Inflation and growth

Chapter 4

Theoretical Framework

4.1 How inflation affects Economic Growth: Theoretical debate

Inflation and growth has been the area of interest for economists since long. Many theorists have tried to explain the relationship between them but no complete explanation can be put forward. Though every theory is based on some observed phenomenon but each of them only gives a part of complete explanation. The previous inflation-growth theories were built on cyclical observations. Persistent inflation is regarded as a post World War II phenomenon (Gokal & Hanif (2004)). These theories proposed a positive relation between inflation and economic growth. The similar theme was propagated by Keynesian school of thought. However the scenario changed in 1970's when the world economies registered very low rates of growth while inflation rate remained sky high. This phenomenon gave rise to new explanations of inflation and growth relationship and proposed a negative relation between them.

This chapter primarily focuses on different theoretical explanations which have been put forward by different theorists. In the end a brief overview of inflation and growth in Pakistan will be presented.

4.1.1 Classical Growth Theory

Adam Smith is regarded as the founder of Classical Growth Theory and proposed a supply side growth model. Smith related the output growth to labor, capital and land inputs. He proposed the assumption of increasing returns to scale and regarded savings as most important factor affecting the growth rate. Therefore income distribution in the economy assumed the pivotal position in determining the growth. Though no explicit relationship between inflation and growth was proposed by Smith but one could easily derive an implicit negative relation from his propositions. He proposed that as the rate of inflation rises the profits of investors fall because of higher wage costs (nominal wages are assumed to be fully flexible in classical school of thought). Thus, higher inflation leads to lower profits and lower savings which in turn declines rate of growth (Gokal & Hanif, 2004).

4.1.2 AD and AS Framework

The Keynesian model is primarily based on aggregate Demand and Aggregate supply analysis. The hallmark of this theory is that it presented an upward sloping AS curve in the short-run (in response to vertical classical AS curve). It is this feature which has made AD very important in Keynesian school of thought as changes in demand can now lead to both changes in prices and changes in output Dornbusch, et al (1996).

Long-run does not present such an easy explanation as all the shocks causing the short-run relation iron-out in the Long-run steady state. According to (Dornbusch, et al, 1996) a long-run adjustment path is formed on the basis of short-run dynamic equilibria. This long-run adjustment initially follows a positive relation between inflation and growth and later on it turns out to be negative. This positive relation is attributed to the time inconsistency problem which means that every producer believes that the prices of his output are increasing while that of others' remaining the same. So he produces more output and thus the overall output rises. Blanchard and Kiyotaki (1987) on the contrary believe that this positive relation is due to the agreements which the firms have already made to provide the output in future. So they have to produce even at increased price level. Later on the relationship becomes negative which describes the phenomenon of stagflation when output falls or remains constant against rising prices (Gokal & Hanif, 2004).

4.1.3 Monetarist School of Thought

Milton Friedman is regarded as the founding father of monetarist school of thought. As it is evident from the name, money has been assigned a pivotal role in this theory. It mainly focuses on the long-run supply side properties of the economy. Friedman who spearheads the school of thought has emphasized on the importance of money and believed that it is actually the rate with which money in an economy grows that determines its growth rate. If the growth rate is lesser than the money growth, inflation will take place. Monetarists believe that the inflation has no real effect. It only affects the nominal variables. Thus Friedman believed that if in an economy the prices double, nominal wages also double, thus keeping the real wages constant. Same is true for all real variables. In this way he supported his argument of neutrality of money. That is money does not have any real effects. However several empirical studies have proved it otherwise and it was observed that inflation does have sizeable real effects (Burno and Easterly, 1995).

4.1.4 Neo-classical Theory

Early neo-classicals (Solow, 1956) believed that there exists no relationship between inflation and growth as growth was assumed to be exogenously determined (Ray, 1998). Things remained the same until Mundell(1963) provided a mechanism relating inflation and economic growth. He believed that when inflation rises, it reduces the wealth of the people as the return on real money balances falls. As a result people switch other assets which raise their price and pulls down the interest rate. This boosts up the investment in the economy and growth takes place.

Tobin (1972) also presented a similar mechanism which relates inflation with economic growth. Simply put he proposed that when rate of inflation rises it induces people to substitute interest bearing assets with money leading to greater capital intensity and thus boosts up economic growth.

Stockman (1981) another neo-classical theorist provided another explanation to relate inflation and growth. He developed a model according to which an increase in inflation could substantially decrease the output level. He assumed money as a compliment to capital. So when inflation rises the buying power of money decreases which leads to low capital accumulation and thus to a declining growth rate. In this way Stockman provided a healthy explanation for negative relation between inflation and economic growth.

4.1.5 Neo Keynesian School of Thought

Neo-Keynesians are basically an off-shoot of Keynesians School of thought. The primary features of their theory are the concepts of potential output and the associated rate of unemployment. Potential output is that level of output which an economy can produce when all of its available resources are fully utilized. Associated with it is the concept of natural rate of unemployment which refers to that rate of unemployment which prevails when output equals the potential level of output. It was argued that when unemployment equals the natural rate of unemployment, inflation will neither increase nor decrease and this level of unemployment is also called non-accelerating inflation rate of unemployment (NAIRU). According to this theory, inflation depends on the level of actual output (GDP) and the natural rate of employment.

Three cases of output and unemployment are discussed below along with the suggested inflation response to them.

First suppose GDP is lower than the potential level of output and unemployment rate is above the natural rate of unemployment, ceteris paribus, inflation will decrease as the producers will go for filling up the excess capacity of the economy. So inflation will come down. In this way inflation will move opposite to the growth. Now suppose if the GDP is greater than the potential level of output and thus the unemployment rate is below the natural rate of unemployment, the inflation will increase as the producers will raise their prices. This leads to stagflation in the economy. In the end if unemployment rate equals NAIRU the inflation rate will remain as such until some external supply shock disturbs the balance.

4.1.6 Endogenous Growth Theory

As it is evident form the name, the endogenous growth theory primarily rests its analysis on the factors which are directly involved in the process of production (Todaro, 2000). This theory does not take into account the exogenous variables affecting the growth performance of an economy. To make the things simple it primarily focuses on the return on capital. A negative relationship between inflation and growth has been suggested by this theory as it is believed that with a rising inflation trend the return on capital will fall which will lead to a plunge in the growth rate (Marquis and Reffert, 1995).

Endogenous growth theory further advances the analysis by proposing that if the capital is taxed it will affect its accumulation which will in turn adversely impact the growth rate. A similar proposition can be made for inflation tax on human capital. So when expected inflation rate increases the marginal value of today's last unit of consumption will reduce which will induce people to work less and go for more leisure. When the amount of labor has been reduced, it will permanently lower the marginal product of capital which will result in a slower rate of capital accumulation and thus leading to a lower rate of growth (Gomme, 1983).

4.2 Trends in Inflation and Growth: Pakistan's Perspective

It is evident from the literature review presented earlier that inflation and growth rate are negatively related to each other. However to make the analysis more subtle it would be advantageous to discuss the inflation and growth trends which economy of Pakistan has registered over the period of time.

The above shows the fluctuations in the real per capita GDP growth rate and the inflation rate in Pakistan for the last five decades. It can be observed that in the first half of the sixties the growth rate declined and inflation rate surged. Similarly the reverse pattern is observed in the later half of the same decade when growth rate was considerably improved against the declining inflation rate. In mid Seventies again the growth rate and inflation depicted a negative relation when growth rate fell against rising inflation trends. Similar pattern is observed in the Nineties.

To get a better overview of the fact the way growth rate have varied with respect to inflation rate consider the following .

Source: Economic Survey of Pakistan, 2008-09.

The shows the ten year average of GDP growth rate and the inflation rate. Starting with the Fifties the inflation rate in the economy was low coupled with low growth rate as well. On the contrary the relation became negative in the Sixties when inflation rate was observed to be quite low against very high rates of economic growth. Again in the Seventies inflation rate surged along with a plunge in the rate of growth. Similar pattern is observed in the later decade. The recent year s also confirm the negative trend when inflation rate was recorded to be 22.3 percent with a growth rate of only 2 percent[1].

From the above discussion it can be concluded that inflation and growth rate have been negatively related to each other. This observation is in accordance with the empirical findings we have observed in the previous chapter. Mubarik (2005) has reported the similar results in which it was maintained that inflation hampers economic growth.

[1] Economic Survey of Pakistan, 2008-09.

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