Can’t opt for high inflation to promote growth: RBI

RBI has clarified that it could not espouse a policy of tolerating higher inflation in order to promote growth because such a stance would not yield the desired results. RBI cited a study which, although, gave empirical evidence that lower real interest rates could stimulate growth and investment, it didn’t recommend a policy of higher inflation tolerance as the means to lower real rates. The study was conducted in the backdrop of criticism that the RBI was adopting an anti-inflationary monetary policy stance to the impediment of growth.

As per the study, the incremental capital output ratio has increased in recent quarters and correspondingly, the implicit marginal productivity of investment has also declined. As a result, lower levels of real interest rate would have also contributed to the slowdown in growth.

Why RBI can’t adopt a policy which tolerates high inflation?
  • The negative impact of inflation on growth outweighs its positive impact if real rates are lowered beyond a threshold.
  • Tolerating higher inflation with growth supportive monetary policy response is unlikely to stimulate growth to the desired extent since the adverse impact of higher inflation on growth would more than offset the favorable impact of growth supportive monetary policy.
  • The adverse growth impact of high inflation was seen to operate primarily through compression of consumption demand since investment demand is more sensitive to lower real rates than higher inflation.
What is real interest rate?

 The real interest rate is the rate of interest an investor expects to receive after allowing for inflation. It can be described more formally by the Fisher equation, which states that the real interest rate is approximately the nominal interest rate minus the inflation rate. If, for example, an investor were able to lock in a 5% interest rate for the coming year and anticipated a 2% rise in prices, he would expect to earn a real interest rate of 3%.

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