if lower rates generate higher demand and higher inflation, people may produce more believing that they are getting more revenues, not realizing that high inflation reduces what they can buy out of the revenues. Following the saying, \u201cYou can fool all the people some of the time\u201d, bursts of inflation can generate growth for some time. Thus in the short run, the argument goes, higher inflation leads to higher growth<\/em>.\u201d<\/p>\nThe trouble is that this inflation eventually catches up with growth. As Rajan said: \u201cAs the public gets used to the higher level of inflation, the only way to fool the public again is to generate yet higher inflation. The result is an inflationary spiral which creates tremendous costs for the public<\/em>.\u201d<\/p>\nTake a look at the following table.<\/p>\n
\n\n\n\n\n\n\nYear<\/td>\n | Inflation (in %)<\/td>\n | Economic Growth (in %)<\/td>\n | Fiscal Deficit as a % of GDP<\/td>\n<\/tr>\n | \n2007-2008<\/td>\n | 6.2<\/td>\n | 9.32<\/td>\n | 2.54<\/td>\n<\/tr>\n | \n2008-2009<\/td>\n | 9.1<\/td>\n | 6.72<\/td>\n | 5.99<\/td>\n<\/tr>\n | \n2009-2010<\/td>\n | 12.37<\/td>\n | 8.59<\/td>\n | 6.46<\/td>\n<\/tr>\n | \n2010-2011<\/td>\n | 10.45<\/td>\n | 8.91<\/td>\n | 4.8<\/td>\n<\/tr>\n | \n2011-2012<\/td>\n | 8.39<\/td>\n | 6.69<\/td>\n | 5.73<\/td>\n<\/tr>\n | \n2012-2013<\/td>\n | 10.44<\/td>\n | 4.47<\/td>\n | 4.85<\/td>\n<\/tr>\n | \n2013-2014<\/td>\n | 9.68<\/td>\n | 4.74<\/td>\n | 4.43<\/td>\n<\/tr>\n | \n <\/td>\n | <\/td>\n | <\/td>\n | <\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<\/td>\n | <\/td>\n | <\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n In 2007-2008, things were going well for India. The gross domestic product(GDP) grew by 9.2 per cent. The fiscal deficit was at 2.54 per cent of GDP. The inflation was at 6.2 per cent. Then the financial crisis struck in 2008-2009. The government decided to tackle the slowdown in growth by increasing its expenditure. In the process the fiscal deficit went up as well. Fiscal deficit is the difference between what a government earns and what it spends.<\/p>\n The fiscal deficit reached 5.99 per cent of the GDP. Next two financial years the economic growth crossed 8.5 per cent. The rate of inflation also entered double digits. The extra expenditure did manage to create growth, but it also created inflation.<\/p>\n This ultimately caught up with economic growth. The economic growth fell to below 5% levels in 2012-2013 and 2013-2014.<\/p>\n Hence, high inflation ultimately caught up with growth. But it did create growth for two years and during that period the Manmohan Singh government looked good. In fact, if the Lok Sabha elections were around that period, the Congress led United Progressive Alliance would have done much better than it eventually did.<\/p>\n The larger point is that any government has only got a period of five years to show its performance and in that period it has to do whatever it takes. If that means turning on inflation to create growth, then so be it. The trouble is that once you get inflation going, it is very difficult to control, as we clearly saw between 2007-2008 and 2013-2014. But the lessons of that are still not appreciated.<\/p>\n In fact, there is another lesson to learn here. As Vijay Joshi writes in India\u2019s Long Road\u2014The Search for Prosperity<\/em>: \u201cThe Indian state has systematically underestimated the prevalence and the cost of \u2018government failure\u2019. It often intervenes, arbitrarily or to correct supposed market failures, without any clear evidence that the market is failing, and so ends up damaging resource allocation and stifling business drive<\/em>.\u201d<\/p>\nWhile, inflation ultimately catches up with economic growth, it ends up helping the government in another way. The government finances its fiscal deficit by borrowing. When it borrows the absolute level of government debt goes up. Despite this, government debt expressed as a proportion of the gross domestic product, might come down, because the GDP in nominal terms is growing at a faster pace than the debt, due to high inflation.<\/p>\n As Joshi writes: \u201cFrom 2008 onwards, fiscal consolidation [in fact, the government was spending more] was meagre but this did not stop the debt ratio falling from 80 per cent of GDP in 2008-2009 to 68 per cent in 2014-2015. This is because high inflation eroded the value of debt<\/em>.\u201d<\/p>\nDue to inflation, the nominal GDP (which is not adjusted for inflation like real GDP, and against which total debt is expressed) went up at a much faster pace than the total debt of the government. This led to government debt expressed as a proportion of GDP falling.<\/p>\n Given this, there is more than one reason for the government to love inflation.<\/p>\n The column originally appeared on July 20, 2016, in Vivek Kaul’s Diary on Equitymaster<\/a><\/p>\n","protected":false},"excerpt":{"rendered":"The Reserve Bank of India(RBI) governor Raghuram Rajan has often been accused of not cutting the repo rate fast enough and in the process hurting economic growth. Repo rate is the interest rate at which RBI lends to banks. The hope is that once the RBI cuts the repo rate, banks will cut their lending … <\/p>\n Read more<\/a><\/p>\n","protected":false},"author":2,"featured_media":0,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"qubely_global_settings":"","qubely_interactions":"","_monsterinsights_skip_tracking":false,"_monsterinsights_sitenote_active":false,"_monsterinsights_sitenote_note":"","_monsterinsights_sitenote_category":0,"jetpack_post_was_ever_published":false,"_jetpack_newsletter_access":"","_jetpack_dont_email_post_to_subs":false,"_jetpack_newsletter_tier_id":0,"_jetpack_memberships_contains_paywalled_content":false,"_jetpack_memberships_contains_paid_content":false,"footnotes":""},"categories":[30,77],"tags":[917,1083,1740,2908,3921],"qubely_featured_image_url":null,"qubely_author":{"display_name":"Vivek Kaul","author_link":"https:\/\/vivekkaul.com\/author\/vivekkaul\/"},"qubely_comment":0,"qubely_category":"Equitymaster<\/a> Vivek Kaul's Diary<\/a>","qubely_excerpt":"The Reserve Bank of India(RBI) governor Raghuram Rajan has often been accused of not cutting the repo rate fast enough and in the process hurting economic growth. Repo rate is the interest rate at which RBI lends to banks. The hope is that once the RBI cuts the repo rate, banks will cut their lending…","jetpack_sharing_enabled":true,"jetpack_featured_media_url":"","_links":{"self":[{"href":"https:\/\/vivekkaul.com\/wp-json\/wp\/v2\/posts\/4598"}],"collection":[{"href":"https:\/\/vivekkaul.com\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/vivekkaul.com\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/vivekkaul.com\/wp-json\/wp\/v2\/users\/2"}],"replies":[{"embeddable":true,"href":"https:\/\/vivekkaul.com\/wp-json\/wp\/v2\/comments?post=4598"}],"version-history":[{"count":0,"href":"https:\/\/vivekkaul.com\/wp-json\/wp\/v2\/posts\/4598\/revisions"}],"wp:attachment":[{"href":"https:\/\/vivekkaul.com\/wp-json\/wp\/v2\/media?parent=4598"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/vivekkaul.com\/wp-json\/wp\/v2\/categories?post=4598"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/vivekkaul.com\/wp-json\/wp\/v2\/tags?post=4598"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}} | |