Households’ Inflation Expectations and Monetary Policy in India

– Studying the Public’s Learning Rules∗

Giridaran Subramaniam†

Research Intern
Reserve Bank of India
http://rbi.org.in

Toulouse School of Economics

http://www.tse-fr.eu

September 30, 2013

Abstract
In this paper I study the public’s learning rules concerning monetary policy, by studying
how the Reserve Bank of India’s monetary policy actions, such as changes to the policy Repo
Rate, affect households’ inflation expectations. The basic premise is that households receive
news regarding the central bank’s monetary policy actions through a medium – an information
source – which could differ cross-sectionally across households’ characteristics. Using data from
the Inflation Expectations Survey of Households (IESH) program conducted by the Bank, I
find that households immediately lower their long-term (one year ahead) expectations, while
their short-term (three months ahead) expectations adjust rather slowly, in response to a rate
hike. Further, I check whether the public’s learning rules differ cross-sectionally across their
occupation. I find that households’ occupation does not have any significant cross-sectional
variation in learning about monetary policy actions. These findings however do not provide
ample evidence to draw precise inference on timing and magnitude of responses, which calls for
a deeper look into the theory in this field. However, cursory inference can be drawn based on
the sign of the coefficients. (JEL Classification: E31, E52)
Keywords: Households’ Inflation Expectations, Monetary Policy, Learning Rules, Survey Data

∗
I thank my my guides, Saibal Ghosh and Ajay Prakash, for their invaluable insights and constant support. I am
indebted to G.V. Nadhanael and Himanshu Joshi for helpful comments and suggestions. I am also grateful to the
staff of the Prices and Monetary Research Division and the Department of Statistics and Information Management
for assisting with data and other administrative work. This working paper was drafted as part of an internship and
presented at the Department of Economic and Policy Research, Reserve Bank of India, Mumbai.
†
Email: giri.cs24@gmail.com

Electronic copy available at: http://ssrn.com/abstract=2362245

1 Introduction
In a speech delivered on inflation expectations in 2012, Deepak Mohanty, Executive Director, Re-
serve Bank of India (RBI), highlighted the importance of inflation expectations in monetary policy
analysis. “The state of inflation expectations greatly influences actual inflation”, he said, “and,
thus, the central bank’s ability to achieve price stability”, Mohanty (2012). The RBI observes that
maintaining price stability is one of it key objectives as the monetary authority, and to this regard,
anchoring inflation expectations falls within the ambit of the RBI’s core functions. Many central
banks around the world study data on inflation expectations before taking any course of monetary
policy action. Central banks and academics also study the role and relevance of inflation expecta-
tions to monetary policy. In this study, I aim to draw from these studies, and use relevant theory
and methodology to apply it to the Indian context.
Data on inflation expectations can be classified broadly into two categories: (i) market-based
information, and (ii) survey-based measures. Using financial market data, such as the difference
between yields of inflation-indexed bonds and normal ones, or simply by looking at the yield curve,
one can extract a measure of the markets’ expectations on future inflation. Further, collecting
information on expectations through survey of households and professional forecasters is another
method widely adopted by central banks, mainly to gauge the performance of monetary policy.
Households form their inflation expectations by collecting bits and pieces of information on
prices and economic activity from various sources. It is obviously impossible for households to keep
track of all commodities and changes in their respective prices over time. Hence, their inflation
expectations for the future would largely be affected by the basket of goods they consume regu-
larly and news shocks concerning the future economic situation. It is plausible to suppose that
households also respond to the central bank’s monetary policy action, for instance, while pursuing
a contractionary (expansionary) monetary policy to bring down (increase) inflation. I further posit
that households receive information regarding the central bank’s monetary policy actions through
a medium that acts as the information source. This information source varies across households’
characteristics. For instance, this could channel through the news media (for the general public),
or through financial advisors’ analysis and information that traders observe on the financial market
(for financial sector employees), or through announcements of cost of living adjustment allowance
(for government employees) and so on and so forth. Assuming that this information transmission
channel is efficiently functioning, in principle, households must immediately lower their forecasts
in case of a contractionary monetary policy action, such as a rate hike. This is the basic premise
behind this study.
Since September 2005, the RBI has been conducting an inflation expectations survey of house-
holds (IESH) on a quarterly basis. The survey covers 4,000 individuals from 12 cities across the
country, and captures their expectations of movements in inflation indices over the next three
months and one year (RBI, 2010). Currently, due to stringent data dissemination policy only the
aggregated dataset is available for research, and data from the initial three years are not accurate
enough for study. Hence the dataset ranges from September 2008 until June 2013, at a quarterly

Electronic copy available at: http://ssrn.com/abstract=2362245

frequency, and is aggregated on various demographic parameters such as age, gender and occupation
of respondents, and city in which survey was undertaken. Also, quantitative data (point estimates)
of expected inflation rate – current perception, three-month ahead forecast, and one-year ahead
forecast – and qualitative data of future price movements are available for the entire time period.
Obviously, there are evident restrictions while using this aggregated dataset. Firstly, I am not
allowed to control for individual characteristics; Bryan and Venkatu (2001) find that households’
inflation expectations vary quite significantly over individual characteristics, especially over gender.
Secondly, the time period over the entire sample is quite small to conduct meaningful time series
tests of rationality and adaptiveness.
While professional forecasters are assumed to form their expectations in a rational manner,
households would be subject to bounded rationality and imperfect information acquisition issues
while forming their expectations. Their figures of expected inflation are due to be influenced largely
by the basket of goods that they consume, which may or may not coincide with any of the official
indices of the RBI. Hence, there could be a lot of discrepancy between expected and actual inflation
figures. Further, households may be subject to what Sims calls ‘rational inattention’, which is due
to limited information processing capacity. Inflation is usually computed using an index, and this
index tracks the changes of prices of various commodities, assigns weights to them relevant to the
average consumer’s basket and then computes a rate known as the inflation rate. Households might
not be capable to collate and process price changes in all commodities that they consume, assign
weights according to their consumption basket and compute an index – hence, data on households’
inflation expectations do not interest every economist.
Given these issues regarding survey data on expectations, it is still relevant to study survey data
on inflation expectations for assessing the effect of monetary policy on expectations. Computing
inflation expectations from data on bonds could be biased for the simple reason that the financial
market only involves agents who trade on it, thereby excluding quite a lot of people, whereas
household surveys cover individuals across a gamut of occupation categories. Also, even though
households’ inflation expectations may not really coincide with any of the RBI’s official inflation
data, at the aggregate level, inflation expectations definitely have an impact on economic activity,
such as starting up new projects, signing loan contracts, buying machinery, investing in land etc.
– on aggregate demand, per se. I do not lay any emphasis on the magnitude of these expectations
but use them only to draw directional inference.
The rest of the paper is organised as follows. In section 2, I briefly discuss the related literature,
focussing broadly on empirical work. In section 3, I offer an explanation towards the motivation
behind this study, where I discuss my basic premise, and highlight its relevance. Section 4 provides
a description of the dataset I use in which I provide summary statistics and discuss potential issues
regarding estimation. Section 5 explains the empirical strategy I adopt to study the basic premise of
the paper and discusses results to important findings, while the remaining tables to other statistical
tests and robustness checks can be found in the Appendix. Section 6 concludes and Section 7
summarises the discussions that took place during the presentation.

2
2 Related Literature
Disagreement on Expectations: Mankiw et al. (2004) build upon the fact that data on expected
inflation show that there is always a considerable amount of disagreement on expectations, and
posits that this disagreement itself may be an interesting variable for studying its relevance to
monetary policy and the business cycle. Using survey data from three different sources, they test
the basic hypotheses: rational and adaptive expectations. They test for biases in expectations,
whether households fully use information, whether forecasting errors are persistent, and other such
questions. The paper also tests the simple macroeconomic model of sticky information (Mankiw
and Reis, 2002), by studying whether or not it is able to capture the extent of disagreement in their
survey data. All of these tests require a large sample period to provide robust results. The paper
establishes stylized facts and is one of the seminal papers in the area of inflation expectations with
reference to monetary policy and the business cycle.

Are households fully rational?: Evidence from empirical work suggests that households may
not be fully rational while forming their expectations, in contrast to what economists tend to assume
in their models; instead they indulge in some form of adaptive expectations formation behaviour.
Curtin (2006) serves as an elaborate reference to various theoretical models and empirical tests
regarding inflation expectations: whether households’ formation of expectations are rational or
adaptive, cross-sectional variation in expectations, digit preference, and many other such topics
on expectations formation. On a closely related note, Carroll (2003) suggests that households’
expectations might be drawn by looking at professional forecasters, who may be considered rational.
Although households’ expectations are never rational in the usual sense, using a framework where
households derive information from news reports of the views of professional forecasters, his model
captures households’ expectational dynamics quite well. Estimates from the model suggest that
stickiness may be driven rather by ‘inattention’ on the part of households, thereby having important
macroeconomic consequences.
Bernanke (2007), in his speech at the National Bureau of Economics Research (NBER) Summer
Institute, made a case for studying learning in macro models and called for more research into the
public’s learning rules, that would thereby help improve the central bank’s capacity to assess its own
credibility, to evaluate the impact of its policy decisions and communications strategy, and perhaps
to forecast inflation as well. This contributes to one-third of the motivation towards setting up the
basic premise of my paper.

Inflation Targeting: Kelly (2008) studies the causality between inflation expectations and in-
flation in the United Kingdom. The paper finds that since the introduction of inflation targeting
by the Bank of England, expectations are less sensitive to past inflation rate. The paper adopts
a purely statistical approach using vector autoregressions between retail price index (RPI) based
inflation, inflation expectations of the general public and that of business economists, finance direc-
tors, academic economists and trade unions. Using Granger causality testing, the author finds that

3
before inflation targeting was introduced, RPI inflation seems to have caused expectations, while
there is no causality running in the opposite direction. However, when inflation targeting was in
place, the author finds no causality between RPI inflation to expectations of both, the general public
and professional forecasters. The paper questions whether a change in causality implies a change in
the mechanism by which inflation expectations influence inflation or whether it indicates a change
in the manner in which agents form their expectations. The findings are definitely interesting and
raise questions on the possible role of inflation targeting on anchoring inflation expectations.

Indian Context: Patra and Ray (2010) adopt a computationally intensive approach to generate
future inflation and then study the determinants of inflation expectations by estimating a new-
Keynesian type Phillips curve. To generate inflation expectations they follow an unbiased and
parsimonious method of modelling the actual inflation process, that assumes rational behaviour
while forming expectations. Then they use an expanding window approach to generate next period’s
inflation;this estimation is robust across various diagnostics.
Their new-Keynesian type Phillips curve takes into account country-specific characteristics, such
as the stance of monetary and fiscal policies, marginal costs and exogenous supply shocks. This they
do by including the growth rate of government expenditure and percentage changes in prices of fuel
and primary goods in their equation. Their findings imply that high and climbing inflation could
easily impact people’s anticipation of future inflation driving it up permanently. Further, they also
suggest that the central bank is better off acting against inflationary pressures immediately instead
of delaying it to a later date, when expectations have risen far too high. They also find, empirically,
that the real interest rate has a significant effect on inflation expectations, as compared to fiscal
policy or exchange rate changes, thus establishing the importance of the rate channel relative to
the quantity channel, towards controlling future inflation. This findings – that the real rate has a
largely significant effect on inflation expectations – forms the other other one-third of my motivation
towards the basic premise of this paper. To my knowledge, this is the only paper on the topic of
inflation expectations and monetary policy with respect to India. One main criticism could be that
the estimation procedure forces the authors to implicitly assume that agents form their expectations
rationally.

RBI Report (May, 2010): The survey report by the RBI offers a detailed description of house-
holds’ price inflation expectations and how they survey was conducted, how expectations vary across
households’ key characteristics and how they compare and contrast with actual inflation figures. Us-
ing quarterly data that has been collected from the IESH program starting from September, 2005,
the report offers baseline descriptive and summary statistics, discusses trends and areas for im-
provement with regard data quality in further survey rounds. The survey results were compiled
and studied by the Technical Advisory Committee on Surveys (TACS), which was constituted of
members from the RBI and other academic bodies and provides a brief snapshot of households’ price
and inflation expectations in India. However, there is still vast potential to study the disaggregated
data along the lines of the various studies listed above, and establish important findings with respect

4
to inflation expectations in the Indian scenario (as was also mentioned by Deepak Mohanty in his
speech).

Narrative Approach to Monetary Policy: Romer and Romer (1989), employing what is fa-
mously known as the narrative approach, analyse the real effects of nominal disturbances of monetary
policy actions by looking at historical episodes of the US Federal Reserve’s attempts to reduce infla-
tion. They adopt a unique method identifying specific monetary disturbances from historical data
and constructing a dummy variable that captures this information, then using it as an instrument
that describes monetary policy surprises. This helps them to isolate and study the effects of anti-
inflationary or contractionary policies on log industrial production and employment. Their results
enable them to conclude that monetary policy actions taken by the central bank systematically
affect real output. The main advantage of using this method is that it overcomes the question
of direction of causality (“the old question of what is driving what when two economic variables
are moving in conjunction”), which is difficult to answer in studies that use vector autoregressions
of money and output. Drawing from this approach, I model monetary policy actions as dummy
variables to study the effect of monetary policy disturbances on households’ inflation expectations.
This forms the last one-third of my motivation towards this approach.

3 Expectations Formation and the Information Source

Most of the research on expectations formation addresses questions pertaining to expectations being
rational or adaptive, or the effect of individual characteristics on expectations, or the impact of sticky
information and information processing issues on expectations formation. Bernanke (2007), in his
NBER speech, calls for more research into the public’s learning rules concerning the central bank’s
policy actions. Patra and Ray (2010) find empirically that inflation expectations are affected most
significantly by the real interet rate; albeit these expectations are statistically generated by modeling
past inflation data implementing a computationally intensive approach. Drawing from these two
works, I construct my basic premise.
Households form their expectations of future inflation by collecting bits and pieces of information
on prices and economic activity from various sources. It is obviously impossible for households to
keep track of all commodities and changes in their respective prices over time. Hence, their inflation
expectations for the future would largely be affected by the basket of goods they consume regularly
and other news shocks concerning the future economic situation. In the light of news shocks, it is
plausible to suppose that households also respond to news regarding the central bank’s monetary
policy actions, for instance, while pursuing a contractionary (expansionary) monetary policy to
bring down (increase) inflation. This is what is better known as the public’s learning rules.
Delving on the public’s learning rules, I further posit that households receive information re-
garding the central bank’s monetary policy actions through a medium that acts as the information
source. This information source varies across households’ characteristics. For example, this could

5
channel through the news media (for the general public), or through financial advisors’ analysis
and information that traders observe on the financial market (for financial sector employees), or
through announcements of cost of living adjustment allowance (for government employees) and so
on and so forth. Assuming that this information transmission channel is efficiently functioning, in
principle, households must immediately lower their forecasts in case of a contractionary monetary
policy action, such as a rate hike, by the central bank. I study whether households respond to
changes in the RBI’s policy Repo Rate (repurchase rate) significantly.
Further, I hypothesise that households’ who differ in their occupation also differ in their learning
rules. This means that the information source for households varies cross-sectionally in efficiency;
some households’ expectations might respond much quicker to policy actions and others, much
slower. For instance, financial sector employees may process information on the central bank’s
monetary policy action more quickly than a housewife might. This hypothesis draws inspiration
heavily from Mankiw et al. (2004), wherein they posit that disagreement itself might have significant
effects on monetary policy and the business cycle. Although I do not delve into the next logical step,
that is to analyse how this disagreement can impact monetary aggregates, studying whether there
exists some disagreement itself throws some light on the public’s learning rules – the information
source.
This study gains relevance for various reasons. Firstly, I attempt to study the public’s learning
rules with respect to the central bank’s monetary policy actions concerning inflation. This could
have important implications for the central bank’s communication strategy and in evaluating the
implications of its policy decisions. Secondly, I delve into the learning rule (which I call the in-
formation source) and empirically analyse whether this differs cross-sectionally across households’
occupation or not. This forms a first step towards studying the information transmission process
of monetary policy action. Thirdly, and lastly, this also highlights whether the public understands
the central bank’s basic monetary policy actions, in the light of controlling future inflation. To my
knowledge, this is the first paper that adopts this kind of approach to study the public’s learning
rules in forming inflation expectations.

4 Data Description
Considering the important role of inflation expectations as an input for monetary policy, the RBI,
in September 2005, started the inflation expectations survey of households (IESH) – a survey of
the price and inflation expectations of Indian households. The survey is conducted in twelve cities
at a quarterly frequency and quota sampling is used to get adequate representation of gender,
age and categories. The twelve cities covered in the survey are the major metropolitan cities –
Delhi, Kolkata, Mumbai, Chennai – represented by 500 households, and eight other cities – Jaipur,
Lucknow, Bhopal, Ahmedabad, Patna, Guwahati, Bangalore and Hyderabad – represented by 250
households each. The male and female respondents in the group are usually in the ratio of 3:2.
Table 1 summarises the respondent profile in this survey.

6
 In the first few rounds, the survey questionnaire underwent considerable number of changes and
a Standing Committee in the RBI found several internal inconsistencies with the dataset for the
initial few years. From September 2008 onwards, the dataset is supposed to have shown satisfactory
improvements in quality and was hence recommended to be placed in the public domain. This is
the dataset that I have used in this study.

Table 1: Respondent Profile: Share in total sample (per cent)

Respondents category Target Share

Financial Sector Employees 10.0
Other Employees 15.0
Self-employed 20.0
Housewives 30.0
Retired persons 10.0
Daily workers 10.0
Other Category 5.0
Source: RBI Monthly Bulletin (May, 2010),
Inflation Expectations Survey of Households

The survey asks both quantitative as well as qualitative responses from households. A qualitative
question only asks households the direction of future inflation – whether prices might increase (i)
more than, (ii) equal to, or (iii) lower than the current rate, or whether there would be (iv) no
change in prices, or whether (v) prices might decline. A quantitative question asks households their
point estimate for future inflation – their three-month ahead and one-year ahead expectations. The
survey also asks households what their current exectation of the inflation rate is. In this paper I
only make use of quantitative data.
The survey establishes certain standard findings concerning households’ inflation expectations
that have been confirmed in other studies. Future inflation expectations of households is largely
determined by their current expectations of the inflation rate. This is in a sense a confirmation
of the adaptive expectations theory. Households’ expectations are found to be more adaptive than
rational, which confirms with the findings of Curtin (2006) The survey also finds a high level of
variability in households’ expectations during periods of high inflation. This has been observed
internationally as well. Logue and Willett (1976) show with the help of statistical evidence that
there exists a strong and positive relationship between the variability of inflation and the inflation
rate itself, across all countries, except for those with moderate levels of inflation. Cukierman and
Wachtel (1979) explores the possibility of accommodating a theory of differential expectations within
a rational expectations framework. Using data from the Livingston survey of forecasters and the
SRC consumer survey, they test their theory to find that the variance of expected inflation correlates
positively with the level of inflation.
The survey also finds that among the different characteristics of households, such as age, gender,

7
city and occupation, city is the largest source of variation among households’ expectaitons. This
is counterintuitive because there is considerable amount of variation in the price indices between
cities. Figure 1 plots monthly CPI inflation across eleven cities that are also covered in the IESH1 .
There is considerable amount of variation among cities themselves, and some deviation from the
average as well. This maybe due to the fact that consumption baskets vary across cities, since there
is sufficient amount of difference in consumption habits as well. Food items constitutes most of
the commodities contained in the CPI-IW, and consumption habits of food vary drastically across
states.

Figure 1: Citywise Monthly CPI Inflation

Figures (a) and (b) show data from households’ expectations on future inflation – three months
ahead and one year ahead. Volatility in expectations has reduced since 2010 and has hence roughly
remained constant. The focus of any study on inflation expectations must be placed more towards
longer-term expectations rather than shorter-term expectations, simply because inflation in the
1
Data on actual CPI-IW inflation was not available for Patna and hence I did not include it in this study. That
reduces the dataset down to eleven cities.

8
short term can be largely affected by shocks (ECB, 2012). However, I study both, the three-month
ahead and the one-year ahead expectations to see if the results vary significantly.

Figure 2 (a): Expected Inflation: 3 months ahead

Figure 2 (b): Expected Inflation: 1 year ahead

9
5 Empirical Strategy and Results
5.1 City-wise Analysis
Using data from the IESH program and city level CPI-IW2 inflation, I construct a panel of ob-
servations ranging across 11 cities and 19 time points. Comparing inflation expectations with the
city-level inflation rate derived from CPI-IW series is justified for two reasons. Firstly, households
face prices that prevail in their immediate environment, which would be within the city they live in.
Note that there is considerable amount of variation in CPI-IW inflation data across cities (Figure
1). Hence, even when forming expectations, one could argue that households will be basing them
on prices prevailing in their own cities. Secondly, consumption habits, most of which are closely
related to cultures in India can be assumed to be homogenous within cities and hence the basket
of goods consumed by households would be relatively similar within cities. At the national level,
there is immense diversity in consumption habits, specfically in the food basket. Although there is
no literature that backs this, this is a reasonable assumption.
Following the idea behind the narrative approach of studying the effect of monetary policy actions
on real variables from Romer and Romer (1989), where they analyse whether nominal disturbances
to monetary policy have real effects, I code monetary policy actions into a dummy variable – one
signifies a hike in the policy Repo Rate, and zero stands for both, a decrease and no change in the
rate3 .
I study the following specification4 , an error-learning model, which is a form of adaptive expec-
tations (Curtin, 2006),
X
e
πi,t = αi + µ π̃i,t + ϕp Dt−p (1)
p
e denotes expected inflation, i denotes cities, α is a set of cross-section fixed effects
where πi,t i
(dummy variables), π̃i,t is the difference between households’ expected inflation and actual inflation
e − π a ) , and D
(city-level) (π˜i,t = πi,t i,t t−p is the monetary policy action dummy variable.
Using data on households’ inflation expectations from both, the short-term forecast (three months
ahead) and the long-term (one year ahead) forecast, actual CPI-IW inflation and the RBI’s policy
rate hikes data, I study the specification in (1). Results in Table 2 and Table 3 summarize the
results.
2
Only data on CPI-IW is available at the city level, whereas these figures are not available for other indices such
as the wholesale price index (WPI).
3
Obviously, timing is a serious concern in this method, because the RBI at times changes its monetary policy
stance in between time periods (quarters), whereas data on inflation expectations is available only on a quarterly
basis. Hence, we might not be able to draw any serious precise conclusions on timing.
4
I study many other specifications, such as rational expectations and (purely) adaptive expectations, however only
this specification renders significant coefficients.

10
Dependent Variable: EXP3
Method: Panel least squares
Periods included: 16
Cross-sections included: 11
Total panel (balanced) observations: 176

Variable Coefficient Std. Error t-Statistic Prob.

C 10.188 0.477 21.389 0.000
REPO 0.616 0.458 1.345 0.181
REPO(-1) 0.835 0.429 1.945 0.054
REPO(-2) 0.256 0.445 0.576 0.566
REPO(-3) -0.930 0.495 -1.880 0.062
ERROR3M 0.385 0.103 3.727 0.000
Effects Specification
Cross-section fixed (dummy variables)

R-squared 0.700 Mean dependent var 11.083

Adjusted R-squared 0.672 S.D. dependent var 3.223
S.E. of regression 1.846 Akaike info criterion 4.151
Sum squared resid 545.318 Schwarz criterion 4.439
Log likelihood -349.251 Hannan-Quinn criter. 4.268
F-statistic 24.882 Durbin-Watson stat 0.975
Prob(F-statistic) 0.000

Table 2: City-wise – 3 Months ahead Expectations

In Table 2, EXP 3 stands for households’ three months ahead (or one quarter ahead) inflation
expectations, REP O is the dummy variable containing information on monetary policy shocks,
and ERROR3M is the error or the difference between expected inflation and actual inflation. This
specification also contains cross-section fixed effects (αi ) for cities, to control for fluctuation in levels
across cities.
We observe that households lower their forecasts on inflation only after 3 full quarters, which
allows us to draw more than one inference. Firstly, households might not actually be responding to
the monetary policy shock, but to a visible reduction in actual CPI-IW inflation, due to the respec-
tive monetary policy shock. Secondly, it could as well be due to the monetary policy shock itself,
and the significantly long delay could be attributed to: (i) a delay on the part of the information
transmission mechanism concerning the RBI’s monetary policy action, or (ii) a delay on the part
of agents’ information processins capacity. These effects, although interesting to study, are hard to
separate in this kind of specification.
In Table 3, EXP 1 stands for households’ three months ahead (or one quarter ahead) inflation
expectations, REP O is the dummy variable containing information on monetary policy shocks, and
ERROR1Y is the error or the difference between expected inflation and actual inflation. Here also,

11
I make use of cross-section fixed effects, given by αi in (1).

Dependent Variable: EXP1

Method: Panel least squares
Periods included: 7
Cross-sections included: 11
Total panel (balanced) observations: 77

Variable Coefficient Std. Error t-Statistic Prob.

C 12.454 0.145 85.886 0.000
REPO -0.565 0.057 -9.880 0.000
REPO(-1) 0.633 0.144 4.384 0.000
ERROR1Y 0.160 0.038 4.150 0.000
Effects Specification
Cross-section fixed (dummy variables)

R-squared 0.853 Mean dependent var 12.875

Adjusted R-squared 0.822 S.D. dependent var 2.356
S.E. of regression 0.994 Akaike info criterion 2.989
Sum squared resid 62.298 Schwarz criterion 3.416
Log likelihood -101.101 Hannan-Quinn criter. 3.160
F-statistic 27.982 Durbin-Watson stat 1.610
Prob(F-statistic) 0.000

Table 3: City-wise – 1 Year ahead Expectations

I also test for the redundancy of cross-section fixed effects by running a F -test and a Chi-square
test. The statistics provide enough evidence to reject the null that these cross-section fixed effects
(dummy variables) are redundant. The results of these statistical tests are provided in the Appendix.

5.2 Occupation-wise Analysis

Next, motivated by the fact that a particular households’ occupational characteristics may influence
the speed (or efficiency) of information acquisition, I proceed to test whether households’ occupation
shows any significant evidence towards their expectations formation process. To this end, I run
the same specification as in (1), but now i denotes occupation. Due to lack of availability of
disaggregated data, I test whether households’ occupation has any significant cross-sectional fixed
effect on determining inflation expectations. Table 4 and Table 5 summarize results to the estimation
of equation (1). Table 6 and Table 7 show results from a redundancy test of cross-section fixed effects
to test whether there is any significant cross-sectional variation in this specification.

12
Dependent Variable: EXP3
Method: Panel least squares
Periods included: 17
Cross-sections included: 7
Total panel (balanced) observations: 119

Variable Coefficient Std. Error t-Statistic Prob.

C 10.317 0.543 18.997 0.000
REPO(-1) 1.691 0.557 3.039 0.003
REPO(-2) -1.556 0.843 -1.846 0.068
ERROR3M -0.465 0.156 -2.987 0.003
Effects Specification
Cross-section fixed (dummy variables)

R-squared 0.483 Mean dependent var 10.824

Adjusted R-squared 0.440 S.D. dependent var 2.078
S.E. of regression 1.554 Akaike info criterion 3.800
Sum squared resid 263.469 Schwarz criterion 4.034
Log likelihood -216.145 Hannan-Quinn criter. 3.895
F-statistic 11.321 Durbin-Watson stat 0.777
Prob(F-statistic) 0.000

Table 4: Occupation-wise – 3 Months ahead Expectations

13
Dependent Variable: EXP1
Method: Panel least squares
Periods included: 17
Cross-sections included: 7
Total panel (balanced) observations: 119

Variable Coefficient Std. Error t-Statistic Prob.

C 10.735 0.588 18.250 0.000
REPO(-1) 1.791 0.549 3.263 0.001
REPO(-2) -1.926 0.771 -2.500 0.014
ERROR1Y -0.527 0.144 -3.654 0.000
Effects Specification
Cross-section fixed (dummy variables)

R-squared 0.541 Mean dependent var 11.577

Adjusted R-squared 0.503 S.D. dependent var 2.135
S.E. of regression 1.505 Akaike info criterion 3.736
Sum squared resid 246.877 Schwarz criterion 3.970
Log likelihood -212.275 Hannan-Quinn criter. 3.831
F-statistic 14.262 Durbin-Watson stat 0.725
Prob(F-statistic) 0.000

Table 5: Occupation-wise – 1 Year ahead Expectations

Redundant Fixed Effects Test: Equation (1)

3 Months ahead Expectations
Test cross-section fixed effects

Effects Test Statistic d.f. Prob.

Cross-section F 0.189 (-6,109) 0.979
Cross-section Chi-square 1.232 6 0.975
Table 6: Occupation-wise – Test for redundant fixed effects 3 Months ahead Expectations

Redundant Fixed Effects Test: Equation (1)

1 Year ahead Expectations
Test cross-section fixed effects

Effects Test Statistic d.f. Prob.

Cross-section F 0.121 (-6,109) 0.993
Cross-section Chi-square 0.794 6 0.992
Table 7: Occupation-wise – Test for redundant fixed effects 1 Year ahead Expectations

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 Results from Table 6 and Table 7 show that the cross-section fixed effects (dummy variables) are
indeed redundant implying that the fixed effects (FE) model is not the right one. This implies that
there is no cross-sectional variation in the expectations formation process, for both short-term and
long-term expectations. Thus, cross-sectional variation in occupation does not affect the information
acquisition process. The public’s learning rules of monetary policy actions do not vary with the
type of occupation. This hints that there is probably something more to this theory and calls for
more research into this field of public’s learning of monetary policy actions against inflation.

6 Conclusion
In this paper, I study the relationship between households’ expectations of future inflation and
the RBI’s monetary policy actions, to assess whether the policy actions directed towards inflation,
such as rate hikes, have an impact on these expectations. It is plausible to assume that households
draw information on the central bank’s monetary policy actions through a medium that acts as the
information source (what is otherwise known as the public’s learning rules). The information source
could vary across households’ characteristics, for example, households’ occupation; the information
transmission channel could vary in efficiency. For instance, the information source could be the news
media (for the general public), or financial advisors’ analysis or information that traders observe
on the financial market (for financial sector employees), or through announcements of cost of living
adjustment allowance (for government employees), and so on and so forth. This forms the basic
premise behind this study.
Using data from the RBI’s inflation expectations survey of households program, I study whether
a change in the Bank’s monetary policy stance has a significant impact on households’ inflation
expectations. I find that in the short-term, households alter their expectations only after three full
quarters, whereas in the long-term, households adjust their expectations immediately. Further, I
hypothesise that households differing in occupation also differ in their learning rules, and I proceed
to check whether households’ occupation has any significant effect on their expectations formation
process. I do not find any evidence suggesting that variation in households’ occupation results in the
delay in learning about the RBI’s monetary policy action, although a more microfounded approach
might provide contrasting results.
My findings come with with a few drawbacks, largely due to the lack of access to the disaggregated
dataset from this survey. Most of the results from the empirical estimation could be improved upon
with more granular data. In this paper, I have used data from the inflation expectations survey of
households, that were aggregated to various levels (city-wise, occupation-wise etc.), and this in my
opinion is the biggest drawback of this paper. Also, throughout this study, I do not place emphasis
on households’ exact point estimate of inflation. It is obvious that during the course of the survey,
when households were asked about their expected inflation, they do not actually have the capacity
to compute even a nearly exact inflation rate. But when aggregated, data from these kind of surveys
can give us a directional indication, and hence the inertia of expected inflation. Therefore, most of

15
the analysis here is based on this fact rather than the magnitude of expectations.
This study also reiterates the importance of studying the theory behind how households draw
information regarding the central bank’s monetary policy actions in controlling inflation, such as
rate hikes. More research on the information source – the public’s learning rules – through which
households draw their information could throw light upon other interesting aspects, such as timing
and magnitude of the impact behind altering inflation expectations. Lastly, this also highlights
whether the public understands the central bank’s basic monetary policy actions, in the light of
controlling future inflation.

7 Discussion
During the presentation, a number of views by seminar attendees were raised regarding theory,
methodology and conclusions. One participant suggested that using feasible generalized least
squares for estimation instead of panel least squares could provide more robust results and im-
prove the Durbin-Watson statistic. He also suggested coding the policy dummy variable in three
steps: (-1, 0, 1), instead of a dummy variable with binary values, indicating that this strategy
is more indicative of all the regimes – namely, a contraction, a neutral stance, and an expansion
(in the current framework, both an expansion and a neutral stance are together coded as a zero).
Further, he also suggested studying the same specification using an interaction variable between
actual inflation and the policy rate dummy, or a business cycle variable, or the output gap. Another
participant suggested that the next logical and interesting step, by way of theory, would be to study
whether these inflation expectations themselves affect the wage-bargaining and formation process,
by looking at real wage data. Yet another participant raised the concern on how to interpret a
positive coefficient in any one of the lags in such a specification. Another suggestion that was raised
was that possibly including current expectations in the specification could improve some of the
results.

16
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 Appendix

Redundant Fixed Effects Test: Equation (1)

3 Months ahead Expectations
Test cross-section fixed effects

Effects Test Statistic d.f. Prob.

Cross-section F 7.576 (10,160) 0.000
Cross-section Chi-square 68.227689 10 0.000
Table 8: City-wise – Test for redundant fixed effects 3 Months ahead Expectations

Redundant Fixed Effects Test: Equation (1)

1 Year ahead Expectations
Test cross-section fixed effects

Effects Test Statistic d.f. Prob.

Cross-section F 19.009 (10,63) 0.000
Cross-section Chi-square 107.078 10 0.000
Table 9: City-wise – Test for redundant fixed effects 3 Months ahead Expectations

19