Professor Ravindra H. Dholakia, Dr. Jai Chander, Smt. Ipsita Padhi, and Shri Bhanu Pratap co-authored a report titled “Threshold level of  economy Inflation — Concept and Measurement” that was published on the Reserve Bank of India’s website on May 24, 2021.

The idea of threshold inflation in economy is examined in this paper, and it is defined as the long-run equilibrium rate of inflation that maximises steady-state growth within the relevant range of values. The study’s empirical findings show that emerging market nations have higher threshold inflation and growth than advanced nations.

Let me clarify the study, which is essentially a study of the threshold inflation rate that maximises long-term growth in an economy and its impact on the fiscal and current account deficits (CAD).

The research is 46 pages long, including seven chapters and appendices A1 through A6.

Let me explain in layman’s terms what the phrases fiscal deficit, GDP, and inflation mean.

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A fiscal deficit occurs when a government’s revenue falls short of its spending. A government with a budgetary deficit is spending more than it can afford.

A fiscal deficit is measured as a percentage of GDP, or simply as total dollars spent over income. In any situation, the income figure only includes taxes and other receipts, not money borrowed to make up the difference.

The total monetary or market worth of all finished goods and services produced within a country’s boundaries at a given moment is known as the gross domestic product (GDP).

What about inflation?
  • Inflation is defined as the rate at which the value of a currency declines, resulting in an increase in the overall level of prices for goods and services.
  • Demand-Pull inflation, Cost-Push inflation, and Built-In inflation are three forms of inflation that are occasionally used to classify it.
  • The Consumer Price Index (CPI) and the Wholesale Price Index (WPI) are the two most often used inflation indices (WPI).
Inflation Threshold – Definition and Measurement

Speaking in the authors’ tongue ‘Macroeconomic management in any economy normally begins with the establishment of key aggregate targets to be met over a five- to ten-year time horizon. The growth rate of real GDP, retail inflation rate, fiscal deficit (FD) to GDP ratio, and current account deficit (CAD) on the balance of payments to GDP ratio are the most common metrics in most countries.”

What about our country?

The goal of FD/GDP and inflation rate were assigned to the Ministry of Finance and the Central Bank of the country, namely, RBI, in our country, because fiscal and monetary policy are more carefully defined macroeconomic policies.

To bolster my case, I’ll actually quote the applicable legislation.

Between 2003 and 2010, the Central Government passed the Fiscal Responsibility and Budget Management (FRBM) Act, and comparable legislation was passed in every state government in India.

In India, inflation targeting was formally established on June 27, 2016, when the Reserve Bank of India (RBI) Act was amended. Both of these pieces of legislation set official targets for the FD/GDP ratio and the inflation rate, which were to be met over a long period of time.

We also understand that only two of the four targets will be considered for achievement, with the remaining two being ignored.

               Section 206C(1H) of the Income Tax Act 1961 at a Glance.

Our Prime Minister set the ambitious goal of achieving a $5 trillion GDP by 2024-25, meaning an annual real growth rate of 8% for the next six years (GoI, 2019). Although the CAD/GDP target has not been formally set, most economists and analysts believe it is wise to keep it around 3%. Whenever there is a discussion on central government expenditures to be incurred/actually incurred, these targets are given the attention they deserve.

When inflation is higher than the threshold level, estimated at 6 per cent for India, reduction in inflation rate leads to a much smaller gain in the long-term growth compared to when inflation is lower and rises towards the threshold level, according to a Reserve Bank of India study.

The Study estimated the trade-off between long run inflation and steady State growth (SSG) rate, whereby the long-term growth would fall by 40 basis points/bps (or 0.4 percentage point) if the initial inflation rate was less than the threshold rate.

However, the findings of the present study caution the policy makers not to ignore the probable cost of lower inflation in terms of lower long-term growth of output and employment and hence lower rate of the poverty reduction.

These costs and benefits of fixing a long-term inflation target will have to be considered while making the choice, the authors opined.

The findings of the Development Research Group (DRG) Study show that the threshold inflation and corresponding growth are not unique for a country but depend on the other two parameters – Fiscal Deficit (FD)/GDP and Current Account Deficit (CAD)/GDP.

If a country chooses the target values of FD/GDP and CAD/GDP to be achieved in the long run, its potential output  economy growth gets determined through the corresponding value of threshold inflation.

“If the country then chooses an inflation target that is lower than the threshold level, it cannot achieve its potential output growth and the system would remain in long-run disequilibrium requiring constant policy interventions to stabilize,” the authors said.