The Hindu Business Line : Will higher inflation spur growth?

FOR various understandable reasons, a powerful viewpoint has gained ground in recent months calling for a larger fiscal deficit and a higher growth rate of money supply than the current 15-16 per cent per annum. The proponents of this view recognise that the inflation rate will move up but argue that a higher inflation rate will boost the economic growth rate.

Currently, the point-to-point annual inflation rate is within 3 per cent; in 2000-2001 the annual average inflation rate was 7.2 per cent. It is also held by these circles that the market interest rates should be further brought down from the current levels of 6-9 per cent, as this would help improve the growth rate of industrial production.

The underlying assumption in this line of policy advice is that the economy is currently working below its capacity. The actual output is said to be below the potential output in the manufacturing sector. In this context, the 2000-2001 Report on Currency and Finance released by the RBI seems to have given a measure of guarded empirical support to the proposition that moving up the annual inflation rate to about 5 per cent might probably help close the gap between actual and potential output and, thus, improve the growth rate of the economy in the current phase.

The RBI researchers have introduced a reverse U-shaped curve as signifying the relation between the inflation and growth rates. Up to a point, as in the case of an umbrella shaped curve, higher inflation rates are associated with higher growth rates, but this relation ceases to hold when the inflation rate reaches the threshold level of 5 per cent, beyond which an increase in inflation rate will lead to a reduction in the growth rate.

The Chakravarty Committee had specified an upper bound of 4 per cent for the inflation rate. Chakravarty himself had stated that even if there is a positive relation between a higher inflation rate and the growth rate, the former should be eschewed on the score of social justice to the vast masses of unindexed and insecure population in the community. This population will consist of old persons, unorganised labour, marginal and small farmers, etc.

In received monetary theory, the idea of a trade-off between inflation and employment has been thrown out on the ground that for any given changed inflation rate, there will be corresponding adjustments in prices, wages, etc., as would erase the possibility of the emergence of either higher real savings/investments and/or higher productivity levels.

Consequently, the employment rate, and probably the growth rate, will remain unaffected. Even in respect of any improvement in current output closer to potential output/employment, there will only be transitory effects. Thus, any ongoing state of expectations and emerging contracts about the future will all get adjusted to the given positive inflation rate. This eventually led to the proposition that any given and maintained inflation rate cannot be raised on the empirical score that it will improve output/employment and growth rate.

It was Friedman who pointed out that, at a positive inflation rate, there are costs of acquiring higher money and real balances, and these are a welfare loss. Hence, opinion has swung round to a zero inflation rate as the desired goal of monetary authorities. Strong empirical evidence of the entire world in the post-War period supports the hypothesis that there is no positive correlation between inflation and growth rates; actually, the correlation is negative.

Take the Indian experience from 1970-71 to 2000-01. Of the 23 sequential regression exercises concerning the effect on the growth rate of the inflation rate, in 17 cases there was a negative relation. A positive relation was seen only in six of the sequential regression exercises. Clearly the empirical evidence is against the probability of a positive relation.

Any umbrella-shaped curve with a threshold rate of inflation as, say, an empirical optimum, seems to go against received empirical monetary theory. It has to assume that, as we move up the inflation rate, re-contracts will not take place and that expectations are static at the old inflation rate. In India, imagine the consequences when, while the rest of the world has an inflation rate of within 2 per cent, the rate here continues to be 5 per cent. This means that the exchange rate will go on moving down in order to protect exports; that whatever import duty cuts are adopted, they have no effect on import volumes as the exchange rate too will move down continuously.

Further, the wage and salary adjustments at the governmental level will have to go on taking place, and the chance of revenue deficits coming down becomes bleaker and bleaker. The expected inflation rate will also become 5 per cent and, given the intermediational margin of 3-4 per cent, lending rates cannot fall below 8-9 per cent. Foreign capital will require adjustments for falling exchange rates and will be attracted to countries where inflation rates are close to the world level. Of course, within the economy the woes of the lower middle classes and unorganised labour and of old persons will go on increasing.

The recent improvement in the poverty situation, particularly after 1995-96 is very much due to the impact of falling inflation rates in terms of prices of foodgrains, etc. But all this assumes that the inflation rate will stay put at 5 per cent. This will not happen. It is bound to keep moving up. There are, of course, other issues: Will a higher inflation rate lead to a potential reduction in savings? And, given that the nominal rates will not go up proportionately, will there be a rise in the capital output ratio, etc.

The incentive for cost reduction and productivity improvement will be less when credit is easier than otherwise. There are solid arguments for a monetary policy targeting of a zero inflation rate in a country like India from the angles of a) social justice from a distributive angle; b) fiscal prudence and overall economy of unproductive expenditure; c) promotion of exports; d) stable exchange rate; e) improvement of savings and investment; and f) protection of the economy from external shocks with sufficient cushions.

The Graph depicts growth rates of GDP on the X axis and annual inflation rates on the Y axis. The experience of 30 years of the mixes of the two rates is indicated. There are six cases of below 5 per cent inflation rates. Of this, in four cases, the growth rates were 5 per cent plus. There are six cases of inflation rates of 5-6 per cent. Three of these have growth rates of 5 per cent plus. There are 14 cases of inflation rates between 6 per cent and 11 per cent. Of these, ten cases are of 5 per cent plus growth rates. But one case is of a negative growth rate.

There are five cases of inflation rates of 12 per cent and above. Of this, there is only one case of a growth rate of 5 per cent plus. But there is one case of a negative growth rate.

The threshold rate of 5 per cent may be the upper tolerant limit. But there is no evidence to show that below the limit growth rates will be lower. In fact, the highest growth rate here of 9 per cent was with an inflation rate of 1.2 per cent.

The next highest of 6.4 per cent growth rate was obtained with a 3.3 per cent inflation rate. Of the five cases of below 4 per cent inflation rates, there were three cases of 5 per cent plus growth rates. No definite umbrella-type curve or a reverse umbrella-type curve can be clearly derived.

All sorts of relations can be postulated: zero/low inflation and high growth rate; high inflation and high/low growth rates; moderate inflation and high/low growth rates, etc., The general conclusion is that no conclusion can be drawn about any positive relation between inflation and growth rate!

Inflation occurs for various reasons; high inflation rates in India have been witnessed under war and warlike situations, acute scarcities in foodgrains, heavy raises in oil prices, large and growing revenue deficits, large and growing inflows of exchange inflows which are monetised, but the increasing exchange flows turned into increasing reserves, and so on.

There are probably no cases of large productive credit expansions associated with rising prices. It is in the last context that people talk of the probable productivity effects of moderate inflation rates.

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