The Reserve Bank of India, on Thursday, said it could not adopt a policy of tolerating higher inflation in order to promote growth because such a stance would not yield the desired results.

“While lower real interest rates can stimulate growth and investment, the central bank cannot adopt a policy of higher inflation tolerance as the means to lower real rates because beyond a threshold, the negative impact of inflation on growth outweighs its positive impact,” the RBI said, citing a study. The study was conducted in the backdrop of criticism that the central bank was following an anti-inflationary monetary policy stance to the detriment of growth.

“...tolerating higher inflation with growth-supportive monetary policy response is unlikely to stimulate growth to the desired extent since the adverse impact of higher inflation on growth would more than offset the favourable impact of growth-supportive monetary policy,” it said.

It further said the adverse growth impact of high inflation was seen to operate primarily through compression of consumption demand, since investment demand is more sensitive to lower real rates than higher inflation.

Empirical evidence

“While this paper finds empirical evidence that lower real interest rates can stimulate growth and investment, it does not recommend a policy of higher inflation tolerance as the means to lower real rates,” it said.

In India, the study added, “the incremental capital output ratio has increased in recent quarters and correspondingly, the implicit marginal productivity of investment has also declined.

As a result, lower levels of real interest rate would have also contributed to the slowdown in growth.”

The real interest rate refers to the difference between the actual interest rate and inflation.

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