By Jay Thakkar and Harshal Sharma


There is great debate over the belief whether inflation promotes economic growth or not. The relationship between inflation and growth is a controversial one not only in theory but also in empirical findings. A group of economists supporting Keynes are of the opinion that inflation is a factor that contributes to economic growth. Keynesian theory states that inflation leads to redistribution of income and wealth. Keynes favors mild inflation on the grounds that it tends to increase business optimism due to rising prices, resulting in high profit expectation that stimulates further investments, output, employment and income. However, another group of economists are of the view that inflation does not contribute to economic development but on the contrary, works as an inhibitor. For instance Milton Friedman completely disagrees with the policy of development through inflation. We have tried to investigate the interactive effects between inflation and economic growth for India and the need for regulating inflation in its current developing phase.

The Relationship between Economic Growth and Inflation

The relationship between inflation and economic output is very delicate. Investors highly value GDP growth, as cash flows that are the key driver of valuation/performance of company’s stocks won’t increase if economic output of a country is falling or is in a steady state. On the other hand, if there is too much growth in GDP it leads to an increase in inflation, which undermines stock market gains as the money and future profits become less valuable than they are today. Today, most economists agree that a growth rate of 2.5 – 3.5% is safely attainable without any negative effects.

Over time, the growth in GDP would lead to inflation, and the rate will keep on rising as inflation engenders inflation. Once this progression starts, it doesn’t take much time for it to become a self-reinforcing feedback loop. The Rational Expectations Theory suggests that in the times of increasing inflation, households tend to spend more money as they are aware of the fact that the money will be less valuable in the future. Because of more expenditure by the people, there is an increase in GDP in the short run that leads to further increase in the prices of the goods and services. Also, a very peculiar feature of inflation is that the effects of inflation are nonlinear, i.e. 10% inflation is not just twice as harmful as 5% but much more than that. Most advanced economies have learned these lessons through experience. In 1980s when there was a prolonged period of high inflation in the US, the economy was restored only by going through a painful period of high unemployment and lost production, as prospective capacity remained idle.

So what is the ideal inflation level? While some economists insist that advanced economies should aim to have 0 percent inflation i.e. stable prices, the general consensus is that a little inflation is actually a good thing.

Relationship between GDP and CPI Growth Rate for India

The graph below plots the quarter on quarter GDP growth rate and CPI growth rate. It can be observed that economic growth rate is inversely related to CPI growth rate.


It can be observed that there is a significant relationship between GD growth rate and inflation growth rate represented by a negative correlation coefficient. The value of adjusted R square is low due to other factors like exchange rate, technological development, natural resource availability, social and political conditions that influence the economic growth.

Major Reasons why Economic Growth and Inflation Control can’t go together

When inflation is high, interest rates are hiked. The reason being, a high interest rate will discourage additional borrowings. This shall reduce the amount of money people have in their hands to spend. Traditional economic theory suggests that as demand falls, prices also fall. Thus, RBI aims to control inflation by increasing interest rates. When economic activities falter, a cut in interest rates is required. This is because companies need to borrow in order to invest in new projects. A fall in interest rates reduces cost, thereby increasing profitability. This encourages borrowing, which in turn, helps fuel the economy.

A high interest rate is detrimental to growth. Companies discontinue expansion or growth plans due to high interest rates. They are forced to cut costs to maintain profits. This passes across the economy including the labor market. A low interest rate can cause a rise in inflation. This is a result of more money in the system. This leads to an overall price rise as demand increases. A high interest rate controls inflation but retards growth. In contrast, a low interest rate is beneficial for overall economic growth. Therefore, both economic growth and inflation cannot be targeted together.

RBI’s Stance

The goal of RBI’s monetary policy is primarily price stability, while keeping in mind the objective of growth.

The Dr. Urjit Patel Committee Report posited a few key recommendations; in 2014 a “glide path” for disinflation was announced. The aim was to maintain the CPI inflation at 8% by January 2015 and below 6% by January 2016. The Agreement on Monetary Policy Framework between the Reserve Bank of India and Government dated February 20, 2015 wants to maintain the consumer price index-combined (CPI-C) below 6% by January 2016 and 4% (+/-) 2% for the financial year 2016-17 and all subsequent years. Whilst formulating the monetary policy we focus on price stability and growth. However, the focus on each of these objectives varies across time depending on the evolving macroeconomic conditions. Various changes in the economic environment will dictate alteration of the objectives to facilitate the maintenance of price stability to ultimately achieve growth.

The Reserve Bank of India controls the amount of money in the system as well as the dominant interest rates. It reviews its policy regularly through the credit policy. This is dependent on multiple macro-economic factors like inflation, industrial production data and job growth. This often leads to a debate over growth and inflation control. India has never followed inflation targeting as a tool to control inflation. But, according to Narasimham and Rajan committee the central bank clearly lacks direction and needs one tool to focus on develop their monetary policy. They say that in a country like India where the central bank is independent of the government and the inflation rate is considerably low, a monetary policy targeted around keeping the inflation rate low and stable will accelerate output growth. Inflation targeting helps in reducing inflation volatility and inflationary impacts of shocks. It also leads to increased anchoring of inflation expectation.

There was a lot of backlash regarding this move as people felt that the central bank has various factors to monitor such as price stability, growth and financial stability and that India does not have the framework for the successful implementation of IT such as developed financial markets, confidence of global markets, and independence of RBI. Inflation targeting would also restrict the RBI’s ability to respond to financial crises or unforeseen events. It could also lead to potential instability in the event of large supply side shocks.


A macroeconomic policy ideally should aim at high economic growth accompanied with low levels of inflation. However, in reality, accomplishing both a low inflation rate and a rising economic growth is never possible. However, low inflation rate does not indicate slow economic growth. In situations of excess money, consumers begin the process of bidding which results in escalation of the cost of goods. In the case of Indian economy, a number of studies failed to establish any conclusive relationship between inflation and economic development. Low level of inflation is advantageous for development, but once inflation goes below a certain level it retards economic development. Therefore, it is mandatory to perform inflation control at an acceptable level to promote optimum economic growth.


Year Quarter Total Gross CPI GDP growth rate CPI growth
2011-12   Q1 19717.87 106.489
Q2 19109.98 110.658 -3.08% 3.91%
Q3 20737.12 112.553 8.51% 1.71%
Q4 21501.59 113.311 3.69% 0.67%
2012-13   Q1 20779.26 117.29 -3.36% 3.51%
Q2 20468.18 121.458 -1.50% 3.55%
Q3 21743.09 123.922 6.23% 2.03%
Q4 22474.99 126.098 3.37% 1.76%
2013-14   Q1 22164.9 128.856 -1.38% 2.19%
Q2 21990.4 134.773 -0.79% 4.59%
Q3 23122.19 138.172 5.15% 2.52%
Q4 23566.2 136.493 1.92% -1.22%
2014-15   Q1 23805.34 138.971 1.01% 1.82%
Q2 23781.78 143.769 -0.10% 3.45%
Q3 24661.67 143.769 3.70% 0.00%
Q4 25026.12 143.689 1.48% -0.06%
2015-16   Q1 25514.35 146.048 1.95% 1.64%
Q2 25520.95 149.446 0.03% 2.33%
Q3 26353.58 151.445 3.26% 1.34%
Q4 26883.03 151.245 2.01% -0.13%

Table 3

Source: RBI website


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harshal-sharmaAbout the author:

The author is currently a student of batch 2015-17. His area of interest is Banking, Economics and Corporate Finance. You can contact him at

img-20161015-wa0007About the author:

The author is currently a student of batch 2015-17. His area of interest is Economic Analysis, Corporate Finance and Investment Banking. You can contact him at


Ashwath Narayana B Sanket

Tuhina Kumar


The aim of this research paper is to critically examine how important it is to have the appropriate rate of GST and how this rate will affect government revenue. This is done by analyzing the various factors that affect the appropriation of the GST rate. We will also examine the impact of GST on inflation and the effects of having a high or low RNR rate. We conclude by examining the long-term effects of implementing GST.

Need for GST

In developing countries like India, the government plays an important role in augmenting the growth and development, given the paucity of private capital and initiative. The government is also responsible for supporting the economically backward classes, maintaining law and order and security of the country (9). To carry out these responsibilities, the government needs sufficient revenue. Revenue collection is done through various means like taxes, fines, fees and charges, and foreign grants of which taxes form a major chunk.

Row Labels Sum of Revised 2014-15 Sum of Budget 2015-16
Direct 705628.0 797995.0
Corporation tax 426079.0 470628.0
Income tax 278599.0 327367.0
Wealth tax 950.0
Indirect 545763.2 651495.6
Customs 188713.0 208336.0
Service tax 168132.0 209774.0
Taxes of union territories 3437.8 3577.0
Union excise duties 185480.4 229808.5
Grand Total 1251391.2 1449490.6

Table 1: Revenue from taxes, Source: (8)

The government earns 14,49,490 crores from taxes, the breakup of which is given in Table 1. Indirect taxes contribute a significant 44.95% to the total tax revenue. Hence, it is important to streamline this tax base. Introduction of GST will remove the multiplicity of taxes and simplify the tax structure.

Revenue Neutral Rate (RNR)

Since GST is a value added tax that provides tax credits for the taxes charged on the preceding stage of production, it will eliminate the cascading effects of taxes. This, in turn, might reduce the total government revenue from indirect taxes. To avoid this loss in revenue, the government will have to raise its taxes. This increased tax rate that ensures the government earns consistent revenue is called the revenue neutral rate (RNR). The committee headed by the Chief Economic Advisor of India, Arvind Subramanian, submitted a report that suggested an RNR of 15-15.5%. The principle behind calculating this RNR is defined by the following basic equation:


where ‘t’ is the RNR, ‘R’ is equal to the revenue generated from the current sales tax (12.5%) and the exercise tax (14%). This revenue which will be replaced by the GST is estimated to be 3.28 lakh crore from the center and 3.69 lakh crore from the state, which sums up to 6.97 lakh crores (Excluding revenues from petroleum and tobacco for the Centre, and from petroleum and alcohol for the States) or 6.1 per cent of GDP. Now the total potential tax base ‘B’ should be determined to calculate the RNR(1).

The committee has used three methods to determine the total potential tax base; the macro approach, the indirect tax turnover (ITT) approach, and the direct tax turnover (DTT) approach. This paper will explain the macro approach. In this approach, the tax base is calculated using the data from national income accounts. As per the Arvind Subramanian report, the base ranges from 59 per cent to 67 per cent of the GDP. This calculated base excludes the basic food items, petroleum, and electricity(1).

As stated earlier, the total revenue to be replaced by the GST is 6.1 per cent of the GDP. By using the basic formula t=R/B, the GST RNR ranges from 9.1 (0.061/0.67) to 11.1 per cent (0.061/0.55). For OECD (Organization for Economic Co-operation and Development) countries, there is commonly a loss of 10 to 20 per cent in revenue (1). Taking this loss into account the RNR ranges from 9-11 per cent to 11-14 per cent(1).

The aforementioned approaches have their own merits and demerits because of the underlying assumptions and data used. The Subramanian committee evaluated these and made suitable adjustments to arrive at an RNR rate of 15-15.5%

Standard Rate of GST

The standard rate is calculated using the below mentioned formula (1):

R=αLG +βSG +γSS +μDG

Where ‘R’ is the RNR, ‘LG’ is the lower rate on goods, ‘SG’ is the standard rate on goods, ‘SS’ the standard rate on services, and ‘DG’ the demerit rate on goods; α, β, γ, and μ are the respective shares of these four rates in the underlying tax base, and together add up to 1(1). Hence the whole rate structure depends on policy choices about exemptions, what commodities to charge at a lower rate, and what to charge at a higher rate. Figure 1 shows the standard rate of GST in some emerging economies.

pic1Figure 1: Standard rate of GST in high income and emerging markets economies, Source: (1)

The average standard rate in emerging market economies (EME’s) is 14.1% and the highest standard rate is 19% while for high income countries, the average standard rate is 16.8%. As India is an emerging market economy, an RNR of more than 15-15.5% will lead to a standard rate of 19-21%(1).

It should be kept in mind that GST is a regressive tax, which means that an increase in price due to increase in tax rates will extract a higher proportion of income from a consumer belonging to a lower income group. Developed countries can effectively offset the impact of regressive taxation by increasing their government spending and introducing many social security schemes. But India, being an emerging economy, will be unable to do so in their already limited budget. Hence India needs to be cautious of very high interest rates.

Learnings from other countries

As observed in countries like Australia, New Zealand and Canada, the implementation of GST will lead to a one-time price increase in the short-run but this inflationary effect will be stabilized in the long-run.

Canada follows a dual-rate GST system like the proposed GST system in India. Its initial GST rate of 7% lasted for 15 years after which it was reduced twice by 1% in 2006 and 2008. Canada has been decreasing its dependence on the consumption tax, which is contrary to the world trend. Many studies have proved that consumption tax is the most efficient way of taxation(5). This means that a reduction in consumption tax leads to a very small change in the economic well-being of people as it causes a very small distortion effect on an individual’s decisions and does not change their investment decisions or the type of economic activity they practice. So the cut in the tax rate would only lead to a minimal increase in the consumption expenditure in the short run and might not lead to an increase in savings or investment to have any long term effect. Hence, Canadian government’s decision to reduce the GST rate may not be in the best interest of the economy at large.

Also, the GST system has become increasingly complex over time like the sales tax on manufacturing goods(5). This is mainly due to the complexity of Canadian tax legislation, the number of taxes companies are subject to, and the multi-jurisdictional tax system. Furthermore, as more people came under the purview of the taxation system (because GST is a broad based tax), more people had to deal with this complex tax structure increasing their adjustment costs. A useful learning from Canada’s example is that a country should keep the taxation structure fairly simple to comply with. Also, as consumption tax is the most effective way of taxation, India should increase its dependence on indirect taxes.

Another useful learning can be taken from the example of Malaysia that faced a lot of opposition from its businesses even after providing 1.5 years to prepare for the change in the tax regime(6). Since India plans to implement GST from 1st April 2017, it may be very challenging for the businesses to adjust to this change in less than nine months.

Using Malaysia’s strategy, India could also release a probable tax structure for each segment to aid this transition.

Inflationary impact

 It is essential to understand the inflationary impact of GST on different goods and services. Some necessary goods will be exempted from taxes as the poor may not be able to afford them at high prices. For example, if we consider the pharmaceutical sector, it expects to gain from the overall increase in efficiency due to costs saved on the supply chain. However, if the rate is more than 12%, it will have a negative effect as healthcare is a necessity and it should be charged at a low rate with input credit funds available so that the end cost does not increase considerably(2). It will be interesting to see how existing indirect tax exemptions and inverted tax structures are modified to ensure that the overall costs of pharmaceutical products do not increase on account of GST.


Figure 2: Weightage of different categories in CPI, Source: (1)

Moreover, a major part of the Consumer Price Index (CPI) basket (as shown in exhibit 3) which includes categories like food and beverages, clothing and rent, are either exempted or taxed at low rates as these are essentials for the lower income group. The effective tax rate on CPI is 10.4%. However, this includes goods outside the purview of GST like petrol, diesel, and alcohol. If we exclude these items, only 46% (approx.) of the CPI will be taxed. Out of this, 32% is taxed at a low rate and only 15% is taxed at a normal rate. This builds up to an effective tax rate of 7% on CPI because these excluded goods are charged at very high rates (1).

However, if a good is exempted from taxes, it does not necessarily mean that the net tax charged on that good is zero. This is primarily because the embedded taxes on inputs, like the taxes paid on fuel during the transportation of these goods, are carried forward to the final product. Also, if food, fuel, and light are exempted from taxes and the Public Distribution System (PDS) continues to subsidize, the net price impact on the consumption of these goods for the poor will be minimal.

The proposed GST structure is a dual-rate tax structure and its inflationary impact will depend on the RNR rate and the standard rate. An RNR of 15% with a lower rate of 12% and a standard rate of 17-18% will have no inflationary impact(3). This is so because the revenue received by the government remains the same. Moreover, while the prices of some goods will go up, the prices of some other goods will go down negating the inflationary pressure. A higher RNR of 17-18% with a lower rate of 12%, a standard rate of 22% will have an inflationary impact of 0.3% if only the headline tax rate is considered. Furthermore, when the change in price is adjusted to the cascading input taxes, the net inflationary impact will be around 0.7% (1).

Effect of different rates of RNR

Since we don’t know the RNR rate, we can only speculate the effects of a high and low RNR rate. If a low rate of RNR is set, it will lead to a fall in revenue. As the center has promised to compensate the states for any loss of revenue over a five-year period, it will have a huge negative impact on the center as it has to support the states while it faces fall in its own revenue. Also, if this compensation is delayed, then it will lead to a loss of trust between the center and the state. The loss in revenue can also lead to a reduction in the growth rate of the country and this will further reduce the revenue(4).

We need to keep in mind that India is a developing country with diverse needs. Economic and social disparities have to be addressed while we simultaneously invest in education, healthcare, transport, energy, infrastructure etc. to boost development. This requires huge capital investments. GST rate will be set in order to meet these investment demands and any loss of revenue due to a reduction in rate will defeat the purpose of this taxation system.


In the long-run, GST is expected to benefit the economy in many ways. It provides credits on input taxes paid at the previous stage of production, decreasing the burden of tax on the end consumer. It also fosters greater compliance due to its multi-point collection system and an invoice trail that minimizes tax evasion because one needs to issue and obtain invoices in order to set-off the taxes from the previous stage of production. It increases the efficiency of the supply chain by saving travel time due to a reduction in hindrances and better warehousing and distribution of goods, leading to more cost-efficient decision making. On the whole, it will induce growth in the economy by creating an integrated economy with a common market while increasing the ease of doing business by streamlining the tax structure.


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About the authors:


The author is currently a student of the PGDM batch of 2016-18. His areas of interests are micro and macroeconomics. He is also a Committee member of TAPMI Toastmasters Club. You can contact him at:


The author has done economics and is currently a student of finance in the PGDM batch of 2016-18. Her areas of interest are Economics and Finance. The author also has a keen interest in the financial news of around the world. You can contact her at:


By- Purvee Khandelwal

One of the main tools to control growth is raising or lowering interest rates. Lower interest rates encourage people or companies to spend money, rather than save. But when interest rates are at almost zero, central banks need to adopt different unconventional policies – such as pumping money directly into the financial system i.e. quantitative easing, or QE.

How does it work?

The Central bank purchases financial assets – mostly government bonds – from pension funds, insurance companies, and banks, among other institutions, with electronic cash. It paid for these bonds by creating new central bank reserves – the type of money that bank use to pay each other and the amount of commercial bank money used for lending purposes.

Who has tried QE?

Between 2008 and 2016, the US Federal Reserve in total bought bonds worth more than $3.7 trillion. The UK created £375bn ($550bn) of new money in its QE program between 2009 and 2012. Then in August 2016, the Bank of England said it would buy £60bn of UK government bonds and £10bn of corporate bonds, amid uncertainty over the Brexit process and worries about productivity and economic growth.  The Eurozone began its program of QE in January 2015 and has so far pumped in $600bn of extra money.

What are the expected gains?

 The new money swells the size of bank reserves in the economy by the quantity of assets purchased—hence “quantitative” easing. Like lowering interest rates, QE is supposed to stimulate the economy by encouraging banks to make more loans. The idea is that banks take the new money and buy assets , such as give loans, to replace the ones they have sold to the central bank. That raises stock prices and lowers interest rates, which in turn boosts investment, spending, and consumption.

What are the risks?

The biggest concern is that pumping more money into the economy could ultimately lead to an inflation problem. Also, the newly created money usually goes directly into emerging markets (through financial markets) and commodity-based economies. Thus, local businesses may not get adequate loans. BRICS countries argue that such actions amount to protectionism and competitive devaluation as QE causes inflation to rise in their countries and penalizes their industries. Thus, a far more effective way to boost the economy would be for the Central bank to create money, grant it directly to the government, and allow the government to spend it directly into the real economy. However, this could also lead to reckless spending by government. Hence, the debate on what tool to use to boost growth continues.

Dr. Urijit Patel’s Contribution to Economic Development of India

AUTHOR- Nimisha Khattar

Popularly known as the Inflation Warrior, Dr. Urijit R Patel, has been associated with RBI since 2013. He has played a key role in formulating and shaping the monetary policy of India. With his appointment as the new RBI Governor, we can expect the government to continue with the existing macroeconomic policy.

An Economist from Yale University, Dr. Patel, believes that in order to make India a country characterized by stable growth, inflation needs to be in control. Dr. Patel has brought about many significant changes. Adopting Consumer Price Index as the base, instead of Wholesale Price Index, for measuring inflation in an ‘inflation targeting approach’ was one revolutionary reform.

Dr. Patel has been a great critic of the excessive government spending and subsidies. Time and again, he has emphasized the need for a discipline in fiscal expenditure. In order to control inflation, since the degree of correlation between monetary policy and fiscal policy is high, the greatest contribution by Dr. Patel has been to keep inflation in the targeted rate bracket of 4% ± 2% in the recent years.

Apart from his contribution in controlling the inflation by increasing the interest rates and reducing fiscal expenditure, one of the smart moves that Patel committee came up with was setting up a team of six members instead of one alone, for deciding the policy rates. This has led to minimization of risk and has helped in making the process a democratic one.

Considered as an owl (a symbol of wisdom) by the ex-RBI Governor, Dr. Raghuram Rajan, Dr. Patel had been advising central government on some major issues as well – like the development of debt market, growth of foreign exchange market and the banking sector.

Thus, it can be concluded that Dr. Urijit Patel’s contribution played a massive role in the economic development of India and going by the logic of keeping repo rate higher than the CPI, as remarked by him in the committee recommendation, let’s also keep our faith in the owl higher and stronger.