A time‐varying parameter model of inflation in India

Purpose – In the past two decades, there has been a remarkable decline in inflation in both developed and developing countries, in sharp contrast to the period immediately preceding it. Interestingly, the behaviour of inflation in India broadly exhibits such a pattern. For much of the 1970s and 1980s, India experienced recurrent bouts of high inflation together with sub‐par economic performance. Since the 1990s the inflation record has been far better. The purpose of this paper is to answer an important question about what ultimately brought on this improved economic outcome. Design/methodology/approach – A time‐varying parameter model for inflation is proposed which nests all the plausible explanations. The time variation in parameters is modelled as driftless random walks, and is estimated using the median unbiased estimator. The median unbiased estimate helps in addressing the pile‐up problem, which arise if variances of the state specification are small. In such cases the maximum likelihood estimates are biased towards zero. Kalman Filter algorithm is used to obtain the time path of the parameters of the reduced form equation. Findings – The estimated time paths of the reaction function coefficients suggest gradual changes in the rule coefficients. It has been found that while better monetary policy and structural change have played a non‐trivial role, good luck and exchange rate regime have played a major role in the moderation of inflation in the 1990s. This interpretation suggests that to prevent a resurgence of 1970s‐style inflation, the central bank should reinforce as much as possible its commitment to low inflation by institutional, operational, and rhetorical means. Otherwise, sooner or later, luck will dry out and high inflation could return. Originality/value – A time‐varying parameter model for inflation in India is proposed which nests the various plausible explanations for moderate inflation in the recent decade. Most empirical and theoretical studies on inflation dynamics have concentrated on developed economies. This paper pays attention to the international dimension of the issue. The reduced form model is estimated using time‐varying parameter estimation technique.