Inflation, financial development, and growth: A trilateral analysis
One sentence summary: Higher inflation (up to 4%) is associated with larger growth
effects of financial deepening.
The corresponding paper by Peter L. Rousseau and Hakan Yilmazkuday has been published at Economic Systems.
The corresponding paper by Peter L. Rousseau and Hakan Yilmazkuday has been published at Economic Systems.
The working paper version is available here.
Abstract
A large body of evidence links financial development to economic growth, yet the channels through which inflation affects this relationship and its stability have been less thoroughly explored. We take an econometric and graphical approach to examining these channels, and find that higher levels of financial development, combined with low inflation, are related to higher rates of economic growth, especially in lower-income countries, but that financial development loses much of its explanatory power in the presence of high inflation. In particular, small increases in the price level seem able to wipe out relatively large growth effects of financial deepening when the annual rate of inflation lies between 4 and 19 percent, whereas the operation of the finance-growth link is less affected by inflation rates above this range. Growth is generally much lower, however, in such high inflation settings where financial development is typically repressed.
Non-technical Summary
The burgeoning literature on the link between financial development and economic growth has made much progress over the past fifteen years by using panel data to examine differences in growth rates across broad samples of countries over long periods of time. These studies affirm that financial deepening and the expanding financial services that accompany it are growth promoting. Fewer studies, however, examine whether particular economic conditions, such as the inflationary environment, affect the strength of the basic finance-growth relationship.
In this study, we illustrate the trilateral relation between inflation, finance, and growth using a series of three-dimensional graphs that offer an appealing visual interpretation. The method allows us to quantify directly the growth rates that might be achieved along the continuum of possible combinations of financial development and inflation with both regression planes and non-planar surfaces, providing intuitive answers to questions of how to interpret sets of coefficients from linear regressions and more complex non-linear ones. In particular, the method allows us to characterize the cost of inflation in terms of losses in the effectiveness of financial deepening for a broad range of countries as well as subsets of high- and low-income ones. We also use a data-driven methodology to determine precise multiple inflation thresholds where the relationships between finance and growth appear to shift.
Our results suggest that small increases in the price level seem able to negate relatively large growth effects achieved through financial deepening when the annual rate of inflation lies between 4 and 19 percent, whereas the operation of the finance-growth link is less affected when inflation rates lie outside this range. We also demonstrate just how low growth rates generally are in high inflation settings where financial development is typically repressed and show that the negative effects of inflation are more severe for the low-income countries in our sample than for the higher-income ones.
In this study, we illustrate the trilateral relation between inflation, finance, and growth using a series of three-dimensional graphs that offer an appealing visual interpretation. The method allows us to quantify directly the growth rates that might be achieved along the continuum of possible combinations of financial development and inflation with both regression planes and non-planar surfaces, providing intuitive answers to questions of how to interpret sets of coefficients from linear regressions and more complex non-linear ones. In particular, the method allows us to characterize the cost of inflation in terms of losses in the effectiveness of financial deepening for a broad range of countries as well as subsets of high- and low-income ones. We also use a data-driven methodology to determine precise multiple inflation thresholds where the relationships between finance and growth appear to shift.
Our results suggest that small increases in the price level seem able to negate relatively large growth effects achieved through financial deepening when the annual rate of inflation lies between 4 and 19 percent, whereas the operation of the finance-growth link is less affected when inflation rates lie outside this range. We also demonstrate just how low growth rates generally are in high inflation settings where financial development is typically repressed and show that the negative effects of inflation are more severe for the low-income countries in our sample than for the higher-income ones.
To be clear, though our graphical analysis will, among other things, characterize combinations of finance and inflation that are associated with given levels of growth in real per capita income, we do not claim that policymakers actively engage in any real tradeoff between financial development and inflation in maintaining growth and macroeconomic stability. Rather, we note that controlling inflation through monetary policy can be accomplished at relatively low cost, especially when done in a measured fashion, and that restoring smooth operations of the financial sector after a bout of inflation can be far more costly. All of this points to monetary control as a crucial first step in achieving robust economic growth.
The corresponding paper by Peter L. Rousseau and Hakan Yilmazkuday has been published at Economic Systems.