Correlated Shocks, Hysteresis, and the Sacrifice Ratio: Evidence from India

Abstract

In an emerging market subject to frequent shocks output sacrifice from disinflation depends not only on the Phillips curve slope but also on shifts in demand and supply. Introducing shocks and correlations between shocks in a Kalman filter based estimation, the slope flattens, correlation between permanent output shocks (supply) and output gap (demand) shocks is negative and a new decomposition of output between trend and output gap shocks is obtained. The flat supply curve is robust to parameter changes, and business cycle turning points are tracked well, but the decomposition varies. More stable inflation expectation and rise in forward-looking behaviour increases volatility of trend growth and reduces the output gap. Inflation targeting had such effects in India. Estimated sacrifice ratio varies with the period and method, but it rises to 6.7 over 2011-17 if such hysteresis is included. Simultaneous equation estimation corroborates the results. In the estimation period, inflation targeting affected expectations but not inflation.