The Effect of Crude Oil Prices on Inflation and Interest Rates in India: Evidence from DCC-GARCH Model

Abstract

Understanding the empirical linkage between oil prices and inflation is imperative as all monetary authorities attempt to keep inflation under check. This paper examines the time-varying correlations between crude oil prices and two major macroeconomic variables, inflation and interest rates in India. A dynamic conditional correlation GARCH analysis is applied to study the impact of oil price fluctuations on Indian Economy. Results of DCC-GARCH show that correlation between WPI (Wholesale price index) and international crude oil prices remains positive and close to one for majority of period except during the subprime mortgage crisis of 2007-09 when these two become negatively correlated. The results from DCC-GARCH suggests that global crude oil prices have significant effect on inflation but no direct effect on interest rates. However, results from Granger causality test indicates that oil prices will be able to affect interest rates at appropriate lag levels.

Keywords: Oil prices, Inflation, DCC-GARCH, Interest rates, Financial crisis.

JEL Classification: C32, E44, P28, Q43