Relation between Growth and Inflation in

accordance to growth of Indian economy in

different phases.

FOR SUBMISSION IN THE SUBJECT OF

INDIAN ECONOMY

Submitted To

Prof. Balachandaran Sathyan

Submitted By

CHAITANYA POONIA

2nd Year BA.LLB (Hons)

BA0160013

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 ACKNOWLEGEMENT

I would like to extend my gratitude to the many people who helped to bring this research project
to fruition. For that, I would like to thank Prof. Balachandaran Sathyan, for providing me the
opportunity of expressing my talent and opinion of particular case. I am so deeply grateful for his
help, professionalism, valuable guidance and support throughout this project and through my
entire study that I do not have enough words to express my deep and sincere appreciation. I am
gratefully indebted to her for his very valuable comments on this project work.

My thanks also go to the all my friends for their numerous conversations, questions and help.
Finally, I must express my very profound gratitude to my parents for providing me with unfailing
support and continuous encouragement throughout my research of study and through the process
of researching and writing this project. This accomplishment would not have been possible
without them.

CHAITANYA POONIA

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 Contents
Introduction ..............................................................................................................4
Stages of Economic Growth ....................................................................................5
Models of Growth.....................................................................................................5
Structural changes in the 1980s ..............................................................................7
Why did growth not accelerate in the 1990s?........................................................7
Inflation and Growth ...............................................................................................8
Inflation, macroeconomic stability and growth ....................................................9
Test to Determine Long Term Effect of Inflation on Growth ...........................10
Test to Determine Short term inflation Growth Relation..................................12

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 Introduction
Indian economy has been through a lot of ups and downs over the years. The article tries to
accumulate the growth of the economy over the years. Various governments have followed
various policies for the growth of the economy. However, this article focuses more on the
industrial growth and statistical analysis of the growth rather than comparing different policies of
the governments. In pursuance of the same the article also tries to create some sort of
relationship between growth of the economy and inflation during that phase of the growth.

The first part of the article concentrates on the evolution of Indian economy and growth of
agricultural and industrial sectors. It also discusses about models used as a tool to determine of
the actual growth in an economy. These tools also show how inflation is an essential ingredient
for calculating growth of an economy.

Later the discussion moves towards the timeline of Indian economy and how various policies and
political factors have lead slowing down or the acceleration of growth of the economy in
different phases.

Lastly the effect of Inflation on growth has been brought up. Inflation in the short term aids
growth as Monetary Policies inject money and cause inflation. This excess money supply leads
to demand stimulus which lead to Growth. In the long run however high inflation is inversely
correlated with growth .This is because the Long term growth of the economy depends on
investment spending. Investment spending and capital Generation is inversely proportional to
high inflation and the uncertainty it brings. The report also throws a light on the regression tests
which have been designed in order to attain the relationship between inflation and growth.

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 Stages of Economic Growth
India was a predominantly rural economy at the time of independence in 1947, with agriculture
accounting for approximately 75 percent of the work force and 55 percent of GDP. It is
recognized that in the early stages of development, the extra growth that an economy receives is
due to the reallocation of labor from the low productivity agricultural sector to the higher
productivity non-agricultural (industrial) sector. Only later do factor accumulation and
technological change matter as contributors to higher growth.
Economic growth and economic reforms in India have shown lack-lustre performance of Indian
industry. And this in large part explains the low rate of GDP growth in India in the first five
decades after independence. Even today, profits and money making activity are viewed with
contempt by many policy makers and most politicians. Industrialists are constantly under
suspicion. For most of the post economic reform period, Indian industry has paid a considerably
higher cost of capital than most of its competitors. In addition, the one advantage India
ostensibly had, cheap labour, was reduced to zero (if not negative) by both an overvalued
exchange rate and restrictions on employers for hiring and firing. All of these policies have
contributed to India’s pitifully lower share of industry, compared to an economy at its level of
development and size. The figures are too stark to be missed: in 2006, industry’s share of GDP in
India was only 26 percent.

Models of Growth
Though there are several factors that contribute to economic growth, the principal determinants
are few. In identity terms, economic growth is the sum of factor accumulation and productivity
growth. Research has centred on the decomposition of factor accumulation (the rate of return to
different factors) and the decomposition of productivity growth.

Monetary Policy – Money Supply growth

In India, money supply growth still reigns supreme in the minds of policymakers. All policy
documents of the RBI, and policy pronouncements, contain copious references to the level of
growth, how it is missing its target level and how deviations of growth from this target level are
believed to be linked to inflation.

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The monetary accommodation of this price change leads to a strong correlation between
inflation, money supply growth and GDP growth. The fact that this correlation ceases to appear
for any period after or before lends strong support to the hypothesis that money supply growth,
in the broad observed ranges holds little information about inflation or GDP growth in India.

While it may appear as if the volatility in money supply growth is large, it is actually the smallest
in India among all countries of the world and smallest by a large margin. The mid-1990s
monetary tightening (starting in early 1995) is an important case in point, as has been the recent
2007 and 2008 tightening of monetary policy. In both instances, the policy was in response to a
surge in WPI inflation; in both instances, domestic demand, “overheating”, was considered the
real culprit. In both instances, the rise in inflation was imported. Thus, in both instances, policy
for constraining domestic inflation was in response to factors determining international inflation.
Indian inflation, GDP deflator, fell by 2.4 percentage points. Approximately the same decline is
obtained for other inflation measures like CPI. It also turns out that 1994 was a year of global
inflation. The world median inflation rate in 1994 was 13.3 percent, and registered an
acceleration of 3.5 percentage points over 1993. The wholesale price inflation in India also
peaked in 1994, but consumer price inflation did not – and nor did the GDP deflator. The GDP
deflator was not then available on a quarterly basis, but data on CPI was, albeit with a 2 month

Fiscal Policy

The second major belief of Indian policymakers (besides money supply growth) has been that
fiscal deficits, again in the broad ranges observed in India for both growth and inflation. A
favourite policy recommendation, for both developed and developing economies, has been:
“reduce the fiscal deficit”. Unlike money supply growth, there is plausible economic reasoning
behind this recommendation. The benefits of deficit reduction are supposed to be manifold:
greater efficiency in production, less losses in government undertakings, and less “crowding out”
of private investment.

The Indian policy on fiscal deficits (until 1999) was as follows. The Ministry of Finance (MoF)
set a very high assured interest rate on savings for depositors in “small savings” funds.

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Administered interest rates were kept high in the 1990s, despite rapidly falling inflation, because
of the government’s preoccupation, and belief, and one fully endorsed by the RBI’s tight
monetary policy, that GDP growth of 7 % meant overheating and higher future inflation.

Perceived future inflation had to be reduced, and this could only be done via more monetary
tightening. So administered interest rates, in the form of interest rates on “small savings”
administered by different state governments, were kept at a nominal level of 12.5 percent or
higher.

Structural changes in the 1980s

GDP growth shows a clear acceleration from an average of 2.8 percent in the 1970s to a level
double that in the 1980s – 5.7 percent per annum. Hence the conclusion about a trend setting
growth acceleration in the early 1980s seems to be valid.

A re-examination of Indian growth data, however, suggests that there was minimal acceleration
.This conclusion is based on two considerations. A large acceleration or breakout in GDP growth
seems to be based on a comparison of 1980s vs. 1970s. But for most countries, 1970s is a bad
“benchmark” and most countries would anyway show a marked acceleration in the 1980s. The
1970s were a turbulent period for the world economy, with food, commodity and oil prices sky-
rocketing and bringing in their wake stagflation. The 1980s were a lot better in terms of lower oil
prices and lower world inflation. India was not immune to these events. GDP growth in the
1950s and 1960s averaged 4 percent; the 1970s average was only 2.8 percent .So the real
acceleration in the 1980s is about 1.7 percentage points (5.7 minus 4 percent).

Why did growth not accelerate in the 1990s?

Responding to economic reforms, GDP growth did accelerate and averaged above 7.4 percent in
each of the three years 1994 to 1996. But this acceleration to potential had some unintended
consequences. The irony is that the government itself (or elements within it) did not believe that
the reforms it had instituted would increase the potential GDP growth rate to above 7 percent.

In the mindset of the Indian politicians, and most policy makers, it was inconceivable that the
Indian economy could grow at East Asian growth rates; the doubling of the rate of growth above

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Hindu rates of 3.5 percent was considered impossible; the 7 plus percent growth rate was
considered as an overheating phase deserving a strong policy response. Possibly it was the crisis
of 1991 that prevented policymakers from realizing that an expansion from 5.7 to 7.4 percent
growth was the mildest of accelerations. When this acceleration coincided with global , and
domestic inflation, the RBI panicked and tightened monetary policy to an unprecedented degree.
Further, the RBI did not cut interest rates in response to the decline in worldwide, and domestic,
inflation in the mid to late 1990s. By keeping deposit rates at high double digit levels, and
inflation collapsing, the RBI ensured that real rates reached double digit levels. This caused the
growth to collapse, as documented in the previous section.

Inflation and Growth

Considering the effect of Inflation on Growth there are two aspects. In the short-run there is a
positive relation between inflation and growth while in the long , cross-country studies indicate a
negative relationship between the two in the longer run.

There is now considerable evidence to show that investment is one of the most important
determinants of the long-run rate of growth. Developments in the theory of investment behavior
have focused on the role of instability and uncertainty in determining investment. Inflation as an
indicator of macroeconomic instability is hypothesized to have an adverse impact on investment
and hence on growth. The estimates of the private investment function in the manufacturing
sector support this hypothesis. The private investment function for agriculture points towards the
role of public investment and credit in encouraging private investment in this sector. Tradeoffs
between inflation and growth that emerge in the medium run, as a result of government policies
relating to consumption and investment, are also examined using an economy-wide econometric
model. The analysis suggests that higher growth can be achieved by controlling inflation and
increasing public investment. Let us examine the relationship between growth and inflation in
India.

In the short run, the relationship between growth and inflation is usually positive. Policies that
raise output (for example, expansionary fiscal and monetary policies) also raise prices. Inflation
is undesirable because it adversely affects some sections of the population (especially the poor
and those whose earnings are not indexed to prices), distorts relative prices, leads to an

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appreciation of real exchange rates, erodes the value of the financial assets and creates
instability. The ultimate policy objective is a higher level of well-being for the population, but a
conflict arises in the means of achieving it—by higher growth or by lower inflation. There is a
trade-off involved and both cannot be achieved together. A tightening of fiscal and monetary
policies may achieve lower inflation but only at the cost of growth. The government needs to
find the right balance between contractionary and expansionary policies to maximize the well-
being of its people.

However, some recent cross-country evidence suggests that long-term growth requires
macroeconomic stability, which includes low inflation. The idea that a stable macroeconomic
environment is conducive to investment, and therefore also for growth, underlies the
International Monetary Fund–World Bank stabilization and structural adjustment programs. It is
only recently that this issue has been addressed formally to establish the empirical relationship
between the two. Low inflation, sustainable budget deficits, realistic exchange rates and
appropriate real interest rates are among the indicators of a stable macroeconomic environment.
A number of studies suggest that low inflation is positively related to higher investment and
long-term growth. As an indicator of a stable macroeconomic environment, the inflation rate
assumes greater importance. The role of macroeconomic stability has been found to be of
particular importance under a reform program. Sustainable government policies are more likely
to attract private investment, both foreign and domestic, than higher growth in output. Even
though higher short-term growth may be achieved by allowing high inflation, the new approach
suggests that lower inflation may be chosen, even if accompanied by lower growth, because it
creates an environment conducive to higher long-term growth. The emphasis on investment and
the ensuing role of public investment in infrastructure and agriculture, along with
macroeconomic stability, lower budget deficits and inflation, creates new trade-offs. In
developing countries, resources are limited and government borrowing and/or inflationary
financing of public investment can also crowd out private investment.

Inflation, macroeconomic stability and growth

Macroeconomics has, until recently, focused on the positive short-term relationship between the
rate of increase in prices, and output. Recently there has been an exploration into the nature of

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the long-term relationship between inflation and long-term growth in output. Developments in
growth theory have resulted in both a theoretical and an empirical analysis of the effect of
inflation on long-term growth. Theoretically the relationship has been located in the effect of
inflation on investment. If investment is assumed to be the engine of growth in a model of
endogenous growth, an adverse impact of inflation on investment implies an inverse relationship
between inflation and growth. Empirical evidence supports the hypothesis of an inverse
relationship between inflation and long-term growth. This is in contrast to the short-term
experience, where inflation and output growth occur together.

Among the reasons why high inflation is likely to be adverse for growth are

• Economies that are not fully adjusted to a given rate of inflation usually suffer from relative
price distortions caused by inflation. Nominal interest rates are often controlled, and hence real
interest rates become negative and volatile, discouraging savings. Depreciation of exchange rates
lag behind inflation, resulting in variability in real appreciations and exchange rates.

• Real tax collections do not keep up with inflation, because collections are based on nominal
incomes of an earlier year (the Tanzi effect) and public utility prices are not raised in line with
inflation. For both reasons, the fiscal problem is intensified by inflation, and public savings may
be reduced.

This may adversely affect public investment.

• High inflation is unstable. There is uncertainty about future rates of inflation, which reduces the
efficiency of investment and discourages potential investors.

Test to Determine Long Term Effect of Inflation on Growth

The first test is to determine whether the effect of inflation on long term growth is negative or
not. This negative correlation theory developed in the 1970’s when the world economy was
going through high inflation and low growth .It is generally valid for high inflation period as
high inflation creates uncertainty and effects investment. Therefore we study a period of high
inflation in the Indian Economy that is from period 1990 to 1998. Since we are studying the
long term effect of growth we introduce a two year lag that is the inflation figures of 1990 is
compared with the GDP Growth figures of 1992 and so on.
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 9.00

8.00 Linear
y = -0.3253x + 9.3055
7.00
R² = 0.3316
6.00

5.00 Series1

4.00 Poly. (Series1)

Polynomial Linear (Series1)

3.00
y = -0.054x3 + 1.6432x2 - 16.385x + 59.591
2.00
R² = 0.4665
1.00

0.00
0 5 10 15

In order to find the relation both linear and polynomial models were explored,

In Linear model we got result as follows.

Regression Statistics

Multiple R 0.575865

R Square 0.331621

Adjusted R
Square 0.236138

Standard Error 1.252307

Observations 9

Standard
Coefficients Error

Intercept 9.305508 1.81159

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 X Variable 1 -0.32527 0.174539

To find for greater accuracy a Polynomial regression model was also tested using the trendline
option

The polynomial regression model gave an equation of -0.054x3+1.643x2-16.38x+59.59

The R2 in this case was 0.466 which is a greater fit for the data.

Conclusion

During high inflation period there is indeed a negative correlation between growth and inflation
in the long run(2 year time lag). The Polynomial model gives a better fit than the linear model
maybe because of the multiplier effect of growth damping of inflation. That is due to growth
slowing due to inflation there is a further decrease in investment and further growth slowing .
The 2 year lag shows the long term effect and a test done with no time lag got R 2 as 0.1 which is
insignificant which shows that long term effect is predominant.

Test to Determine Short term inflation Growth Relation

As we have seen in the short run inflation is positively correlated with growth. This is because
when growth is low the Central Bank pumps money into the system to stimulate growth what
this money does is to boost output in the short term as demand rises. Therefore there is a positive
correlation between the two. Since the period between 1980 to 1987 witnessed low growth this
period is taken for the study.

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 8.00

7.00 Linear
y = 0.3419x + 2.0953
6.00 R² = 0.4268

5.00

4.00 Series1
Linear (Series1)
3.00
Poly. (Series1)
2.00
Polynomial
1.00 y = -0.0657x3 + 1.9112x2 - 17.49x + 55.153
R² = 0.9726
0.00
0 5 10 15

Linear Regression Results

Regression Statistics

Multiple R 0.653323

R Square 0.42683

Adjusted R
Square 0.331302

Standard Error 1.056427

Observations 8

Coefficients

Intercept 2.095292

X Variable 1 0.341898

Polynomial Regression Results

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The Results of the Polynomial regression shows that y=-0.065x3+1.911x2-17.49x+55.15 and
R2=0.972.

Conclusion

As can be seen whenever the Central Bank has increased money supply in the short run it has led
to increased growth in the short run. This is due to a demand stimulant. The fit of the Polynomial
regression is very good probably due to taking into account of multiplier effect and the recursive
relation between inflation and growth.

Over a longer time period also we see such a positive relation but the effect is not pronounced
due to growth changes due to supply side shocks.

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