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A Theory of Growth and Threshold Inflation with Estimates

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Abstract

For an inflation targeting Central Bank, a precise estimate of the threshold inflation in the economy is important. Existing studies provide estimates without any coherent theory of growth and threshold inflation and hence suffer from several limitations about concept and measurement. The present paper attempts to develop such a theory to establish a stable steady state growth solution. It also operationalizes the theory through a model with support from the Indian data for specific components of the model to derive the required functional form. Final estimates in India with annual data from 1995–96 to 2017–18 show that the threshold inflation and associated optimal growth vary considerably as rates of fiscal deficit and current account deficit on the balance of payments vary. The current combinations of the long term four policy targets of 4% inflation; 8% growth; 6% fiscal deficit (to GDP); and 2% current account deficit (to GDP) are internally inconsistent and hence not achievable. Now that there is an opportunity to revise the inflation target for the period after March 2021, the present paper argues for choosing from the menu of internally consistent options for all these four policy targets to avoid unnecessary costs.

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Notes

  1. It is a received doctrine that inflation in the long run is a monetary phenomenon. The second stream of literature, therefore, investigates relationships between inflation and growth of real variables in the economy.

  2. Sustainable combined fiscal deficit in India in the long run with the growth target of 8–8.5% and inflation rate of 5.4–6% would be in the range of 9.2–9.5%, because the nominal growth would be at least 14% and effective interest rate on government debt would be 7% or less. Therefore, the Debt-GDP ratio would not increase even with Primary Deficit of 4.7% of GDP. Adding interest payment of 4.7–4.8% of GDP, the sustainable fiscal deficit comes to around 9.5%. Thus, fiscal deficit of 7% or even 7.5% would lead to a decline of Debt-GDP ratio by about 2–2.5% points per year, provided the nominal growth is around 14% per annum.

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Acknowledgements

I am grateful to RBI for providing assistance through their Development Research Group project. I am also grateful to Prof. Kruti Lehenbauer from UIW, San Antonio, USA for going through the draft and making useful comments and suggestions. Any remaining errors and omissions are my responsibility.

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Correspondence to Ravindra H. Dholakia.

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Appendix

Appendix

See Tables 3, 4, 5 , 6, 7, 8, 9.

Table 3 Regression results for inflation uncertainty measured through relative price variation on average inflation rate in India
Table 4 Cross Correlations between Inflation and Growth
Table 5 Regression Results for Eq. (11) in the Text
Table 6 Regression Result for Eq. (12) in the text
Table 7 Regression Result for Eq. (14) in the text
Table 8 Regression result for Eq. (13) in the text
Table 9 Regression result for Eq. (15) in the text

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Dholakia, R.H. A Theory of Growth and Threshold Inflation with Estimates. J. Quant. Econ. 18, 471–493 (2020). https://doi.org/10.1007/s40953-020-00215-x

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