PGEXP 2011-13Group 2 * Sanjay Kumar Mishra (Roll -107) * Dharmendra Kumar (Roll – 112) * Debashish Roy (Roll – 232) |
CORRELATION BETWEEN GROWTH AND INFLATION WITH SPECIAL REFERENCE TO INDIA & CHINA
One of the most fundamental and central macroeconomic policy objectives of the governments, central bankers and economists has been to sustain high growth rate with low inflation. The influences of other macroeconomic variables like aggregate demand, unemployment and investment and that of factors like human and natural capital and technology on economic growth are well-established. But when it comes to the ...view middle of the document...
Disinflationary policies to lower the inflationary expectations involve sacrifice by way of keeping the unemployment level ‘high’ thus causing ‘lowering’ of output, which again means reduction in GDP growth.
Though the above linearity in the relationship appears plausible in the short run and in economies with low unemployment level; the impact of long-term inflation over the growth rate and also how growth rate impacts the inflationary tendencies remains unclear. Empirical evidence of the relationship between growth and inflation across the various stages of economies is somewhat inconclusive. This is due to the fact that nature and impact of prices vary with the degree of ‘development’ in the economy. But, still most of the studies do indicate that growth tends to become slower at high and prolonged inflationary conditions. Inflation as an indicator of macroeconomic instability is considered discouraging for investment and hence also has an adverse bearing on the growth of the economy in the long run. And this very fact gives impetus to monetary policies which seek to usher in and sustain price stability to reduce uncertainties in decision making, which is crucial for economic growth.
In the Keynesian model of AD-AS, the short-run AS curve is upwardly sloping meaning any shift in AD curve due to increased demand would increase the price as well as output implying a positive relation between inflation and growth in the short-term. Under this model, there is a trade-off between inflation and output in the short-run but no such link in the long run.
Neo-classical economist Tobin (1965) postulated portfolio framework; where individuals shift from money to alternative asset (capital) with increase in inflation as return to money falls. The shift in the curve results in higher steady-state capital stock, which simply put lead to increased capital intensity and thus higher level of growth. The framework shows that higher inflation raises the output level permanently but the growth is temporary – from one steady-state to another steady- state. Tobin also argued that due to downward rigidity in prices (including wages), the adjustment in relative prices during growth is better achieved by upward price movement of some of the individual prices – suggesting both-way positivity in the relationship.
In contrary, the studies of other neo-classical economists like Stockman (1981) and Cooley and Hansen (‘Inflation Tax in a Real Business Cycle Model’, American Economic Review, 1989) indicates a negative relation between the two variables. Stockman argued that inflation erodes the purchasing power of money prompting in reduction in purchase of both consumption goods and capital which correspondingly lead to fall in steady-state output level. Cooley and Hansen basing their argument that quantity of labour declines in the time of inflation and as marginal product of capital is directly related to quantity of labour, the return on capital falls...