Reducing supply shock-led inflation in emerging markets

A large literature identifies structural aggregate demand-supply shocks and obtains their effect on growth and inflation. Unlike earlier studies, we do this with Indian data after inferring the structure of aggregate demand and supply as well as dominant interaction of shocks by testing alternative identification strategies and selecting that with consistent results. We find identification with elastic long run supply and policy tightening in response to frequent adverse supply shocks fits the data better. But this policy response increases instead of decreasing the impact of supply shocks on inflation, worsening an already high growth sacrifice, because the identification allows demand shocks to affect output in the long-run. These results explain why demand tightening following food inflation led to low growth and persistent inflation in 2010s India, while sustaining demand with supply-side moderation of supply shocks gave a robust low inflation recovery post–pandemic, and point to suitable future policy responses.