Does higher inflation mean higher economic growth?

by Shaun Richards

The issue of inflation is a hot topic in economics right now. Indeed this morning has suggested that to quote Glenn Frey the heat is on in India.

The wholesale price-based inflation hit an all-time high of 12.49% in May on the back of a spike in prices of manufactured products, crude petroleum, and mineral oils.

It touched the double-digit mark of 10.49% in April (2021). This is the fifth straight month of an uptick in WPI inflation. ( Business Today)

It is the five months in a row of rises which bothers me more than the all-time high which is influenced by the pandemic driven lows of last year. The vibe has also been reinforced by this.


So the issue in May has pushed into June and as an aside a higher oil price has negative consequences for the Indian economy. But for out purposes today the issue is one of inflation risks.

The Reserve Bank of India

We can stay on the sub-continent for the latest central banking missive assuring us that inflation is good. Earlier this month the RBI produced a working paper looking at this.

The concept of threshold inflation is linked to the level of inflation beyond which it becomes detrimental to economic growth.

There are a lot of begged questions in the assumptions but applying them to India the researchers get to this.

 For macroeconomic policy targets consistent with maintaining fiscal deficit at 6.0 per cent and current account deficit at 2.0 per cent of GDP, our estimates suggest a threshold inflation level of 6.1 per cent and optimal growth rate of 7.5 per cent for India.

As you can see they are juggling several plates at once but in principle they are replicating the western approach. What I mean by that is we are seeing an attempt to raise the inflation target by 50% or from 2% to 3%. Well in India a 50% rise takes you from 4% to 6%. The extra 0.1% is the same as when Everest was estimated to be 28,000 feet high so they made it 28,002 as otherwise they thought they would not be believed.

They then ram their point home in case we missed it.

If we consider the inflation target at 4 per cent instead of the threshold level of 6 per cent, the long-term growth rate would decline by about 80 bps.

By contrast if you miss the inflation target on the upside the issues created are relatively smaller, in fact much smaller.

On the other hand, if we consider the inflation target of 8 per cent instead of the threshold level of 6 per cent, the long-term growth rate would decline by only about 30 bps.

I suppose it is kind of them to so explicitly confirm one of the themes of my work.

 Thus, the trade-off between long-term inflation and growth is not symmetric on both side of the threshold inflation.

If you prefer it can be expressed in terms of economic growth.

When the inflation target is less than the threshold level, the sacrifice is 0.4 per cent point growth per one per cent point reduction in long-term inflation. However, if the inflation target exceeds the threshold level, the sacrifice of growth is only 0.15 per cent point per one per cent point increase in the long-term inflation.

Extraordinarily clever for a number if not picked at random has in fact been pulled out a hat.

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The claimed gains are put up simple terms for politicians.

If the threshold inflation rate is somehow considered to be too high, the policy makers can choose a lower inflation target only by consciously sacrificing long-term real growth of GDP.


In a country with so many poor I am sure that pretty much everyone reading this with thing of it as a big deal.

 Of course, there are arguments in favour of lower inflation rate in terms of its favourable redistribution impact particularly on the poor and the financial stability concerns.

The problem here is one of the swerves in this type of analysis which appears in the early part.

The Keynesian analysis of non-neutrality of money assumes that nominal wages are more rigid than prices. Increase in money resulting in higher price level, therefore, leads to a decrease in real wages that would bring about an improvement in real economic activity (Rangarajan, 1998). This was loosely interpreted to mean higher inflation resulting in higher growth.

They deny this is being used and instead point to this.

 In an open economy, the rate of inflation can become an important determinant of the steady state rate of growth. It can influence TFPG through its effect on investment and effectiveness of research and development expenditure (Briault, 1995).  ( TFPG = Total Factor Productivity Growth )

Thus they are in fact assuming that higher inflation leads to higher economic growth via what we have come to call the “productivity fairy”. Personally I do not see a link between inflation and productivity. Also on the dynamic world in which we live and exist there is no “steady state rate of growth” and the conclusion is thus castles in the sky.

 Thus, the steady state growth would occur at the threshold inflation in an economy left to market forces. Since this is a base case, the government can avoid unnecessary adjustment costs in practice by targeting long-term inflation and growth respectively at the threshold inflation and steady state growth.


The conclusion is an interventionist and central planners dream. It feels like something from the 1960s and 70s with a “white-heat of technology” add on. In the credit crunch era we have seen a familiar trend where such ideas start with a single central bankers and the spread. Some years back it was Charles Evans of the Chicago Fed pushing the higher inflation target line and now we see it has become official policy.

With inflation running persistently below this longer-run goal, the Committee will aim to achieve inflation moderately above 2 percent for some time so that inflation averages 2 percent over time and longer‑term inflation expectations remain well anchored at 2 percent.

Actually that is now out of date as inflation is not only above target but if the May CPI reading is any guide may well be considerably above it.

Where this falls down is that the research is designed to come to the conclusion that it does. I have already highlighted the productivity issue and with it comes the related one of wages and real wages in particular. This has been a troubled area for years and maybe decades for example the “lost decade” in Japan is one of a lack of real wage growth and my home country the UK has struggled too. Thus, in my opinion, and there is plenty of evidence to back it up you cannot simply assume higher inflation will lead to higher wage growth. The nominal wage rigidities of economic theory have got worse. We see examples of this regularly in the news and this may well be backed up by official numbers too.

Real average hourly earnings for all employees decreased 0.2 percent from April to May, seasonally
adjusted, the U.S. Bureau of Labor Statistics reported today…..Real average hourly earnings decreased 2.8 percent, seasonally adjusted, from May 2020 to May 2021.

Then we have the issue of assuming a steady-state for an economy at a time when we have seen waves of uncertainty. It is hard not to laugh as the theorists describe their theoretical world but describe one which has not much of a relation to the real one leaving us Seasick like Steve.

Cause I started out with nothing
And I’ve still got most of it left



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