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Forecasting Consumer Price Index Inflation in India: Vector Error Correction Mechanism Vs. Dynamic Factor Model Approach for Non-Stationary Time Series

Author

Listed:
  • Bhattacharya, Rudrani

    (National Institute of Public Finance and Policy)

  • Kapoor, Mrigankshi

    (Birla Institute of Technology and Science)

Abstract

Short to medium term forecasting of inflation rate is important for economic decision making by economic agents and timely implementation of monetary policy. In this study, we develop two alternative forecasting models for Year-on-Year (YOY) inflation in Consumer Price Index (CPI) in India using a large number of macroeconomic indicators. The YOY CPI inflation and its predictive indicators are found to be non-stationary and cointegrated. To address this issue, we employ Vector Error Correction Model (VECM) and Dynamic Factor Model (DFM) modified for non-stationary time series to forecast CPI inflation. We find that in terms of Root Mean Square Error (RMSE), the VECM model performs marginally better than the DFM model. However, both models are found to have the same predictive accuracy using Diebold-Mariano test.

Suggested Citation

  • Bhattacharya, Rudrani & Kapoor, Mrigankshi, 2020. "Forecasting Consumer Price Index Inflation in India: Vector Error Correction Mechanism Vs. Dynamic Factor Model Approach for Non-Stationary Time Series," Working Papers 20/323, National Institute of Public Finance and Policy.
    • Handle: RePEc:npf:wpaper:20/323
    Note: Working Paper 323, 2020
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    References listed on IDEAS

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    Cited by:

    1. Patnaik, Ila & Pandey, Radhika, 2020. "Four years of the inflation targeting framework," Working Papers 20/325, National Institute of Public Finance and Policy.
    2. Badola, Shivani & Mukherjee, Sacchidananda, 2020. "Factors Influencing Access to Formal Credit of Unincorporated Enterprises in India: Analysis of NSSO's Unit-level Data," Working Papers 20/326, National Institute of Public Finance and Policy.

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    More about this item

    Keywords

    CPI Inflation ; India ; Forecasting ; Vector Error Correction Model ; Dynamic Factor Model;
    All these keywords.

    JEL classification:

    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods

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