A Study On Economic Analysis of Inflation: The Regime Switching Approach

Abstract

The main objective of the study is to identify and estimate inflation based on the regime-switching model. The sixty years data set on consumer prices for India is obtained from World Bank. This study employed the Markov regime-switching model using simple switching regression (OPG - BHHH/ Marquardt) rather than legacy methods to forecast the time series. The success of the Markov regime-switching model is prominent due to its unique estimation feature, which is independent of its past records. The Regime‐ switching model depicts cyclic or periodic attributes, where the variables suddenly switch the direction and magnitude responding to some strong triggers such as economic shocks, which can be presented in various “regimes.” The regimes are assumed as the outcome of a stochastic process. The stochastic process estimates four regimes. The estimated equation corresponding to the regime-switching model replicates the actual time series of the Consumer Price Index. The study explains and estimates the effects of underlying triggers such as economic shocks, pandemics etcetera on the movements of inflation. The study reflects the effect of the 1973 oil crisis coupled with the US stock market crash of 1973-74. The impact of the 2008-09 recession and the effect the of Covid-19 pandemic is also evident in inflation. The study concluded that the estimated four regimes can be employed to forecast the impact of similar economic shocks. The rise in the inflation index was witnessed due to the effect of the subprime crisis. The study suggests that a sharp rise in recent inflation was observed due to stringent restrictions of Covid-19. The study also suggests policy measures to anticipate and formulate policies to counter such economic triggers. This research mainly contributes to the existing literature by suggesting the policymakers in formulating suitable policies and directions to tackle inflation leading to a robust economy. It will help the investors make investment decisions consequent to the robust economy and the literature in terms of statistical analysis to estimate the impact of economic shocks on inflation.