Propagation Mechanisms in Inflation: Governance as key

Resurgence in Indian inflation since 2007 was associated with sharp food and oil price inflation. Propagation mechanisms that allow these relative prices to affect aggregate prices include governance failures, the effect of food prices on wages, exchange rates on costs and the response to cost shocks in firm price-setting. The paper analyzes these mechanisms. Supply shocks took the form of upward shifts of an aggregate supply elastic in the sense costs did not rise with output. First round effects have to be allowed since of asymmetric price adjustment. Estimations show it was multiple supply shocks rather than persistent second round price effects that caused inflation. Output remained below potential. In such a structure, the best policies are those that reduce average production costs. Policy induced demand tightening to anchor inflationary expectations and prevent a wage-price spiral that could shift up costs imposed a large output sacrifice. Policy contraction generally exceeded the fall in output. A large negative demand impulse over 2010-12 constrained growth more than inflation. The analysis provides a new understanding of how supply constraints affect the economy