Review Paper
Impact of Inflation on Economic
Growth in India: An Empirical Analysis
Shafia Zahra1[*] and Javed Akhtar2
1-Research Scholar, Department of Economics,
University of Allahabad, Prayagraj, Uttar Pradesh, India.
2-Associate Professor, Department of Economics,
University of Allahabad, Prayagraj, Uttar Pradesh,
India.
Corresponding
Author: Shafia Zahra Key
words: Inflation, Economic Growth, Liberalisation Privatisation Globalisation reforms
ARTICLE DETAILS ABSTRACT
This study looks at the complex link that
exists between India's economic growth and inflation from 1990 and 2022.
India, whose economy is changing quickly, must simultaneously manage
inflationary pressures and maintain strong economic development. The
objectives of this research are to determine the ideal inflation threshold
for maximum growth, investigate the relationship between these two crucial
macroeconomic variables, and comprehend how inflation expectations affect
economic activity. In order to capture the dynamic interactions between
inflation and growth, the research article combines the use of time-series
data with econometric models, such as the Engle Granger cointegration
test, the Augmented Dickey Fuller test, and the error correction model. It
is anticipated that the results would provide a more nuanced picture of how
inflation affects economic growth in India and emphasize how crucial it is
to keep inflation within a target range in order to promote sustainable
development. The result shows that there is a long-run negative
relationship between inflation and GDP growth rate in India. Inflation is
harmful rather than helpful to growth. These results have important policy
implications. In order to contribute to
the larger conversation on macroeconomic stability and development in
India, this research paper attempts to suggest policymakers on methods for
striking a balance between inflation control and economic growth by
offering empirical data and useful insights. The findings will provide
insightful direction for formulating long-term economic success strategies
that simultaneously lessen the negative impacts of inflation.
- Introduction
India, the world's fifth-largest economy by nominal GDP, has experienced
a significant economic transformation over the past few decades. This
transformation began in earnest with the economic liberalization reforms of the
early 1990s, which marked a shift from a predominantly agrarian and closed
economy to a more diversified and globally integrated economic powerhouse. The
year 1991 saw the beginning of economic liberalization in India, which was a
turning point in the country's monetary policy framework and economic
environment. India's economic policies were marked by significant government
intervention, regulation, and protectionism before these changes. A paradigm
change was brought about by the liberalization era, which placed an emphasis on
deregulation, market-driven growth, and increased interaction with the global
economy. These reforms included deregulation, reduction in import tariffs, and
encouragement of foreign investment, which collectively spurred rapid
industrialization and growth in the services sector. Despite these
advancements, India's economic landscape is characterized by notable
fluctuations in growth rates and persistent inflationary pressures. A major
worry for economists and decision-makers throughout the world has been the
complex link between inflation and economic growth. The inflation-growth
trade-off is a phenomenon that presents both possibilities and major obstacles
for economic management. Inflation in India has historically been driven by
various factors, including supply-side constraints such as inadequate
infrastructure and logistics, volatile agricultural production due to
dependency on monsoons, fluctuating global commodity prices, and demand-side
pressures from a growing population and expanding middle class. The interplay
of these factors creates a complex environment for managing economic stability.
It is essential to comprehend the trade-off between growth and inflation when
creating monetary policy. If left unchecked, inflation weakens buying power,
breeds uncertainty, and has the potential to topple the economy. On the other
hand, raising living standards, lowering poverty, and creating jobs all depend
on economic growth. The Reserve Bank of India (RBI), the nation's central bank,
and other authorities have always sought to strike the
correct balance between promoting growth and containing inflation.
The Reserve Bank of India (RBI), tasked with maintaining price
stability, has employed various monetary policy tools to control inflation
while supporting economic growth. These tools include adjusting interest rates,
managing liquidity in the banking system, and regulating foreign exchange
markets. However, the effectiveness of these policies has often been challenged
by external shocks such as global financial crises, oil price volatility, and
domestic structural issues like fiscal deficits and a high reliance on informal
economic activities.
1.1
Trend Analysis of
Inflation and Growth in India
The period since 1991 has seen significant changes in the conduct of
monetary policy in India. The adoption of new monetary policy frameworks,
tools, and targets has aimed to address the evolving economic challenges. This
study seeks to analyse the inflation-growth trade-off
in the context of these changes, exploring how the paradigms of monetary policy
have shifted in response to domestic and global economic conditions.
1991-2000: Economic Liberalization and Growth
Inflation: The early 1990s saw
high inflation due to various economic factors, including the balance of
payment crisis. However, after economic liberalization measures were introduced
in 1991, inflation gradually stabilized.
Growth: Economic reforms in the early
1990s led to increased foreign investment, industrial growth, and overall
economic expansion. This decade is often referred to as a period of economic
resurgence for India.
2001-2010: Steady Growth and
Moderate Inflation
Inflation: Inflation remained
relatively moderate during this period, with some fluctuations due to global
factors like oil prices and domestic factors such as food inflation.
Growth: India experienced steady
economic growth during these years, driven by sectors like IT, services, and
manufacturing. The GDP growth rate averaged around 7-8% annually.
2011-2020: Mixed Performance
Inflation: Inflation started to
rise again in the early 2010s, primarily driven by food and fuel prices. The
government implemented various measures to control inflation, but it remained a
concern.
Growth: India faced challenges in
sustaining high growth rates during this period due to global economic
slowdowns, domestic policy issues, and structural challenges. GDP growth rates
fluctuated between 5-8% annually.
2021-2022: Pandemic Impact
Inflation: The COVID-19
pandemic disrupted supply chains, leading to short-term inflationary pressures,
especially in essential goods and services. Central banks took measures to
manage inflation amidst economic uncertainty.
Growth: The pandemic caused a
significant economic slowdown in 2020, followed by a gradual recovery in 2021
and 2022. Various fiscal and monetary policies were implemented to support
growth and recovery.
Overall, India has seen a transformation in its economy over these
decades, transitioning from a largely closed economy to a more open and
globally integrated one. Inflation and growth trends have been influenced by
both domestic policies and global economic conditions.
1.2
Importance of
Studying the Inflation-Growth Relationship in India
Understanding the relationship between inflation and economic growth is
crucial for several reasons. Firstly, inflation erodes the purchasing power of
consumers, leading to a decrease in real income and potentially reducing
overall consumption and savings. High inflation can also create uncertainty in
the economy, affecting investment decisions by businesses and hampering
long-term economic stability. Conversely, low or moderate inflation is often
associated with economic growth, as it can stimulate spending and investment by
reducing the real burden of debt. Economic growth, on the other hand, is
essential for improving living standards, reducing poverty, and providing
employment opportunities. In a developing country like India, sustained
economic growth is critical for addressing socio-economic challenges such as
income inequality, unemployment, and underdevelopment in rural areas.
Therefore, policymakers need to strike a delicate balance between controlling
inflation and fostering economic growth to achieve inclusive and sustainable
development.
In the Indian context, this balance is particularly challenging due to
the diverse and complex nature of the economy. Factors such as the significant
contribution of agriculture to GDP, regional disparities, and the role of
informal sectors add layers of complexity to the inflation-growth nexus.
Additionally, India's integration into the global economy exposes it to
external economic shocks, further complicating the task of managing inflation
and sustaining growth. For instance, a rise in global oil prices can lead to
cost-push inflation, affecting various sectors of the economy and putting
upward pressure on domestic prices.
- Review of Literature
Friedman, M. (1968) Milton Friedman introduced the concept of the natural rate of
unemployment and emphasized the long-term neutrality of money. He argued that inflation is always a monetary phenomenon and that
monetary policy can only affect real variables in the short run.
Barro, R. J. (1995) Barro examined cross-country data and
found a negative relationship between inflation and economic growth. His
findings suggest that higher inflation rates tend to reduce economic growth,
primarily through reduced investment and productivity growth.
Sarel, M. (1996) Sarel identified a threshold effect of
inflation on economic growth. His study suggests that inflation below a certain
threshold level may not have significant adverse effects on growth, but beyond
this threshold, the negative impact on growth becomes more pronounced.
Khan, M. S., & Senhadji, A. S. (2001)This paper explores the nonlinear relationship between inflation and growth,
suggesting that low to moderate levels of inflation may not harm growth, but
high inflation rates are detrimental. They identify threshold levels of
inflation for developing and developed countries.
Ghosh, A., & Phillips, S. (1998) Ghosh and Phillips find that inflation
is negatively associated with growth, with the effect being more severe at
higher inflation rates. They emphasize the importance of maintaining low
inflation to foster economic growth.
Bruno, M., & Easterly, W. (1998) The authors analyse
inflation crises and their impact on long-term economic growth. They conclude
that moderate inflation does not harm growth, but inflation
crises—characterized by very high and volatile inflation rates—have significant
negative effects on growth.
Mishkin, F. S. (2007) Mishkin discusses the
dynamics of inflation and its implications for monetary policy. He highlights
how expectations of future inflation play a crucial role in the inflation
process and the importance of central bank credibility in managing inflation
expectations.
Rangarajan, C. (1998) Rangarajan provides an in-depth
analysis of India's monetary policy and its impact on inflation and growth. He
discusses the role of the Reserve Bank of India in managing inflation and
promoting economic stability through various policy measures.
Balakrishnan, P., & Parameswaran, M. (2007) This study focuses on the factors driving economic growth in India,
including the role of inflation. The authors argue that moderate inflation, if
managed well, can coexist with high economic growth and emphasize the need for
structural reforms to sustain growth.
Jha, R., & Dang, T. (2012) Jha and Dang examine how inflation
variability affects the inflation-growth relationship in developing countries,
including India. They find that high inflation variability exacerbates the
negative impact of inflation on growth, stressing the importance of stable
inflation rates for economic development.
The literature on the relationship between inflation and economic growth
is extensive, highlighting a consensus on the adverse effects of high inflation
on economic growth. Studies such as those by Barro
(1995) and Ghosh and Phillips (1998) emphasize the negative
correlation between inflation and growth, particularly at higher inflation
rates. The concept of a threshold level of inflation, as explored by Sarel (1996) and Khan and Senhadji
(2001), suggests that low to moderate inflation may not significantly harm
growth, but beyond a certain point, the negative impact intensifies.
Behavioural insights, such as
those discussed by Mishkin (2007), underscore the
role of inflation expectations in shaping economic outcomes. The Indian
context, addressed by Rangarajan (1998) and Balakrishnan and Parameswaran
(2007), reveals the complexities of managing inflation in a diverse and rapidly
developing economy.
This review of literature provides a foundational understanding for the
current study, which aims to investigate the specific dynamics of inflation and
economic growth in India, identify optimal inflation thresholds, and assess the
role of inflation expectations in influencing economic activity. The findings
will contribute to informed policymaking and strategies for achieving balanced
and sustainable economic growth in India.
- Objective
To analyse the historical trends in inflation
and economic growth in India from 1990 to 2022
To provide policy
recommendations based on the empirical findings
Hypothesis
H0: There
is no significant relationship between inflation and economic growth in India
H1: There is a significant
relationship between inflation and economic growth in India
- Research Methodology
The secondary data for this research was obtained from the Reserve Bank
of India's official website, focusing on two primary variables: the Consumer
Price Index (CPI) as an indicator of inflation, and the Gross Domestic Product
(GDP) growth rate as an indicator of economic growth. Initially, the stationarity of these variables was checked using the
Augmented Dickey-Fuller (ADF) test. The results indicated that both CPI and GDP
growth were non-stationary at their levels. However, after taking the first
difference of the data, both series became stationary. Following this, a
regression analysis was conducted on the first differenced data to examine the
relationship between CPI and GDP growth.
To further validate the findings, the stationarity
of the residuals from the regression was tested using the ADF test, which
confirmed that the residuals were stationary at their level. This suggested a
potential cointegration between the CPI and GDP
growth series. To delve deeper, the Engle-Granger cointegration
test was employed to assess the long-term relationship between the variables.
The test results indicated that the series were cointegrated,
signifying a long-term equilibrium relationship between CPI and GDP growth.
Subsequently, an Error Correction Model (ECM) was developed to capture both the
short-term dynamics and the long-term equilibrium relationship between the two
variables.
Table 1: Augmented Dickey Fuller
test GDP at Level
At level: GDP series non
stationary
Table 2: Augmented Dickey Fuller
test GDP at First difference
At first difference:
series stationary
Table 3: Augmented
Dickey Fuller test CPI at Level
At level: series non
stationary
Table 4: Augmented Dickey Fuller
test CPI at first difference
At first difference: series
stationary
Table 5: Regression analysis GDP as dependent variable
The model has a very
high R-squared value, suggesting that CPI explains a significant portion of the
variation in GDP.The coefficient for CPI is positive,
indicating that there is a positive relationship between CPI and GDP. However,
it's not statistically significant at the typical significance levels (p-value
> 0.05), suggesting caution in interpreting the impact of CPI on GDP.The F-statistic is highly significant, indicating that
the model as a whole is statistically significant.The
Durbin-Watson statistic is very low (0.581611), suggesting potential
autocorrelation in the residuals, which could affect the reliability of the
model.
Table 6: Regression analysis CPI as dependent variable
The model has a very
high R-squared value, suggesting that GDP explains a significant portion of the
variation in CPI. The coefficient for GDP is positive, indicating that there is
a positive relationship between GDP and CPI. Moreover, it's statistically significant
at the 1% level, indicating a strong impact of GDP on CPI. The F-statistic is
highly significant, indicating that the model as a whole is statistically
significant. In summary, the model indicates that GDP has a statistically
significant impact on CPI, explaining a significant portion of its variation.
Table 7: Residual series
Residual series:
Stationary at the level it means variables are cointegrated
and the regression that we have run is not spurious
Table 8: Engle granger Cointegration
test
Cointegration test between
CPI (Consumer Price Index) and GDP (Gross Domestic Product) shows that both CPI
and GDP have tau-statistics and Z-statistics with p-values below the
conventional significance level of 0.05 (indicated as 0.0030 and 0.0031,
respectively). This suggests that the null hypothesis of no cointegration
is rejected, indicating a long-term relationship between CPI and GDP.
Regarding the
intermediate results, the number of stochastic trends in the asymptotic distribution
is crucial for interpreting cointegration results.
Both GDP and CPI have one stochastic trend, which aligns with the theory of cointegration, where variables with the same number of
stochastic trends can have a long-term relationship.
Table 9: Error Correction Model for CPI on GDP
The model suggests that
DGDP and the constant term have a significant impact on DCPI, while the lagged
error correction term (LAGGED ECT) does not appear to be significant.
Table 10: Error
Correction Model for GDP on CPI
DCPI has a significant
positive impact on DGDP. This implies that changes in DCPI are associated with
notable changes in DGDP. The lagged error correction term also influences DGDP
positively, indicating a long-term relationship or adjustment process between
the variables. However, the constant term is not significant, suggesting that
the intercept may not provide meaningful information for predicting DGDP in
this model.
Overall, the model
suggests that DCPI and the lagged error correction term are important
predictors of DGDP, while the constant term is not significant. Autocorrelation
in the residuals may need to be addressed for a more robust model.
From above
two Error Correction Model following results can
be interpreted
For the GDP model, the
significant coefficients for DCPI and the lagged error correction term along
with a higher R-squared value suggest a stronger and more meaningful error
correction mechanism. This means that changes in DCPI and adjustments towards
equilibrium have a substantial impact on GDP.
On the other hand, for
the CPI model, while GDP does have a significant impact, the significance of
the lagged error correction term is weaker, implying that the correction
mechanism for CPI may not be as robust as in the GDP model.
So, based on these
interpretations, results of error correction model suggests that the model with
GDP as the dependent variable has a more meaningful and stronger correction
mechanism compared to the CPI model.
- Conclusion
The motivation behind this study stems from the latest advancements in
the field on the correlation between inflation and growth, as well as the
seemingly incongruous data presented for both rich and developing economies.
The cointegration and error correction models have
been utilized in this work to use yearly data to empirically investigate the
short- and long-term dynamics of the inflation-economic growth link in India.
One of intriguing findings of the study is the inverse relationship
between inflation and economic growth.
The
Engle-Granger cointegration test results indicate a
statistically significant long-term relationship between GDP and CPI, with CPI
exerting a negative influence on GDP in the long run. Further analysis using
the Error Correction Model (ECM) reveals that the model with GDP as the
dependent variable exhibits a stronger and more meaningful error correction
mechanism compared to the CPI model. The significant coefficients for DCPI
(Delta Consumer Price Index) and the lagged error correction term in the GDP model,
along with a higher R-squared value, indicate a robust correction mechanism.
This implies that changes in DCPI and adjustments towards equilibrium have a
substantial impact on GDP. On the other hand, while GDP does have a significant
impact on the CPI model, the significance of the lagged error correction term
is weaker, suggesting that the correction mechanism for CPI may not be as
robust as in the GDP model.
In
conclusion, the analysis highlights the importance of considering both GDP and
CPI dynamics in understanding the long-term relationship between inflation and
economic growth. The findings support the existence of a cointegrating
relationship between GDP and CPI, with CPI playing a significant role in
influencing economic growth dynamics over time. Based on the analysis of the cointegration test and the Error Correction Model (ECM)
results, here are some policy recommendations such as Given the negative long-term
relationship between GDP and CPI, policymakers should focus on coordinating
monetary policies to manage inflationary pressures while promoting sustainable
economic growth.
This
coordination can involve setting appropriate interest rates, managing money
supply, and monitoring inflation expectations. Implementing an inflation
targeting framework can help anchor inflation expectations and maintain price
stability. Central banks can set clear inflation targets and use monetary
policy tools to achieve these targets, thereby contributing to a stable
economic environment conducive to growth. Fiscal policies should be aligned
with economic goals to support long-term growth while controlling inflation.
This includes prudent government spending, efficient tax policies, and measures
to improve fiscal discipline and transparency. Structural reforms aimed at
enhancing productivity, promoting investment in key sectors, and improving the
business environment can boost economic growth without leading to significant inflationary
pressures.
These reforms
may include labour market reforms, infrastructure
development, and regulatory simplification. Continuous monitoring and analysis
of economic data, including GDP, CPI, and other relevant indicators, are
crucial for policymakers to make informed decisions. Regular assessments of the
cointegration relationship between GDP and CPI can
guide policy adjustments and fine-tuning. Investing in human capital,
education, and skill development can enhance the economy's capacity to innovate,
adapt to technological advancements, and sustain long-term growth without
excessive inflationary effects. Trade policies that promote exports,
encourage foreign direct investment (FDI), and foster economic integration can
contribute to economic growth while mitigating inflationary pressures through
increased competitiveness and market access. Strengthening financial sector
regulations, enhancing risk management practices, and ensuring the stability of
financial institutions are essential for maintaining macroeconomic stability
and supporting sustainable growth.
To ensure a balanced
approach to economic management, policymakers should prioritize monetary policy
coordination, inflation targeting, and fiscal reforms. This includes aligning
fiscal policies with growth objectives, implementing structural reforms to
enhance productivity and investment climate, and fostering international trade
integration. Additionally, continuous data monitoring and analysis, coupled
with capacity-building initiatives and measures to promote financial stability,
are crucial for sustaining long-term growth while managing inflationary
pressures. By adopting these policies, policymakers can foster an environment
conducive to economic stability, resilience, and sustainable growth in the face
of evolving global economic dynamics.
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