Monetary Policy and Modelling Inflation in a Non-linear Framework in an Open Economy: Fresh Evidence from India

Central banks globally prioritize keeping inflation low and stable around a predetermined target because inflation volatility creates significant economic disruptions for the real economy, particularly affecting the population with fixed or limited income. To this end, the present article analyses the inflation trajectory in India since 1951-52. The descriptive analysis indicates that a fall in inflation and its volatility has strengthened the credibility of the monetary policy from a credit-targeting to a rule-based inflation-targeting framework. The study also examines the impact of potential macroeconomic determinants such as fiscal policy, monetary policy, output gap and trade openness on Consumer Price Index (CPI) and Wholesale Price Index (WPI) based inflation in the Indian context in an open economy framework for the period 1996-97Q1-2023-24Q4. Using the Brock–Dechert–Scheinkman (BDS) independence test, the study explicitly identified the non-linear nature of the determinants of inflation and applied the non-linear autoregressive distributed lag (NARDL) technique to evaluate their impact on inflation. The results reveal significant asymmetric effects of fiscal deficit on inflation with an inflationary impact on CPI inflation but dis-inflationary impact on WPI inflation. Trade openness exhibits an anti-inflationary response to CPI inflation and a positive response on WPI inflation. Further, a price puzzle is observed in the case of CPI. The findings emphasize the importance of effective fiscal consolidation and suggest the index-sensitive impacts of determinants of inflation in India. Wald tests and dynamic multipliers provide robustness to the results.

JEL Codes: C22, E31, E42, E52, E58