Appropriateness of Inflation Indices for an Open Emerging Economy
GLOBALIZATION: OPPORTUNITIES & CHALLENGES, P. Verma, P. Bala Bhaskaran, P. M. Madhani, eds., Wisdom Publications for the IBS Ahmedabad
25 Pages Posted: 9 Jul 2008 Last revised: 14 Jul 2008
Date Written: July 9, 2008
The objective of this research is to understand the relative significance of wholesale price index vis-a-vis consumer price index as an indicator of inflation for an open emerging economy like India.
The scope of such analysis can be extended to test the efficacy of the current monetary policy framework of the central bank, i.e., the Reserve Bank of India. Over the last three-and-half decades the Indian economy has emerged as a growing economy with significant changes in its economic policy stance. It has focused more on liberalization, free play of market forces and increase in competition. The role of foreign sector has also increased significantly as the volume of trade has increased along with the increase in the inflow and outflow of capital. In this context, the RBI has made an attempt to include exchange rate management in its set of objectives along with control of inflation and high economic growth and development.
In fact, the three objectives often operate in opposite directions. Increase in economic growth rate may result in higher inflation and appreciation of the domestic currency, which in turn may lead to a slowdown in the foreign trade, affecting the future economic growth negatively. Similarly, allowing the domestic currency to depreciate indefinitely may result in an increase in the inflow of foreign capital, and economic growth may pick up, but that will cause an increase in the money supply, which leads to inflation. Hence, it is essential that the central bank designs its monetary policy in such a way that appropriate balance is maintained among all the three objectives of the macroeconomic policy. This can be a complicated task for the RBI since the three objectives are more like three corners of a triangle, with forces in opposite directions.
Considering the significance of price stability, especially the control of inflation, in the long-term sustainable development of any economy, it has been accepted as the single most important objective of central banks world over: whether it is considered along with the objective of rapid economic growth, as has been the case with the Indian and some other emerging economies; or an effort to maintain the sharp balance between inflation and exchange rate, as in case of some of the open economies. Moreover, choice of an appropriate indicator of inflation is equally crucial. Measured through the changes in the price indices, several measures of inflation can be calculated. Broadly classified in the category of wholesale price index and consumer price index, these indices reflect changes in two different segments of the economy. Considering the economic transformation, the question of relevance of both measures of inflation arises, mainly because they are exclusive by nature, i.e., each measure neglects the impact of the other segment. Further, each measure has a different interrelation with the rest of the macroeconomic variables. In this context the question of appropriateness of the inflation indices arises. Effectiveness of monetary policy depends upon this decision to a large extent.
Here, the hypothesis is that the major macroeconomic variables are closely interlinked, which suggests that targeting a set of well-balanced macroeconomic objectives is more essential for the monetary policy of the RBI rather than singling out inflation as a target in the light of economic liberalization and globalization.
This hypothesis has several aspects:
One, since price stability is the prime objective of the monetary policy of the RBI, its interrelation with the other macroeconomic variables such as money supply, economic growth, foreign exchange rate and foreign exchange reserves gains much significance.
Two, the choice of a particular measure of inflation, that is, wholesale price index or consumer price index, is to be made depending upon their appropriateness as a monetary policy target. The relative explanatory power of the two models - one based on wholesale price index and the other based on consumer price index - can be one method to decide this.
Three, accuracy of forecasts is also an important factor. It is not wise to utilize one indicator of inflation only because it has a better explanatory power, but poor forecasting ability, since the monetary policy may be designed on the past performance, but is supposed to regulate the economy in future.
The macroeconomic model for India is tested using the vector auto regression (VAR) analysis for five variables, namely, economic growth rate (gross national product), money supply (M3), inflation rate (wholesale price index for all commodities and consumer price index for industrial workers), foreign exchange reserves and real effective exchange rate (REER for 36 countries) for a 36-year long time series from 1970-71 to 2005-06. This time series helps in understanding the changing importance of the macroeconomic variables due to the introduction of new, liberal economic policy that has integrated the Indian economy to the global economy.
The conclusion drawn from this study reveals that so far wholesale price index has been a more relevant target for monetary policy as it is more closely interrelated to the rest of the macroeconomic variables. The model based on the wholesale price index performs better even in forecasting. Though, the difference between the two models is not very wide. Mainly the problem is due to the absence of a more comprehensive measure of consumer price index, which can be substituted for the wholesale price index for all commodities. Further, fluctuations in the prices of goods entering into the foreign sector of the economy require sufficient representation in any such measure of inflation. This calls for a serious attempt at constructing a core measure of inflation, inclusive of wholesale prices, consumer prices and prices of traded goods and services. Finally, the linkages between inflation and exchange rate fluctuations need greater inquiry, so that the RBI can adopt an appropriate long-term and short-term target mix for its monetary policy.
Keywords: inflation, monetary policy, exchange rate, emerging economy
JEL Classification: E31, E52
Suggested Citation: Suggested Citation