Relationship between the inflation and the economic growth

Chapter 2

Literature Review

Glezako (1978) empirically estimated the relation between the inflation and the economic growth. The purpose of the study was to investigate the extent to which the neglected "pattern of inflation" might contribute to clarifying the relationship between inflation and growth. By pattern of inflation it was meant how the annual price changes take place in a country over a specific time period. Variables involved in the study are the the real per capita income growth rate, inflation rate (CPI growth rate) and price instability index (calculated on the basis of price -expectation model using maximum likelihood technique for estimations). Data has been collected from 40 countries over a period of 15 years (1953-1968). Later on growth rate of per capita income was regressed on inflation rate and price instability index and significant negative coefficients of inflation rate were found confirming the negative relation between growth rate and inflation rate.

Fischer (1983) in response to Sidrauski carried out an extensive empirical study in order to develop a correlation between the rate of inflation and the economic growth. In his article he put forward the view that as the rate of inflation increases, the real balances decreases. This decrease in real balances adversely affects the efficiency of the factors of production thus suppressing the growth rate. For empirical testing of the proposed negative relation between inflation and growth rate data from 51 countries was collected over the period of 20 years (1961-1981). Regression line was estimated in which growth rate was regressed on its own lag, inflation and its first lag. To capture the impact of structural breaks (high oil inflation) data was divided into 2 time periods (1961-1973 and 1973-1981). The results thus obtained confirmed the negative relation between the inflation and the growth rate both within the same time period and between different time periods.

Barro(1995) attempted to find out the empirical evidence of a proposed negative relation between inflation and economic growth. This study included different variables like fertility of land, education etc in regression model and then eliminated the impact of all others but inflation. Data from over 100 countries was collected over a period of 30 years (1960-1990). The variables included CPI, real per capita GDP and investment to GDP ratios. Regression line was estimated and keeping the effect of other variables constant it was inferred from the study that the inflation and growth rate are negatively related in such a way that 1 percent increase in inflation leads to 0.02-0.03 percent decrease in the growth rate. It may be pointed out here that the significant regression coefficients do not imply the causality of growth rate and inflation as various other related factors play their role in determining the above mentioned relation, of which the most important are government policies (monetary and fiscal policies).

Burno and Easterly(1995) in their study on inflation and long run economic growth proposed a nonparametric statement of high rate of inflation as “ an annual rate of inflation over 40 percent”. The main focus of the study was to analyze the impact of severe inflation crisis on the growth rate. Panel data on CPI and per capita growth rate was collected from 25 different countries of the period of 31 years (1961-1992). Multiple regression has been run to estimate the impact of different rates of inflation using the dummy variable technique. A strong negative relation between growth and the inflation was found at fairly high rates on inflation. This relation becomes ambiguous at lower rates of inflation. An important finding made in this study was that as the inflation rate falls from a high mark, the growth rate recovery is remarkable.

Sarel (1995) examined the possibility of non-linear effects on economic growth, it observes an obvious structural break in the function which shows relationship between inflation and economic growth. The main focus of the study was to confirm the view of negative relationship between inflation and the economic growth. Variables involved in the model include population, GDP, consumer price indices, terms of trade, real exchange rates, government expenditures and investment rates. In this study panel data from 87 countries over the period of 20 years(1970-1990) was collected. Data was divided into 12 equal groups and dummy variable technique and OLS method was employed for estimation purposes. The study observed the existence of structural break at 8 percent rate of inflation. Below this level the inflation and output growth was observed to have either a weak positive or no relation. On the contrary as the rate of inflation exceeds 8 percent a strong and highly significant negative relation was observed. The plus point of this study was that it used terms of trade effects to minimize the overstated negative correlation between output growth and inflation.

Clarke (1997) analyzed the adverse effects of inflation n economic growth in a rich cross country panel data. The primary objective of this study is to probe into the fact that why the relationship between growth and inflation is not consistent in every study. For this a large amount of data has been collected on population, real GDP per capita, and investment spending as a fraction of GDP and annual CPI from Summers and Heston [19911 Penn World Tables (mark 5) and International Financial Statistics (IFS) series. 85 countries were included in the study and data on above mentioned variables was collected over the period of 20 years (1950- 1970). Multiple regressions were estimated and it was concluded that inflation indeed retards economic growth but this relationship is highly dependent on model specifications. These can be affected by choice of the countries in the sample and also by the choice of the time period.

Christoffersen and Doyle (1998) carried out a panel data study in order to examine the relationship between national product and rate of inflation. This paper primarily concerns with the export market growth and the structural reforms. Panel data used in this study was quite imbalance (different time periods were used for different countries- longest time series was of 8 years: 1990-1997) Following variables and data sources were used for constructing the. Annual real GDP data, population, and the share of exports in GDP were obtained from IMF desk officers (with their estimates for 1997), data on the transition reform index from de Melo et al. and updated it using the data from EBRD Transition Reports, information on the direction of trade to 1996 from the Direction of Trade Statistics of the IMF, and the war dummy was also used. Sarel's (1996) approach to modelling the kinked relationship between inflation and output was adopted. Thus, two inflation terms are used: log inflation, and log inflation less a threshold. They found a strong link between output and export market growth and it was observed that inflation has been associated with weaker output only above a threshold inflation rate. Here we see that they have used an unbalanced panel data with fairly small time series range with can lead to misleading results in certain cases.

Ghosh and Phillips (1998) observed that relationship between growth and inflation is quite complex. Bivariate relation is expected to be nonlinear while multivariate relationship may complicate the analysis by the inclusion of more variables which themselves maybe affected by inflation. In this study panel data from 145 countries over the period period of 36 years(1960-1996) was collected. The variables involved were real per capita GDP and average CPI. A penal regression was run to check the robustness of inflation- growth relationship. Using the above mentioned data and techniques the argument for non linear relation between growth and inflation was proved as inflation showed positive correlation with growth at very low values( threshold was calculated to be 2.5) while above that a highly significant negative relation was observed. Using these results it was suggested that growth can be facilitated even by lowering moderate inflation.

Burdekin, Denzau, Keil, Sitthiyot and Willett(2000) analyzed how the rate of inflation affects the wconmic growth of a country. The primary focus of the study is to observe how the sustained rise in the rate of inflation hampers growth variables. In this study separate analysis has been presented for the developing and the industrial countries. Data has been collected from 72 countries (21 industrial and 51 developing) over the period of 24 years (1967-1991). Variables involved in the study are inflation rate (CPI growth rate), real per capita GDP, population groath rate, government expenditure, the black-market exchange rate premium and the terms of trade. Previous period real per capita GDP has also been included as an explanatory variable. The model has been designed on Sarel's study to account for different thresholds of inflation. Generalized least square (GLS) has been used to for estimation purposes. Based on above methodology it was concluded that negative effect of inflation on economic growth starts as it crosses the threshold of 8percent in industrial countries while for developing countries it has been found to be 3 percent. It was further concluded that marginal growth of inflation declines as the inflation rate increases.

Faria and Carneiro (2001) investigated the relationship between inflation and output with the primary focus on the long run relationship between them. Brazil was the target country and the time series data used in this study involves the monthly inflation rate and real output for the period January 1980 to July 1995. The Brazilian Institute of Economics and Geography was used as the primary data source for the study The authors used a bivariate time series vector autoregressive (VAR) model based on methodology following the Blanchard and Quay (1989) decomposition to find any long run relationship. Using above mentioned variables and the techniques it was observed that the inflation and the output growth rate had no long run relation in Brazil but a significant negative relation was found in the short run. The results obtained from this contradict the conclusions of contemporary studies, most of which supported the negative long run relationship.

Khan and Senhadji(2001) examined the relationship between growth rate and inflation prevailing in the economy. The main purpose of this paper was to determine certain threshold effects of inflation on growth rate. For this purpose they separately analyzed the effects inflation in developing and developed economies. Data was collected from 140 countries over the period of 38 years (1960-1998). In this study the variables involved the inflation rate (percentage change in CPI) and GDP (in local currencies, constant at 1987 prices). Log transformations were used to eliminate extreme values and techniques like non linear least square (NLLS) and conditional least squares were used for estimation purposes. Using above mentioned data and methodology the threshold level of inflation was observed to be 1-3 percent in developed countries and 11-13 percent in developing countries. Below these values no significant relation between inflation and growth rate was found while above these threshold values strong negative relation was observed. These results support the view that low inflation facilitates economic growth.

Arai, Kinnwall and Thoursie(2002) carried out a cross country study to find empirical evidence for negative relation between the inflation and the growth rate. In this study special attention was paid to heterogeneity of countries and the time specific shocks. Inflation rate was calculated using CPI data and per capita GDP growth rate was used as growth indicator. Panel data was collected from 115 countries over the period of 35 years (1960-1995). Generalized method of moments has been used for the estimations purposes. The results thus obtained indicate that no systematic inter-country correlation exists between inflation and the growth rate but negative relation between them is quite evident for the periods of high oil price shocks.

Gillman, Harris and Mátyás (2002) presented the monetary model of economic growth for the estimation of relationship between rate of inflation and economic growth. For this study an extensive panel data was collected from 41APEC and OECD countries over the period on 37 years (1961-1997). Variables involved in the study were per capita GDP (constant at US$1995), growth rate of real GDP, GDP deflator (as measure of inflation) and percentage of gross domestic investment in GDP. The analysis was disintegrated in three categories depending upon the rate of inflation (50 percent, 100 percent and 150 percent). The dummy variable technique was used and multiple linear regression was estimated. A significant negative relation between inflation and the growth rate was found for OECD countries while similar results were obtained for APEC countries using instrumental variable technique.

Gokal and Hanif (2004) examined the relationship between growth and inflation, specifically on the context of Fiji. The primary objective of the study was to determine any possible causal relationship between inflation and economic growth. For this the data set consisted of 34 years of annual observations from 1970-2003) and the variables included average annual CPI, CPI growth rates and real GDP growth rate. To find the causal relation correlation and granger causality techniques have been employed. The results concluded that there is a weak negative correlation between inflation and economic growth. The granger causality test further confirmed that a uni-directional causality exists from growth to inflation. These results are consistent with most of the previous empirical findings and the theories of inflation and growth.

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