Whether Inflation Can Boost To The Growth

A Myth Or a Reality

Remember the days of Great Depression of 1929 when millions of people have lost their employment. At that time the Great  Eonomist

Lord J.M. Keynes had propounded the General  theory of Employment , Interest and Money in 1936, which was considered as panacea from come out from the trap of Great Depression and trusted upon the solution given by him through the Pump Priming. Pump Priming is the action taken to stimulate an economy, usually during a recessionary period, through government spending and interest rate and tax reductions. Because The Keynesian theory of employment states that the cause of unemployment is the deficiency of effective demand and unemployment can be removed by raising effective demand.

With the increase in effective demand the production in the economy goes up.  Which in general envisage that if the Government does not have  sufficient money to  generate the employment, they should  borrow from the central  bank and generate employment. In his theory he assumed that the inflation will not increase much till the economy reaches to full employment level. Though later on this classical theory was criticized by the other group of Economists.

But no one can deny that on the basis of Keynesian  theory even in modern times the Government is resorting to borrowings from Central Bank directly or indirectly to maintain the pace of growth by which generating employment.

But here the question comes whether the Government can borrow from Central Bank or from the market without any limit . Till  31^St  March 1997 Central Government was borrowing from RBI  as per their requirement, which in turn was creating Ad-hoc Treasury Bills providing funds to Central Government against it. It was accused that an economic policy which relied on borrowing to boost growth had contributed to economic crisis. The idea of fiscal deficit had not yet made its debut.

It was only after the economic reforms of 1991 that the concept of fiscal deficit came into vogue. Till then, what constituted the budget deficit was broadly equivalent to net credit from the RBI. By its nature there was no check on such deficit financing as the government was not made adequately responsible for its borrowing excesses. After the concept of fiscal deficit was introduced, the next big reform in this area was when over a period of three years starting from 1994 and ending in 1997, the government’s recourse to the issuance of ad hoc treasury bills to finance its budget was completely stopped.

An agreement between RBI and the Government was signed on 9^th  September 1994 that stipulated that ad hoc treasury bills would be discontinued from 1st April 1997. And this landmark agreement led to discontinuance of system of monetized deficit to fiscal deficit. Therefore the necessity for issuing treasury bills arises because of the periodic nature of receipts of Government while Government’s expenditure is on continuing basis.

While tax and other revenue collections are coming to the Government exchequer at quarterly or other fixed intervals. Thus to bridge the gap between the timing of Government receipts and expenditure, the Government borrows money on a short term basis by issuing Treasury bills.

These Treasury bills were of 91 days. 182 days Treasury bills were introduced in November 1986 on an auction basis. The 182 days Treasury bills were replaced by the introduction of 364 days Treasury bills on a fortnightly auction basis since April 1992 . When the 91 days ad hoc treasury bills were discontinued in April 1997, to enable finer cash management of the government and to provide avenue to state governments and some foreign central banks to invest surplus funds, 14 days Treasury bills were introduced 1n April 1997.

Subsequently, the 14 days and 182 days Treasury bills were discontinued in April ,1992. Currently, 91 days, 182 days( reintroduced in May 1999) and 364 days Treasury bills are sold on an auction basis. This borrowing of the central government is the main component of the fiscal deficit.

In order to help the government to meet its temporary mismatches in its receipts and payments, the RBI introduced a scheme of Ways and Means Advances (WMA). The new scheme of WMA helped the government obtain necessary cash at a mutually agreed interest rate to meet its temporary needs. The day the government used up 75% of this limit, the RBI would start floatation of a fresh round of government securities.

In consultation with the central government, the limit for Ways and Means Advances for the first half of the year 2023-24(April 2023 to September 2023) has been fixed 1,50,000 Crore.  With the discontinuation of ad hoc treasury bills and introduction of WMA, the idea of the government’s budget deficit, capturing the government’s total borrowing requirements in a year became the key indicator of the deficit or the gap between the government’s total revenues and expenditure.

Then to curtail this tendency to borrow from Central Bank unscrupulously in India The Fiscal Responsibility and Budget Management Act,2003 (FRBMA) is an Act of the Parliament of India was commenced from 5^th July 2004.FRMBA was aim to institutionalize financial discipline, reduce India’s fiscal deficit, improve macroeconomic management and the overall management of the public funds by moving towards a balanced budget and strengthen fiscal prudence.

The main purpose was to eliminate revenue deficit of the country and bring down the fiscal deficit to manageable 3% of the GDP by March 2008 which was never met and the deadline fixed was extended further. In 2021-22, the Govt. of India has not provided a target for the next three years and proposed to amend the FRBM Act to accommodate the higher fiscal deficit. The Govt’s aim to steadily reduce to fiscal deficit to 4.5% of GDP by 2025-26.

  The main objectives of the FRMBA can be summarized as under:

1. To introduce transparent fiscal management systems in the country
2. To introduce more equitable and manageable distribution of the country’s debt over the years.

• To aim for fiscal stability for India in long run

Additionally, the Act was expected to give necessary flexibility to RBI for managing inflation in India.

It is evident from the above  till 31^st March 1997 the RBI was   required to bridge the uncovered gap in budget by creating Ad-hoc Treasury Bills as security for printing the Notes. Which was giving the inflationary pressure to the economy.  Due to continued deficit financing  the rupee value was falling in terms of other currencies particularly in terms of US $.  Thus to maintain the parity in the value of the Rupee , the RBI has been adopting various steps including directly effecting the availability of adequate funds in the economy through Liquidity Adjustment Facility by resorting to Repo and reverse Repo operations. Which are considered as key policy rates of RBI monetary policy.

In its last meeting in April 2023 the MPC had decided to pause for the first time after it began rate hike cycle aiming to reduce inflation in May 2022. Soon after April 2023 meet, retail inflation fell to 18 months low at 4.7%.The RBI mandate is to keep retail inflation in the range of 2-6%.Since the April 2022 RBI was continuously resorting to  Repo rate hike, it increased to 250 basis point which is  at present pegged to 6.50%  and during the current MPC meet held between 6 to 8^th June 2023 RBI has continued to  maintain status quo as the committee felt that still the inflation has not come down to its comfort level to cut the policy rate.

Though some of the empirical studies conducted in the past gave an inference that the relationship between fiscal deficit, government expenditure and economic growth in India  they found  that  government expenditure  had positive impact on economic  growth  which inturn put pressure on inflation, while fiscal deficit had a negative impact on economic growth.

The empirical studies conducted gave this conclusion that when government  is resorting excessive borrowing  from the market had negative impact on growth. This we can understand this way. When government is raising public debt it has a coupon rate on which it has to service from time to time and further since it is a sovereign debt on maturity the payment has to be made. When government debt increases the government has to make budgetary provision for the interest payments in the budget thus if this  increases in the budget  which affect the growth prospects due to reduced left over.

The summary of these empirical studies stipulates:

1. High fiscal deficits can also lead to higher borrowing costs for the government which can crowd out private investment and reduce economic growth.
2. High fiscal deficits can also reduce the purchasing power of the people and adversely affect the economy. Inflation can occur when the government prints more money to finance its deficits which can increase the supply of money and reduce its value

• High fiscal deficits can lead to a reduction in public savings, which can lead to lower investment and slower economic growth.

The following table gives a trend of GDP growth in percentage terms vis-à-vis trend in inflation rate in percentage terms during last ten years. Though there may be a slight differences in computation of their calculation periods.

Concludingly, we can say inflation can’t  be considered as a booster to the growth , rather we can say it had an impediment to the growth . If inflation is too high the real growth rate will be too low. There may be some linear growth in nominal terms can be sometimes visible but that is only a myth will vanish shortly.

B.S.Khatri

General Manager  (Retired)

Reserve Bank of India

Jaipur  

Disclaimer: The views  expressed in the article are his own views and do not represent to the institution he belonged. The data and study material referred in the article are taken from the published material and the author do not owe any responsibility for the accuracies of the same.