Deriving India's potential growth from theory and structure

Abstract

Estimates suggest that Indian aggregate supply is elastic but subject to upward shocks. If supply shocks make a high persistent contribution to inflation, it implies second round pass through is occurring, implying growth has reached its potential. This measure of potential growth draws on both theory and the structure of the Indian economy. It turns out supply shocks largely explain inflation. Output reached potential only in the years 2007-08 when growth rates exceeded 9 percent. In the period 2010-11 there was no sustained excess of growth over potential. Inflation was due to multiple supply shocks, rather than second round effects. Estimated linear and Markov switching policy rules suggest there was over correction in 2011.They show a two percent underestimate of potential output leads to a 50 basis point rise in policy rates.