Macroeconomic Stability in India: Vector Error Correction Estimation of the Causal Relationship between Inflation, GDP, Money Supply, Interest Rate, Exchange Rate, and Fiscal Deficit

Abstract

The significance, nature, and direction of the effect of inflation on economic growth and macroeconomic stability are contentious both in theory and empirical analysis. This paper examines the causal relationship between inflation and macroeconomic variables – interest rate, exchange rate, money supply, GDP, and fiscal deficit – in India, during the period 1986 to 2016, applying the vector correction (VECM) estimation method. The macro variables are stationary at first difference, and a cointegrating and causal relationship exists between the wholesale price index and interest rate, exchange rate, GDP, broad money, and gross fiscal deficit. The VECM estimates reveal that money supply and GDP are the most important macro variables in explaining the variations in inflation. The estimated error correction term shows that the short-run disequilibrium is corrected by about 20 percent every period towards the long-run equilibrium. The impulse response results show that inflation responds positively to the money supply from the start to the 9th period. To promote economic growth and keep inflation low, money supply and budget deficits need to be rationalised.

Keywords: GDP, Inflation, Interest Rate, Exchange Rate, Money Supply, Fiscal Deficit, VECM Estimation

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