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Inflation and GDP – A Complicated Relationship (Part II)

Inflation and GDP – A Complicated Relationship (Part II)

By Chaahat Khattar

This article is the second part of a series of two articles by Chaahat Khattar. Find the first part here.

To understand how inflation plays a critical role and how much the governments’ focus on it, let us analyse two poles apart real situations.

The Collapse of the Zimbabwean Economy

We all know that Zimbabwe’s economy is crippled because of hyperinflation. So much so, at one point in time, their annual inflation rate touched a staggering 11.2 million percent[1]. This poses a very interesting puzzle/challenge for economic enthusiasts. When Zimbabwe has such few goods and too much money, then why does it have such high inflation? Realistically, a high unemployment rate usually implies less money in the hands of the public, and hence a low demand. Then why does there exist a situation of hyperinflation?

To understand this, we need to travel back to the start of the new millennium i.e. the early 2000’s.

Zimbabwe’s infamous President, Robert Mugabe, to increase his foothold in Democratic Republic of the Congo, went for an atrocious funding exercise which included higher salaries for the army and government officials. As per various sources, Zimbabwe was reporting incorrect war funding to the International Monetary Fund by perhaps USD 22 million a month[2].

As per various sources, Zimbabwe was reporting incorrect war funding to the International Monetary Fund by perhaps USD 22 million a month.

Due to a shortage of output, printing of money increased money supply while the real GDP of Zimbabwe remained unchanged (or changed insignificantly). The inflation was also exacerbated by a paucity of supply. Because basic goods were in short supply, it was easy for market prices to increase and create a spiral effect of ever-rising prices. Ironically, Zimbabwe’s price controls on basic goods made things worse because the cost of production in Zimbabwe had been increasing faster than prices, suppliers had little incentive to supply. This made the shortage worse and turned inflation into hyperinflation.

The classic case of Zimbabwe is theoretically backed by the Monetarism thought of economics. The monetarists believe that MV is equal PY, where M is equal to Money Supply, V is equal to Velocity of circulation, P is equal to Price Level and Y is equal to National Income (or real GDP). If we assume a constant V and a constant Y, an increase in the money supply will lead to increase in prices (i.e. a situation of hyperinflation). Therefore, the moot point is that for an economy to be on track, both the GDP, as well as the supply of money, in the economy has to be balanced.

The Case of The Polar Opposite: Japan

Coming down to the far east side of the world, there rests the third largest developed economy in the world – Japan. It is the world’s largest creditor nation, generally running an annual trade surplus and having a considerable net international investment surplus. As a matter of fact, United States of America (USA) owes Japan around USD 1.1 trillion making Japan the second largest lender to USA.

However, Japan is swimming into deflation which has dogged the otherwise flourishing economy for the best part of two decades.

However, Japan is swimming into deflation which has dogged the otherwise flourishing economy for the best part of two decades. It is largely attributable to Japan’s central bank, Bank of Japan’s (BOJ) strategy of keeping a tight monetary policy when the inflation was sub zero and immediately tightening as soon as deflation ended.

 Shinzo Abe

Japan follows a tight monetary policy in accordance with Abenomics named after Japanese Prime Minister Shinzo Abe’s economic reforms | Source: Google Images

While demand for Japanese exports increased worldwide, its local demand kept on shrinking. This made the Japanese government announce billion dollar stimulus packages to keep the industries alive and that could have been only funded through public debt. As a result, Japan’s public debt rose to 233 percent of its GDP which is worse than US’s 80 percent and even worrying than Greece’s 155 percent[3].Japan, under the ‘Abenomics’ (Japanese Prime Minister Shinzo Abe’s economic reforms) has adopted several measures (including printing money) to increase inflation in the economy to bring GDP back on track and push people to shop and raise inflation in the economy.

Switzerland and Singapore: Stars at Pole Balancing

The most stable economies in the world, keep a thorough check on both inflation and growth.

Take the case of Switzerland. Its economy is far ahead of its European Union (EU) neighbours. Switzerland has clocked a GDP growth of over 2 percent against EU’s 1.3 percent and unemployment remains as low as 3.2 percent against EU’s 9.6 percent. Moreover, Switzerland’s 2015 budget has closed with only 34.4 percent debt to GDP ratio. Switzerland’s central bank, Swiss National Bank (SNB) has a monetary policy strategy made up of three crucial elements viz., a definition of price stability (the SNB equates price stability with a rise in the national consumer price index of less than 2 percent per year), a medium-term conditional inflation forecast, and, a target range for a reference interest rate, which is the Libor for three-month investments in Swiss francs. The amazing growth story of Switzerland is attributable to freedom government has granted to its industries, policy makers, public and restricting government’s own spending.

Another pinnacle of a sustainable economy is Singapore and its central banker cum financial regulator Monetary Authority of Singapore (MAS) plays the most important role. MAS has adopted an exchange rate policy instead of an interest rate policy to maneuver the economic growth in Singapore[4]. As part of this unconventional strategy, MAS keeps control over Singapore dollar (SGD) by a managed float i.e. a regime of maintaining currency rate within a band determined based on the basket of currencies of its largest trading partners. Therefore, Singapore relies on foreign exchange rate as a tool of monetary policy.

As far as interest rates are concerned, they are largely determined by foreign interest rates and investor expectations of the future movement of the SGD. So far, this has acted as a weapon hitting two targets at the same time i.e. maintaining price stability (by way of reduced foreign exchange volatility) and sustainable economic growth. Interestingly, the Singapore dollar has performed better that its major trading partner currencies. This indicates a strong economy with high productivity growth and high savings rate. Forecasting a higher inflation ahead, MAS increased the band of SGD movement. By increasing the band, the SGD is able to appreciate at a faster pace. The appreciation of the SGD makes it more expensive for the foreigners to buy Singapore’s assets and at the same time increase export prices thus slowing down the economy and bringing down inflation.

Growth in India: A Game of Thrones

Coming back to our nation, inflation and GDP most of the time (especially in critical times such as the period of early 90s and recessionary phase of late 2008-09) have had an inverse relation. Higher inflation had eaten GDP and slowed economic growth of the nation and low/moderate inflation saw the economy either grow or at least maintained stable.

It is easily understood that to manipulate growth, monetary policies are the swiftest modes as fiscal policies would take ages to come into effect.

And knowing that governments have no more than five years to show miraculous economic recoveries to come to back power, they do need short cuts to boost GDP. This is when they look up to the RBI to increase money supply into the economy.

But the RBI cannot do so blindly, as it may lead to inflationary pressures. In the long term, it can lead to a sudden fall in demand or create a liquidity trap (a situation where banks do not want to lend to consumers and consumers do not want to spend – they intend to save for a ‘rainy day’).

The control over inflation and GDP had always been a bone of contention between the RBI and the Government of India. As soon as RBI was set up in the year 1926, it fueled the controversy as to who would control it. While some advocated that Imperial Bank (predecessor of State Bank of India) should control it but the government denied it stating that it was politically impracticable. It was in 1933 when a White Paper on the new constitutional reform was assumed that the central bank of India would be free from political influence[1].

Intervention: The Monetary Policy Framework

Forward it to 2014, the newly elected Prime Minister of India, Mr. Narendra Modi had a herculean task (one of the many) in his hand. The government always had the reputation of pressuring the central bank to reduce interest rates and to let the GDP rise. The Narendra Modi government had to reset its equation with the RBI.

The newly appointed RBI governer Urjit Patel has a decisive role to play in India’s Economic growth | Source: Getty Images

To achieve this, the newly elected government introduced the Monetary Policy Framework, which now has been enacted by making amendments to the Reserve Bank of India Act. It, both on paper and practically, allows the RBI to operate monetary policies in India with recommendations from the government. Coincidently (or incidentally), it was Urjit Patel under whose leadership a committee was formed which suggested the formation of such a framework. The framework allows all decisions to be taken through a voting process by members from different avenues including the government. However, in all circumstances, the Governor has the power to break in case of any deadlock in any decision.

The framework also makes it clear that the inflation targets will be determined by the government in terms of CPI, in consultation with the RBI[2]. And as a matter of fact, for the next five years, the government has set an inflation target of 4 percent (with a cushion of 2 percent on both the sides).

Friends or Foes: Numbers shall speak

Globally we have all kinds of economies. Economies such as that of USA and Japan which provide complete autonomy to the central bank while deciding the monetary policy of the country. Economies like the United Kingdom where the central bank takes decisions in consultation with the government. In fact, India’s monetary policy framework has striking similarities with the Monetary Policy Committee (MPC) model followed by the United Kingdom.

While many may argue that central bank should be completely independent, we must appreciate one important fact that India is a fast developing nation. Here, the situations are very dynamic and we are interdependent upon a lot of economic factors which requires representation from all stakeholders while taking any decision. Formation of committees with representation both from the government and the central bank would be less prone to mistakes.

RBI, on one hand, has the technical qualifications to take macroeconomic decisions. On the other hand, the government represents the public and their aspirations to grow and develop. In short, there might be tussle between the two institutions but the end result would always lead to the betterment of the people.

Chaahat Khattar is an ardent economist and is working with an international consultancy firm. He is an MBA and pursuing Masters in Business Laws. He is also a Harvard University alumnus and a certified financial modeller.








Featured Image Courtesy : Unsplash

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