BackCosts of deviating from 5% inflation mark
Stabilizing long-term inflation around 5% will minimize inflation-induced distortions in relative prices, argues a new study
PremiumSince April, retail inflation in India has hovered above the 6% upper limit set by the Reserve Bank of India (RBI). Such high inflation rates can widen the disparity between prices of different products, new research published in the Economic and Political Weekly suggests.
The study, by Sartaj Rasool Rather of Birla Institute of Technology and Science, Dubai, argues that any inflation rate significantly above or below 5% widens ‘relative price dispersion’ and can create price distortions. Dispersion in relative prices refers to cross-retailer variation in prices of a particular good relative to the prices of other goods.
Relative prices may differ across sellers due to real factors, such as changes in technology and preferences. But nominal factors, such as inflation or changes in overall price levels, also affect relative prices as prices of different products typically change at different rates.
Frequent changes in relative prices lead companies to revise their labour and raw material contracts as well as their prices and supply decisions. Unnecessary price distortions can therefore be costly. Because different firms face different costs, Rather explains, variation in relative prices increases even more during periods of high inflation, says Rather.
However, he finds that dispersion in relative prices increases during periods of both high and low inflation. This indicates that it is not the absolute inflation rate, but its deviation from a certain threshold level, that determines the extent of variation in relative prices.
According to the analysis of India’s retail inflation data from 2013 to 2018, that threshold rate comes out to be 5%—consistent with the official target set by the RBI.
The study suggests that the monetary policy goal of stabilizing long-term inflation around 5% will not only reduce other welfare costs, but will also ¬minimise inflation-induced distortions in relative prices.
Also read: In Search of Optimal Inflation
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