Inflationary Pressure and Indian Economic

Growth

XAVIER INSTITUTE OF MANAGEMENT
BHUBANESWAR
Submitted by,
Nisha Padhi (U113155)
INTRODUCTION

Inflation as defined by classical economists is Inflation shows rise in the price level and fall in the
value of money. It is the rate at which the general level of prices for goods and services is rising,
and, subsequently, purchasing power is falling. Central banks attempt to stop severe inflation, along
with severe deflation, in an attempt to keep the excessive growth of prices to a minimum.

Fig 1: India Inflation Rate over the Years


Fig 2: Inflation Rate of Different Countries



Persistently high inflation is a key macroeconomic challenge facing India. The recent slowdown in
economic growth notwithstanding, high consumer price inflation over the past several years has
brought about double-digit inflation expectations, high and rising demand for gold, has chipped
away at households financial savings and undermined the stability of the rupee. Importantly, high
inflation has disproportionately hurt the poor.
Inflation is a condition, when cost of services coupled with goods rise and the entire economy seems
to go haywire. Inflation has never done good to the economy. However, whenever there is expected
inflation, governments around the world take appropriate steps to minimize the ill effects of
inflation to a certain extent. Inflation and economic growth are parallel lines and can never meet.
Inflation reduces the value of money and makes it difficult for the common people. Inflation and
economic growth are incompatible because the former affects all sectors as indicated by:
CPI or Consumer Price Index: A rise in the CPI indicates inflation. The CPI or the consumer
price index is used as an index for salaries, wages, contracted prices, pensions. This is done
to adjust with the inflation effects. It is an important economic indicator.
GDP or Gross Domestic Product: The gross domestic product is another important economic
indicator and is usually inflation adjusted. This is an important tool for measuring the rate of
inflation.
INFLATION OVER THE LAST DECADE


Fig 3: Movements in Real GDP (Factor Cost) & WPI
In the aftermath of the recent global financial crisis in 2008, as growth gradually recovered, inflation
gained momentum in India. Inflation remained higher and persisted at above the comfort level of
the Reserve Bank of India. The debate of growth-inflation trade-off and the role of monetary policy
reappeared and have once again acquired center stage of recent policy debate.

Fig 4: World Inflation and Indias Inflation Rates over the years
If we divide the last decade since 2000-01 into two periods till 2008-09, and thereafter it
throws up some useful insights. Growth was reasonably sustained at relatively higher levels, with
wholesale price inflation at reasonably low levels in the first phase. During this period, while high
growth rates were associated with low inflation, it is very difficult to answer whether low inflation
contributed to high growth or high growth contributed to low inflation.
Since 2009-10, while inflationary pressures have increased, one can also argue that the slowdown in
growth has further accentuated inflationary pressures. One interesting statistic is that in the 32
quarters in 2000-01 to 2008-09, growth rate exceeded inflation rate in as many as 23 quarters, and
only in nine quarters did the inflation rate exceed the growth rate.
Strangely, in as many as 13 of the 17 quarters in 2008-09 and the first quarter of 2012-13, inflation
exceeded the growth rate, and only in four quarters did growth exceed the inflation rate.
Secondly, during the period, till 2008-09, while movements in growth rate and inflation rate showed
a negative association, as argued earlier, it is a puzzle whether higher growth rate led to lower
inflation or lower inflation to higher growth. From the graph that plots movements in GDP growth
and wholesale price inflation rates, there seems to be some kind of a contemporaneous relationship
between the two.
The story from 2009-10 becomes somewhat different. There is a fall in growth rate, but the inflation
rate remains persistently at higher levels and also well above the growth rate in GDP.



0
2
4
6
8
10
12
14
2008 2009 2010 2011 2012
World
EDE
WPI(India)
CPI(India)
COSTS OF INFLATION

Inflation, though a nominal variable, imposes real costs on the economy.
Inflation erodes the value of money. India is a moderate inflation country with the 62-year
long-term average inflation rate being 6.7 per cent, notwithstanding occasional spikes in
inflation. Yet during this period the overall price level has multiplied 45 times. This means
that ` 100 now is worth only ` 2.2 at 1950-51 prices. Since price stability is a key objective of
monetary policy, central banks are obviously concerned with inflation.
High and persistent inflation imposes significant socio-economic costs. Given that the
burden of inflation is disproportionately large on the poor, and considering that India has a
large informal sector, high inflation by itself can lead to distributional inequality. Therefore,
for a welfare-oriented public policy, low inflation becomes a critical element for ensuring a
balanced progress.
High inflation distorts economic incentives by diverting resources away from productive
investment to speculative activities. Fixed-income earners and pensioners see a decline in
their disposable income and standard of living. Inflation reduces households savings as they
try to maintain the real value of their consumption. Consequent fall in overall investment in
the economy reduces its potential growth. With a high inflation of over two years we are
already seeing a fall in household savings in financial assets, particularly in bank deposits. At
the same time households preference for gold has increased. This is putting additional
pressure on our balance of payments.
Economic agents base their consumption and investment decisions on their current and
expected future income as well as their expectations on future inflation rates. Persistent
high inflation alters inflationary expectations and apprehension arising from price
uncertainty does lead to cut in spending by individuals and slowdown in investment by
corporates which hurts economic growth in the long-run.
Inflation rises and turns volatile; it raises the inflation risk premium in financial transactions.
Hence, nominal interest rates tend to be higher than they would have been under low and
stable inflation.
If domestic inflation remains persistently higher than those of the trading partners, it affects
external competitiveness through appreciation of the real exchange rate.
As inflation rises beyond a threshold, it has an adverse impact on overall growth. The
Reserve Banks technical assessment suggests that the threshold level of inflation for India is
in the range of 4 to 6 per cent. If inflation persists beyond this level, it could lower economic
growth over the medium-term.



GROWTH VS INFLATION

The recent softening trend seen in headline wholesale price inflation (especially its core
component) and also in global commodity prices demonstrates yet again the criticality of supply
shocks in determining the performance of the Indian economy.
The combination of low growth and sticky or gradually declining inflation we are now seeing is well
explained by demand contraction along an aggregate supply (AS) curve that is almost flat, but
subject to repeated shifts due to changes in expectations and cost variables. Upward shifts raise
the general level of inflation. With such a combination, demand contraction generates a high growth
cost, but without much effect on inflation.
The International Monetary Funds latest World Economic Outlook has pointed to the AS curve
becoming flatter in advanced economies, which means inflation responding less to cyclical factors.
This is partly because of better anchoring of inflation expectations, so that wages (and, therefore,
price levels) do not respond much to changes in employment rates as before.
SHIFT VARIABLES

In India, too, average wage levels now respond less to cyclical variables such as growth. Rather, they
respond more to shift variables. That especially includes food price inflation which shifts the entire
AS curve upwards. A shifting yet more-or-less flat AS curve is more natural in a country that has large
numbers of its people transiting from low to higher productivity employment.
It follows from this that the primary policy objective in India should be to try and affect the variables
that lead to shifts in the AS curve. Credible anchoring of wage-price expectations is, no doubt,
necessary after a period of sustained high inflation, but this requires only a small excess of potential
over actual output.
A large negative output gap (i.e. actual output being less than full-capacity output) helps only if
wages and other costs fall steeply as growth falls which is not the case in India where wages
respond less to growth than shift factors such as food price inflation. It makes the case all the more
strong to have lower agricultural support price increases, for instance, to anchor overall inflationary
expectations.
CASE FOR RATE CUTS

Since recent inflation numbers have turned out less than what were forecast, a reduction in policy
rates by the Reserve Bank of India (RBI) is compatible with anchoring inflation expectations. The
announcement of an expected WPI headline inflation of five per cent in March 2014 in the RBIs
annual monetary policy, below the current six per cent levels, will also help anchor expectations.
On the whole, inflation is coming down irrespective of the indices that one may refer to, while
growth remains weak. What is particularly worrying is that lead indicators for services, which have a
significant share in Indias GDP today, are negative. Expenditures such as on purchases of homes,
vehicles and consumer durables are quite interest-rate elastic. Lower loan rates will certainly help
here, apart from also improving banks asset quality as borrowers experience less payment stress.
Keeping these in view, the latest repo rate cut by the central bank was more than warranted. While
the RBI has resorted to significant cash reserve ratio cuts and open market operation injections, its
liquidity adjustment facility or LAF window has continued to be in deficit mode for the past many
quarters.
A major reason for this has been the large cash balances maintained by the Centre and the States
with the RBI. Since under current accounting norms, balances, whether of cash or of food, do not
show up in deficits until they are spent or used, governments have an incentive to carry large
inventories. This will change if interest costs or revenue foregone on account of governments
holdings of inventories are treated as expenditure.
Apart from availability of liquidity, its cost also matters. A fall in borrowing rates through the LAF will
reduce cost of funds for bank, thereby helping them lower loan rates.
RISK FACTORS

At the same time, since CPI inflation and food inflation remain high, policy rate cuts have to be small
and conditional upon future price falls. Thankfully, inflation levels are coming down and these could
be further aided by projections of bumper harvests worldwide and hopes of a normal monsoon in
India. While banks are constrained to fully pass on the benefits of policy rate cuts because of slow
deposit growth making it difficult to reduce the rates on these they may still be able to do so
once savers see better real rates with inflation falling.
The same goes for rural real wages, which are still rising. But the rate of increase is only about 2.5
per cent now, compared with 20 per cent levels as an initial reaction to spiralling food prices. The
current account deficit (CAD) remains uncomfortably high, requiring structural changes that reduce
relative production costs of domestic exports and import substitutes. Softening oil and gold prices
can improve the CAD in the short-term, giving further leeway for rate cuts.
In the Indian context, good macroeconomic coordination would involve proper allocation of
stabilisation responsibilities between the Government and the RBI to achieve the best growth-
inflation outcomes. Poor coordination occurs when monetary tightening by the RBI as a response to
food price inflation hits manufacturers just when their costs are rising. Or government transfers
create demand for a diversified food basket, which then further pushes up food prices, without
addressing marketing and other restrictions in agriculture that constrain supply response.
Examples of good coordination are removing unnecessary restrictions and other institutional
inefficiencies that raise costs to allow monetary policy to support demand, just as lower cash
balances by the Government with the RBI would improve liquidity management. Reduction in fiscal
deficit would help to the extent it reduces transfers and artificial demand created for supply-
constrained non-tradable goods. Here, pressure from rating agencies may have helped. That, along
with the strategic decision to cap petroleum subsidies, will go some way in meeting deficit targets
despite election pressures.
If the supply-side is important for controlling inflation, but the latter is regarded to be primarily the
RBIs responsibility, which can only tame it through demand contraction, the result is real
coordination failure. It, then, entails unnecessarily large output sacrifice to curb inflation which is
what we are seeing.
CAUSES OF INFLATIONARY PRESSURES

Inflation mainly happens as a result of an increase in demand without a corresponding increase in
supply. Before this decade, external factors such as oil price hike, gulf crisis, wars etc. used to lead
to inflation .We examine the various causes of inflationary pressures in India:-
Deregulation of administered prices such as petrol, diesel etc. and other measures
such as caps on number of subsidised cylinders a household can use leads to upward
movement in the prices.
Supply shocks which happen due to adverse monsoon conditions leads to increase in
demand in agricultural sector which can spill over to other sectors.
Increase of indirect taxes in the recent budget of 2012.
Increase in the prices of crude oil imports which lead to price rise in all those
industries which use it as raw material. For e.g. power, petroleum products.
Increase in money in the hands of people due to increased Government spending in
schemes like NREGA.
Increase in population which leads to increase in demand.
IMPACTS OF INFLATION

To the contrary belief, the impacts of inflation are many. It can be either positive or negative and
many a times even both.
Negative Impact

It leads to an apparent rise in the opportunity cost of holding money. Where, opportunity
cost can be defined as the next best alternative.
Inflation creates uncertainty. This uncertainty is a huge deterrent factor, when it comes to
making investments and savings.
If production is not rapid enough to counter the rising demand, it will obviously lead to
inflation. In such a scenario, humans get selfish and start hoarding goods, to reap the
benefits later on.
Positive Impact

Higher revenues and profits: A low stable rate of inflation of say between 1% and 3% allows
businesses to raise their prices, revenues and profits, whilst at the same time workers can
expect to see an increase in their pay packers. This can give psychological boost and might
lead to rising investment and productivity.
Tax revenues: The government gains from inflation through what is called fiscal drag
effects. For example many indirect taxes are ad valorem in nature, e.g. VAT at 20% - so as
prices rise, so does the amount of tax revenue flowing into the Treasury.
Cutting the real value of debt: Low stable inflation is also a way of helping to reduce the real
value of outstanding debts there are many home owners with huge mortgages who might
benefit from a period of inflation to bring down the real burden of their mortgage loans. The
government too might welcome a period of higher inflation given the huge level of public
sector debt!
Avoiding deflation: Perhaps one of the key benefits of positive inflation is that an economy
can manage to avoid some of the dangers of a deflationary recession

It is a general belief that high rates of inflation and hyperinflation are actually a cause of more than
called growth of the money supply. But, this however may not be the entire truth. Money supply
growth standalone doesnt cause inflation. A lot of economists feel that in case of liquidity trap,
which is a common phenomenon, large money based injections are like pushing on a string. The
views on what factors and reasons lead to moderate to slow inflation are extremely varied and
different. Low and moderate level inflation are a result of demand and supply play. Fluctuations and
changes in real demand for goods and services as well or variations in the the pace and acceleration
of money supply measures lead to such moderate or low level of inflation. Here in particular we
refer to Money Zero Maturity supply velocity.
Today, most economists favour a low and steady rate of inflation. Low (as opposed to zero or
negative) inflation can still be tackled and used to reduce the severity of economic recession. This is
done by enabling and ensuring that the labour market adjust more quickly in case of a downturn,
and reduces the risk that a liquidity trap destroys the entire economy. The monetary authorities
normally have the task of keeping the inflation level low and stable. Normally these monetary
authorities consist of the central banks which control monetary policy through
The setting of rate of interest
Through the operations of open market
Through the setting of cash reserve ratio, statutory liquidity ratio and other banking reserve
requirements.








CONCLUSION

High output growth and low inflation are among the most important objectives of macroeconomic
policy. But there are perceived trade-offs between lowering inflation and achieving high growth.
Empirical evidence emphasizes that the growth-inflation relationship depends on the level of
inflationat some low levels, inflation may be positively correlated with growth, but at higher levels
inflation is likely to be harmful to growth. In other words, the relationship between inflation and
output growth is non-linear. If such a non-linear relationship exists, then it should be possible to
estimate the inflexion point, or threshold, beyond which output growth becomes costly. In this
context, several studies have examined the relationship between inflation and long-run growth in a
non-linear framework.
It must be emphasised here that the concepts of inflation target and inflation threshold are distinct.
Inflation targeting is a construct of monetary policy making in which a central bank announces a
target and then steers its policy tools towards achieving that target. Inflation threshold is a point of
inflexion for the growth-inflation trade-off. Therefore, inflation threshold need not necessarily be
the target of monetary policy. In fact, the inflation objective or the target level of inflation for
monetary policy should be lower than the inflation threshold, considering the existence of significant
lags in the transmission of monetary policy measures and the costs of inflation.
Viewing the simultaneity factor between growth and inflation, the RBI should take a chance
stimulate growth by creating easy credit and interest rate conditions, without waiting for the
inflation rate to come down.
The push to growth, in turn, can accelerate the process of inflation easing. On the other hand, if the
RBI waits for inflation to come down, then growth may get further worse, resulting in a low-growth,
low-inflation trap.
Inflation coming down to acceptable levels on its own, or by maintaining a hawkish stance, cannot
happen in the immediate future. Since the government has taken the much-delayed step to push
reforms, the RBI should also show a more positive response to revive investor confidence, both
within India and from abroad.