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Inflation - An Impediment to Growth

Posted in Finance Articles, Total Reads: 5023 , Published on September 06, 2011

India’s household saving rate has declined to 13 year low due to high inflation. High inflation is has reduced the household’s disposable income. High inflation impacts how the common man spends on daily expenses. High inflation reduces both real income and purchasing power. Indians are known for their high savings rate in the form of deposits with banks, non banking financial companies, provident and pension funds. But due to inflation the savings have reduced to 9.7% of GDP in 2010-11 as compared to 12.1% of GDP in 2009-2010.  The last time savings rate as a percentage of GDP dipped below 10% was in 1997-98. But that reduction was accompanied by reduction in GDP growth to 4.3%. On the contrary, GDP growth rate in 2010-11 was 8.5%.


Inflation Rise

Often people confuse nominal and real values in their everyday lives because they are misled by the effects of inflation. For example, a worker might experience a 6 per cent rise in his money wages – giving the impression that he or she is better off in real terms. However if inflation is also rising at 6 per cent, in real terms there has been no growth in income.

Inflation reduces savings as people money loses its value. Savers will lose out if nominal interest rate is lower than inflation leading to negative real interest rates. For example if there is a high inflation of 6% and nominal interest rate on the savings account is 4%, this will result into real interest rate of -2% on savings. This will result into people spending rather than saving.

As the inflation increases, prices increases lead to higher wage demands as people try to maintain their living standards. In order to meet the employee’s expectations, business increases their prices to maintain their profits which further put pressure on the wages. This is known as wage spiral.

The effect of inflation is more on those employees with poor bargaining power like those people in the labor market with low paid jobs. They see their real value of their pay fall. Inflation can also favor borrowers at the expense of savers as inflation erodes the real value of existing debts. And, the rate of interest on loans may not cover the rate of inflation.

Inflation also disrupts business planning and budgeting. As the prices are continuously increasing it becomes really difficult to plan capital spending and investment. This has overall effect on planned capital spending. Lower investment results in lower growth which is harmful to economy’s growth.

Higher inflation may also cause loss of competitiveness in the international market. As the prices in the domestic market increase beyond a certain limit, exporters also need to increase the price in the international market which makes it less attractive. Increased prices in the domestic market may lead to higher imports leading to worsening balance of payments.

The current higher inflation in India can be attributed to higher than planned for fiscal deficit. There is a positive relationship between inflation and fiscal deficit. The government itself has expressed fears that it may not be able to meet its fiscal deficit target of 4.6% of GDP in this financial year mainly due to a slowdown in the economy initiated by inflation and sustained by successive rises in interest rates. Another reason of higher inflation is supply side delays. In order to improve supply side, it will need reforms in the area of supply chains, reducing loss and wastage of food grains and other food items, better warehouse management, better management of the targeted public distribution scheme, improving agricultural productivity etc. Current stance of RBI of raising interest rates is not helping inflationary pressure. It is only addressing demand side inflation. This policy needs to expand to include fiscal consolidation and substantial improvements on the supply side. A higher interest rate policy may not end up inflation but may end up lowering growth.

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