Inflation and economic growth: A review of the international literature

Akinsola, Foluso A.; Odhiambo, Nicholas M. Article Inflation and economic growth: A review of the international literature Comparative Economic Research. Central and Eastern Europe Provided in Cooperation with: Institute of Economics, University of Łódź Suggested Citation: Akinsola, Foluso A.; Odhiambo, Nicholas M. (2017) : Inflation and economic growth: A review of the international literature, Comparative Economic Research. Central and Eastern Europe, ISSN 2082-6737, De Gruyter, Warsaw, Vol. 20, Iss. 3, pp. 41-56, https://doi.org/10.1515/cer-2017-0019 This Version is available at: https://hdl.handle.net/10419/184440 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. Terms of use: Documents in EconStor may be saved and copied for your personal and scholarly purposes. You are not to copy documents for public or commercial purposes, to exhibit the documents publicly, to make them publicly available on the internet, or to distribute or otherwise use the documents in public. If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by-nc-nd/4.0 Comparative Economic Research, Volume 20, Number 3, 2017 10.1515/cer-2017-0019 FOLUSO A. AKINSOLA*, NICHOLAS M. ODHIAMBO** Inflation and Economic Growth: a Review of The International Literature Abstract This paper surveys the existing literature on the relationship between inflation and economic growth in developed and developing countries, highlighting the theoretical and empirical indications. The study finds that the impact of inflation on economic growth varies from country to country and over time. The study also finds that the results from these studies depend on country‑specific characteristics, the data set used, and the methodology employed. On balance, the study finds overwhelming support in favour of a negative relationship between inflation and growth, especially in developed economies. However, there is still much contro‑ versy about the specific threshold level of inflation that is appropriate for growth. Most previous studies on this subject just assume a unidirectional causal relation‑ ship between inflation and economic growth. To our knowledge, this may be the first review of its kind to survey, in detail, the existing research on the relationship between inflation and economic growth in developed and developing countries. Keywords: inflation, economic growth, developed countries, developing countries JEL: E31, O42, O47 Foluso A. Akinsola, Nicholas M. Odhiambo * Postdoctoral Research fellow in Macroeconomic Policy Analysis, College of Economics and Management Sciences, University of South Africa, e‑mail: [email protected] ** Professor in Macroeconomic Policy Analysis, College of Economics and Management Sciences, University of South Africa, e‑mail: [email protected] 42 Foluso A. Akinsola, Nicholas M. Odhiambo 1. Introduction The relationship between inflation and economic growth is of great interest in mac‑ roeconomics and monetary policy modelling. Although the relationship between the inflation rate and economic growth has been studied extensively, nevertheless the exact relationship is not well defined. Findings concerning the direct relation‑ ship are not uniform across the existing literature on the subject. Different studies have focused on different countries and country groups and have employed differ‑ ent proxy variables and methodologies in measuring the relationship between infla‑ tion and economic growth. The empirical results and policy recommendations vary and sometimes are in conflict. Previous studies are inconclusive in terms of provid‑ ing any policy recommendations that can be applied consistently across countries. These differences seem to be a result of different data sets, specific country charac‑ teristics, and the different methodologies employed. Although many recent studies assert the school of thought that inflation retards and negatively influences econom‑ ic growth, earlier studies asserted that inflation promotes growth. Empirical find‑ ings on this subject in the existing literature fall into four categories: inflation does not have any influence on economic growth (Wai 1959, Dorrance 1966, Sidrauski 1967, Cameron, Hum & Simpson 1996); inflation has a positive impact on econom‑ ic growth (Mallik & Chowdhury 2001, Rapach 2003, Benhabib& Spiegel 2009); inflation has a negative influence on economic growth (Friedman 1956, Stockman 1981, Fischer 1983, Barro 1995, Valdovinos 2003); and inflation impacts econom‑ ic growth in terms of specific thresholds (Aydin et al. 2016, Ghosh & Philips 1998, Bruno & Easterly 1998, Khan, Semlali& Smith 2001, Drukker, Gomis‑Porqueras &Hernandez‑Verme 2005, Kremer, Bick &Nautz 2009, Vinayagathasan 2013). This paper aims to review the existing literature on the nexus between infla‑ tion and economic growth, highlighting the theoretical and empirical evidence. The remainder of the paper is divided into four sections. Section 2 reviews the theoretical literature on the relationship between inflation and economic growth. Section 3 explicates the empirical literature on the relationship between inflation and economic growth. The conclusions are presented in Section 4. 2. The relationship between inflation and economic growth: a theoretical framework Inflation can be defined as the continuous increase in the general level of prices of goods and services over time or, more simply, as too much money chasing too few goods. Inflationary periods bring about a continuous decline in the purchasing 43Inflation and Economic Growth… power of money. Studies on inflation and growth can be traced as far back as the classical economic theories and up to modern theories. Today the relative impor‑ tance of inflation in propelling economic growth remains a subject of debate. This paper offers a detailed review of the literature on growth theories concerning the relationship between inflation and economic growth. Most central banks’ mone‑ tary policies aim to maintain a low inflation rate and high economic growth. Very high inflation affects the economy drastically, but there is some evidence that mod‑ erate inflation might also affect output growth in the long run (Temple 2000). Ai‑ yagari (1990) posits that there is no benefit in lowering inflation towards zero. As propounded by Adam Smith, the classical theory assumes that there are three factors of production: land, labour, and capital. Savings is considered the most important determinant of economic growth. No direct relationship exists between inflation and its tax effect on the profit level and output. The assumption that capitalists compete in the labour market, which leads to an increase in wage costs. Therefore, the relationship between inflation and economic growth is im‑ plicitly negative, leading to higher wages and a reduction in a firm’s profit level (Gokal & Harfi 2004). Later, the classical economic theory stated that output and employment are determined by the short‑run production function of labour and capital, and not by the creation of money, For example, Y= A f (K, L), where Y is output, A is the level of technology, K is accumulated capital, and L is the labour force. Therefore, economic growth can be attained only if the labour force or capi‑ tal accumulation rises with the level of technology to prevent diminishing returns of growth induced by an increase in capital or the labour force (Snowdon & Vane 2005). The popular Say’s Law, as propounded by Jean Baptiste Say, only regard‑ ed money as a medium of exchange. Moreover, the only determinant of economic growth is investment, which is influenced by savings. An increase in savings re‑ duces the interest rate, thereby increasing investment to balance out the reduction in consumption due to higher levels of savings. However, a decrease in savings will increase the interest rate and depress investment, and hence depress econom‑ ic growth (Baumol 1999). Another aspect of the classical theory is the quantity theory of money. It states that money does not affect real variables in the long run, but can determine price levels in an economy. Although the relationship between inflation and economic growth is not stated clearly in the classical theory of growth, it is implicitly as‑ serted that there is a negative relationship between the two variables. Boyd and Champ’s (2006) analysis starts with the theoretical insight that inflation reduces 44 Foluso A. Akinsola, Nicholas M. Odhiambo the real return on assets. Specifically, it discourages saving and encourages bor‑ rowing, which raises the nominal interest rate. A rise in the nominal interest rate, in turn, discourages investment and hence discourages growth. The conventional view on inflation holds that inflation should not be too high, but should be moderate and stable in order to enhance economic growth. Lucas (1973) posits that inflation should be low in order to propel economic growth by making “prices and wages more flexible”. Sidrauski (1967) posits that inflation has no effect on growth because money is neutral. In his paper, money is introduced in the utility function. Tobin (1965) believes that money and capital are perfect substitutes; hence, inflation will have a long‑run positive effect on growth. On the other hand, the “cash in advance model” of Stockman (1981) argues that money and capital are comple‑ mentary. Their paper examined the effect of anticipated inflation on the steady‑state capital stock in an economy, where money is introduced through a cash‑in‑advance constraint rather than through the utility functions of individuals. They assert that there is a negative long‑term relationship between growth and inflation. However, the real effect of money will be different if money serves as a transitionary through a “shopping time technology”. “Inflation represents a tax on real balances; the real effects of altering that tax depend on what we assume about the role and nature of money” (Dornbusch and Frenkel 1973: 141). Feldstein (1982) believes that the re‑ lationship between inflation and the tax system could affect the lending decisions of consumers and, ultimately, affect the cost of capital and dampen investment, lead‑ ing to a decline in economic growth. Fischer (1993), Barro (1995; 1996), and De Gre‑ gorio (1993) found evidence for a negative link between inflation and growth. The most recent inflation‑growth theory postulated is the non‑linear effect of inflation on growth, which is explained through money demand elasticity (Gillman and Ke‑ jak 2005). In the endogenous model, the relationship between inflation and growth is introduced through the marginal product of capital (physical or human). The literature has tried to answer the question regarding the level at which inflation starts suppressing long‑run growth in terms of threshold and sensitivi‑ ty. Most of the empirical studies have confirmed the negative and non‑linear im‑ pact of inflation, especially beyond a certain threshold level (Sarel 1996; Ghosh and Philips 1998; Bruno and Easterly 1998; Khan and Senhadji 2001; Gillman and Kejak 2005). The marginal effect of inflation on growth is stronger when the lev‑ el is at lower rates (Ghosh and Philips 1998) The inflation‑growth relationship can also be affected by other macroeconomic variables (e.g., trade openness, and degree of financial development, and public expenditure). For example, Eggoh and Khan (2014) observed that macroeconomic factors like trade openness with an excess de‑ mand gap can lower the cyclical movement of inflation and output growth in a com‑ petitive economy. The literature has also reported various inflection points and the fact that coun‑ try‑specific studies on inflation and output are more reliable than panel studies. There is still a great deal of controversy about the specific threshold level of in‑ 45 Inflation and Economic Growth… flation that is appropriate for growth. The non‑linear relationship is also sensitive to different methodologies, cross control studies (developing and developed coun‑ tries), and country studies. 3. The empirical literature on inflation and growth The relationship between inflation and growth has been well analysed, with diver‑ gent results. Malla (1997), for example, examined the impact of inflation on growth for 11 OECD and Asian countries using panel analysis. The result showed that for OECD countries there was no relationship between inflation and growth, contrary to theories on inflation and growth. However, for Asian countries, there was a signif‑ icant negative relationship between inflation and growth. Bruno and Easterly (1998), while using the threshold model for 26 countries, established that a higher inflation rate retards growth and lower inflation costs an economy less. A country is in a high inflation crisis when its inflation is above the threshold level of 40%. The evidence regarding the exact threshold of inflation that is detrimental or beneficial to economic growth is inconclusive, even when the same group of countries is analysed. Khan and Senhadji (2001) analysed the threshold effect of inflation on economic growth for 140 industrialized and developing countries using a non‑linear square method. Using the dataset from 1960 to 1998, they predicted an inflation threshold, in terms of achiev‑ ing the desired rate of growth, of 1 to 3 percent for industrialized countries and 7 to 11 percent for developing countries. In the same year, Gylfason and Herbertsson (2001) analysed 170 industrialized and developing countries from 1960 to 1992 using panel regression. They found that an inflation rate of between 10 and 20 percent had a negative effect on economic growth. Gillman, Harris, and Mátyás (2004) assessed the inflation and growth nexus for a panel of 29 OECD and 18 APEC member coun‑ tries from 1961 to 1997, using Pearson’s cointegration and fixed and random effect methods. They also noticed a negative inflation‑growth effect, which was stronger at lower levels of inflation. The negative effect of inflation for the OECD countries is significant, and the results are similar for APEC countries. Mubarik and Riazud‑ din (2005) examined a threshold analysis for Pakistan and concluded that an inflation rate of above 9% had a negative impact on economic growth. Erbaykal and Okuyan (2008) analysed the relationship between inflation and economic growth for Turkey, using quarterly data from 1987Q1 to 2006Q2. They employed the cointegration and causality test, bounds test, and WALD test. They found that no significant long‑term relationship existed between inflation and growth, but a negative significant relation‑ ship did exist between the two variables in the short term. They also found a unidi‑ rectional causal relationship flowing from inflation to economic growth. Munir and Mansur (2009), using a dataset from 1970 to 2005 and the endogenous threshold au‑ 46 Foluso A. Akinsola, Nicholas M. Odhiambo toregressive (TAR) model, found that an inflation rate of above 3.89% had a negative impact on economic growth, while an inflation rate below this threshold had a positive impact on growth. Ozdemir (2010) examined the dynamic linkages between inflation uncertainty, inflation, and output growth for the UK, also using quarterly data from 1957Q2 to 2006Q4. The vector auto‑regressive fractionally integrated moving aver‑ age (VARFIMA) was performed to examine the causal effect between inflation and growth. The author divided the sample data into three sub‑periods and analysed the whole sample and sub‑period sample data. The result for the whole sample revealed that inflation uncertainty determines economic growth. In addition, output growth un‑ certainty has a positive impact on the inflation rate and output growth rate, but no rela‑ tionship was found for the sub‑period analysis. Therefore, inflation uncertainty is one of the most crucial determinants of economic growth. Odhiambo (2011) also examined the causal relationship between inflation, investment, and economic growth in Tan‑ zania. He found a unidirectional causal flow from inflation to economic growth. Abbott and De Vita (2011) investigated the impact of inflation on growth under different exchange rate regimes for 125 countries from 1980 to 2004. They employed panel analysis and found that developing countries that adopted flexible exchange rate regimes experienced lower growth than those countries that adopted fixed or in‑ termediate exchange rates. Akgul and Ozedemir (2012) assessed the non‑linear rela‑ tionship between inflation and growth for Turkey. They found that an inflation thresh‑ old of 1.26% is appropriate for economic growth. An inflation rate of above 1.26% had a negative impact on growth, while a rate below 1.26% had a positive impact on growth. Kremer et al. (2013) carried out another study for 124 industrialized and non‑industrialized economies using the dynamic panel threshold model. They found a threshold of 2 percent for industrialized countries and 17% for non‑industrialized countries; any rate above this level was detrimental. In the same year, Vinayagathasan (2013) analysed 32 Asian countries using the same methodology of dynamic thresh‑ old analysis, and a threshold of 5.43% was determined. A rate above the threshold had a negative impact on growth, while a rate below the threshold had no significant effect on growth. Tung and Thanh (2015), using a two‑stage least squares method‑ ology for Vietnam data from 1986 to 2013, found that an inflation rate of above 7% had a negative impact on economic growth. A very recent study conducted by Baha‑ rumshaha et al. (2016) on inflation, inflation uncertainty, and economic growth in 94 emerging and developing countries employed the system generalized method of mo‑ ments (SGMM). The study found that inflation harms growth only in non‑inflation crisis countries, and inflation uncertainty indeed promotes growth. High inflation pro‑ motes negative growth, and a low inflation rate promotes high growth. The negative cost of not keeping inflation in check outweighs the positive benefit from uncertainty in non‑inflation crisis countries in all three regimes. They also found that inflation un‑ certainty has a positive effect on growth through a precautionary motive when infla‑ tion reaches moderate ranges (5.6–15.9%). Table 1 presents a summary of some of the previous studies on the relationship between inflation and economic growth. 47 Inflation and Economic Growth… Table 1. Summary of Literature on Inflation and Economic growth S/N Study Purpose Year Covered Estimation Method Variables Summary of Findings 1 Khan and Senhadji (2001) Threshold effect in inflation and economic growth for 140 industrial‑ ized and develop‑ ing countries 1960 to1998 Non‑linear least square method (NLLS) Growth rate of GDP, CPI index, gross do‑ mestic investment, population growth, terms of trade An inflation rate threshold of 1 to 3 percent was posited for industrial‑ ized countries and 7 to 11 percent for developing countries. Percentag‑ es higher than the abovementioned had a negative impact on econom‑ ic growth and below the abovemen‑ tioned, percentages had no impact on economic growth. 2Gylfason and Herberts‑ son (2001) Threshold effect in inflation and economic growth for 170 industrial‑ ized and develop‑ ing countries 1960 to 1992 Panel regression GDP growth, GDP per capita, inflation (GDP deflator), openness, gross domestic fixed investment, primary exports, secondary ed‑ ucation An inflation rate of between 10 and 20 percent had a negative effect on economic growth. 3 Mubarik and Riazud‑ din (2005) Examined the in‑ flation and growth nexus for Pakistan 1973 to 2000 Threshold anal‑ ysis Real GDP, population growth, CPI, invest‑ ment growth rate An inflation rate of above 9% had a negative impact on economic growth. 4 Munir and Mansur (2009) Examined the in‑ flation and growth nexus for Ma‑ laysia 1970 to 2005 Endogenous threshold autore‑ gressive (TAR) model Real GDP growth, gross fixed investment, FDI, growth rate of ex‑ port of goods and ser‑ vices An inflation rate of above 3.89% had a negative impact on econom‑ ic growth; however, an inflation rate below this had a positive impact on growth. 48 Foluso A. Akinsola, Nicholas M. Odhiambo S/N Study Purpose Year Covered Estimation Method Variables Summary of Findings 5 Hasanov (2011) Examined the in‑ flation and growth nexus for Azerbai‑ jan (as a transition economy) 2000 to 2009 Threshold model Real GDP per capita, CPI, gross fixed capital formation A 13% inflation rate threshold was found. An inflation rate above this threshold had a negative im‑ pact on growth, while a rate below this threshold had a positive effect on economic growth. 6 Kremer et al. (2013) Examined the in‑ flation threshold and growth nexus for 124 industrial‑ ized and non‑in‑ dustrialized econ‑ omies 1950 to 2004 Dynamic panel threshold model GDP per capita, infla‑ tion (GDP deflator), trade openness, terms of trade An inflation rate of 2% and 17% was posited for industrialized and non‑industrialized countries, re‑ spectively. Any rate over this threshold had a negative effect on growth and below this threshold had no significant effect on econom‑ ic growth. 7 Akgul and Ozdemir (2012). Assessed the non‑linear rela‑ tionship between inflation and growth for Turkey Month‑ ly data from 2003 to 2009 Two‑regime TAR model GDP per capita, infla‑ tion (GDP deflator), trade openness, terms of trade An inflation threshold of 1.26% was determined. An inflation rate above this had a negative impact on growth, while a rate below this had a positive impact on growth. 8 Tung and Thanh (2015) Examined the in‑ flation threshold and growth nex‑ us for Vietnam (as a transition economy) 1986 to 2013 Two‑stage least square(2‑SLS) and generalized method of mo‑ ments (GMM) GDP per capita, CPI, trade openness, terms of trade, gross domes‑ tic investment, popu‑ lation growth, dummy variable if inflation is higher than the threshold percentage An inflation rate of above 7% had a negative impact on economic growth. 55 Inflation and Economic Growth… Khan M.S. & Senhadji A.S. (2001), Threshold effects in the relationship between inflation and growth, ʻIMF Staff papersʼ, 48(1), 1–21. Kremer S., Bick A. &Nautz D. (2013), Inflation and growth: new evidence from a dynamic panel threshold analysis, ʻEmpirical Economicsʼ, 1–18. Kremer S., Bick A. & Nautz D. (2009), Inflation and growth: New evidence from a dynamic panel threshold analysis, SFP 649 Discussion Paper No. 036. Zuberlin: Humboldt‑Universität. Lucas R.E. (1973), Some international evidence on output‑inflation tradeoffs, ʻThe American Eco‑ nomic Reviewʼ, 63(3), 326–334. Malla S. (1997), Inflation and economic growth: Evidence from a growth equation, Department of Economics, University of Hawaiâ I at Monoa, Honoulu, USA. Mallik G. & Chowdhury R.M. (2001), Inflation and economic growth: Evidence from South Asian countries, ʻAsian Pacific Development Journalʼ, 8, 123–135. Mubarik Y.A. & Riazuddin R. (2005), Inflation and growth: An estimate of the threshold level of in‑ flation in Pakistan, State Bank of Pakistan. Munir Q. & Mansur K. (2009), Non‑linearity between inflation rate and GDP growth in Malaysia, ʻEconomics bulletinʼ, 29(3), 1555–1569. Odhiambo N.M. (2012), Inflation dynamics and economic growth in Tanzania: a multivariate time series model, ʻJournal of Applied Business Research (JABR)ʼ, 28(3), 317–324. Ozdemir Z.A. (2010), Dynamics of inflation, output growth, and their uncertainty in the UK: an em‑ pirical analysis, ʻThe Manchester Schoolʼ, 78(6), 511–537. Rapach D.E. (2003), International evidence on the long‑run impact of inflation, ʻJournal of Money, Credit, and Bankingʼ, 35(1), 23–48. Sarel M. (1996), Nonlinear effects of inflation on economic growth, ʻStaff Papersʼ, 43(1), 199–215. Sidrauski M. (1967), Rational choice and patterns of growth in a monetary economy, ʻAmerican Economic Reviewʼ, 57, 534–544. Snowdon B. & Vane H.R. (2005), Modern macroeconomics: its origins, development and current state, Edward Elgar Publishing. Stockman A.C. (1981), Anticipated inflation and the capital stock in a cash‑in‑advance economy, ʻJournal of Monetary Economicsʼ, 8, 387–393. Temple J. (2000), Inflation and growth: Stories short and tall, ʻJournal of Economic Surveysʼ, 14, 395–426. Tobin J. (1965), Money and economic growth, ʻEconometrica: Journal of the Econometric Soci‑ etyʼ, 671–684. Tung L.T. & Thanh P.T. (2015), Threshold in the Relationship between Inflation and Economic Growth: Empirical Evidence in Vietnam, ʻAsian Social Scienceʼ, 11(10), 105. Valdovinos C.G.F. (2003), Inflation and economic growth in the long run, ʻEconomics Lettersʼ, 80(2), 167–173. Vinayagathasan T. (2013), Inflation and economic growth: A dynamic panel threshold analysis for Asian economies, ʻJournal of Asian Economicsʼ, 26, 31–41. Wai U.T. (1959), The relation between inflation and economic development: a statistical inductive study, ʻStaff Papers (International Monetary Fund)ʼ, 7(2), 302–317. 56 Foluso A. Akinsola, Nicholas M. Odhiambo Streszczenie INFLACJA A WZROST GOSPODARCZY: PRZEGLĄD LITERATURY MIĘDZYNARODOWEJ Artykuł stanowi przegląd istniejącej literaturę dotyczącej zależności między inflacją a wzrostem gospodarczym w krajach rozwiniętych i rozwijających się, z uwzględnieniem zarówno aspektów teoretycznych jak i empirycznych. W wyniku przeprowadzonego ba‑ dania stwierdzono, że wpływ inflacji na wzrost gospodarczy jest zróżnicowany w różnych państwach i w czasie. Opracowanie wskazuje również, że wyniki tych badań są zależne od specyfiki danego kraju, wykorzystanego zestawu danych i zastosowanej metodologii. Generalnie badania wskazują na występowanie zdecydowanie negatywnego związku mię‑ dzy inflacją a wzrostem gospodarczym, zwłaszcza w krajach rozwiniętych. Nadal jednak istnieje wiele kontrowersji na temat konkretnego progu poziomu inflacji, który jest korzyst‑ ny z punktu widzenia wzrostu. Większość wcześniejszych badań nad tym tematem zakłada jedynie jednokierunkowy związek przyczynowy między inflacją a wzrostem gospodarczym. Niniejsze opracowanie jest być może pierwszą próbą dokonania szczegółowego przeglądu istniejących badań nad zależnościami między inflacją a wzrostem gospodarczym w kra‑ jach rozwiniętych i rozwijających się. Słowa kluczowe: inflacja, wzrost gospodarczy, kraje rozwinięte, kraje rozwijające się