Inflation–Growth Trade-off

The inflation-growth trade-off arises because monetary policy influences both aggregate demand and prices. Lower interest rates can support consumption, investment and output but may intensify inflation, while higher rates can restrain inflation but weaken demand and near-term growth. The trade-off is mainly short-run and depends on spare capacity, inflation expectations and the source of inflation.

How monetary policy affects inflation and growth

Monetary policy affects spending through interest rates, credit conditions, asset prices, the exchange rate and expectations, usually with time lags.

• When output is below potential, monetary easing can raise demand and production with relatively limited price pressure.
• When demand approaches productive capacity, further stimulus is more likely to raise prices than real output.
• Monetary tightening lowers demand and inflationary pressure but can temporarily reduce investment, employment and output growth.

Why supply shocks sharpen the trade-off

An adverse supply shock, such as a rise in input costs or disruption of production, can simultaneously raise prices and reduce output. Monetary policy cannot directly restore the lost supply, so either policy response carries costs.

• Tightening cannot remove the original supply constraint, but it can restrain demand, limit second-round price increases and prevent inflation expectations from becoming unanchored. Its cost is weaker output and employment when activity is already under pressure.
• Accommodating the shock can protect near-term growth, but persistent inflation may spread to wages and other prices, eventually requiring stronger tightening.
• Unlike supply-driven inflation, demand-driven inflation can generally be restrained more directly through tighter monetary conditions, though at a cost to near-term output.
• In the long run, monetary policy cannot permanently raise real growth above potential output; durable growth depends chiefly on productivity, investment and structural capacity.

India's flexible inflation-targeting framework

The Reserve Bank of India Act, 1934, as amended in 2016, states that the primary objective of monetary policy is to maintain price stability while keeping in mind the objective of growth. This flexible inflation-targeting framework allows policy to consider output conditions and the nature of shocks, while recognising that stable prices support sustainable growth.