INFLATION VS GROWTH

Submitted To: Prof JS Parmar HPUBS

Submitted By: Tanya Verma Roll No: 2439 MBA 3rd Sem

INFLATION VS GROWTH
One of the most important economic concepts is inflation. At its most basic level, inflation is simply a rise in prices. Over time, as the cost of goods and services increase, the value of a currency is going to go down because you won't be able to purchase as much with that unit of currency as you could have last month or last year. Of course, it seems like the cost of goods are always going up, at least to an extent, even when inflation is thought to be in check.

How is Inflation Measured? There are two main indices used to measure inflation. The first is the Consumer Price Index, or the CPI. The CPI is a measure of the price of a set group of goods and services. The "bundle," as the group is known, contains items such as food, clothing, gasoline, and even computers. The amount of inflation is measured by the change in the cost of the bundle: if it costs 5% more to purchase the bundle than it did one year before, there has been a 5% annual rate of inflation over that period based on the CPI. The second measure of inflation is the Producer Price Index, or the PPI. While the CPI indicates the change in the purchasing power of a consumer, the PPI measures the change in the purchasing power of the producers of those goods. The PPI measures how much producers of products are getting on the wholesale level, i.e. the price at which a good is sold to other businesses before the good is sold to a consumer. The PPI actually combines a series of smaller indices that cross many industries and measure the prices for three types of goods: crude, intermediate and finished. Generally, the markets are most concerned with the finished goods because these are a strong indicator of what will happen with future CPI reports. The CPI is a more popular measure of inflation than the PPI, but investors watch both closely.

Effects of Inflation on Economic Development The effect of inflation on investment occurs directly and indirectly. Inflation increases transactions and information costs, which directly inhibits economic development. For example, when inflation makes nominal values uncertain, investment planning becomes difficult. Individuals may be reluctant to enter into contracts when inflation cannot be predicted making relative prices uncertain. This reluctance to enter into contracts over time will inhibit investment which will affect economic growth. In this case inflation will inhibit investment and could result in financial recession. In an inflationary environment intermediaries will be less eager to provide long-term financing for capital formation and growth. Both lenders and borrowers will also be less willing to enter long-term contracts. High inflation is often associated with financial repression as governments take actions to protect certain sectors of the economy. The effect of inflation and economic growth is manifested in the following cases: 1) Investment: If the prices of goods increases and people have to compensate for the increase in price, they usually make use of their savings. In the event when savings are depleted, fund for investment is no longer available. An individual tends to invest, only if savings of an individual is strong and has sufficient money to meet his daily needs. 2) Interest Rates:

Whenever inflation reigns supreme, it is a well known fact that the value of money goes down. This leads to decline in the purchasing power. In the event, when the rate of inflation is high, the interest rates also rise. With increase in both parameters, cost of goods will not remain the same and consequently people will have to shell out more money for the same goods. 3) Exchange Rates: Inflation and economic growth are affected by exchange rates as well. Exchange rates denote the value of money prevailing in different countries. High rate of inflation causes severe fluctuations in exchange rates. This adversely affects trade (export and import), important business transaction across borders and the value of money also changes. 4) Unemployment: Growth of a nation depends to a large extent on employment. If rate of inflation is high, unemployment rate is low and vice versa. This theory is propounded by economist William Philips and this gave rise to the Philips Curve. 5) Stocks: The returns a company offer, on investment fully depend on the performance of the company. Past performance, current position of the company and future trends decide how much money (in form of bonus or dividend) is to be returned to the investors. Owing to inflation, several monetary as well as fiscal policies are impacted.

How important is the inflation-growth trade-off? The long-run rate of growth is determined by real factors: technical progress, demographics and the savings rate. Inflation on the other hand is a monetary phenomenon. Prima facie we expect them not to be related. We can think of some qualifications: Inflation is a tax on money holders. A change in the rate of inflation can therefore change wealth-holders preference between holding their wealth in the form of money or in the form of real assets and thus affect the growth rate. However, given the small proportion of total wealth which is held in the form of money, such effects are likely to be small. Inflation volatility increases uncertainty in a money-using economy thereby increasing the riskiness of investment projects and affecting the growth rate adversely. However, apart from hyperinflationary situations the additional inflation risk is likely to be small compared to other sources of risk such as exchange rate variations, labour or infrastructure environment, or political and climate uncertainty. Inflation makes debtors better off because debt repayment now imposes a smaller burden in real terms. For the same reason it makes creditors worse off. Any increase in expenditure by the former would be cancelled in part by the decrease in

expenditure by the latter and only the small residual that would remain one way or the other would affect growth. If the tax system imposes taxes at different rates based on money income, inflation changes the burden of taxes. Rising money income puts people in higher tax slabs even though the real purchasing power of that income might have been eroded in the meanwhile by inflation. This effect would persist till the time tax slabs are revised. This effect is also likely to be small except in hyperinflation.

Thus, for moderate rates of inflation, the rate of inflation is unlikely to be related to the rate of long-run growth.

Monetary Policy and the Management of Expectations Monetary policy affects inflation through its effect on aggregate demand. Since inflation today depends on inflation expected tomorrow, what matters is not just todays policy but also the expected policy response to future events. The policy regime matters more than particular decisions. A credible anti-inflationary stance makes monetary policy more effective by anchoring inflationary expectations. If the monetary authority is seen as being committed to its inflation targets there is much less danger of a temporary inflation shock turning into a persistent wage-price spiral. On the other hand, if the monetary authority is seen as being willing to accommodate inflationary pressures, the private sector begins to expect any inflationary trend to persist and it becomes harder to fight inflation.

Indias Inflation Rates The inflation rate in India was last reported at 8.43 percent in July of 2011. From 1969 until 2010, the average inflation rate in India was 7.99 percent reaching an historical high of 34.68 percent in September of 1974 and a record low of -11.31 percent in May of 1976. Inflation rate refers to a general rise in prices measured against a standard level of purchasing power. The most well known measures of Inflation are the CPI which measures consumer prices, and the GDP deflator, which measures inflation in the whole of the domestic economy.

On 1st September 2011, Food price index rose 10.05 per cent, its highest in nearly six months, and the fuel price index climbed 12.55 per cent in the year. In the previous week, annual food and fuel inflation stood at 9.80 per cent and 13.13 per cent respectively. The primary articles index was up 12.93 per cent, compared with an annual rise of 12.40 per cent a week earlier. India's central bank has raised interest rates 11 times since March 2010 to tame headline inflation, which stood at 9.22 per cent in July. The Reserve Bank of India continues to expect inflation to start easing by November-December.

RBIs Dilemma Taming Inflation or Economic Growth

The job of a central bank is not enviable, at least not in a growth-obsessed economy like India. When it does not get hawkish enough, it gets termed as being behind the curve, and when it does get hawkish, we implore it to stop for fear of hurting growth. The Reserve Bank of India (RBI) has been in a similar dilemma of late. On the one hand, rising inflation has forced it to raise rates, whereas on the other, industry captains (banks and business leaders) and certain sections in the government are calling for a pause in rate hikes. What such people fail to recognise is the fact that growth is going to slow down anyway even if the RBI does not hike rates. High inflation brings down growth all by itself. Instead of

asking the RBI to stop, one should think of ways to bring down inflation. There simply cannot be any trade-off between inflation and growth. The choice is clear ensure price stability and growth will automatically come in an economy like Indias. For the central bank, price stability comes first and it should remain so. Going back to the books, RBI has already raised rates 10 times starting March 2010, hiking repo rate from 4.75 pct to 7.5 pct and reverse repo rate from 3.25 pct to 6.5 pct. This makes it one of the most aggressive central banks in the world in terms of fighting inflation. The fact that despite this inflation has refused to come down, points to the structural nature of inflation. The journey that began with high food price inflation in 2009 has culminated in high wage inflation which together with rising input prices, has led to a spike in prices of manufactured goods. And this is what the RBI is most worried about. To add to woes, questions are being raised on the quality of inflation data that is being doled out. There have been consistent upward revisions in WPI inflation figures since July 2010. Inaccurate data makes the job of a central bank even tougher. Going ahead, we expect the RBI to hike rates further by 50 to 75 bps over the course of the next one year (including a 25 bps hike expected in the policy meet on July 26). Manufacturing inflation is picking up (has risen to approx. 7.5 pct), commodity prices refuse to come down (crude prices are back above $95/bbl) and possibility of another round of quantitative easing in the U.S. (QE III) is emerging. Amid all this, we expect RBI policy stance to remain firmly hawkish/anti-inflationary at least in the near term. Growth is indeed getting hurt in this process as can be seen from the deceleration in GDP and industrial output growth as well as moderation in the pace of credit growth. But inflation is yet to be tamed. Over the past year, most forecasts (including forecasts from some of the most eminent economists and policy makers) calling for a peak in inflation have fallen flat. The question now facing the RBI is price stability or growth? It seems to be going ahead with the former.

Why India faces lower growth, higher inflation? Indian policy makers have been a unique breed until this policy in saying that monetary tightening will check inflation without affecting growth. Now, the very idea of monetary tightening is to affect growth in order to check inflation. That understanding seemed to be missing when the Budget was announced - it was based on a 9 per cent GDP growth. Growth is also a casualty of the lack of sufficient actions by the government to ease the chronic supply constraints. For an economy that will hit $2 trillion in size in the current fiscal year, policy makers do not appear to have a good handle on, for example, the shifting trends in the industrial sector, labour market, and, most importantly, inflation dynamics. That inflation is high and an important issue is not new. But the relevant inflation rate and what the central bank is targeting for the effectiveness of its monetary stance cannot be mere academic discussions. The answers to these questions have an important bearing on how effectively the central bank can check inflation and manage inflationary expectations. At the very outset, the RBI's unique focus on wholesale price index (WPI) inflation, which captures mainly input prices, is also one of the contributors to higher inflation

expectations. That in no way takes away the impact of higher global commodity prices and the too-loose-for-too-long fiscal policy that also boosted consumer spending. In 2010, for example, inflation rates in Thailand, South Korea and Malaysia according to the producer price index (PPI) were well above consumer price index (CPI) inflation rates, despite the reliance on currency appreciation as well in some cases. It is nobody's case that the gap will be similar in India's case - we just don't know since there is no reliable CPI measure. But central banks in these countries did not get everyone to focus on the higher PPI inflation. Doing that would have undermined their policy, but that is precisely what is happening in India. The RBI concludes that higher WPI-based core (non-food manufactured goods) inflation reflects that aggregate demand is strong enough to allow firms to pass on higher input costs. But that is similar to what is seen in these other economies, but their central banks reach a different conclusion for monetary policy purposes due to their focus on the CPI. It is more than likely that the pass- through of higher input prices into final consumer prices in India is not of the same magnitude as indicated by WPI-based core inflation. But we do not have a good grasp of that, and that potentially raises the risk of over-tightening. This was true even in the last tightening cycle; the only time WPI-based core inflation fell in recent years was when commodity prices collapsed in the post-Lehman global financial crisis. It had nothing to do with the tightening by the RBI. In fact, the tightening by the RBI has delivered little check on WPI-based core inflation despite higher rates and slowing growth because its inflation measure is basically much more sensitive to global commodity prices than is typically the case with CPI inflation. WPI-based core inflation has an important bearing on the RBI's policy rate decisions but, surprisingly, it doesn't offer any guidance or forecast to anchor expectations. The issue of the relevance of WPI-based core inflation becomes even more important as in a recent speech (after the policy review on 3rd May), the RBI governor states, "The headline inflation index is the wholesale price index, and that does not, by definition, reflect the consumer price situation." In the same speech, we are also told that targeting CPI-based core inflation rather than headline inflation is not a feasible solution since an inflation index, with half the basket of food excluded from it, hardly reflects the reality. The Slippery Slope Some Suggestions The expected spread of food price inflation in India to more industrial categories has provoked a crescendo of calls for sharp monetary tightening. Such a response would be appropriate if excess demand were driving inflation. But the current high wholesale price index (WPI) inflation follows prolonged cost shocks and a period of very low inflation. This low base overstates inflation. Policy should rather reduce inflationary expectations without hurting the supply response.

1) Supply Response

The supply response is especially important since India is in a catch-up growth phase. Investment is occurring to relieve specific bottlenecks. Data from Indias Central Statistical Organisation (CSO) shows that fixed investment has remained above pre-crisis levels of 32 per cent of GDP. There is a sharp rise in the production of capital goods. Continuing high investment implies there cannot be a large excess of demand over capacity. Good growth and sales help spread manufacturing costs. If productivity rises, the price-line can be held. A good monsoon after a bad one should see a sharp jump in agricultural production and softening of food prices. Inflation in primary articles will fall from this month onwards because of the base effect and manufactured goods inflation from November. But wages and commodity prices are pushing up costs. Sustained high food price inflation raises wages, since food is still above 50 per cent of the average consumer basket. That procurement prices have held steady this year, after excessive hikes in the past few years, will provide some relief. But over the longer term, structural measures, such as better infrastructure and empowering more private initiatives, are required to improve agricultural supply response. That the National Rural Employment Guarantee Scheme (NREGA) has raised rural wages is a good thing, but the emphasis has been on employment and not productivity, although it has the potential to raise both. A wage rise exceeding that in agricultural productivity raises food prices. Or else rupee appreciation is required to let wages rise without inflation. Prices normally are sticky downwards. So, with monetary accommodation, a relative price change raises the general price level. What goes up doesnt readily come down except for commodities. But in India administered prices impart an upward bias even for food and fuel. The petrol price decontrol was required prices will now be free to fall as well as rise. But the timing of the price rise, when inflation is dangerously high, is unfortunate. Past oil price hikes have not led to sustained inflation because they either followed or led to severe monetary tightening. The attempt to conserve the macroeconomic stimulus can be consistent with falling inflation only if it enables a supply response. Post-reform India has had loose fiscal and tight monetary policy. Direct subsidies created hidden indirect costs and raised debt. But inflation harms electoral prospects, so instead of inflating debt away, a severe monetary tightening would be imposed. There would be a large sacrifice of output, but little reduction in chronic cost-driven inflation.

2) Fiscal Consolidation
The government now seems to be trying a better combination: Imposing fiscal consolidation so monetary policy can be more accommodative. Lower debt, deficits and interest rates are useful attributes for a more open economy to have. But rather than raise tax rates that push up prices and costs, a better approach to fiscal consolidation is to reduce wasteful government expenditure. Plugging leakages and cutting allocations in areas where budgets have not been spent would create better incentives to spend. The government has a poor record in spending effectively. Tax revenues have started rising again with growth, but this boom should not be squandered like the last one. The contribution of economic growth was 55 per cent and of spending cuts was 35 per cent to Canadas successful deficit reduction in the 1990s.

3) Monetary Policy
A sharp rise in interest rates has severe consequences. We saw the collapse in industry following such a rise in the late 1990s and in July 2008. Policy should rather follow a path of gradual rise in interest rates conditional on inflation. The knowledge of future rise will reduce inflationary expectations, if combined with action to reduce costs. A short-term nominal exchange rate appreciation reduces costs. This can be very useful to contain a temporary spike in oil or food prices and will become more effective as petrol prices are free and food prices reflect border prices. Today, the price of Washington apples determines that of Indian apples. The current depreciation runs counter to the attempt to reduce inflation. Changing one exchange rate prevents thousands of nominal price changes that then become sticky and persist, requiring painful prolonged adjustment. Small steps give the freedom to respond to evolving circumstances. But to walk with baby steps one must start early and coordinate action over several fronts.