Inflation Thresholds and Growth

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Inflation Thresholds and Growth

One sentence summary: Economic growth is accelerated by standard growth variables only when inflation is below 8%.

 

 

 

The corresponding paper by Hakan Yilmazkuday has been published at International Economic Journal.

The working paper version is available here.


Abstract

This paper investigates inflation thresholds that lead to higher growth rates using five-year averages of standard variables for 84 countries from 1965 to 2004. The historical experience has important policy implications for developing countries: (i) the catch-up effect has worked only when inflation is below 12%; (ii) the positive effect of human capital on growth has been present and significant when inflation has been below 15%; (iii) financial development has been effective only when inflation has been below 10%; (iv) government size has negatively affected growth when inflation has been below 10%; (v) trade has positively affected growth when inflation has been below 8%.


Non-technical Summary

The negative effects of high inflation on growth is well accepted. But which rate of inflation is considered as high? This paper investigates inflation thresholds that lead to higher growth rates using five-year averages of standard variables for 84 countries from 1965 to 2004. The novelty of this paper is due to considering the stimulus effects of inflation thresholds on the contribution of other country characteristics on growth. This involves investigating inflation thresholds for the catch-up effect to hold, for human capital to have positive effects on growth, for financial development to be effective on growth, for government expenditure to be ineffective on growth, or for international trade to have positive effects on growth.

The negative effects of high inflation on growth have been extensively discussed in the earlier literature. One of the main stories for high inflation hurting growth is increasing relative price variability. Another story about high inflation hurting growth is through its effects on financial activity. High inflation also interferes with the accurate valuation of firms, the assessment of individual projects, leading to higher macroeconomic volatilities.

This paper considers thresholds in inflation through a continuous analysis (i.e., rolling-window two-state-least-squares regressions) with constant sample sizes in order to capture any possible nonlinearities in growth regressions. The empirical analysis has (but not limited to) the following innovative implications on the significance and the expected sign of the explanatory variables of growth, independent of which variables are included in the regression analysis or which measure of financial depth is used: (i) the catch-up effect works only when inflation is below 12%; (ii) the positive effect of human capital on growth is present and significant when inflation is below 15%; (iii) financial development is effective only when inflation is below 10%; (iv) government size negatively affects growth when inflation is below 10%; (v) trade positively affects growth when inflation is below 8%.

 

Business Cycles through International Shocks: A Structural Investigation

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Business Cycles through International Shocks: A Structural Investigation

One sentence summary: Through structural Bayesian estimations of an open-economy DSGE model on 16 countries, it is found that international shocks explain around 70% of output fluctuations.

The corresponding paper by Hakan Yilmazkuday has been published at Economics Letters.

The working paper version is available here.

Abstract
This paper investigates the sources of output volatility by decomposing the international shocks into finance and trade shocks. Through structural Bayesian estimations of an open-economy DSGE model on 16 countries, on average, it is found that international shocks explain around 70% of output fluctuations. Across countries, the decomposition of international shocks shift toward trade shocks as the price stickiness falls, as steady-state real interest rate increases, as the weight given to output in the Taylor rule increases, or as the interest-rate smoothing increases.

Non-technical Summary
The devastating effects of the 2008 crisis on world output have one more time triggered the research on business cycles. In a global world, from an accounting point of view, crises are contiguous through either international finance (i.e., nominal) shocks or international trade (i.e., real) shocks. By also considering real and nominal domestic shocks, this paper is an attempt to decompose the sources of volatility in output into four possible shocks: (i) international finance shocks through foreign interest rates, (ii) international trade shocks through transportation/trade costs, (iii) technology shocks through productivity, (iv) monetary policy shocks through central bank behavior. An open-economy dynamic-stochastic-general-equilibrium (DSGE) model is structurally estimated for 16 countries using state-of-the-art Bayesian estimation techniques.

Regarding country-specific details, United Kingdom (respectively, Singapore) has the lowest (respectively, highest) degree of price stickiness among 16 countries. The weight given to inflation in the Taylor rule is highest (respectively, lowest) for Japan (respectively, Indonesia), while the weight given to output is highest (respectively, lowest) for United Kingdom (respectively, South Africa). The highest (respectively, lowest) degree of interest-rate smoothing belongs to Japan (respectively, South Africa). When it comes to shocks, on average, Indonesia is exposed to the highest degrees of technology and monetary policy shocks, Costa Rica is exposed to the highest degree of foreign interest rate shocks, and Singapore is exposed to the highest degree of international trade cost shocks.

In order to gauge the importance of the individual shocks on the output volatility, we compute variance decompositions of output for all 16 countries. Instead of representing country-specific variance decomposition tables, we investigate how the variance decomposition of output changes across countries with respect to country-specific characteristics. The results show evidence for significantly higher contributions of international shocks (i.e., international trade costs and foreign interest rate shocks) relative to national shocks (i.e., technology and monetary policy shocks). In particular, significant effects of international finance shocks on output volatility (about 50%, on average) are followed by the effects of international trade costs (about 20%, on average), monetary policy (about 20%, on average), and technology (about 10%, on average).

According to the figure above, the effects of international trade costs and technology (respectively, foreign interest rate) shocks on output volatility are higher (respectively, lower) in countries with lower price stickiness; this is mostly because changing domestic prices reflect international trade costs and technology changes through substitution effect between domestic and foreign goods. 

According to the figure above, the effects of international trade costs and technology (respectively, foreign interest rate and monetary policy) shocks on output volatility are higher in countries with lower discount factors; this is mostly because impatient countries are affected immediately from such costs through substitution effect between domestic and foreign goods. 

The weight given to output in the Taylor rule seems to be an indicator in the figure above, where the effects of international trade costs and technology (respectively, foreign interest rate) shocks on output volatility are higher (respectively, lower) in countries with higher output considerations in the Taylor rule; this reflects the additional distortionary effect of higher interest rates, again, through substitution effect between domestic and foreign goods. 

Interest-rate smoothing seems to have a positive (respectively, negative) contribution on the effects of international trade costs, technology, and monetary policy (respectively, foreign interest rate) shocks on the output volatility in the figure above; this is mostly because of an income effect that lacks the balancing contribution of interest-rates through international trade costs in the IS curve which leads output exposed to more international trade costs and technology shocks.