(WP18/2017) Inflation in India: Behavior of Major Components
Understanding the effect of monetary policy (change in interest rate) on several sub-components of inflation, as some of them are believed to be dominated by other than demand-side dynamics, is important to analyze the effectiveness of monetary policy. VAR models, which are widely used to study monetary policy impulse, suffer from degrees of freedom constraints and hence, studying the behavior of several sub-components of inflation for monetary policy innovation using a standard VAR model may not be feasible. Taking advantage of the FAVAR method, in this paper we have extracted the impulse response functions for several important sub-components of wholesale price (WPI) inflation. The results show that even though most of the sub-components of WPI inflation behave as expected, for protein items’ inflation and primary non-food articles’ inflation, supply-side constraints are not as over-bearing as commonly perceived.
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