Inflation & Growth
Inflation & Growth
Inflation & Growth
DIRECTOR & CE, ICRIER
How important is the inflation-growth tradeoff?
The long-run rate of growth is determined by real factors: technical progress, demographics and the
savings rate. Inflation on the other hand is a monetary phenomenon. Prima facie we expect them not to be
We can think of some qualifications, of course:
Inflation is a tax on money holders. A change in the rate of inflation can therefore change wealthholders’ preference between holding their wealth in the form of money or in the form of real assets and
thus affect the growth rate. However, given the small proportion of total wealth which is held in the
form of money, such effects are likely to be small.
Inflation volatility increases uncertainty in a money-using economy thereby increasing the riskiness of
investment projects and affecting the growth rate adversely. However, apart from hyperinflationary
situations the additional inflation risk is likely to be small compared to other sources of risk such as
exchange rate variations, labour or infrastructure environment, or political and climate uncertainty.
Inflation makes debtors better off because debt repayment now imposes a smaller burden in real
terms. For the same reason it makes creditors worse off. Any increase in expenditure by the former
would be cancelled in part by the decrease in expenditure by the latter and only the small residual that
would remain one way or the other would affect growth.
If the tax system imposes taxes at different rates based on money income, inflation changes the burden
of taxes Rising money income puts people in higher tax slabs even though the real purchasing power of
that income might have been eroded in the meanwhile by inflation. This effect would persist till the
time tax slabs are revised. This effect is also likely to be small except in hyperinflation.
Thus, for moderate rates of inflation, the rate of inflation is unlikely to be related to the rate of long-run
Growth vs. Inflation: India, 1951-2011
growth rate of GDP at
2005-06 to 2010-11
2000-01 to 2005-06
1995-96 to 2000-01
1990-95 to 1995-96
1980-81 to 1990-91
1970-71 to 1980-81
1960-61 to 1970-71
1950-51 to 1960-61
The Indian evidence above shows the lack of any simple
unidirectional relationship between inflation and growth.
The short-run inflation-output tradeoff
Demand-side inflationary pressures arise from excess
demand pushing actual output above the economy’s
long-term output level, raising the marginal cost of
production of firms. Firms in turn raise prices to cover
their marginal costs.
Cost-side inflationary pressures come from rising
prices of domestic raw materials and imported goods.
The role of expectations
Inflationary pressures determine the rate of change of the
inflation rate. Excess demand accelerates the rate of inflation
compared to the expected rate of inflation. Deficient demand
slows it down.
Even without any demand-side or cost-side pressures firms
increase prices if they expect other firms to do so …
... workers press for increase in their wages if they expect other
workers to receive higher wages and firms to increase prices.
Managing inflationary expectations is essential for inflation
For example, following an oil price shock, if firms expect
monetary policy to accommodate the shock they would
immediately raise the price of non-oil commodities even before
the exhaustion of their existing oil stocks.
Monetary policy and the management of
policy affects inflation through its effect on aggregate
Since inflation today depends on inflation expected tomorrow, what
matters is not just today’s policy but also the expected policy response
to future events. The policy regime matters more than particular
A credible anti-inflationary stance makes monetary policy more
effective by anchoring inflationary expectations. If the monetary
authority is seen as being committed to its inflation targets there is
much less danger of a temporary inflation shock turning into a
persistent wage-price spiral.
On the other hand, if the monetary authority is seen as being willing to
accommodate inflationary pressures, the private sector begins to expect
any inflationary trend to persist and it becomes harder to fight
The course of monetary policy
The RBI has raised the repo rate* 10 times and by 275 basis points since
Between 2009-10 and 2010-11 the WPI inflation rate has gone up by 576
basis points from 3.80% to 9.56%.
By not responding aggressively enough to inflationary pressures the RBI
faces the risk of inflationary expectations becoming entrenched.
While the RBI’s cautious approach has avoided a major negative impact on
output and employment right now, it creates the risk of having to pay a
much larger price in lost output later when it has to fight the inflationary
expectations which are becoming entrenched now.
A policy of easy money does not bring any growth dividend in the long-run
since actual output cannot be kept above the economy’s productive capacity
permanently and the growth of productive capacity is determined by real
and not monetary forces.
* The repo rate is the rate at which the RBI lends money to commercial banks.
External constraints on monetary policy
The short-run interest rates in the US are close to zero. The long-
run rates have been pushed down by the two rounds of quantitative
Pursuit of an anti-inflationary high interest rate policy in India
would lead to destabilising capital inflows and appreciation
pressures on the Rupee.
The RBI faces the classic trilemma, One cannot have
fixed exchange rates,
free capital flows
and monetary policy autonomy
at the same time.
The RBI can counter the inflows by allowing the Rupee to
appreciate continuously. But continuing appreciation of the Rupee
would hurt competitiveness and may not still solve the inflow
problem given the unpredictability of foreign investor sentiment.
Recent inflation driven by food prices?
Growing demand for agricultural products arising
from growing income.
Agricultural output growth slower than overall
output growth. A severe drought in 2009-10.
Demand-supply mismatch raises the relative price of
If other prices cannot adjust downward, absolute
prices of agricultural products must rise.
The relative price of food: India, 1994-2010
The relative price of food
is computed as the ratio
of the WPI component
for primary food
commodities to an index
computed from WPI
Food price rise cannot explain
all of current inflation
Between 2009-10 and 2010-11 WPI inflation was 17.7% for primary
products; 12.3% for fuel, power, light and lubricants; and 5.7% for
The overall inflation rate was
How much of this inflation was contributed by primary products?
Manufactured product prices were to remain constant.
Inflation in fuel, power, light and lubricants was to still be 12.3%.
The overall inflation rate would then be only
This can be thought of as the contribution of primary products to
External constraints: correlation between
domestic and world food prices
WPI of Food
World Wheat Prices vs. MSP*
Wheat (Rs./100 kg)
*MSP: Minimum Support Price. A floor price set by the Government of India. Data sources: World-IMF; India-FCI
Monthly Wheat Prices (World vs. India)
Wheat Prices (Rs./100 Kg)
Sources: World-IMF; India-MCX Ltd.
Policy recommendations: short-run
In the short-run the RBI should raise interest rates
sharply to protect its anti-inflationary credibility.
Fiscal consolidation to ensure that fiscal policy does
not work at cross-purposes with monetary policy.
A loose fiscal policy, by increasing the debt burden both
directly and through its effect on interest rates, would prove to
be unsustainable in the long run
As the debt burden rises, the pressure to print money to
finance the fiscal deficit would rise, thereby making it
impossible to pursue an anti-inflationary monetary policy.
Policy recommendations: long-run
Investment in infrastructure and human capital to
ensure that desired growth does not exceed the
productive capacity of the economy.
Investment and promotion of organizational innovations
in agriculture to ensure that food supply does not become
a bottleneck to growth.
Moving towards greater independence for the central
bank and transparency in monetary policy to stabilise
A policy debate on the possibility of imposing selective
capital controls to augment RBI’s policy space.