Econometrics Model and Methods

On
Inflation in India

Submitted to
Prof. GS Gupta

Submitted by
Rohan Dharmadkhari ()
Swati Tripathi ()
Shahida Khan (155121)

Submitted on
15.08.2016

INFLATION IN INDIA

1. Introduction:
Inflation is defined as the percentage change in the value of Consumer Price
Index on a year to year basis. It effectively measures the change in the
basket of goods and services in a year. The factors causing inflation vary
from country to country and determining these factors and their relationship
is important for building a macroeconomic model for inflation in India. The
major factors that we have incorporated in our model are:

Fiscal deficit (as a percentage of GDP)

Exchange Rate
Lending Interest rate
Crude Oil Prices
Growth in money supply
GDP growth rate

An important aspect in econometrics model building is determining the

nexus between these factors and their impact on inflation of the country.
Fiscal deficit
Theoretically fiscal or current account deficit has a direct correlation with
inflation. An increase in fiscal deficit which is caused by excess
government spending increases inflationary pressure in the economy and
a decrease in government spending will reduce deficit as well as have a
downward impact on inflation.
Exchange rates
Exchange rates also have a strong influence on inflation especially for
countries which have high trade volumes. Generally there is an inverse
relationship between inflation and exchange rate. Depreciation in
exchange rate causes an upward effect on inflation by making imports
more expensive and exports cheaper and appreciation and vice versa.
Lending rates
Lending interest rate is the rate at which the public can borrow funds and
it has a strong correlation with inflation. A fall in interest rates makes it
cheaper to borrow funds which in turn causes an increase in spending and
consequently increases inflationary pressure in the economy.

Crude oil prices

Crude oil prices have a direct correlation with inflation. As oil price is an
important input in any economy and is used in critical activities across
various sectors. An increase in oil price puts an upward pressure on input
prices and consequently on the prices of various products and services in
the economy putting upward pressure on inflation. While a fall in crude oil
prices reduces inflationary pressure on the economy.
Growth in Money supply (M2)
One of the important measures of money supply is M2 which is measured
by the amount of cash held by the public, checkable deposits, household
savings, small time deposits etc at any given point of time. There is again
a strong direct correlation between inflation and money supply (M2). An
increase in M2 increases inflationary pressure in the economy and vice
versa.
Growth rate in GDP
GDP or gross domestic output is the aggregate output produced in the
economy. There is a direct relationship between GDP growth rate and
inflation. A high growth rate of GDP is usually accompanied by rising
inflation as it increases aggregate demand as well as wage rate in the
economy which consequently puts an upward pressure on prices giving
rise to inflation.
2. Managerial Implication of Inflation Model
Econometrics models on inflation have important managerial implications
as they play a crucial role in understanding the relationship between
inflation and its various determinants. It helps managers in decision
making with regard to input and output pricing, cost of capital and in
decision with regard to import and export. They also help understand the
various other macroeconomic trends which impact inflation and help in
decision-making.
3. Data collection
The data has been collected on annual basis for thirty years which is
sufficient for running the regression analysis.
Data has been collected from various sources like Bloomberg terminal and
various websites like World Bank, IMF, and CMIE etc

3. Objectives and Methodology:

Through this project we intend to develop an econometric model to
determine inflation in India. We intend to meet the below objectives:
1. Understanding the factors affecting Inflation in India
2. Developing an Econometric model of Inflation
The approaches we will be using are Ordinary Least Squares (OLS) and
Granger Causality Test in VAR.
The study will entail the effect of the independent variables such as Fiscal
Deficit (as percentage of GDP), Exchange rate (INR/USD) , Lending Interest
Rate, Crude Oil Price(USD/Barrel), Growth in Money Supply(M2), GDP growth
rate(GDP) on Inflation.
4. Multiple Linear Regression Model:
The regression equation is:
CPI = 0 +1 FD+2 ER+ 3LR+4OIL+5M2+6GDP +
Where FD = Fiscal Deficit (as percentage of GDP)
ER = Exchange rate (INR/USD)
LR = Interest Lending Rate
OIL = Crude Oil Price (USD/Barrel)
M2 =Growth rate of Money Supply
GDP = GDP growth rate
The data used in the regression is from year 1984 to 2014. The data has
been collected from International Monetary Fund, World Bank, Planning
Commission of India and Reserve Bank of India.
4.1Analysis:
The regression equation can be written as:
CPI = -0.251+0.02 ER - 0.316 LR+0.364 M2+0.648 GDP +
From the ANOVA table, the significance (P value) of the model is 0.013 which
is less than 0.05. This P value suggests that the multiple linear regression
model developed is significant.
F (7, 6) = 6.591, p = 0.013

From the value of adjusted R square which is 0.721, we can conclude that
72.1% of the variance in inflation (dependent variable) can be explained by
the independent variables.
5. Granger Causality Test using Vector Auto Regression:
Granger causality test is a statistical hypothesis test. It is used to test
whether one time series can be used to predict another time series. We can
use the lagged values of time series X to forecast future values of time series
y, if the computed values are significant. The null hypothesis can be defined
as:
H0: X doesnt cause Y.
Ha: X causes Y.
If the significance level is greater than 0.05 the null hypothesis is accepted
otherwise rejected.
Granger causality test doesnt necessarily depicts the true causality.
Manipulation of one variable may still not change another variable if they are
correlated to a third process with a different lag. This test is useful in testing
causality relationship between two variables. When testing causality
relationship between more than two variables, it can lead to erroneous
results at times.
5.1 Analysis: The results are given below in the table. We have used 2 time
lags to make the variables stationary. From the table we can interpret that
Inflation has a unidirectional causality with Exchange rate, Fiscal deficit
shares a unidirectional causality with Crude Oil Price, GDP growth has a
unidirectional causality with crude oil price, crude oil price has a
unidirectional causality with inflation, GDP has a unidirectional causality with
inflation, and Exchange rate, Crude oil prices and Fiscal Deficit have a
unidirectional causality with Interest Lending rate. There is no causality
among other variables.

Serial
No

Null Hypothesis (H0)

Crude oil prices doesn't cause Dollar
1 exchange rate
Fiscal Deficit doesn't cause Dollar exchange
2 rate
GDP growth doesn't cause Dollar Exchange
3 Rate

Probabili
ty

H0 is
true?

0.2628 Yes
0.4348 Yes
0.4930 Yes

4 Inflation Doesn't cause Dollar Exchange Rate

Lending Rate doesn't cause Dollar Exchange
5 Rate
6 Growth in Money Supply M2 doesn't cause
Dollar Exchange rate doesn't cause Crude Oil
7 price
8 Fiscal Deficit doesn't cause Crude Oil Price
9 GDP growth doesn't cause Crude Oil Price
10 Inflation doesn't cause Crude Oil Price
11 Lending rate doesn't cause Crude Oil Price
Growth Money Supply doesn't cause Crude oil
12 price
Dollar Exchange rate doesn't cause Fiscal
13 Deficit
14 Crude oil prices doesn't cause Fiscal Deficit
15 GDP doesn't cause Fiscal Deficit
16 Inflation doesn't cause Fiscal Deficit
17 Lending rate doesn't cause Fiscal Deficit
Growth in Money Supply doesn't cause Fiscal
18 Deficit
19 Dollar Exchange rate doesn't cause GDP
20 Crude Oil Prices doesn't cause GDP
21 Fiscal Deficit doesn't cause GDP
22 Inflation doesn't cause GDP
23 Lending rate doesn't cause GDP
24 Money supply doesn't cause GDP
25 Dollar Exchange rate doesn't cause Inflation
26 Crude oil prices doesn't cause Inflation
27 Fiscal Deficit doesn't cause inflation
28 GDP doesn't cause inflation
29 Lending rate doesn't cause inflation
30 Money supply doesn't cause inflation
Dollar Exchange rate doesn't cause Lending
31 Rate
32 Crude oil prices doesn't cause lending rate
33 Fiscal Deficit doesn't cause lending rate
34 GDP doesn't cause lending rate
35 Inflation doesn't cause lending rate
36 Money supply doesn't cause lending rate
Dollar Exchange rate doesn't cause Money
37 supply
38 Crude oil prices doesn't cause money supply
39 Fiscal deficit doesn't cause money supply
40 GDP doesn't cause money supply
41 Inflation doesn't cause money supply
42 Lending rate doesn't cause money supply

Appendix:

0.0384 No
0.3601 Yes
0.0537 Yes
0.3439
0.0162
0.0194
0.7730
0.4521

Yes
No
No
Yes
Yes

0.9891 Yes
0.7315
0.9623
0.5723
0.3532
0.8470

Yes
Yes
Yes
Yes
Yes

0.3936
0.3340
0.6866
0.4455
0.7012
0.2253
0.4345
0.5577
0.0095
0.7944
0.0046
0.0868
0.2689

Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
No
Yes
No
Yes
Yes

0.0034
0.0491
0.0392
0.2686
0.2644
0.7864

No
No
No
Yes
Yes
Yes

0.7151
0.9453
0.2174
0.6651
0.1187
0.6552

Yes
Yes
Yes
Yes
Yes
Yes

Granger Causality Test:

VAR Granger Causality/Block Exogeneity Wald Tests
Date: 08/14/16 Time: 21:34
Sample: 1984 2014
Included observations: 29

Dependent variable: DOLLAR_EXCHANGE_RATE_INR

Excluded

Chi-sq

df

Prob.

CRUDE_OI...
FD
GDP
INFLATION
LENDING
M2

2.672419
1.665622
1.414670
6.521436
2.042900
5.849528

2
2
2
2
2
2

0.2628
0.4348
0.4930
0.0384
0.3601
0.0537

All

28.62304

12

0.0045

Dependent variable: CRUDE_OIL_PRICE_USD_BARR

Excluded

Chi-sq

df

Prob.

DOLLAR_E...
FD
GDP
INFLATION
LENDING
M2

2.134943
8.241975
7.886367
0.514862
1.587516
0.021945

2
2
2
2
2
2

0.3439
0.0162
0.0194
0.7730
0.4521
0.9891

All

57.03784

12

0.0000

Dependent variable: FD
Excluded

Chi-sq

df

Prob.

DOLLAR_E...
CRUDE_OI...
GDP
INFLATION
LENDING
M2

0.625228
0.076843
1.116209
2.081166
0.332168
1.864725

2
2
2
2
2
2

0.7315
0.9623
0.5723
0.3532
0.8470
0.3936

All

8.734236

12

0.7254

Dependent variable: GDP

Excluded

Chi-sq

df

Prob.

DOLLAR_E...
CRUDE_OI...
FD
INFLATION
LENDING
M2

2.193498
0.752104
1.617269
0.710034
2.980417
1.667146

2
2
2
2
2
2

0.3340
0.6866
0.4455
0.7012
0.2253
0.4345

All

7.190118

12

0.8448

Dependent variable: INFLATION

Excluded

Chi-sq

df

Prob.

DOLLAR_E...
CRUDE_OI...
FD
GDP
LENDING
M2

1.167742
9.322786
0.460243
10.74443
4.889065
2.626782

2
2
2
2
2
2

0.5577
0.0095
0.7944
0.0046
0.0868
0.2689

All

31.42513

12

0.0017

Dependent variable: LENDING

Excluded

Chi-sq

df

Prob.

DOLLAR_E...
CRUDE_OI...
FD
GDP
INFLATION
M2

11.33923
6.026899
6.479165
2.629190
2.660890
0.480536

2
2
2
2
2
2

0.0034
0.0491
0.0392
0.2686
0.2644
0.7864

All

50.30949

12

0.0000

Dependent variable: M2
Excluded

Chi-sq

df

Prob.

DOLLAR_E...
CRUDE_OI...
FD
GDP
INFLATION
LENDING

0.670600
0.112418
3.052463
0.815572
4.262822
0.845741

2
2
2
2
2
2

0.7151
0.9453
0.2174
0.6651
0.1187
0.6552

All

9.530052

12

0.6571