commentary
Jamalpur struck the eastern embankment
near Hempur village in the Navhatta
block of Saharsa district, 75 km below the
Bhimnagar barrage. The floods uprooted
half a million people and engulfed 96
villages in Saharsa and Supaul districts.
People could go back to their villages only
after the Holi festival of 1985 when the
breach was plugged. Bindeshwari Dubey
of the Congress was the chief minister
that year.
In 1991, there was a breach in the western
embankment near Joginia in Nepal that
led to a political crisis in Bihar and the
minister of water resources had to resign
his post. This resignation was never
accepted by Lalu Prasad Yadav who was
Inflation and Public Policy:
Contemporary Dilemmas
Sugata Marjit
There has been much comment
by the media and criticism by
business that the policy of hiking
interest rates to combat inflation
will hurt investment and growth.
But what has India’s experience
been on the relationship between
the real interest rate and the
inflation rate?
Sugata Marjit (smarjit@hotmail.com) is at the
Centre for Studies in Social Sciences, Calcutta.
12
the chief minister at the time. This was a
repeat of the Bahuarawa breach where the
river had receded after eroding the
embankment. The Kusaha breach took
place in the regime of Nitish Kumar and it
will take about a year to get the complete
story. Thus, virtually no ruling party
(including the administration under presi-
dent’s rule) can claim that it was not
involved in such an accident. Yet, the
blame game and mud-slinging continues
unabated. There is no history of these
breaches being plugged before March of
the following year.
As far as the flood victims are con-
cerned, they bear the brunt of the disas-
ter, irrespective of which party is in
E
conomic problems, particularly
those which rise to the status of
social criticality, draw self-­confident
comments, policy suggestions, numerical
assertions and predictions from various
quarters but possibly despair and frustra-
tion from institutional authorities and
technical experts engaged in a deeper
understanding and resolution of the
problem. As important events of today
are rendered useless tomorrow by the all-
powerful media, we are naturally more
interested in quick solutions rather than in
an understanding of the problem.
The business lobby is angry about an
increase in interest rate and they claim, in
popular national magazines, that a rising
interest rate will shave off 2 percentage
points from our 9 per cent GDP growth rate.
Even the most erudite economists and poli-
cymakers such as the chairman of the
United States Federal Reserve or the gover-
nor of the Reserve Bank of India (RBI) will
think 10 times before com­mitting them-
selves to such a numerical figure. But that
does not prevent business journalists or
business lobbies from publishing a state-
ment, which may distort the choice of right
september 6, 2008  EPW   Economic & Political Weekly
government. It is also a fact that the
breaching of the embankments will con-
tinue in future in full view of the political
parties, the water resources department,
police, and the administration. Given the
magnitude of the disaster, in all probabil-
ity the flood victims will be left to fend
for themselves.
All these debates notwithstanding,
the need now is to reach help to the
flood victims in all possible ways and
provide them support until the next
kharif crop season.
[Map 1 has been reproduced from the article
‘Gerrymandering, Poverty and Flooding: A
Perennial Story of Flooding’ by J Albert
Rorabacher, EPW, February 16, 2008.]
set of policies. More recently the govern-
ment has also come out with a prediction of
a lower growth rate, but not as low as sug-
gested in some business quarters.
Close on the heels of such assertions,
follow demands by a political party to
compel the RBI to fix the rupee/$ exchange
rate at Rs 39 a dollar. Again an economist
will shudder with fear and apprehension
if she has to announce a “socially optimal”
nominal exchange rate because she is
liable to her discipline, years of training
and the associated logic. But politicians
are not burdened by such baggage. Thus,
an instruction to RBI is thought to be
a reasonable way-out from inflation.
Demands for windfall tax on oil compa-
nies are also suggested. But such demands
do not need special mention as they are
targeted as a “firm specific tax” where the
“firm” concerned belongs to the “enemy”
of a set of powerful politicians.
In this commentary we try to talk about
the relationship between the rate of infla-
tion, the real interest rate and the GDP
growth rate. We are not going to explain
such a relationship, but we intend to focus
on statistical associations. This will give
us some handle on what to expect of our
growth rate if the RBI keeps on raising the
nominal interest rate in the face of a sus-
tained rise in prices. This will also indi-
cate, however loosely, the association
between inflation and growth, a proxy for
a version of the Indian Phillips curve,
given the well known pollutants in official

Table 1: Pre- and Post-Reform Rate of Growth of
GDP and Rate of Inflation based on WPI
Years Growth Rate Inflation Rate
of GDP Based on WPI
Pre-liberalisation
1980-81 7.2 18.24
1981-82 6.0 9.33
1982-83 3.1 4.90
1983-84 7.7 7.53
1984-85 4.3 6.47
1985-86 4.5 4.41
1986-87 4.3 5.82
1987-88 3.8 8.14
1988-89 10.5 7.46
1989-90 6.7 7.46
1990-91 5.6 10.26
Post-liberalisation
1991-92 1.3 13.74
1992-93 5.1 10.06
1993-94 5.9 8.35
1994-95 7.3 12.60
1995-96 7.3 7.99
1996-97 7.8 4.61
1997-98 4.8 4.40
1998-99 6.5 5.95
1999-2000 6.1 3.27
2000-01 4.4 7.16
2001-02 5.8 3.60
2002-03 4.0 3.41
2003-04 8.5 5.46
2004-05 6.9 6.48
2005-06 8.8 4.38
2006-07 9.7 5.42
2007-08 9.6 2.86
2008 8.1* 10.94*
Source: Handbook of Statistics on Indian Economy, RBI.
*Source of the data on inflation rate for 2008 is EPW, Current
Statistics; volume: June 28-July 4, and value of WPI is for the
month of June 2008.
*Source of the data for the growth rate of GDP is RBI
Publications, Survey of Professional Forecasters – Results of Third
Round relating to Fourth Quarter ended March 2008, and it is a
forecasted value for the year 2008-09.
Correlation Table 1
Growth Rate of GDP
Pre-Reform Post-Reform All Years
(1980-2008)
Inflation rate based on WPI 0.352 -0.347 -0.102
does not fuel inflation if it does not lead
to a continuing wage-price spiral. The
current inflation rate, although stimu-
lated by a sustained rise in oil prices, the
price of steel, etc, is also fuelled by a grow-
ing supply of liquidity as reflected in
growth of all kinds of monetary aggre-
gates. Rising liquidity may stimulate out-
put demand via Keynesian logic, but more
often than not it chases output supply and
causes inflation. As far as my information
goes, the long-run relationship between
growth in money supply and growth in
prices anywhere in the world is almost
one to one. It is as if the quantity theory of
money holds over the long run. But what-
ever it is, the short-run adjustment problem
can be quite critical both from economic
and political perspectives. For example,
runaway inflation threatens the real
income of fixed income earners. The subse-
quent rise in interest rates is supposed to
hurt business groups, giving enough
ammunition to political opponents. If infla-
tion has a negative impact on output, the
waiting period for it to return to the pre-
inflation level can be a long one. So short-
run problems are difficult to handle and
the monetary authority currently has its
hands full in this respect, although over
the long-run there may not be any real
balance effect. The point I would like to make
in the current context is argued out below.
CENTRE FOR DEVELOPMENT STUDIES
Thiruvananthapuram
commentary
The current episode of inflation is caused
both by a rise in international prices over
which we do not have full control and by
an enormous growth in money supply and
liquidity. Thus, a part of the inflation
dynamics is related to our national policies
or policies pursued by the RBI. The other
part is currently beyond our control, such
as a rise in the price of oil or price of steel.
We can try to suppress these artificially, but
eventually we have to face the music. The
growth in demand for oil and steel all over
the world will trouble us as ours has
become an open economy and we have to
import both. In this note I am not going to
analyse the reason behind the rise in inter-
national prices. Instead I shall focus on the
monetary factors.
Even when we were not so affected by
rising world prices, we have been receiving
a huge amount of foreign capital inflows.
Sterilisation as a policy option ran out of
steam, as it was impossible to sterilise so
much. The RBI did try from time to time
but the stocks of transactable bonds
reached an all time low. So money supply
had to grow. Dollar reserves could not be
disposed of at all, partly due to the fact that
it would strengthen the rupee and put
exporters to further distress. For a respon-
sible monetary authority it is important to
have sufficient reserves to fend off specula-
tive outflow. However, growing capital

unemployment statistics. Since we are not Vacancy Announcement

as knowledgeable as business journalists
or as confident as political critics and since
we are fully appreciative of the RBI’s
effort to cool a heated economy, we make
a humble effort to explore the logic of
policy- making at this juncture. If infla-
tion creeps up, the interest rate has to
rise. What does it do to the growth rate?
What really is the association between
the real rate of interest and growth rate
of GDP? For all practical purposes, this is
an explanatory note.
A prelude to our analytical observations
must be presented in terms of a discussion
on factors determining inflation.
Inflation is a state of sustained price rise.
A one-shot rise in prices, however caused,
Economic & Political Weekly  EPW   september 6, 2008
Post-Doctoral Fellows: Applications are invited for two positions in the
Research Unit on International Migration. The scholars, in addition to their
involvement in Unit’s research programme, will be assigned for the research
on ‘migration from Punjab to Britain’ which is interdisciplinary in nature and
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13
commentary
flows have led to an excessive accumula-
tion of reserves. The same problem has
been faced by the Chinese monetary
authority and the policy response has been
somewhat similar. The track record of both
these authorities has been commendable
given the fact that these two major powers
did not really suffer from the Asian financial
crisis in 1997. All said and done we still do
not know, or we do not have any workhorse
of a theory to judge the optimal level of
foreign exchange reserves.
Growth in money supply and liquidity
through an enormous expansion of bank
credit have fuelled aggregate demand
more than aggregate supply can digest
and that is contributing in a significant
manner towards inflation. If this is true
then the RBI policies will be increasingly
put under scanner. This does not mean
that the policies adopted so far have
not been useful. But that is a different
exercise. The point is that if the prices rise
further in the form of a higher inflation
rate, the only relevant policy to tackle
short run adjustment problems has to be
through a rise in the relevant interest rate
either through an increase in the cash
reserve ratio (CRR) or repo rate or a combi-
nation of both. What should be the out-
come of such policies? Interest groups are
already voicing their concerns. Politicians
are also very critical given that elections
are nearby. More significantly, policy
options to RBI are rather limited.
Growth, Inflation and Real
Interest Rates
The connection between inflation and
unemployment has been a favourite topic
for the macroeconomists. The Keynesian
policy of stimulating demand through
f­iscal and monetary measures presumes
that in an excess capacity economy prices
should not increase much with increasing
aggregate demand. In the post-Depression
era in the west there was increasing con-
cern regarding the effectiveness of such
policies when inflation started flaring up.
The famous Phillips curve and the sub­
sequent analyses by the monetarists
demonstrated that there is a cost of reduc-
ing the rate of unemployment through
monetary expansion since the rate of infla-
tion must increase when the rate of unem-
ployment is pushed back from its “natural”
14
level. Since then debates have never But in the post-reform period it is rather
stopped regarding the mechanism by strongly negative (-0.347); whereas in the
which money affects real output in the pre-reform period it is positive (0.352). It is
Pattern of relation between Rate of Inflation and Real Lending Rate
short run, often admit- Figure 1: Pattern of Relation between Rate of Inflation and Real Lending Rate
ting that over the longer 14.00
14.00
run, the quantity theory 12.00
12.00
type of relationship holds 10.00
between the growth of
Real lending rate
8.00
8.00
Real lending rate
money supply and rate 6.00
of inflation.
4.00
4.00
It is a serious problem
2.00
to conceptualise a rela-
0.00
0.00
tionship such as the Phil- 0.00 4.00 8.00 12.00 16.00 20.00
lips curve in an economy
-2.00
Rate of inflation
where most of the prices -4.00
-4.00
Source: Handbook of Statistics on Indian Economy, RBI Bulletin and EPWRF’s ‘Current Statistics’.
are administered, where
unemployment data are not of a desirable difficult to interpret the data, and also deci-
standard, and where a majority of the pher what causes such correlation. But over
workforce remains engaged in unrecorded the past 15 years they are negatively related.
activities. Nonetheless a first hand approx- This is a relationship exactly opposite to
imation is possible if one is willing to what is predicted by the P­hillips curve,
replace the rate of unemployment variable higher inflation implies lower growth and
by the rate of growth of GDP, of course in hence possibly a higher rate of unemploy-
terms of its inverse. Before one goes about ment. Again the “un­­employment” story is
checking their cointegrating properties, hard to rely on. First, if we are getting accus-
given the contemporary concern regard- tomed to a phase of moderately jobless
ing snowballing inflation rates, one would growth in the organised sector, then the rate
like to know, how they move together. of unemployment should not be affected
Table 1 (p 13) gives a picture of roughly a much by a decline in the GDP growth rate.
decade before and after the reform period On the other hand, we do have information
of 1991-92. that the real informal manufacturing wage
The overall correlation between GDP has increased substantially during the same
growth and inflation is negative (-0.102). period. A simple negative correlation will
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september 6, 2008  EPW   Economic & Political Weekly

Table 2: Pre- and Post-Reform
Rate of Growth of GDP and Lending Rate
Year Lending Inflation Rate Real Lending Growth
Rate Based on Rate Based Rate of
WPI (AC) on WPI GDP
Pre-liberalisation
1980-81 16.5 18.24 -1.74 7.2
1981-82 16.5 9.33 7.17 6.0
1982-83 16.5 4.90 11.60 3.1
1983-84 16.5 7.53 8.97 7.7
1984-85 16.5 6.47 10.03 4.3
1985-86 16.5 4.41 12.09 4.5
1986-87 16.5 5.82 10.68 4.3
1987-88 16.5 8.14 8.36 3.8
1988-89 16.5 7.46 9.04 10.5
1989-90 16.5 7.46 9.04 6.7
1990-91 16.5 10.26 6.24 5.6
Post-liberalisation
1991-92 17.88 13.74 4.14 1.3
1992-93 18.92 10.06 8.86 5.1
1993-94 16.25 8.35 7.90 5.9
1994-95 14.75 12.60 2.15 7.3
1995-96 15.46 7.99 7.47 7.3
1996-97 15.96 4.61 11.35 7.8
1997-98 13.83 4.40 9.43 4.8
1998-99 13.54 5.95 7.59 6.5
1999-2000 12.54 3.27 9.27 6.1
2000-01 12.29 7.16 5.13 4.4
2001-02 12.08 3.60 8.48 5.8
2002-03 11.92 3.41 8.51 4.0
2003-04 11.46 5.46 6.00 8.5
2004-05 10.92 6.48 4.44 6.9
2005-06 10.75 4.38 6.37 8.8
2006-07 12.25 5.42 6.83 9.7
2007-08 12.75 2.86 9.89 9.6
2008 12.75* 10.94* 1.81 8.1*
Source: Handbook of Statistics on Indian Economy, RBI Bulletin,
and EPW Current Statistics.
*Source of the data for lending rate in RBI Bulletin; June
volume, and prime lending rate is the average value for the
months of February, March, and April 2008.
*Source of the data on inflation rate for 2008 is EPW, Current
Statistics; volume: June 28-July 4, and value of WPI is for the
month of June 2008.
*Source of the data for the growth rate of GDP is RBI
Publications, Survey of Professional Forecasters – Results of
Third Round relating to Fourth Quarter ended March 2008, and
it is a forecasted value for the year 2008-09.
Correlation Table 2
Growth Rate of GDP
Pre-Reform Post-Reform All Years
(1980-2005)
Real lending rate
based on WPI -0.352 0.041 -0.169
Change of Growth Rate of GDP
Change of real lending
rate based on WPI -0.258 0.3007 0.437
not capture many such things. But it will be
really worthwhile if some serious work is
initiated in tracking the relationship
between inflation and GDP growth.
As hinted earlier, excessive liquidity
growth coupled with rising world prices are
plausible factors fuelling the current infla-
tionary trends. The RBI has been adopting a
method of raising the CRR and repo rates,
thus eventually raising market interest rates
from time to time. Given an ineffective steri­
lisation process, this is the strategy one
Economic & Political Weekly  EPW   september 6, 2008
commentary
would naturally recommend, though I would Simply speaking, the rate of physical
believe we could have been more aggres- capital accumulation has not been
sive on this front and the interest rate s­ubstantial if we take an average of the
should have been raised earlier. The issue last 10 years. It will be somewhere around
of whether the rising interest rate will hurt 25 per cent of GDP. The next issue is
GDP growth seems to have been resolved by whether real interest rates affect long-term
the business and media. It is now left to the i­nvestments. There have been many
people working in the academic and policy studies, including a firm level study con-
spheres to appreciate their wisdom. ducted at the Centre for Studies in Social
A fundamental question in this context Sciences, Calcutta, some years ago on
is what really causes GDP growth in behalf of the IDBI, which show that real
India. If one can identify such a set interest rates do not explain private invest-
of factors, then the next question will ment. There are many other factors such
be how changes in real interest rates as expectations about future demand and
affect such factors. Several contributions infrastructure which are far more impor-
such as by Khasnobis and Bari (2003), tant. Thus physical capital accumulation
Subramanian (2008), Marjit and Das (2008), does not explain our growth process and
Nagaraj (2008), etc, have dealt with similar physical capital accumulation is not very
issues. It is mostly a rise in “productivity” much influenced by the real interest rate.
of some sort that drives our growth. The Table 2 demonstrates the absence of a
overall rate of investment, i  e, the aggre- significant correlation between real interest
gate investment/GDP ratio was moderate rate and GDP growth rate. Again this
even two to three years ago notwithstand- correlation might be an outcome of combi-
ing the fact that suddenly there has been a nation of systematic and idiosyncratic shocks,
huge upsurge, thanks to a p­henomenal etc. But prima facie there is no e­vidence that
rise in private investment. But one must the growth rate will be drastically altered
remember that our high growth phase with an increasing real interest rate.
did coincide substantially with a fairly Now we come to the most shocking rev-
moderate rate of aggregate investment. elation and refutation of popular wisdom.
Call for Conference Papers...
The Character and Trajectory of the Indian Economic Formation
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26- 28th November 2008
University of Delhi, India
Contact: indian.formation@gmail.com
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Intellectually, this conference relates to two preceding theoretical attempts within social science to
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The focus is not to characterise processes in any one sector alone. On the contrary, this conference
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The opening keynote will be given by eminent University of Delhi historian Professor K.M. Shrimali.
This conference has been initiated mostly by Indian scholars. However, the participation of researchers
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On behalf of the conference organising committee:
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of Delhi, Rona Wilson, Ph.D. scholar, JNU, New Delhi and Simon Chilvers, Ph.D. scholar, Faculty of
Graduate Studies, York University, Canada.
The conference is endorsed by Journal of Peasant Studies, Capital & Class, Conference of Socialist
Economists, and Human Geography.
15
commentary
Figure 1 (p 14) plots the rate of inflation
against the real lending rate, i   e, the real
prime lending rate between 1980 and 2008.
It depicts a clear negative relationship. As
the rate of inflation goes up, whatever be the
response of RBI policies and private sector
strategies, eventually real lending rate
actually goes down! It is well known that
rising inflation, ceteris paribus, is a boon to
borrowers; in real terms they have to pay
back less than the initially contracted
amount. If lending was inflation indexed,
the real lending rate should remain the
same before and after inflation. If the nomi-
nal rate adjusts less than the inflation rate,
Global Financial Crisis:
A Long Way from Recovery
Ignatius Chithelen
While there are optimists who
expect a revival in the economic
downturn in the United States,
a downturn which has had a
negative impact on the emerging
markets, the pessimists counter
that there will soon be more
financial turmoil as the housing
crisis, credit contraction and
losses worsen. With the balance
heavily tilted towards the bearish
case, this article argues that most
economies and financial markets  On the financial side, bank credit growth
around the world are likely
to be flat or down over the next
few years.
Ignatius Chithelen (igch@btcapital.biz) is with
Banyan Tree Capital Management, New York.
16
the borrowers must gain and that has hap-
pened in all the years. Whenever the rate of
inflation increased, the borrowers mainly
the business groups always retained some
advantage from higher inflation.
The problem is that the mythical story
of a rise in interest eating into incentives to
invest and hence paralysing growth, rotates
around economic arguments developed
in the pre-historic age of the discipline of
Economics. For reasons obvious to many,
much wisdom is dug out of its grave by
the captains of modern day finance and
technology experts for pressu­rising the
government and creating policy paranoia
T
he global financial crisis, the worst
since the depression of the 1930s, is
unlikely to end soon. Since it began
in mid-2007, the United States (US) econ-
omy has had tepid growth. Some econo-
mists say the US is currently in a recession,
together with Japan and the European
Union (EU). In fact, the Japanese economy
shrank at an annualised rate of 2.4 per
cent in the April to June quarter, while
that in the EU fell by 0.2 per cent. The
downturn in the deve­loped countries has
had an impact on other countries: growth
in most emerging economies has slowed
considerably.
in the US contracted at an annualised 5.8
per cent rate in the April to June quarter,
the largest drop since such data were first
collected in 1947. This credit tightening
has spread from the US, dampening eco-
nomic activity at all levels and around the
world. At one end, even solvent, high
income Americans find it difficult to qualify
for loans to buy a home. At the other end,
several major projects in developing coun-
tries have halted due to lack of equity and
debt capital, including plans in India to
add 90,000 MW of power capacity by 2012.
Equity indexes in the developed countries
are in a bear market, with declines of over
september 6, 2008  EPW   Economic & Political Weekly
of some sort. This also calls for a method
of corporate accoun­ting which must look
into the “real” side of the problem.
References
Basudeb, Guha-Khasnobis and Faisal Bari (2003):
‘Sources of Growth in South Asian Countries’ in
Isher Judge Ahluwalia and John Williamson
(eds), The South Asian Experience with Growth,
Oxford University Press, New Delhi.
Marjit, S and K P Das (2008): ‘Financial Sector Reform
for Stimulating Investment and Economic
Growth: The Indian Experience’, ADB
Volume, Oxford University Press, New Delhi
(forthcoming).
Nagaraj, R (2008): ‘India’s Recent Economic Growth’,
Economic & Political Weekly, 43 (15).
Subramanian, A (2008): India’s Turn: Understanding
the Economic Transformation, Oxford University
Press, New Delhi.
20 per cent. The losses are far mere severe
in emerging stock markets, notably in the
major ones of China and India.
Housing Crisis
Since the crisis was triggered by collaps-
ing home prices in the US, it is likely to
come to an end only after prices reach a
bottom. Stable home prices “will clarify
the level of equity in homes, the ultimate
collateral support for much of the finan-
cial world’s mortgage backed securities”,
says former US Federal Reserve Bank
(Fed) chairman Alan Greenspan [Green-
span 2008]. Over $ 6 trillion of such secu-
rities were created by Wall Street firms, by
packaging individual home loans made in
the US.1 Already some $ 500 billion in
losses on these securities have been recog-
nised by financial and other institutions
around the world. But it is the fear of the
size of the unrecognised losses, and its
i­mpact, that is crippling financial markets.
President George Bush initially said that
his government had no responsibility to
bail out home owners, especially housing
speculators. But, under pressure from
R­epublican congressmen worried about
losing their seats in the upcoming Novem-
ber elections, the Bush administration has
taken some measures. In July the govern-
ment said it is explicitly backing the debts
of Fannie Mae and Freddie Mac (the l­argest
US housing finance companies), thereby
ensuring adequate and cheap funding for
these institutions, which t­ogether provide
financing for 80 per cent of loans being cur-
rently made to home buyers; most of the
other 20 per cent is finan­ced by the Federal