Inflation's impact on Economy

Inflation has an adverse impact on the real economy. The following points are worth noting

1.       High and persistent inflation imposes significant socio-economic costs. Given that the burden of inflation is disproportionately large on the poor, high inflation by itself can lead to distributional inequality. Therefore, for a welfare-oriented public policy, low inflation becomes a critical element for ensuring balanced progress.

2.       High inflation distorts economic incentives by diverting resources away from productive investment to speculative activities.

3.       Inflation reduces households saving as they try to maintain the real value of their consumption. Consequent fall in overall investment in the economy reduces its potential growth.

4.       As inflation rises and turns volatile, it raises the inflation risk premia in financial transactions. Hence, nominal interest rates tend to be higher than they would have been under low and stable inflation.

5.       If domestic inflation remains persistently higher than those of the trading partners, it affects external competitiveness through appreciation of the real exchange rate.

6.       As inflation rises beyond a threshold, it has an adverse impact on overall growth.

7.       RBI's current assessment suggests that the threshold level of inflation for India is in the range of 4-6%. If inflation persists beyond this level, it could lower economic growth over the medium-term.

Hence there is a need for a monetary policy response by the Central Bank to control inflation