The purpose of this paper is to analyse the implications of sharply rising food prices for monetary policy in India and similar emerging economies at present.
This paper uses analytical arguments from relevant macroeconomic literature and evidence from late 1960s US data to examine whether the 1970s stagflation was due to the OPEC price hike. It develops a two person (rich and poor), two commodity (food and non‐food) model to examine the impact of rising food prices on GDP, on measures of inflation, and on welfare, in the model.
Previously neglected evidence indicates that stagflation (simultaneously rising unemployment and inflation) preceded the OPEC price hike. The model results indicate that when food prices rise, the GDP deflator falls relative to the consumer price index (CPI).
The impact of supply shocks should be investigated by carefully examining links between abnormal rainfall and weather and output and prices on commodity by commodity basis. Further, technical issues pertaining to construction of a composite CPI representative of the population need to be explored.
Monetary policy in India (and similar emerging economies) should focus upon a population weighted CPI or some variant thereof.
High GDP growth should not lead to complacency, since when food prices are rising, the overall welfare impact may be negative.
The model presented in this paper explains the sustained divergence in India, in recent years, between the CPI versus the GDP deflator measures of inflation. It also highlights a possible similar divergence between GDP and overall welfare.
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