<p>Sustained high inflation, everyone agrees, is now the number one economic problem in India. How to tame it and what will be the consequences? Economists often talk of a growth-inflation tradeoff. It essentially says that higher growth causes higher inflation and consequently lowering inflation requires sacrificing some growth in GDP. <br /><br />Does this theory hold good in the current Indian context? To answer this question, one first needs to understand the standard logic behind the trade-off hypothesis. Inflation is basically a reflection of aggregate demand outstripping aggregate supply. Generally speaking, growth in aggregate demand would cause some rise in real GDP to meet the demand and some rise in prices. The exact mix would depend on how close to capacity output the economy is currently operating. So, higher growth typically leads to higher inflation. <br /><br />The inflationary situation in India is more complicated than this simple story. The dynamics has also been changing over time. Initially, it was driven by food prices rising as a result of drought. Then as food price inflation moderated, crude oil and other commodity prices have been moving up globally, leading to rise in the cost of production of non-food manufactured goods. Thus, high inflation is being generalised to the non-food sectors. <br /><br />Further, the actual inflation rate has been consistently higher than the official projections. As a result, inflationary expectations are getting strengthened, which, it is feared, may lead to higher wages (to beat the inflation), higher costs and higher prices – triggering the so-called ‘wage-price spiral’. <br /><br />There are many reasons why the oil and commodity price-induced inflation will not come down in foreseeable future: continuing political uncertainty in the oil-producing West Asia and North Africa, the Japanese being forced to switch from nuclear power to oil-based energy after the nuclear accidents, excess global liquidity (generated by loose monetary policy in US in particular) going into speculation in oil and commodities and the rising demand for food, oil and minerals from the high-growth emerging economies. In fact, rising inflation is not confined to India alone – it has become a big worry in many other countries including China and Russia. <br /><br />How does the continuing high inflation impact growth? In a closed economy, if producers raise prices the consumers lose what the producers gain. So, this type of inflation causes a domestic redistribution from consumers to producers with no impact on the overall demand, assuming everyone has the same propensity to spend. The situation is different if, say, oil price goes up globally for which India has to pay higher price for imported oil. This time redistribution is from India to the oil exporting countries. As a result, the total real income of Indians falls and hence aggregate demand for Indian goods and services goes down, leading to a lower growth in GDP.<br /> <br />Negative relationship <br /> <br />There is another reason why we may get a negative relationship. High inflation distorts relative prices in an unpredictable manner as all prices do not go up at the same rate. This introduces an additional element of uncertainty in the investment climate which discourages investment, and hence reduces future growth.<br /><br /> If so, then lowering (instead of raising) inflation would lead to a higher growth. In fact, this is the argument which is being used by the RBI to support its recently announced aggressive monetary policy stance to bring down inflation. It advances the thesis that lowering inflation by contractionary monetary policy would help sustain a higher growth rate in the medium term by reducing uncertainty. However, it would cause some fall in the growth rate in the short run by reducing aggregate demand as costlier finance (this is the ninth successive hike in interest rates announced by RBI) would discourage both consumption (specially credit-financed purchase of houses and cars) and investment expenditure (particularly in the low-profitability infrastructure projects). <br /><br />Following a similar kind of logic, the finance minister has recently expressed his concern that the continuing high inflation combined with contractionary monetary policy may shave off about one percentage point from the growth rate of GDP for 2011-12. The original budget estimate for growth in 2011-12 was 9 per cent which the FM is now bringing down to around 8 per cent. <br /><br />Finally, the link between monetary and fiscal policy. The continuing rise in crude oil price (from $74 in June 2010 to around $110 in May 2011) and the political inability of the government to pass on this rise to consumers is swelling the subsidy burden and worsening the fiscal deficit. A higher deficit would add further demand pressure to inflation and would need additional tightening of monetary policy to contain inflation to any given target. <br /><br />Economic policy advisors have been arguing for a market-determined diesel price for a long time. They believe that freeing diesel price would cause a one-shot rise in the price level but by reducing subsidy bill and government budget deficit it would reduce inflation in the longer run. It remains to be seen to what extent the government can muster the political courage to implement the suggestion. <br /><em><br />(The author is a former professor of economics at IIM, Calcutta)</em></p>
<p>Sustained high inflation, everyone agrees, is now the number one economic problem in India. How to tame it and what will be the consequences? Economists often talk of a growth-inflation tradeoff. It essentially says that higher growth causes higher inflation and consequently lowering inflation requires sacrificing some growth in GDP. <br /><br />Does this theory hold good in the current Indian context? To answer this question, one first needs to understand the standard logic behind the trade-off hypothesis. Inflation is basically a reflection of aggregate demand outstripping aggregate supply. Generally speaking, growth in aggregate demand would cause some rise in real GDP to meet the demand and some rise in prices. The exact mix would depend on how close to capacity output the economy is currently operating. So, higher growth typically leads to higher inflation. <br /><br />The inflationary situation in India is more complicated than this simple story. The dynamics has also been changing over time. Initially, it was driven by food prices rising as a result of drought. Then as food price inflation moderated, crude oil and other commodity prices have been moving up globally, leading to rise in the cost of production of non-food manufactured goods. Thus, high inflation is being generalised to the non-food sectors. <br /><br />Further, the actual inflation rate has been consistently higher than the official projections. As a result, inflationary expectations are getting strengthened, which, it is feared, may lead to higher wages (to beat the inflation), higher costs and higher prices – triggering the so-called ‘wage-price spiral’. <br /><br />There are many reasons why the oil and commodity price-induced inflation will not come down in foreseeable future: continuing political uncertainty in the oil-producing West Asia and North Africa, the Japanese being forced to switch from nuclear power to oil-based energy after the nuclear accidents, excess global liquidity (generated by loose monetary policy in US in particular) going into speculation in oil and commodities and the rising demand for food, oil and minerals from the high-growth emerging economies. In fact, rising inflation is not confined to India alone – it has become a big worry in many other countries including China and Russia. <br /><br />How does the continuing high inflation impact growth? In a closed economy, if producers raise prices the consumers lose what the producers gain. So, this type of inflation causes a domestic redistribution from consumers to producers with no impact on the overall demand, assuming everyone has the same propensity to spend. The situation is different if, say, oil price goes up globally for which India has to pay higher price for imported oil. This time redistribution is from India to the oil exporting countries. As a result, the total real income of Indians falls and hence aggregate demand for Indian goods and services goes down, leading to a lower growth in GDP.<br /> <br />Negative relationship <br /> <br />There is another reason why we may get a negative relationship. High inflation distorts relative prices in an unpredictable manner as all prices do not go up at the same rate. This introduces an additional element of uncertainty in the investment climate which discourages investment, and hence reduces future growth.<br /><br /> If so, then lowering (instead of raising) inflation would lead to a higher growth. In fact, this is the argument which is being used by the RBI to support its recently announced aggressive monetary policy stance to bring down inflation. It advances the thesis that lowering inflation by contractionary monetary policy would help sustain a higher growth rate in the medium term by reducing uncertainty. However, it would cause some fall in the growth rate in the short run by reducing aggregate demand as costlier finance (this is the ninth successive hike in interest rates announced by RBI) would discourage both consumption (specially credit-financed purchase of houses and cars) and investment expenditure (particularly in the low-profitability infrastructure projects). <br /><br />Following a similar kind of logic, the finance minister has recently expressed his concern that the continuing high inflation combined with contractionary monetary policy may shave off about one percentage point from the growth rate of GDP for 2011-12. The original budget estimate for growth in 2011-12 was 9 per cent which the FM is now bringing down to around 8 per cent. <br /><br />Finally, the link between monetary and fiscal policy. The continuing rise in crude oil price (from $74 in June 2010 to around $110 in May 2011) and the political inability of the government to pass on this rise to consumers is swelling the subsidy burden and worsening the fiscal deficit. A higher deficit would add further demand pressure to inflation and would need additional tightening of monetary policy to contain inflation to any given target. <br /><br />Economic policy advisors have been arguing for a market-determined diesel price for a long time. They believe that freeing diesel price would cause a one-shot rise in the price level but by reducing subsidy bill and government budget deficit it would reduce inflation in the longer run. It remains to be seen to what extent the government can muster the political courage to implement the suggestion. <br /><em><br />(The author is a former professor of economics at IIM, Calcutta)</em></p>