How the inflation threshold formula was arrived at

The formulation of the inflation threshold was calculated based on an economic model termed Multivariate Approach. Under this approach, a number of factors were considered that vary with time and do not move in a linear fashion.

For example, the exchange rate and the call money rate follow a non-linear pattern, even as the relationship between them could be linear in nature. (The True Inflation-Target Bullseye)

To determine the threshold level of inflation, the Reserve Bank of India annualised factors such as gross domestic product, US dollar/rupee, weighted average call rate, which roughly follows the monetary policy rate.

The estimation was done using quarterly data from 1996-97 to 2012-13. The threshold for India turned out to be four to six per cent. Inflation above threshold reduces output growth.