Determinants and Forecast of Price Level in India: a VAR Framework

The theoretical association of money supply and exchange rates with prices has been empirically established and shown to be dominant in explaining changes in price levels in India. However, post liberalisation, studies have shown price levels to be impacted by several other factors as also, weakened influence of the traditional factors established by theories. This study aims to find the determinants of price level for the period 1994–2008 using a Vector Autoregression model and test the predictive ability of the model. Our results show shorter and smaller impact of change in money supply and nominal effective exchange rate on price levels. Both money supply and nominal effective exchange rates are found to Granger-cause Consumer Price Index. But, impulse response functions show that the impact of shocks from money supply and nominal effective exchange rates on consumer prices peaks after two lags and is short-lived. Forecast error variance decomposition shows that these demand side factors contribute only 6 % of the forecast error variation in Consumer Price Index.