Threshold Level of Inflation – Concept and Measurement

Abstract

Threshold inflation that maximizes long-term growth in an economy is dependent on fiscal deficit (FD) and current account deficit (CAD). Since the existing empirical literature on threshold inflation lacks a robust theoretical framework, the present study considers the theory developed by Dholakia (2020) to estimate threshold inflation that maximizes steady state growth (SSG). Based on an appropriate degree of polynomial for investment rate and capital productivity with a cross-country data set of 58 countries for the period 1995 to 2018, the study broadly confirms higher threshold inflation with higher growth in emerging market economies as compared to the advanced economies. By introducing country-specific intercept and selected slope dummies, the study finds that the threshold inflation for India is around 6 per cent. An important finding of the study is that the long run trade-off between inflation and SSG is asymmetric such that a reduction in inflation rate leads to a much smaller gain in the long-term growth when inflation is higher than threshold compared to when inflation is lower and rises towards the threshold level. Also, the threshold inflation and corresponding growth are not unique for a country but depend on the other two parameters – FD/GDP and CAD/GDP. Policymakers may choose to set the inflation target below the threshold level only after considering the costs of sacrificing growth and implied poverty alleviation rate with likely benefits in terms of the distributional and financial stability implications which are not examined in this study.