MODELING INFLATION IN INDIA: THE ROLE OF MONEY

This paper studies the role of the real money gap — the deviation of real money balance from its long-run equilibrium level — for predicting inflation in India. Using quarterly data on manufacturing inflation from 1982 to 2007, we find that the real money gap is a significant predictor of inflation in India. Our results show that this variable is a better predictor of future inflation at quarterly horizon than the deviation of broad money growth from its target for the whole sample period. We also document a break in the overall predictability of inflation in the last quarter of 1995. We find that, except for the real money gap, the forecasting power of other predictors under study has declined considerably after 1995.