monetary policy transmission, and the openness of the
economy. Drawing on the experience of several applied country modeling efforts, Berg,

14
Karam, and Laxton (2006b) suggest that the value of lag should lie between 0.5 and 0.9,
with a lower value for countries more susceptible to volatility.
The estimated coefficient of 0.6 for lag is comparable to other emerging markets. The lead
of the output gap ld is typically small, and the estimated value for India is 0.2. The
coefficient estimate on the lead of the output gap indicates that expectations regarding the
future level of the output gap are important. This corroborates the importance of confidence
effects in promoting economic activity in India (Anand and Tulin, 2014). The parameter
RRgap depends on the effectiveness of monetary transmission mechanism, while zgap and

RWygap depend on the importance of the exchange rate channel and the degree of openness.
Significant lags in the transmission of monetary policy imply that the sum of RRgap and

zgap should be small relative to the parameter on the lagged gap in the equation. A RRgap
coefficient of 0.04 implies that a one percentage point increase in real interest rates would
lead a 0.04 percent fall in the output gap the following period. The value for RWygap of 0.1
implies that a 1 percentage point increase in the foreign output gap leads to a
contemporaneous 0.1 percentage point increase in the Indian output gap.

Estimated Philips curve equations:

Coefficient estimates for the core and headline CPI inflation equations are reported in the
tables below:
tc c ,ld 4 tc 4 (1 c ,ld ) 4 tc1 c , ygap ygap t 1 c , z ( z t z t 1 ) c , ( 4 t 1 4 c ,t 1 ) t ,c

Parameter
c ,ld

Prior mean

Posterior mean

0.20

0.26

c , ygap

0.25

0.25

c, z

0.30

0.15

c ,

0.30

0.32

t ff ff ,ld 4 tff 4 (1 ff ,ld ) 4 tc1 ff , ygap ygap t 1 ff , z ( z t z t 1 ) t , ff

Parameter
ff ,ld

Prior mean

Posterior mean

0.20

0.22

ff , ygap

0.25

0.28

ff , z

0.30

0.33

15
The parameters in the core inflation equations depend on the role of expectations and
aggregate demand on inflation, and the degree of pass-through from the exchange rate to
prices. The c ,ld parameter in the core inflation equation determines the forward component
of inflation (while its inverse, 1 c ,ld , determines the backward component). This can be
interpreted as depending in part on the credibility of the central bank, and in part on
institutional arrangements regarding wage indexation and other price-setting mechanisms. A
higher value of c ,ld close to 1 would suggest that small changes in monetary policy cause
large changes in price expectations; while a low value would suggest that inertia and
backward-looking expectations cause prices to respond with greater delays to changes in
monetary policy. The estimated Philips curve for India is backward looking (the backward
looking component in the core inflation is 0.8), suggesting inflation is highly inertial and
shocks to inflation are persistent. Patra and Kapur (2010) have found similar estimates for the
forward and backward looking components.10
The c , ygap parameter depends on the extent to which output responds to price changes and,
conversely, how much core inflation is influenced by real demand pressures, and is typically
between 0.250.50. This parameter is estimated to be 0.25 for India. This is in line with the
literature estimates of 0.2 0.3 (Patra and Kapur, 2010). The c , zgap parameter represents the
short-term pass-through of (real) exchange rate movements into prices, and depends on trade
openness, price competition, and monetary policy credibility. The exchange rate passthrough coefficient is estimated to be 0.15 in India. This is line with the findings of Patra and
Kapur (2010) and other cross country findings that estimate exchange rate pass-through to be
around 0.16 for countries with low (less than 10 percent) inflation (Choudhuri and Hakura,
2001).
Finally, the parameter c , represents the pass-through coefficient from headline to core
inflation that is the extent to which price setters keep their prices rising in pace with past
movements in the headline CPI. If c , is zero, the gap between the past headline and core
inflation, namely, inflation of food and energy prices, will have no effect on core inflation. In
other words, there will be no second-round effects in the economy. Our estimation of the
second-round effect coefficient indicates that if headline inflation exceeds core inflation by
1 percentage point, it will lead to a 0.3 percentage points increase in core inflation in the next
quarter. As expected, the pass-through from headline to core inflation is relatively large. This
estimate is consistent with our analysis of year-over-year inflation dynamics in India (Section
II). However, some caution is warranted in interpreting a rather large pass-through
coefficient. An alternative interpretation of a strong pass-through coefficient estimate may
reflect a faster response of food inflation to aggregate demand, because commodity prices,
10

This is also consistent with the cross-country evidence that finds the co-efficient on expected inflation to be
below 0.5 (Berg et al., 2006a).

16
including food items, tend to be more flexible than non-food prices. Another reason could be
that food inflation may also react faster compared to non-food inflation when inflation
expectations are not firmly anchored.
Estimated uncovered interest parity equation:
z t z z t 1 (1 z ) z t 1 ( RRt RRtRW * ) / 4 tz

The z parameter in the real exchange rate equation determines the relative importance of
forward- and backward-looking real exchange rate expectations. If is equal to 1, the
equation behaves as in the Dornbusch overshooting model, i.e., the real exchange rate is a
function of the future sum of all real interest rate differentials. The estimated coefficient of
0.5 makes monetary policy potentially a more effective tool, though the incomplete exchange
rate pass-through in India somewhat reduces its efficacy.
Parameter

Prior mean

Estimate (posterior mean)

0.60

0.49

Estimated open-economy Taylor-rule equation:

RS t RSlag RS t 1 (1 RSlag ) * [ RRt* 4 t ( 4 t 4 t* 4 ) ygap ygapt ] tRS

Parameter
RSlag

Prior mean

Estimate (posterior mean)

0.80

0.82

1.90

1.88

ygap

0.60

0.64

The parameters in the monetary policy rule equation depend on the speed and
aggressiveness with which the monetary authorities adjust the nominal interest rate, and the
relative importance of the inflation target versus the real activity target. There is a high
degree of interest rate smoothing in India (the coefficient is 0.8), which is in line with the
estimates of this parameter by Mohanty and Klau (2004) and Anand and others (2010). The
value of is 1.9. The estimate of ygap is 0.6, suggesting that the RBI puts weight on
stabilizing real activity, which is expected considering that the RBI has multiple objectives.
B. Shock Scenarios and Policy Implications
The monetary transmission mechanism
The response of inflation, output gap and exchange rate to a monetary policy shock in the
model is similar to that found in other empirical studies on the monetary transmission

17
mechanism. A temporary increase in the nominal interest rate reduces domestic demand and
appreciates the rupee. Output contracts both as a result of decreased domestic demand and as
a result of decreased competitiveness following the real appreciation. The contraction in
demand in turn leads to a fall in inflation.
Figure 3. Impulse Responses to an Interest Rate Shock

The results suggests that at a 100 basis points temporary increase in the interest rate leads to
a peak widening of output gap by almost 1 percent in about 4 quarters, slowing in the core
CPI inflation by about of a percentage point and almost 1 percentage point decline in the
headline CPI inflation, and nearly 2 percent peak real appreciation.
Demand, and food and fuel prices shocks
Exogenous demand shocks could, among other things, be interpreted as changes in the fiscal
policy stance that is not explicitly modeled here. A positive demand shock should raise
output and consequently the output gap and will gradually put upward pressure on prices. To
contain inflation, a tighter monetary policy stance would be required, which in turn will
lower demand and lead to real appreciation. Depending on the persistence of the shock,
inflations would peak after 46 quarters.

18
Figure 4. Impulse Responses to a Demand Shock

Figure 5. Impulse Responses to a Food and Fuel Price Shock

19
Exogenous price shocks could be interpreted as international oil or food price shocks as well
as domestic supply shocks such as shocks related to rainfall.
In response to a 1.5 percentage points jump in food and fuel price inflation (about 6 percent
annualized inflation rate), output gap widens at peak by about 0.5 percentage points, and
headline and core inflation rises by about 0.5 percent. In response, the interest rate increases
by about 80 basis points on impact. Inflation shocks lead to widening of output gap, rise in
inflation and interest rate, and real appreciation. Furthermore, the headline inflation shock
passes through to core inflation, raising it by about 0.2 percentage points.
We can use the estimated model to study the behavior of interest rates in India to examine the
monetary policy stance in India in the last few years. Figure 6 presents actual and modelpredicted nominal interest rates. As is evident,
Figure 6. Interest Rates: Predicted vs. Actual 1/
12
since mid 2008 actual interest rates are
(In percent)
11
consistently below those predicted by the
10
Actual
model, suggesting that monetary policy shocks
9
Predicted
have been negative. The gap between the two
8
7
rates (actual and predicted) was large in 20082009. The gap again opened up in late 2010 and 6
5
averaged about 100 basis points during 2011
4
12. This was highlighted by successive IMF
3
2
India Staff Reports, which argued for a tighter
2000
2002
2004
2006
2008
2010
2012
monetary stance to counter inflation and
Source: IMF staff estimates.
1/ Interest rate corresponds to 3-month Treasury bill yield.
inflationary pressures (IMF, 2011b; and IMF
2012, 2013, 2014a, 2014b).

VI. CONCLUSIONS
India has seen a prolonged period of high inflation, to a large extent driven by persistently
high food inflation. It has made the task of the Reserve Bank of India (RBI) more
challenging, with many arguing that the RBI has very limited role in combating food
inflation, particularly when growth has slowed considerably and external demand remain
subdued. While economists agree that a central bank should look through transitory supply
shocks, they also agree that monetary policy should react to second-round effects.
There is growing evidence that second-round effects could be large in emerging market
economies due to several reasons: high share of food in households expenditure; less firmly
anchored expectations; and highly persistent supply shocks. India has these characteristics,
which suggest that second-round effects are important and play a role in inflation dynamics.

12
11
10
9
8
7
6
5
4
3
2

20
Indeed, recognizing the seminal nature of food inflation and its second-round effects for
inflation dynamics in India, the recently released Urjit Patel Committee Report (RBI 2014,
page 20) recommends:
Since food and fuel account for more than 57 percent of the CPI on which the direct
influence of monetary policy is limited, the commitment to the nominal anchor would need to
be demonstrated by timely monetary policy response to risks from second round effects and
inflation expectations in response to shocks to food and fuel.
As well, our results suggest that monetary policy needs to respond decisively to tackle
Indias high and persistent inflation. Furthermore, as also emphasized in the Patel Committee
Report, headline CPI inflation should be the nominal anchor for monetary policy, with its
persistent and entrenched nature it should be the guiding factor for monetary policy stance. 11
At the current juncture, with food inflation remaining persistently high for five years,
monetary policy needs to remain tight to control generalized inflation. Given elevated and
persistent inflation, the analysis suggests that the RBI may also need to raise rates to tackle
inflation durably, particularly if faced with a persistent and sizable supply-side food price
shock putting pressure on broad-based inflation. As inflation is mostly backward looking,
monetary policy has to maintain a tight stance for a prolonged period of time. Nevertheless,
the recent revisions to the RBIs liquidity management framework should improve monetary
transmission, thereby requiring lower policy interest rate adjustments to contain inflation and
inflationary pressures. As well, given that Phillips curve is relatively flat, progress on
structural reforms to raise potential growth is critical to reduce the burden of adjustment on
monetary policy.

11

See RBI (2014, page 15) The CPI-Combined based headline inflation measure appears to be the most
feasible and appropriate measure of inflationas the closest proxy of a true cost of living indexfor the
conduct of monetary policy.

21
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