Project on Monetary policy - Module: 2 - Growth, Inflation and The Conduct of Monetary Policy
[Source: RBI Report of Currency & Finance 2001-2002]

Monetary Policy and Growth (Contd)

Some Practitioner Perspectives on the Debate

In the economics profession, the impact of monetary policy on output, employment and prices has always been recognised. Recent empirical research developing on the "narrative approach" of Friedman and Schwartz suggests that negative monetary shocks are followed by marked downturns in real economic activity that cannot be predicted from the past behaviour of the economy (Romer and Romer, 1989, 1994a). Furthermore, real effects of the monetary shocks are not only substantial but also long-lived (though not permanent) with the effects remaining up to 3 years. It is found that the Federal Reserve recognises quickly that recessions are underway and typically responds to downturns with prompt and large reduction in interest rates. Discretionary fiscal policy, in contrast, rarely reacts before the trough in economic activity and even then the responses are usually small reflecting inside lags (Romer and Romer, 1994 b). Monetary policy shocks have a persistent effect on output, while inflation displays an inertial response (Christiano et al, 2001). The Bank of England's macro-model shows that a temporary increase (increased for one year and then reversed) of interest rates by 100 basis points lowers output by around 0.20-0.35 per cent after about a year, while it reduces inflation by around 20-40 basis points after a year or so.

Growing recognition of the powerful effects of monetary policy on the real economy explains as to why societies have reposed the conduct of monetary policy with central banks/monetary authorities. In the dispensation of this responsibility, central banks have to take positions on the short run trade-off between growth and inflation; the choice is severely conditioned by the losses of macroeconomic welfare that can result in an inappropriate position occupied in the growth-inflation curve. The conduct of discretionary monetary policy, especially since the 1970s, is centred around the choice of a rate of inflation for the national economy consistent with the choice of a rate of growth. In developing countries, the dilemma becomes sharper, especially with the conviction that there are segments in the growth-inflation curve in which some inflation is beneficial for growth. In recent years, monetary authorities have increasingly come out of the closet to reflect growth considerations, both explicitly and implicitly, in their objective functions. Even in countries which have adopted inflation targets as the goal of monetary policy, output considerations (reflected in the deviations of output from target growth) are explicitly incorporated in their monetary policy frameworks (Table 5.1)). In 2000 and 2001, the process has come full circle with the Federal Reserve almost single-handedly undertaking the task of soft-landing the US economy and revitalising growth. Increasingly, monetary policy is viewed as an integral element of macroeconomic policies for growth and stability.

At the operational level, there is also a recognition that the growth-inflation curve has non-linear segments, i.e., inflation at some low level has positive effects for growth by 'greasing the wheels' of the economy, but there is a point beyond which inflation can be harmful for growth. Multiplicity of objectives entails assignment of degrees of importance, depending on the hierarchy of macroeconomic priorities. Consequently, the weights set for growth and inflation by the monetary authority must reflect an understanding of the functioning of the economy.

A proximate starting point to the resolution of the dilemma is the identification of the threshold (optimal, tolerable) level of inflation beyond which it has negative effects on growth. Empirical investigation of the location of the threshold have proliferated in the literature since the 1970s. Early efforts were based on estimating Phillips curve type relationships with high frequency data (Fischer, 1983). Subsequently, the threshold inflation was estimated under growth accounting frameworks. The empirical evidence produced in the second half of the 1990s suggests that there exists a significant and negative correlation between high inflation and growth. Inflation volatility is robustly and negatively correlated with growth variability at high levels of inflation. The threshold rate of inflation in industrial countries is placed in the range of 1-3 per cent (Fischer, 1996).

At the same time there is a strong argument against zero inflation (Akerlof et al, 1996). Resistance to nominal wage cuts brings with it rigidity in real wages and some inflation is necessary to allow real wages to adjust. This has been expressed as a case against price stability and inflation at 3-4 per cent has been suggested as a long run target (Krugman, 1996). Several recent studies incorporating developing countries, including India, have empirically located threshold inflation rates in the range of 8 per cent (Sarel, 1996) to 40 per cent (Bruno and Easterly, 1995). The range is relatively wide for samples including developing countries since measured productivity in the traded sectors in these countries is generally higher than in the non-traded sectors. Measuring threshold inflation in a cross-country framework runs the risk of being influenced by extreme values since samples include countries with inflation as low as 1 per cent and as high as 200 per cent and even higher. The appropriate inflation threshold, therefore, needs to be estimated for each country separately (Rangarajan, 1997).

In the 1970s, although there was considerable concern about inflation in the face of oil price hikes and agricultural supply shocks, there was a lack of consensus about the tolerable rate of inflation (Singh, Shetty and Venkatachalam, 1982). The reference of the Chakravarty Committee to 4 per cent as the acceptable rise in prices can be regarded as the first influential fix on the threshold rate of inflation in India. Testing for the threshold within the framework of a macroeconometric model suggested a range of 5 to 7 per cent, initially 6-7 per cent and eventually 5 to 6 per cent (Rangarajan, 1997). Employing a variety of methodologies, studies conducted in the Indian context obtain a range from 4 to 7 percent for the threshold inflation rate. The lower bound of 4 per cent may be regarded as output-neutral inflation rate with the positive effects of inflation petering off after 7 per cent. At an inflation rate of 10 per cent, inflation has adverse consequences for growth. There is not much empirical support for the trade-off between the anticipated rate of inflation and output growth although the adverse effects of inflation surprises on output growth are robustly confirmed. A recent study suggests that for inflation of up to 6.5 per cent, the growth objective of monetary policy can take precedence over the price stability objective. However, once the inflation level reaches 6.5 per cent, price stability objective should be given greater relative importance (Samantaraya and Prasad, 2001). With prolonged price stability at the global level as well as in India, the threshold can be expected to move downwards.

The various empirical studies conducted for estimating the threshold inflation for India show that the results are sensitive to the methodology, the period of study and the choice of plausible factors determining growth or 'conditioning' variables. There is no consensus on the specification of the appropriate model for estimating the growth-inflation relationship, perhaps because the relationship itself is changing fairly rapidly. Accordingly, updating the estimate of the threshold inflation to take into account these underlying shifts assumes importance. Obviously, in this exercise, feasible computation takes precedence over analytical finesse. In this section, the methodology adopted by Sarel (1996) is employed to estimate the threshold inflation in India as a point estimate as opposed to the range estimates. The Sarel 'spline' technique is intuitively appealing as it specifically incorporates non-linearity in the inflation and growth relationship. It employs a search procedure to identify the structural break or 'kink' in the growth-inflation curve. This yields a unique estimate of threshold inflation. The threshold inflation in this study is estimated under a production function framework where real output is regressed on capital, labour, actual inflation rates and inflation dummies characterising alternate inflation regimes by using the Sarel methodology - which derives the threshold level corresponding to the maximum fit of the model represented by the value of the adjusted R2. Based on this, threshold inflation for India estimated for the period 1970-71 to 1999-2000 is 5 per cent (Table 5.2).