The Growth Inflation Trade Off

Jul 21, 2012


- By Asad Dossani, Author, The Lucrative Derivative Report

Asad Dossani
Earlier in the week, Indian inflation data came out better than most analysts had expected. Inflation has fallen to 7.25%, the lowest level in 5 months. Still, this level is not low enough that inflation is not a problem. The RBI governor's comments still suggest that they are willing to keep rates high, and sacrifice some growth in order to restrain inflation.

The growth inflation trade off is a well-known phenomenon. The Reserve Bank of India (RBI) can lower rates, which would increase growth but also increase inflation. Alternatively, the RBI can hold or raise rates, which would hurt growth but also decrease inflation. So what is the right thing to do?

The fact is that not everyone is affected in the same way by growth and inflation. For certain people, high inflation and high growth makes them worse off, as compared with low inflation and low growth. And vice versa for others.

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For example, someone who earns a fixed wage and works in a sector that is not affected much by growth (e.g. teachers and civil servants), would much prefer lower inflation and low growth. High growth doesn't really benefit them, but high inflation reduces their spending power due to their fixed wages.

These wages tend to not keep up with inflation, so they would benefit from central bank policies that aim to contain inflation. The same applies to those on the lowest of income levels. Individuals who work as drivers, servants, etc., all tend to have fixed wages that are unlikely to keep up with high inflation.

On the other hand, consider an individual that works in sales. A large portion of his earnings comes from commissions, and higher GDP growth will usually result in more sales, more business, and higher income. Individuals who work in industries that depend a lot on economic conditions will usually benefit from higher growth, even if it means higher inflation at the same time. Entrepreneurs and business owners would fall in the same category.

As an investor, if you have a large stock portfolio, you are more likely to benefit from pro-growth policies at the expense of inflation. If you are primarily invested in fixed deposits, then inflation is the biggest enemy. In general, the richer you are, the more likely you are to invest in stocks, so the more likely you are to favor growth.

The growth inflation trade off affects different groups of society in different ways. This explains why businesses tend to complain most about the RBI keeping interest rates high. And also why the poor and middle class complain most about high inflation. The RBI's job is to correctly balance this trade off, so that everyone is better off in the long run.

is a financial analyst and columnist. He actively trades his own and others' funds, investing primarily in currency, commodity, and stock index derivative products. Prior to this, he worked at Deutsche Bank as an analyst in the FX derivatives team. He is a graduate of the London School of Economics. Asad is a keen observer of macroeconomic trends and their effects on global financial markets. He is deeply passionate about educating investors, and encouraging individuals to take part in and profit from financial markets. To put it colloquially, he wishes to take Wall Street products and turn them into Main Street profits!

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3 Responses to "The Growth Inflation Trade Off"

PHM Salih

Jul 23, 2012

RBI's job is really unenviable what with the tight-rope walking it has to do to get the trade-off correctly balanced. It is common knowledge that inflation hurts the common man more than what he benefits from a higher growth.

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praveen Bhargava

Jul 22, 2012

India is a developing country with a large population of 1210 Million people to have food,cloth and house to lead a somewhat comfortable life.
In this background Indian Economy needs high growth with more employment.The negative effect of high growth comes in the shape of high inflation but that can be absorbed on the expense of more industrial/business activity as well as more employment.

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Kuldeep Nayar

Jul 22, 2012

There are more fixed wages earners than investors & businesses. So it behooves the RBI to make inflation control it's first priority. The sooner we understand this truth, the better would be the chances of growth with stability. Western economies live with very low inflation & modest growth. But they innovate, develop new & efficient technologies constantly. We need more innovation than growth. The better we are in R&D, the better will be our economic stability and happier will be the general populace. A country of billion plus people and yet we are always buying foreign technology, what a shame! Policies must be framed to encourage greater investment in innovation rather than baying at the RBI to do something. Let the financial services be subservient to innovation and manufacturing and not vice versa.

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