Extracting information on inflation from consumer and wholesale prices and the NKE aggregate supply curve
Since consumer prices are a weighted average of the prices of domestic and of imported consumption goods, and producer prices feed into final consumer prices, wholesale price inflation should cause consumer price inflation. Moreover, there should exist a long-term equilibrium relationship between consumer and wholesale price inflation and the exchange rate. But we derive a second relation between the price series from an Indian aggregate supply function, giving reverse causality. The CPI inflation should Granger cause WPI inflation, through the effect of food prices on wages and producer prices. These restrictions on causal relationships are tested using a battery of time series techniques on the indices and their components. We find evidence of reverse causality, when controls are used for other variables affecting the indices. Second, both the identity and the AS hold as long-run cointegrating relationships. There is an important role for supply shocks. Food price inflation is cointegrated with manufacturing inflation. The exchange rate affects consumer prices. The insignificance of the demand variable in short-run adjustment indicates an elastic AS. There is no evidence of a structural break in the time series on inflation. Convergence is slow, and this together with differential shocks on the two series may explain their recent persistent divergence.
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