With fast decelerating economic growth and sharply rising inflation, there is a growing belief about India facing stagflation.
Stagflation is said to happen when an economy faces stagnant growth as well as persistently high inflation.
Typically, inflation rises when the economy is growing fast. That’s because people are earning more and more money and are capable of paying higher prices for the same quantity of goods. When the economy stalls, inflation tends to dip as well because there is less money now chasing the same quantity of goods.
Its because with stalled economic growth, unemployment tends to rise and existing incomes do not rise fast enough and yet, people have to contend with rising inflation. So people find themselves pressurised from both sides as their purchasing power is reduced.
Over the past six quarters, economic growth in India has decelerated with every quarter. In the second quarter (July to September), for which the latest data is available, the GDP grew by just 4.5%.
In October inflation was a 16-month high and the November inflation, at 5.54%, is at a three-year high. Inflation for the rest of the financial year is expected to stay above the RBI’s comfort level of 4%.
Are these indications of stagflation?
It may appear India is facing stagflation but there are some broad reasons to believe otherwise:
Although India is not growing as fast as we have in the past or as fast as we could, India is still growing at 5% and is expected to grow faster in the coming years. India’s growth hasn’t yet stalled and declined. Year on year, our GDP has grown in absolute number, not declined.
Retail inflation has been quite high in the past few months, yet the reason for this spike is temporary because it has been caused by a spurt in agricultural commodities after some unseasonal rains.
Retail inflation has been well within the RBI’s target level of 4% for most of the year. A sudden spike of a few months, which is likely to flatten out in the next few months, it is still early days before one claims that India has stagflation.
The Central Bank could use Monetary policy to try and reduce inflation. Higher Interest rates increase the cost of borrowing and this will reduce aggregate demand (AD). This will be effective for reducing inflation, but, it will cause a bigger fall in GDP.
Another solution to stagflation is to increase aggregate supply through supply-side policies, for example, privatisation and deregulation to increase efficiency and reduce costs of production.
The best policy measure is to reduce personal and business taxes because they tend to reduce labour costs and raise demand for labour. Similarly, sales tax and excise duties should be reduced in order to prevent the price level from rising.