Inflation and Growth: The Role of Institutions
One sentence summary: The effects of inflation on growth are negative and significant in countries with stronger institutions, whereas they are positive and significant in countries with weaker institutions.
The corresponding paper by Hakan Yilmazkuday has been accepted for publication at Journal of Economics and Finance.
The working paper version is available here.
Abstract
This paper investigates the effects of inflation on per capita income growth for 36 developed and developing countries by using structural vector autoregression models that are robust to the consideration of endogeneity by construction. The results show evidence for heterogeneity of such effects across countries that are shown to be further connected to the strength of their institutions. While the effects of inflation on growth are negative and significant in countries with stronger institutions, they are positive and significant in countries with weaker institutions.
Non-technical Summary
Price stability is the main concern of monetary authorities, although benefits of economic growth are much larger than those of eliminating macroeconomic instability. Therefore, knowing the relationship between inflation and growth is essential to have an optimal balance between monetary and growth policies.
Abstract
This paper investigates the effects of inflation on per capita income growth for 36 developed and developing countries by using structural vector autoregression models that are robust to the consideration of endogeneity by construction. The results show evidence for heterogeneity of such effects across countries that are shown to be further connected to the strength of their institutions. While the effects of inflation on growth are negative and significant in countries with stronger institutions, they are positive and significant in countries with weaker institutions.
Non-technical Summary
Price stability is the main concern of monetary authorities, although benefits of economic growth are much larger than those of eliminating macroeconomic instability. Therefore, knowing the relationship between inflation and growth is essential to have an optimal balance between monetary and growth policies.
The theoretical literature provides mixed evidence on this subject, where the effects of inflation on growth can be positive, negative or insignificant. Empirical evidence mostly based on panel regressions is also mixed, where the effects of inflation can be negative or insignificant, based on countries investigated.
This paper contributes to this discussion by investigating the causal relationship between inflation and per capita income growth by using the implications of a structural vector autoregression (VAR) model, which is robust to the consideration of endogeneity by construction. The investigation is achieved for 36 countries over the period between 1970-2017, where control variables such as trade openness, financial development and government size have also been used. Since the estimations have been achieved for each country individually, the initial conditions of countries (e.g., initial human capital, initial development, initial institutions, etc.) are also controlled for (by estimated constant terms). The estimation results are further used to estimate the inflation elasticity of growth over time, which is defined as the cumulative response of growth divided by the cumulative response of inflation, both following an inflation shock.
The estimated inflation elasticity of growth measures are highly heterogeneous across countries, providing evidence for significantly positive, significantly negative or insignificant relationships between inflation and growth. Consistent with the mixed evidence suggested by the literature, it is implied that the effects of inflation on growth depend on the country investigated.
To have an explanation for this heterogeneity across countries, in a secondary analysis, we investigate the relationship between country-specific measures of inflation elasticity of growth and country-specific strength of institutions. The corresponding results show that the effects of inflation on growth are negative and significant in countries with strong institutions, whereas they are positive and significant in countries with weak institutions.
Regarding the economic intuition behind our results, on one hand, the positive effects of inflation on growth are consistent with the idea that weak institutions can result in poorer access to direct capital; therefore, additional money (and thus higher inflation) can be used as substitute for capital in these countries. Such a positive effect, for example, can be achieved through borrowing of governments from their central banks in countries with weak institutions. On the other hand, the negative effects of inflation on growth are consistent with the idea that inflation can hurt growth due to political power of urban workers in countries with strong institutions, where governments can impose price controls to fight against inflation that would lead into shortages and thus lower growth.
The corresponding paper by Hakan Yilmazkuday has been accepted for publication at Journal of Economics and Finance.