Inflationary effects of oil price shocks in Indian economy

• Published date: 01 August 2017
• Date: 01 August 2017
• Author: George Varghese
• DOI: http://doi.org/10.1002/pa.1614

■Commentary

Inflationary effects of oil price shocks in

Indian economy

George Varghese*

Institute for Financial Management and Research

Stabilising inflation around certain preconceived level remains the predominant objective of monetary authorities all

over the world as its variability has crucial ramifications on the real economy. However, the effective operation of

monetary policy to this end largely hinges on the nature and dynamics of inflation both in the short-run and long-

run. In this context, the present study focuses on theoretical investigation of how crude oil price fluctuations affect

inflation in a real economy. Moreover, the study examines the nature of relationship between crude oil price fluctua-

tions and inflation and its impact with reference to Indian economy.

The study suggest that, in India, although the price of petroleum products are insulated against international crude

oil price fluctuations by way of subsidies in order to curb inflation, in the long run, inflation manifest itself in the form

of worsening fiscal deficit and undermine the sustainability of public debt. Copyright © 2016 John Wiley & Sons, Ltd.

INTRODUCTION

Understanding the nature and dynamics of price

fluctuations has dominated the macroeconomic re-

search both on theoretical and empirical front over

the years. It is widely believed that growth rate of

money determines the rate of inflation in long run.

As described in the famous Quantity theory of

money, there exists a proportional relationship be-

tween inflation and the growth rate of money. How-

ever, the short run dynamics of inflation is more

complicated in nature. Conventional models of

price adjustments have stressed the role of inflation

expectation, the degree of economic sluggishness in

goods and labour markets and changes in relative

prices as the main determinants of inflation in the

short run. In fact, it is commonly believed that

changes in supply side factors generally called sup-

ply shocks cause transitory deviation of inflation

from its underlying trend by changing certain

relative prices.

1

For example, a negative supply

shock in crude oil results in temporary upward

pressure in headline inflation

2

by raising the relative

prices of food articles. Similarly, positive supply

shock in crude oil reduces the headline inflation.

However in classical framework, where price are as-

sumed to be perfectly flexible, such relative price

shocks should not lead to inflation (Friedman,

1975). In such a framework, in response to a relative

shock, some firms increase their nominal prices

while others decrease such that the price increase

cancel out the price decrease, thereby leaving the

aggregate price level unchanged.

In contrast to Freidman’s view, Ball and Mankiw

(1992) argue that the large desired adjustments in

energy sectors triggered quicker upward adjust-

ments in nominal prices of such sectors. Nonethe-

less, the fall in the equilibrium prices in other

sectors were too little to warrant downward price

*Correspondence to: George Varghese, Institute for Financial

Management and Research.

E-mail: george.v@ifmr.ac.in

1

Fundamentally, supply shocks are believed to cause changes in

certain relative prices (Ball & Mankiw, 1992).

1

The raw inflation figure as reported through the Consumer Price

Index (CPI) that is released monthly by the Bureau of Labour Sta-

tistics. The CPI calculates the cost to purchase a fixed basket of

goods as a way of determining how much inflation is occurring

in the broad economy.

Copyright © 2016 John Wiley & Sons, Ltd. 1 of 9

Journal of Public Affairs

Volume 17 Number 3 e1614 (2017)

Published online 8 August 2016 in Wiley Online Library

(www.wileyonlinelibrary.com) DOI: 10.1002/pa.1614