Monday, January 16, 2012

Inflation Thresholds and Growth

 

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%.