The conduct of monetary policy has engaged significant attention in recent times and it is no different this time in the run up to the policy on January 29, 2013. Banks and industry have been clamouring for an easy monetary policy in terms of lower interest rates for a while now. Against the chorus for monetary easing, RBI has so far not obliged with a rate reduction and in fact has recently emphasised that inflation rates are still at uncomfortably high levels. It is pertinent to note here that the central bank has been single-mindedly focusing on containing inflation since March 2010. In recognition of such monetary policy conduct, we examine the potential short-run trade-off between growth and inflation in this piece.
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 is beneficial for growth. However, at higher levels/beyond a threshold level, inflation can be inimical to growth. In the Indian context, the threshold inflation estimated for the period 1970-71 to 1999-2000 is 5% (RBI estimates). This means that at inflation rates beyond this level, growth is impacted adversely. Alternatively, attempts to reduce inflation beyond this point would necessitate a reduction in output. However, in recent times, RBI itself has clarified that in view of the changing economic scenario and rigidities in inflation rate, the threshold inflation rate may be revised (December 2, 2012, RBI Governor).
One logical corollary of the short-run trade-off between inflation and output is that a sacrifice of output is inevitable in the pursuit of inflation reduction. This loss of output is referred to in the economic literature as the sacrifice ratio. There are several estimates of sacrifice ratios for developed countries, but for developing countries, such estimates are limited (see table). For example, for 19 OECD countries during 1963-1997, the sacrifice ratio was on an average 3.2: for most of the countries, the ratio lay in a range of 2-4, although outliers—1.6 (Japan, Italy and the Netherlands) and 7 (Norway)—were also observed.
RBI has estimated that, for India, the sacrifice ratio turns out to be almost 2 over the period 1975-2000. This effectively implies that a reduction in the inflation rate by 1 percentage point would require a reduction in output by 2 percentage points from its potential level. This means that statistically, if the inflation rate were to reduce