IS INFLATION THE NECESSARY EVIL ?

 

Understanding the "Inflation":

सखी, सैयाँ, तो खूबई कमात हैं
मँहगाई डायन खाए जात है

These are very popular lines from the song of a Hindi movie #Peepli live which depicts the negative influence of inflation on the pockets of a common man. It is an established hard fact  that high inflation affects the common man badly .

On the other side ,we need to understand whether inflation is always  bad or its a necessary evil,which is pre requisite for the growth of the economy. If it is so then what should be the range of this required inflation .

INFLATION IS NECESSARY FOR GROWTH :

• Inflation is the sustained rise in the general level of prices for goods and services .
• This increase in the prices  is on account of increase in the demand of goods and services.
• It means that increase in demand results in inflation across the Economy .
• This demand in the economy is responsible for creating demand for the factories and industries which make these industries running fueling the economy growth.

This virtuous cycle clearly proved that inflation is necessary for creating growth in the economy.

INFLATION GROWTH TRADE OFF-

• It is established that inflation within the range is beneficial for growth .
• Central banks all over the world (India included) posit that there is a potential trade-off between growth and inflation in the sense that inflation at low levels promotes growth.
• However, at higher levels/beyond a threshold level, inflation can be inimical to growth which is defined in the context of overheating of the economy.

 Overheating of the Economy:

• When there is high growth in the economy then there is increase in aggregate demand .
• Existing Productive capacity is unable to keep pace with increase in aggregate demand .
• Prodcuctive capacity has exhausted its capacities as the economy is in the situation of the full employment.
• This situation in the economy when existing productive capacity is not fulfilling the  aggregate demand is said to be Overheating of the Economy.
• In this situation,if This demand continues to increase then it will keep  prices in the economy to increase which further increases inflation.
• In this complex situation, Central bank/RBI intervenes in the form of Contractionary Monetary policies (https://economydecodified.blogspot.com/search/label/Conventional%20Monetary%20policy) that increases Interest rates which slows down the consumption of goods and services  and eventually  reducing the prices.
• Such intervention also hampers the flow of money to the financial sector which eventually effects the growth.
• Hence sacrifice of output /Growth is inevitable in the pursuit of inflation reduction. 
• This loss of output to contain inflation is referred to as the sacrifice ratio. 

 Now question arises what should be the optimum range of inflation to fuel the growth in the economy. In the Indian context, Inflation targeting defines this optimum range of inflation. 

Inflation Targeting :

Based upon the recommendations of Urjit Patel Committee, In Feb 2015, Monetary policy framework agreement was signed between the Reserve Bank of India (RBI) and GOI. This was followed up with the amendment to the RBI Act, 1934 in May 2016 to provide a statutory basis for the implementation of the Flexible Inflation Targeting (FIT) framework.

Flexible Inflation Targeting:

• The framework provided for the implementation of the flexible inflation targeting framework and then onwards primary objective of RBI is price stability while keeping growth in mind.
• The Monetary Policy Committee (MPC) was set up and is  entrusted with the task of fixing the policy rate (repo rate) required to contain inflation (Inflation targeting) within the specified target level. 
• The amended RBI Act  provides for the inflation target to be set by the Government of India, in consultation with the Reserve Bank, once in every five years.
•  Accordingly, the Central Government has set 4 per cent Consumer Price Index (CPI) inflation as the target for the period from August 5, 2016 to March 31, 2021 with the upper tolerance limit of 6 per cent and the lower tolerance limit of 2 per cent. 
• Inflation Targets have  been  retained for the coming 5 years ie from April 1, 2021, to March 31, 2026 .

Conclusively, we can say that Inflation is a necessary evil if it remains within the defined range as defined in Inflation targeting in case of India.