This chapter has presented a survey of the developments that have led to the current framework of conducting monetary policy. Financial market volatility has led modern central banks to choose interest rates as the main instrument for conducting monetary policy, and at the same time a breakdown of the stable relationship between output and monetary aggregate and the failures of exchange rate pegs has motivated most central banks to adopt an inflation rate as the primary goal of monetary policy. Recently, inflation forecasting has emerged as one of the key intermediate targets for monetary policy because of the argument that it is to be highly correlated with the socially optimal inflation rate, the goal variable.
From the foregoing discussion, it is clear that among the different monetary regimes inflation targeting on the one hand requires relatively more discipline in terms of fiscal management and central bank independence while on the other hand it requires greater financial depth and sophistication in manipulation of instruments. Developing countries, such as India, find it hard to qualify on these accounts. With the combined fiscal deficit of Central and State Governments (during 1990s) remaining in the range of 8-10 percent of gross domestic product (GDP), more than 25 percent of the time and demand liability of the banking sector held in government securities as SLR and the ratio of gross to net borrowing of the government resting around 0.67 does not bode well central bank independence in India. Because of the
high fiscal deficit the central bank finds it difficult to reduce CRR drastically. In order to avoid interest rates rises in the face of otherwise borrowing needs of the Government the RBI is constrained to finance it at lower cost.
There has been no liberalization in the area of directed credit. Commercial banks are required to direct 40 percent of their commercial advances to the priority sector, which consists of agriculture, small-scale industry, small-scale transport operators, artisans etc. At present the percentage of directed credit appears to be too high and needs to be narrowed down to potentials growth and highly focused areas.
Further the reforms are a very recent phenomenon in India. Financial depth is beginning to develop. Thus, it will take quite some time before the pre-requisites of inflation targeting as available in the developed economies is achieved in India. After the financial sector reforms commencing in 1991 the situation must have improved particularly with the abolition of automatic monetisation, decontrol of most of the deposits and lending rates and reduction in quantitative controls since 1997. Therefore, it does not prevent the monetary authorities in India from commencing the process of inflation targeting. The spirit of the monetary regime directed towards inflation control need not necessarily be the exact inflation targeting, practiced in developed countries. The most important thing is to understand the behaviour of the economy and develop an inflation model based on the maximum available information and start working with model improvements as time passes. The objective of this report has the same spirit.
Chapter 4
The Inflation-Growth Nexus in
India
4.1 INTRODUCTION
Achieving and sustaining high economic growth has been the top priority of policymakers around the world. While the process of achieving high growth may lead to an increase in inflation due to the pressure on inputs exerted by the excess demand, sustaining the growth requires that inflation be kept under control. In the long run, inflation reduces growth by reducing the efficiency of investment and productivity growth. Several recent studies, for example, Fischer (1993), Gregorio (1993), Barro (1995), Fry, et al. (1996), Ambler and Cardia (1997), and Ghosh and Phillips (1998) have shown a long-run negative relationship between inflation and growth based on cross-country and panel regression analyses. Corden (1996) observed that one of the strong features of newly industrialized economies like Singapore, Taiwan, Malaysia, and Thailand was very low levels of inflation over a long period between 1961-91. During this period these countries had an average annual inflation level ranging between 1.7 and 4.0 percent.
Although there is no single optimal level of inflation, two per cent inflation is considered a benchmark of price stability by Feldstein (1996) and certain other studies.46 The inflation targeting countries also have inflation targets in a similar range of 1-3 percent. On several occasions, the then Governor of the Reserve bank of India (RBI), Rangarajan (1998), stressed the need for bringing down the inflation
46 Fischer (1994) suggests a range of 1-3 percent; Summers (1991) considered that optimal inflation should be positive; ‘perhaps 2-3 percent’ as the losses from a low inflation level are likely to be small.
rate in India to be on par with its trading partners’ level of inflation47. Rangarajan’s concern seems to emerge from the following channel of adverse effect of inflation. For a given nominal exchange rate and foreign inflation, a higher rate of domestic inflation means a higher rate of appreciation for the domestic currency with an accompanying loss of export competitiveness. An adverse impact on exports may affect economic growth in different ways, such as a decrease in imports of technology and intermediate products, balance of payment pressures and a net fall in aggregate demand.
However, some other studies have concentrated on specifying a threshold level of inflation. For example Sarel (1996) and Bruno and Easterly (1998) show that the harmful effects of inflation are not universal, but appear only above the 'threshold' level of inflation. In a cross-country analysis, Sarel (1996) finds evidence of a significant structural break at 8 percent inflation in the function that relates economic growth to inflation.
Some country specific time series studies have explored the relationship between inflation and output (Bullard and Keating 1995), and inflation and productivity (Jarrett and Selody 1982 and Cameron, et al. 1996). However, these studies lack concentration on growth. If inflation is found to impact on the growth rate, this effect is likely to be more important than any one-off impact on the level of output or productivity (Grimes 1991). Grimes (1991) study is one among very few country specific studies which have tried to analyze the relationship between economic growth and inflation. Based on analysis of 21 industrialized countries, Grimes (1991) concludes that even a low rate of inflation is likely to be detrimental to economic growth.
Kannan and Joshi (1998) recently analyzed a small sample of Indian data from 1981-95 in a static model and concluded six percent as the threshold of inflation
47 It can be pointed out that the widely quoted Chakarvarty Committee report (RBI 1985), recommended an inflation level of about four percent for India. On the relevance o f this recommendation of the Chakravarty Committee report, Rangarajan (1998:63) observes ‘No one in this country is advocating absolute price stability or even the order of price stability that is being sought as an objective in the industrially advanced countries’. Inflation during the recent period of 1991-98 in countries which are the major trading partners of India, like the United State of America (USA), Japan, Germany, United Kingdom and France has been at much lower levels of about 2.66, 1.04, 3.01, 2.95 and 1.76 percent, respectively, compared with 8.22 percent in India. It may be noted that average annual inflation in these countries for the entire sample period o f 1971-98 was 5.10, 4.07, 7.71, 3.35 and 5.96, respectively compared with 8.2 percent in India.
before output growth is adversely affected. This could hardly have been a surprising result, given that the specific period contained only three points of less than six percent inflation. However, they considered a six percent inflation rate may be ‘unacceptably high from the point of view of equity and other welfare considerations and may need to be contained at a feasible lower level’ (Kannan and Joshi
1998:2727).
Such literature, which emphasizes the negative effects of inflation on output growth, casts serious doubts on an approach to conducting monetary policy, which tries to exploit a short-run trade-off between inflation and output. At the same time, if such a negative relationship exists, targeting inflation should become the central theme in conducting monetary policy. From this point of view, it is important to know the causal relationship between inflation and growth, particularly in view of the fact that inflation and economic growth are both endogenous variables.
It is in this context that this chapter examines the inflation-growth nexus in India using annual data for the period 1971-98. Particularly, the questions addressed in this chapter are: (1) Does inflation affects economic growth (measured by the growth of per capita real gross domestic product) in India, (2) whether there is a threshold level of inflation, and (3) Besides its direct effects, does inflation exert any indirect effect on economic growth through other variables? Specifically, how does inflation affect savings and investment in India? The period of this study is reasonable, given that it covers a variety of inflation episodes, while at the same time data on most other variables are systematically and reliably available beyond 1970.
The rest of the chapter is organized as follows: The pattern of inflation in India is discussed in the following section 4.2. Section 4.3 discusses the causal relationship between output growth and inflation is discussed. Estimation of the growth models with non-linear effect of inflation on growth is examined in section 4.4. The effect of inflation on savings and investment is modeled and examined in section 4.5, and section 4.6 presents the concluding remarks.