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A cointegration and error correction approach to the determinants of inflation in India

I, Sahadudheen (2012): A cointegration and error correction approach to the determinants of inflation in India. Published in: International journal of Economics and Research , Vol. 3, No. 1 (2012): pp. 105-112.

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Abstract

No doubt that the persistent rise in the price levels of commodities and services adversely affects the economic performance. The goal of each and every Government is to maintain low and relatively stable levels of inflation. Creeping or mild inflation can be viewed as having favorable impacts on the economy; on the other hand zero inflation is harmful to other sectors in the economy. The right level of inflation, is somewhere in the middle. The study analyzed the major determinants of inflation in India extracting 54 time series quarterly observations. The study employed Johansen-juselius cointegration methodology to test for the existence of a long run relationship between the variables. The cointegrating regression so far considers only the long-run property of the model, and does not deal with the short-run dynamics explicitly. For this, the error correction from the long run determinants of inflation is then used as a dynamic model to estimate the short run determinants of inflation. The study concluded that the GDP and broad money have a positive effect on the inflation in long run. On the other hand, interest rate and exchange rate has a negative effect. The income coefficient is 0.37 and showing significant, implying that in India, a one percent increase in income while others keep constant contributes 0.37% increase in inflation. Similarly the money coefficient is 0.047 and showing significant, implying that in India, one percent increase in money supply leads to a 5% increase in price level.

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