The Reserve Bank of India on 24th May 2021 released on its web site a study titled “Threshold level of Inflation – Concept and Measurement” which is co-authored by Professor Ravindra H. Dholakia, Dr. Jai Chander, Smt. Ipsita Padhi and Shri Bhanu Pratap.
The study examines the concept of threshold inflation and defines it as the long run equilibrium rate of inflation that maximizes the steady state growth within the relevant range of values. The empirical findings of the study broadly confirm higher threshold inflation and higher growth in emerging market economies than in advanced economies.
Let me explain the study which is basically a research on threshold inflation which maximizes long-term growth in an economy and its effect on fiscal deficit (FD) and current account deficit (CAD).
The study consists of 46 pages of write up, 7 chapters, and appendices A1- A6.
Let me explain in simple terms what do we mean by the word’sfiscal deficit, GDP, and inflation.
A fiscal deficit is a shortfall in a government’s income compared with its spending. The government that has a fiscal deficit is spending beyond its means.
A fiscal deficit is calculated as a percentage of gross domestic product (GDP), or simply as total dollars spent in excess of income. In either case, the income figure includes only taxes and other revenues and excludes money borrowed to make up the shortfall.
Gross domestic product is the total monetary or market value of all the finished goods and services produced within a country’s borders in a specific time.
What about inflation?
- Inflation: Inflation is the rate at which the value of a currency is falling and consequently the general level of prices for goods and services is rising.
- Inflation is sometimes classified into three types: Demand-Pull inflation, Cost-Push inflation, and Built-In inflation.
- Most commonly used inflation indexes are the Consumer Price Index (CPI) and the Wholesale Price Index (WPI).
Let us proceed with the RBI study.
Threshold Level of Inflation – Concept and Measurement
Talking in the language of the authors ‘Macroeconomic management in any economy usually proceeds by setting targets of crucial aggregates to be achieved over specified time horizon of five to ten years. In most of the countries these aggregates are growth rate of real GDP, retail inflation rate, fiscal deficit (FD) to GDP ratio and current account deficit (CAD) on balance of payments to GDP ratio.”
What about our nation?
In our nation, fiscal and monetary policy being more precisely defined macroeconomic policies, the targets of FD/GDP and inflation rate were assigned respectively to the Ministry of Finance and the Central Bank of the country, namely, RBI.
Let me actually quote the relevant legislations to strengthen the argument.
the Fiscal Responsibility and Budget Management (FRBM) Act was enacted for the Central Government and similar legislations were passed in every State Government in India during 2003 to 2010.
Similarly, inflation targeting was formally adopted with the amendments to the Reserve Bank of India (RBI) Act, effective June 27, 2016. Under both these legislations, formal targets were set for FD/GDP ratio and inflation rate, respectively, to be achieved over a fairly long time period.
We also understand that only two out of four targets are to be considered for achieving and the other two left out.
Our Prime Minister had set the aspirational target of achieving a $5 trillion economy by 2024-25 implying a real growth of 8 per cent per annum over next 6 years (GoI, 2019). Although the CAD/GDP target is not formally set, it is considered prudent to restrict it to less than 3 per cent by most economists and analysts. Whenever any discussion takes place on expenditure to be incurred/actually incurred by central government, these targets get the required importance.
In this context, the theory of growth and threshold inflation given by Dholakia (2020) provides a framework to effectively address this issue. At the time of setting the inflation target for the long run, the Central Bank of a country should consider the concept and appropriate measurement of threshold inflation rate that maximizes long-term real growth of the economy. In the present study, the authors examine the concept and measurement of threshold inflation in an international context by considering cross-country panel data for 1995-2018. (Data from 58 countries over a period of 3 plus decades were considered.)
Threshold inflation gets the required prominence as the center of the whole research in the other chapters by engaging the researches done by other economists over a period of time.
So, can we understand what is threshold inflation and what relationship it has with the growth of the economy?
The concept of threshold inflation is linked to the level of inflation beyond which it becomes detrimental to economic growth.
The research draws its strength from relying on various historical researches done by various economists over the period of 6 decades of economic sphere as per the details given below:
Mundell (1963), Tobin (1965), Sidrauski (1967a & b), Stockman (1981), Haslag (1995), (1997), Greenwood & Huffman (1987); Cooley & Hansen, (1989); Gomme (1993), . Friedman (1977); Ball (1992); Pindyck (1991); Bernanke (1993); Bertola& Caballero (1994), .Pourgerami&Maskus (1987); Ungar &Zilberfarb (1993), Nasr et al. (2015); Barnett et al. (2018), Choi et al. (1996), . Li (2006); Cizkowicz&Rzonka (2013), Akerlof et al. (1996); Danquah et al. (2011); Rondan& Chavez (2004), Dholakia (2020).
Subjects of research related to inflation ranged from” Direct relationship between inflation and growth “in 1963 to “to “Non-monotonic or invertedU shape relationship between inflation and investment rate; and between inflation and IOCR; and hence between inflation and growth.” In 2020.
The following sentence quoted from the research amplifies the tone of research over the past 6 decades.
“It is evident from Table 1 (page 15 of research) that the early literature emphasizing unidirectional relationship between inflation and economic growth in the long run in either direction is not consistent as it would result in implausible and unrealistic outcomes. Later studies, however, argue convincingly for a non-monotonic – particularly an inverted-U shaped rather than U-shaped – relationship between inflation and growth. Thus, there would be a threshold level of inflation where growth would be maximized. The literature on empirical estimation corroborates the existence of a non-monotonic relationship between inflation and economic growth in the long run.”
What about Indian economists say in the matter, particularly in Indian context?
- In the Indian context, some of the early efforts at investigating the inflation unemployment trade-off were Rangarajan (1983) and Dholakia (1990).
- Rangarajan analysed the relationship for the industrial sector and concluded that there was no trade-off between inflation and unemployment.
- Dholakia (1990) used the extended Phillips curve framework for the whole economy and found a horizontal aggregate supply curve thus denying that there existed a trade-off between inflation and growth in India.
- These studies were, however, based on the pre-liberalization period when prices of many commodities were administered. (With Indian economy aiming for $5 trillion scale, they turn out to be irrelevant as on date)
- More recent studies by Paul (2009) and Dholakia and Sapre (2012) find an upward sloping aggregate supply curve.
- Dholakia and Sapre (2012) incorporate the speed of adjustment in the extended Phillips curve framework and find a positive relationship between output and inflation.
- The research does mention “Some of the early studies suggesting threshold level of inflation in the Indian context are Chakravarty Committee (1985), which defined an annual inflation rate of 4 per cent as the tolerable level, and Rangarajan (1998) that viewed inflation rate at 6 per cent as “acceptable level” which draws the sagacity of our economists. Rengarajan, our former RBI governor has recently (2020) published an economic paper reinforcing his scholarly aptitude and Indian wisdom. I am really very proud of his scholarly aptitude and hard work to match up to world standards.
Table 2 on page 19 quotes 16 committee reports/authors/researchers who have given their “Threshold Inflation Estimates for Indian Economy” spreading the inflation threshold between 4% -6.7% using various research methodologies. The measure used was WPI/CPI or IW.
Though the research goes further technical to buttress the arguments, the names of various research tables given below radically clear our intellectual curiosity about the ultimate results of this serious research.
- Table 1: Literature Review – Theoretical Perspective on Threshold Inflation
- Table 2: Threshold Inflation Estimates for Indian Economy
- Table 3: Lead-Lag Correlations between Inflation and Growth using Panel Annual Data
- Table 4: Summary Statistics for the Final Panel Data Sample used in the Study
- Table 5: Growth Regressions – Results
- Table 6: Threshold inflation and Optimal Growth Estimates
- Table 7: India-specific Threshold inflation and Optimal Growth Estimates
- Chart 1: Long Run Trade-Off between Inflation and Growth in India
- Table 8: Threshold inflation and Optimal Growth Estimates with Terms of Trade
- Table 9: Threshold inflation and Optimal Growth Estimate for Oil Importing Nations
Let me quote direct from the research paper, their say on our economy and the desired results for further growth. (I am not capable of paraphrasing their economic wisdom and hence direct quote from page 31)
“Our model can be flexibly extended to generate country-specific estimates through appropriate adjustments. To show this, we include a binary independent variable for India in our baseline regression model for growth. We also introduce a slope dummy variable by interacting a binary variable with inflation to obtain Indiaspecific estimates.
This model specification essentially adjusts the average mean growth rate and slope of equation with respect to inflation for the sample to derive India-specific estimates6 presented below in Table 7.
For macroeconomic policy targets consistent with maintaining fiscal deficit at 6.0 per cent and current account deficit at 2.0 per cent of GDP, our estimates suggest a threshold inflation level of 6.1 per cent and optimal growth rate of 7.5 per cent for India.
Chart 1 provides the estimated growth – inflation scenarios in India given the alternative combinations of the other policy targets – fiscal deficit and current account deficit as proportion of GDP.”
What will happen in case of India, if various inflation levels are considered?
Page 31, para 1 clearly explains various scenarios and their consequences.
“The chart shows that the local maximum and minimum values of growth rate with respect to inflation rate in India are very close. The growth is maximized around 6 per cent of long-term inflation rate and is minimized around 9.5 per cent of inflation. If we consider the inflation target at 4 per cent instead of the threshold level of 6 per cent, the long-term growth rate would decline by about 80 bps. On the other hand, if we consider the inflation target of 8 per cent instead of the threshold level of 6 per cent, the long-term growth rate would decline by only about 30 bps.
Thus, the trade-off between long-term inflation and growth is not symmetric on both side of the threshold inflation. When the inflation target is less than the threshold level, the sacrifice is 0.4 per cent point growth per one per cent point reduction in long-term inflation. However, if the inflation target exceeds the threshold level, the sacrifice of growth is only 0.15 per cent point per one per cent point increase in the long-term inflation.”
Conclusion
Enough economic wisdom from RBI economists have been given. I agree with the assessment that empirical exercise carried out in the present paper suggests that the growth maximizing inflation rate is lower than the growth-minimizing inflation rate given the values of FD/GDP and CAD/GDP. It is not theoretically correct to say, therefore, that any higher rate of inflation than the threshold level is always inimical to growth.
On the other hand, it is correct to say that inflation rate lower than the threshold rate is always harmful to growth. Therefore, it is extremely important for the policy makers to identify the threshold level of inflation in the economy.
Let me join other intellectuals to request the authorities from the government of India as well as Reserve Bank of India to draw proper lines of inflation, GDP rate or any other economic ratios to achieve the highest rate of growth for our economy keeping in view of the demographic profile of nation as one of the youngest populations leading the nation to unlimited expectations with the capability to achieve it too.
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