Abstract:
Since consumer prices are a weighted average of the prices of domestic and of imported consumption
goods, and producer prices feed into final consumer prices, wholesale price inflation should cause
consumer price inflation. Moreover, there should exist a long-term equilibrium relationship between
consumer and wholesale price inflation and the exchange rate. But we derive a second relation between
the price series from an Indian aggregate supply function, giving reverse causality. The CPI inflation
should Granger cause WPI inflation, through the effect of food prices on wages and producer prices.
These restrictions on causal relationships are tested using a battery of time series techniques on the
indices and their components. We find evidence of reverse causality, when controls are used for other
variables affecting the indices. Second, both the identity and the AS hold as long-run cointegrating
relationships. There is an important role for supply shocks. Food price inflation is cointegrated with
manufacturing inflation. The exchange rate affects consumer prices. The insignificance of the demand
variable in short-run adjustment indicates an elastic AS. There is no evidence of a structural break in
the time series on inflation. Convergence is slow, and this together with differential shocks on the two
series may explain their recent persistent divergence.
