When inflation is higher than the threshold level, estimated at 6 per cent for India, reduction in inflation rate leads to a much smaller gain in the long-term growth compared to when inflation is lower and rises towards the threshold level, according to a Reserve Bank of India study.
The Study estimated the trade-off between long run inflation and steady State growth (SSG) rate, whereby the long-term growth would fall by 40 basis points/bps (or 0.4 percentage point) if the initial inflation rate was less than the threshold rate.
However, if the initial inflation rate was higher than the threshold rate, it would result in an increase of long-term growth by 15 bps.
“...Of course, there are arguments in favour of lower inflation rate in terms of its favourable redistribution impact particularly on the poor and the financial stability concerns,” said authors Ravindra H Dholakia, Jai Chander, Ipsita Padhi and Bhanu Pratap.
However, the findings of the present study caution the policy makers not to ignore the probable cost of lower inflation in terms of lower long-term growth of output and employment and hence lower rate of the poverty reduction.
These costs and benefits of fixing a long-term inflation target will have to be considered while making the choice, the authors opined.
The findings of the Development Research Group (DRG) Study show that the threshold inflation and corresponding growth are not unique for a country but depend on the other two parameters – Fiscal Deficit (FD)/GDP and Current Account Deficit (CAD)/GDP.
If a country chooses the target values of FD/GDP and CAD/GDP to be achieved in the long run, its potential output growth gets determined through the corresponding value of threshold inflation.
“If the country then chooses an inflation target that is lower than the threshold level, it cannot achieve its potential output growth and the system would remain in long-run disequilibrium requiring constant policy interventions to stabilize,” the authors said.