Why persistent high inflation impedes growth? An empirical assessment of threshold level of inflation for India

Abstract

In the policy debate on growth–inflation trade-off and the role of monetary policy in managing the trade-off in the short-run, theoretical and empirical research suggests the presence of a country specific threshold level of inflation. Empirical findings of this paper suggest that for India the threshold level of inflation could be around 6%. The inflation target for monetary policy may have to be somewhat lower than the growth maximizing threshold, since any positive inflation could be a risk to inclusive and sustainable growth objective.

Keywords:

• growth-inflation trade-off
• threshold inflation
• backward-bending Phillips curve
• monetary policy response
• inflation target
• risks to growth

Notes

1. Any estimate of threshold inflation could at best be an approximation, rather than precise. The dynamic process of interactions between growth and inflation could be too complex to be captured by any single approach of estimation. This paper, therefore, uses three alternative approaches of estimation, giving the emphasis on whether all of them point to a similar level of threshold for India.

2. Besides maximum Adjusted R², another pre-requisite in the identification of the threshold level of inflation is whether the sum of signs of the inflation and threshold coefficients reverse signs at the threshold level. Recognizing this limitation of the estimate of threshold based on the regression approach, an alternative approach using VAR has been used which satisfies the requirement of reversal of signs of the combined coefficients.

3. The lag length of the VAR was selected on the basis of SIC criteria (as 1 lag), given the low frequency of data for the 6% threshold. For other threshold levels, the same lag length was retained, given the importance of the sum of the coefficients for this approach. Ideally, though, for each threshold the optimal lag length should have come from AIC and SIC.