Home >Opinion >Three questions on India’s economy

The national commotion over the new poverty data released by the government last month has elements of the bizarre, with television anchors, Twitter gurus and political leaders weighing in on what would be an adequate poverty line for India. The debate on macroeconomic policy is less ridiculous in comparison, though it too is often unconnected with any firm analytical basis.

Three questions should be salient right now. First: What is the rate of economic growth that India can currently sustain without sparking off high inflation? Second: Why is the rupee losing value against the dollar? Third: What is the correct level of interest rates given the current economic situation? The answers could help us get a bit more clarity on what the policy response should be.

Question one: What is the rate of economic growth that India can sustain? The answer is important because it provides clues on whether the government should try to stimulate the economy at this juncture to get it back on track.

There are clear indications of a drop in what economists call the potential growth rate. One rough indication is the puzzling persistence of high consumer inflation as well as a high current account deficit despite the sharp slowdown, a sign of excess demand. A more rigorous way to estimate the potential growth rate is by either using statistical techniques to smoothen time series data on growth or using production functions. The recent empirical evidence clearly points to a large drop in the growth potential of the Indian economy, perhaps to as low as 6%, or about 2.5 percentage points below what it was in 2008.

The slide in the growth potential is strongly linked to the investment crisis. That suggests that policy should focus on getting investment back on track rather than once again stimulating demand with a larger fiscal deficit.

Question two: Why is the rupee losing value? The large trade deficit is perhaps an indication that the Indian economy has lost export competitiveness, which also means it is unable to earn enough dollars to pay for its imports. A cheaper rupee is one way to correct the problem.

There are two reasons underlying the fall in the rupee—high inflation and falling productivity growth. The decline in the international purchasing power of the rupee can be considered to be a mirror image of the decline in its domestic purchasing power because of rising prices. The decline in rupee in the past decade tracks the excess inflation in India compared to its trading partners. It is also interesting to note that the rise of the rupee during the early years of this century was at a time when India had low inflation as well as rising productivity growth. That situation has now reversed.

What actually matters is not the nominal value of the rupee that grabs headlines but its inflation-adjusted real value, which can be calculated in several ways. But what is important to note here is that the real value of the rupee can correct in two ways: a drop in the nominal value or a drastic fall in inflation. The latter has not happened which is why the nominal value of the Indian currency is correcting.

Question three: What should the level of interest rates be? Much ink has been spilt on the issue of whether the Reserve Bank of India should cut rates from their current levels. The question cannot be adequately answered till the underlying problem of what the level of interest rates should be in the first place is sorted out.

The most elegant solution to the problem is to be found in the Taylor Rule, named after the Stanford economist John B. Taylor. It uses measures of the output gap and the inflation gap to calculate the required interest rates at any point of time. The output gap measures the difference between actual and potential economic growth. The inflation gap measures the difference between the actual rate of inflation and the level targeted by the central bank. An earlier instalment of Café Economics had cited three recent studies that had used the Taylor Rule to show that Indian policy rates in recent years have been lower than needed. Indian monetary policy has been too loose.

The entire issue of interest rate policy could then be framed in a different way. An increase in policy rates should be seen as normalization after years of loose monetary policy or a further rate cut could be seen as additional monetary loosening.

To be sure, none of these techniques offer unambiguous answers. Nothing is written in stone. Hence the significant difference of opinion among serious economists about each of these three questions. But what is important is that the ongoing debate on macroeconomic policy needs to take on board the empirical evidence as well as the underlying analytical base.

Too much of the current debate—especially in newspaper, television channels and analyst reports—amounts to nothing more than loose talk.

Niranjan Rajadhyaksha is executive editor of Mint. Your comments are welcome at

To read Niranjan Rajadhyaksha’s previous columns, go to

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