Explain the relationship between inflation and economic growth

explain the relationship between inflation and economic growth

Relationship between Inflation and Economic Growth in Malaysia -. An Econometric of capital) as the primary factor explaining long term growth and the. The second strand of the literature found a negative correlation between inflation and economic growth. Among these studies are Fisher (). The relationship between inflation and economic growth, from diverse direction, Similarly, economic growth is generally defined as a sustained increase in per .

Growth rate of inflation and growth rate of real non-oil GDP. Thirdly, Stockman [ 23 ], puts forward cash-in-advance model in which money is complementary to capital, causing a negative effect on long-run growth. Fourth, new models in which inflation has a negative effect on long-run growth, but only if inflation exceeds certain threshold level. The purpose of this paper, is to examine theoretically and empirically the existence of coherent meaningful relationship between inflation and economic growth in the Saudi economy, using co-integration methodology.

The analysis covers the period of Test for the threshold level of inflation is implemented.

explain the relationship between inflation and economic growth

Figure 1 shows true plot of growth rate of inflation and the growth in non-oil GDP. This paper is organized as follows. Section 1 is the introduction. Section 2 reviews the empirical studies on inflation and economic growth. Section 3 deals with the theoretical model and methodology, and discusses the empirical results and their meaningful interpretations.

Section 4 provides the conclusion and the policy implications. The, appendix is in section 5. The Review of Empirical Literature The relationship between inflation and economic growth is one of the most controversial issues in the field of economics.

Economists and experts from different schools of thoughts, whether they are policy makers, or central banking officials everywhere, not yet reached a conclusive evidence concerning the impact of inflation on growth. The main issue is, whether inflation necessary for economic growth or it is detrimental to growth, and what threshold is to keep necessary growth.

explain the relationship between inflation and economic growth

It is widely believed that moderate and stable inflation rates promote the development process of a country and hence, economic growth. Moderate inflation supplements return to savers, enhances investment and therefore, accelerates economic growth. The suitable level of economic growth and thus the acceptable level of inflation is somewhere in the middle.

Mild inflation might benefit the economy, whereas no inflation is harmful to the economic sectors. Empirical studies are inconclusive yet regarding the impact of inflation on economic growth. Cooley and Hansen [ 4 ], postulate that there exists positive correlation between marginal product of capital and the quantity of labor.

If inflation rises then labor declines and, hence decline in return on capital.

Conflict between economic growth and inflation

They concluded that inflation rise causes permanent decline in the output. Khan and Sendhadji [ 14 ], examined the relationship between high and low inflation with economic growth. They suggested threshold inflation level for both industrial and developing countries. Their work involved using panel data for countries for the period of Their findings confirm the threshold beyond which inflation exerts negative effect on economic growth.

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The threshold estimates are percent and percent for industrialized and developing countries respectively. Barro [ 2 ], used data for countries in order to assess the effect of inflation on economic growth. Other things being equal, a 10 percent rise in inflation per year leads to a reduction of growth rate by 0.

Although the adverse effect looks small, but long-run effects on standards of living are substantial. Sarel [ 20 ], used a joint panel of annual data for 87 countries. Different variables are used among them: GDP, consumer price indices, and government expenditure.

His study covered the time ofand concluded that, there exists structural break which is significant. This break occurs when inflation rate is 8 percent. Gokal and Hanif [ 8 ], reviewed different theories considering the relationship between inflation and economic growth.

Their test revealed that the relationship between inflation and economic growth is weak. Sargsyan [ 21 ], estimated the threshold for the Armenian economy for the period of He concluded that inflation between percent threshold level might benefit the Armenian economy. Munir and Kasim [ 19 ], discussed the relationship between inflation and economic growth in Malysian economy for the period of They found that the relationship is non- linear.

Moreover, the threshold suggests 3. Above this threshold inflation is significantly retards growth rate of GDP. Below the threshold, inflation is statistically significant with positive relationship between inflation and economic growth. Gillman and Harris [ 7 ], presented a monetary model of endogenous growth and specified an econometric model consistent with it. Their findings suggest negative inflation-growth effect.

Lower level of inflation had a stronger effect on growth. Birma [ 3 ], presented theoretical aspects related to the relationship between inflation and economic growth for Romanian economy for the period The methodology being used is VAR model.

The results showed that a sudden increase in the change of output gap does not determine an increase in CPI. So, the hypothesis of the existence of speed limit effect in Romania is rejected. The study also showed positive response of the growth rate of output gap to a positive shock in inflation, with maximum effect after 3 quarters. First, they analyze non-linearity of the relationship between inflation and economic growth, and identify sever thresholds for global sample and for various income specific sub samples.

Second, identifies some country-based macroeconomic features that influence non-linearity. Their results validate non-linearity of inflation-growth which sensitive to the level of financial development, capital accumulation, and trade openness.

Joudaki, et al [ 13 ], have attempted to explain how the relationship between inflation and economic growth has been concentrated. Their hypothesis is two-way causal relationship between inflation and economic growth in Iran during the years Co-integration test is employed. The result is that, the relationship between inflation and economic growth is one sided.

There is a negative significant correlation between inflation and economic growth. Hossain [ 10 ], explores the present relationship between inflation and economic growth for Bangladesh, using annual data on real GDP and GDP deflator for the period of Co-integration methodology, error correction models and Granger causality tests are implemented.

The robustness of the empirical results is examined by controlling for other factors such as shocks e. Finally, they found that countries recover their pre-crisis economic growth rates following successful reduction of high inflation and there is no permanent damage to economic growth due to discrete high inflation crises. His results show that below that structural break, inflation has slightly positive effect on growth but after 8 percent inflation rate, it has powerful negative effect on growth.

These results have been found by using OLS technique after constructing a joint panel database by collecting annual information of 87 countries for the period Using the annual time series data for the period4Khan and Qasim estimate the key determinants of inflation in Pakistan. They disaggregate inflation into food and non-food inflation and suggest a strong role of money supply in accelerating inflation in Pakistan.

Other factors causing inflation, investigated by the researchers, are currency devaluation, value addition in agriculture sector, support price of wheat, import prices and price of electricity. After controlling for labor and capital inputs, the estimated results suggest that for the OECD countries there exists a statistically significant negative relationship between economic growth and inflation including its first difference.

However, the relationship is not statistically significant for the developing countries of Asia. The crucial finding of this empirical analysis suggests that the cross-country relationship between inflation and long-term economic growth experiences some fundamental problems like adjustment in country sample and the time period.

Therefore, inconclusive relationship between inflation and economic growth can be drawn from comparing cross country time-series regressions with different regions and time periods. Short-run consequences of rapid disinflation are addressed by 6Ghosh and Phillipsand find that starting from lower inflation rates; a rapid disinflation is associated with fall in GDP growth.

The relationship between inflation and economic growth (GDP): an empirical analysis

They employ a large panel data set, covering IMF member countries for the period — They find two important nonlinearities in the inflation growth relationship.

At very low inflation rates around 2—3 percent a year, or lowerinflation and growth are positively correlated. Otherwise, inflation and growth are negatively correlated, but the relationship is convex, so that the decline in growth associated with an increase from 10 percent to 20 percent inflation is much larger than that associated with moving from 40 percent to 50 percent inflation.

The empirical results obtained suggest that inflation has been harmful to economic growth in Tanzania. They use a bivariate vector auto-regression composed of output growth and the change in inflation in order to test the hypothesis that inflation has long run impact on output.

They also use the data for the same period to estimate the short run relationship between inflation and real output.

Their results suggest that inflation has real effects on output in the short run. Bangladesh, India, Pakistan, and Sri Lanka.

First, the relationship between inflation and economic growth is positive and statistically significant for all four countries. Second, the sensitivity of growth to changes in inflation rates is smaller than that of inflation to changes in growth rates. These results have important policy implications, that is, although moderate inflation promotes economic growth, faster economic growth absorbs into inflation by overheating the economy.

Therefore, these four countries are on the turning point of inflation-economic growth relationship. The data set covers countries from both groups and non-linear least squares NLLS and conditional least squares methods are used. The empirical results verify the existence of a threshold beyond which inflation exerts a negative effect on growth. Significant thresholds at percent and percent inflation levels for industrialized and developing countries have been found. The view of low inflation for sustainable growth is strongly supported by this study.

explain the relationship between inflation and economic growth

Gillman, Harris and Matyas present an econometric model with the feature of the inflation rate reducing the return to capital, by taking two samples of OECD and APEC member countries over the years Inflation rate is included as central variable and the theory is related with the concept of equilibrium along the balanced growth path that is implicitly includes transitional approaches to the balanced growth rate. The results, consistent with Khan and Senhadjishow that the effective is negative and significant at low inflation rates for the OECD.

When inflation rate going from percent range to a percent range, the negative co-efficient nearly doubles in magnitude and remains highly significant.

Their results show that a weak negative correlation exists between inflation and growth, while the change in output gap bears significant bearing. The causality between the two variables ran one-way from GDP growth to inflation. He finds that this relation tends to be positive and significant below an inflation rate of 2-percent and the structural breakpoint effect occurs at an inflation rate equal to 2-percent.

Beyond this threshold level inflation affects economic growth negatively. The empirical evidence demonstrates that there exists a statistically significant long-run negative relationship between inflation and economic growth for the country as indicated by a statistically significant long-run negative relationship between CPI and real GDP.

He employed the Granger Causality test as an application of the threshold model and finally, the relevant sensitivity analysis of the model. His estimation of the threshold model suggests that an inflation rate beyond 9-percent is detrimental for the economic growth of Pakistan. This in turn, suggests that inflation rate below the estimated level of 9-percent is favourable for the economic growth. Moreover, the sensitivity analysis performed for the robustness of the threshold model also confirms the same level of threshold inflation rate.

They examine long run relationship between the CPI and private sector credit and their results show that there may be no trade-off between inflation and growth in the short run but it certainly exists in the medium and long run. Their estimated results suggest 5 percent inflation target for sustained economic growth and macroeconomic stability for the economy.

The results drawn by Khan and Schimmelpfenning have also been verified in the sense that the long-run excess money supply is the main responsible for inflation in Pakistan.

This study contradicts with Hussain as its results imply that inflation in Pakistan is a monetary phenomenon. The purpose of the paper was met by integrating the Phillips curve framework with Okun's theory.

In the wake of these findings, one might somehow infer that monetary cooperation is sustainable amongst these sample countries. The existence of the long term relationship between these two variables was examined using Bound Test developed by Pesaran et al.

Whereas no statistically significant long term relationship was found with the formed ARDL models, a negative and statistically significant short term relationship has been found. The causality relationship between the two series was examined in the framework of the causality test developed by Toda Yamamoto Whereas no causality relationship was found from economic growth to inflation, a causality relationship was found from inflation to economic growth.

Using annual data and applying new endogenous threshold autoregressive TAR models proposed by Hansenthey find an inflation threshold value existing for Malaysia and verify the view that the relationship between inflation rate and economic growth is nonlinear. The estimated threshold regression model suggests 3. In addition, below the threshold level, there is statistical significant positive relationship between inflation rate and growth.

Econometric Methodology Following the lead of Ahmed and Mortaza and Alfredthe study employs two econometric models to achieve the empirical results. The first is, to examine the extent to which economic growth is related to inflation and vice versa, the theory of Johansen co-integration test and the associated Error Correction Model ECM is applied. Model Specification The primary model showing the relationship between Economic Growth and Inflation is specified thus: The data covers the period from to Unit Root Test The first step involves testing the order of integration of the individual series under consideration.

Researchers have developed several procedures for the test of order of integration.