The study of inflation and economic growth has attracted extensive literature throughout the years. This topic was initially studied under the static models such as IS-LM and AD-AS framework. The static approach could not explain the Dynamic and empirical aspect of inflation and growth therefore the need of dynamic approach was felt to explain the vigorous correlation of inflation and growth. The foundation of neoclassical growth theory advanced to a new monetary growth model. Tobin (1965) constructed monetary growth model based on Solow (1956) growth model. He argued that by increasing the cost of holding money, people substitute to physical capital therefore inflation leads to higher growth rate (40) (Temple) 2000, p.397). The non-neutrality of money in the case of Tobin’s was restated by Fischer (1971), that the steady high level of inflation will cause an increase in the steady state level of capital stock. Sidrauski (1967, 1969) unlike Tobin found super-neutrality of money. He presented a model emphasizing that the steady stock level is independent of inflation rate. He argued that Tobin’s model does not show the condition under which the steady state level is achieved or maintained. Johnson (1966) suggested long-run independency of inflation growth while monetary policy can affect growth in short-run. Stein (1966, 1970), Levhari and Patinkin (1968), Hahn (1969) and Nagatani (1970) pointed out the instability of Tobin’s model. On other hand Friedman (1968, 1978) opposed the idea of inflation and pointed the costs of high inflation and benefits of low inflation. Dornbusch and Frenkel (1974) could not specify any correlation between inflation and growth. Brock (1974) adopted endogenous model under consumer maximization behaviour and utility function. Stockman (1981) constructed a monetary growth model with a Cash In Advance model within one sector. He found negative relation, as an increase in the inflation rate causes a decrease in the real wealth of money holder.
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The endogenous growth theory emerged in late 1980s developed by Romer (1986) and Lucas (1988); new growth theories gave long-run endogenous growth rate based on the assumption that production function is proportional to a broad measure of the capital stock. Capital stock consists of physical stock of machines and the stock of intellectual ideas i.e. knowledge (Ploeg & Alogoskoufis, 1994, p. 772) therefore technology level is explained within the model by taking into account effective labour and human capital. Wang and Yip (1992) reassessed the differences of three approaches of endogenous models; i.e. money in utility function, cash in advance model and transaction cost model. Ploeg and Alogoskoufis (1994) extended endogenous monetary growth model, showing the non-neutrality of money in the long run, suggesting negative and positive effects of money on growth depending on the monetary and fiscal measures. Likely, Rogers and Wang (1993), Jones and Manuelli (1995) and Gillman & Kejak (2003) also contributed to the literature. These mixtures of theoretical models led to vast literature of empirical works. The empirical literature shows mixed results.
Traditional Keynesian approach to inflation and growth was based on the static modelling and analysis. The IS-LM and AS-DS framework was a useful tool in analysing the relation between inflation and growth (as discussed in theoretical section of this paper). However, it was criticized based on the dynamic nature of the crisis in 1950s and 1960s in Latin American Countries. The traditional static approach was criticized based on; first the static nature could not explain the dynamic empirical evidence, second it lacked the micro foundation and third the issues of short-term and long-term dynamics (Krishna and Skott, 2005, p. 9-11). The old view was further developed by Philips (1958) who presented an empirical paper which suggested that there is a positive relationship between money wages and employment level. In other words that achieving high economic performance was positively correlated to increasing inflation. Kaldor (1959) also suggested a positive relation between monetary growth and economic growth. However, Melton Friedman (1968) opposed the Philips preposition of money wages growth being conducive for improvement of employment. He highlighted the limitations of monetary policy; first limitation, monetary policy cannot peg the interest rate. Second, it also cannot peg the employment level in the economy.
Neoclassical growth theory
The early contribution to the literature on money and growth were developed from the neo-classical growth theory. Solow and Swan (1956) presented exogenous growth theory. The Solow model present a relationship of four variables; Output (Y) is dependent on (K, A, L). “K” is capital, “L” is labour and “A” is knowledge or labour effectiveness. This was the pioneer of economic growth theory, this helped economist to extend monetary policy to model in order to study the relationship of money and economic growth (Romer 2006, p. 9).
Neo-classical growth model is the basis for all economic growth related analysis. This model was developed by the work of Solow and Swan in 1956. In Solow model, labour and technology are used as substitutes. In this model, it is assumed that a portion of income is saved which is further invested therefore it shows constant but diminishing returns on labour. Technological progress and constant investment are the main two factors that explain the long term growth of a country. These factors are considered exogenously (Zhang, 2005; p. 77, 78). The neoclassical model is discussed in detail in the section-3 of this paper.
The Mundell and Tobin Model
Mundell (1963) and Tobin (1965) in two different papers “inflation and real interest” and “Money and Growth” respectively showed a positive relationship between inflation and growth. Mundell made few assumptions to build his model. First, it is assumed that wages and prices are flexible in order to maintain continuous full employment so that the share of profit is constant under full employment. Second, wealth is held either in money or shares and the real value of share decided by the real interest rate. Third, it is further assumed that the real investment depends on the real interest rate and savings on the real balances (0000 1963, p. 280). Mundell in his paper suggested that the rate at which interest rate rises is always less than the rate of inflation rise which is caused by the money growth. Therefore, the real interest rate fall which reduces the wealth of people and to achieve the same level of wealth people save more. Thus, stimulated savings have a positive effect on the economic activity (0000 1963, p. 283).
On the other hand, Tobin (1965) suggested similar result. Tobin extended the neo-classical model with monetary framework. He presented the model under the assumptions i.e. first; Government injects money by transfer of payments and people held money either for consumption or for investment which depends on portfolio behaviour. Second assumption is, people held two-assets portfolio either in money or securities. He showed that an increase in the inflation rate makes money less attractive therefore people shifts to an alternative way of storing money which is investing in portfolio. Hence inflation increases the saving rate which will further increase investment therefore the rate of capital accumulation will also increase as it is shown in Figure (1).
Figure 1: The Tobin effect show that an increase in inflation will shift the preferences of people from money to capital (Source; 01, 2004, p.11).In the above figure (1), it is depicted that an increase in the inflation rate makes money less attractive therefore money balances are not held since it does not give rate of return. People start investing their money in other assets that give an attractive rate of return according to portfolio behaviour. As inflation rises from л0 to л1, the return on money falls therefore people will substitute money by other portfolio assets. This shift is clear from Sk to Sk` Thus, as inflation rises there is a permanent increase from K0 to K1. In result the level of investment in the economy increases and economic growth gets stimulus. Therefore there is a positive relation between inflation and capital accumulation. This is true because money affects the real disposal income which further determines the level of consumption or savings (01, 2004, pp. 11-12)
Tobin’s Model was further developed by Johnson (1966) who also represented the neo-classical one sector growth model within monetary extension. He assumed saving and demand function for real balances. He suggested that though, the long-run economic growth is independent of money supply, yet monetary authority can stimulate the economic growth by increasing or decreasing the supply of money in the economy (Johnson 1966, pp. 286). Levhari and Patinkin (1968) developed a model with extension to Tobin’s model. They considered money as consumers’ goods and producers’ goods only. They concluded that individual behaviour will not affected either by increase in the money supply or changes in price level (Levhari & Patinkin 1968, p. 752).
Haslag (1997) pointed that Tobin effect shows a permanent effect of inflation on growth but once steady state level is achieved then there is no growth. Hence, the effect of inflation on growth is temporarily and in transition from one steady state capital level to another steady state capital level (00, 1997, p.13). With progress to these paper, Nagatani (1970) presented a note on Tobin work 1965 “Money and Economic Growth”. He pointed out the instability in the model as it was pin pointed by Sidrauski and Stein respectively. They argued that if we eliminate the Tobin’s assumption of price expectation then people’s expectation cannot be formed it means model cannot be stable. Furthermore, the interaction between market adjustment dynamics and growth dynamics are affected by desirable system behaviour (Natagani 1970, pp. 175).
Counter Revolution of Monetarism
In the late 1960s monetarism emerged strongly by opposing inflation led growth. They argued that inflation is not necessary for long-term qualitative growth since; inflationary policies distort the economic growth in the long run during the process of economic development. They presented the example of Latin American countries where inflationary pressures had created severe price distortion that led to misallocation of resources and other bottlenecks. The other problem in gradual rise in prices in the public utility sector may adopt to restrict further prices which creates large public deficit. This was the case in Argentina, Brazil and Chilli. These arguments and discussions created an inquisitive search for the relationship between inflation and growth (Bear 1967; p. 5-6).
Sidraski’s Super-neutrality Approach
Sidrauski (1967) argued that Tobin tried to show the steady state level but it does not explain that what are the conditions under which the steady state is achieved or it is maintained? There is no reason why the economy should remain at the steady state level whereas the dynamic economic market affects the conditions of growth. Hence, the steady state level is dependent to the household or individual behaviour under which the economy grows. Sidrauski extended the Solow-Swan model into monetary structure in order to analyse the problems related to a stabilized equilibrium growth path in monetary economy. He assumed an alternative as real asset where people can have a choice; either invest in capital or held Government bonds in their portfolios. Conclusion suggested super neutrality of money; it means that money does not affect the real variables in the long run but it is the rate of change of monetary expansion that will affect the steady state level of capital accumulation (Sidrauski; 1967, pp.796-7). However, He also suggested that it still depends on the household or individual behaviour towards inflation. In fact, He referred this phenomenon as dependent on people’s happiness, where people savings can vary. Unlike Tobin assumption that people saving to output ratio is fixed. (00 1997, pp. 13). Similarly Sidrauski (1969) once again constructed a monetary growth framework within utility optimization model. He suggested that steady stock level is independent of inflation rate.
Mundell, Tobin and Sidrauski’s papers were followed by other research papers. Stein (1966) presented a model showing the relationship of monetary variables, growth and the ratio of financial assets of the private sector to the stock of money. He suggested that monetary variables do affect the real variables. Thus, money is not neutral (Stein, 1966 pp, 465). He also presented a positive relation between inflation and capital intensity. However, the suggested that price stability can prevail if there is a balance in portfolio assets (Stein, 1968, pp. 950). Stein (1970) once again evaluated the monetary growth policy. His findings again suggested that the monetary growth does affect the capital intensity in the economy but he still remained unsure about the effective monetary growth model.
Dornbusch and Frenkel (1973) adopted a new approach to evaluate the effect of inflation on growth. The main objective was to analysis the channels through which inflation affect the real variables. The conclusion of his findings was ambiguous and did not specify the effective correlation between inflation and growth. Brock (1974) studied the relationship of money and growth as an endogenous approach by using firms and consumer’s maximization behaviour to analysis the long-term perfect foresight. The conclusion of his research achieved the underlying objectives. First, an equilibrium model approach where expectations were analysed endogenously. Second high inflation horizon created marginal disutility for households. When the rate of nominal transfers was increasing then the steady state level declined and finally the welfare cost of inflation create a Pareto notion of optimum. Harkness (1978) evaluated the effect of money on real balances. He suggested that any kind of expectation on transfer and inflation rate can affect the steady state rate of return on real balances and this can generate the phenomenon of non-neutrality of money (P. 711)
The above conflicting theories and views regarding the money and growth remained unanswered and therefore empirical research could solve the underlying relationship between inflation and growth. Wallich (1969) carried out an empirical analysis of money and growth. His paper was based on 43 countries and the data was selected for the years 1956-1965. His findings suggested a negative relationship between inflation and growth which was contrary to Mundell and Tobin’s effect (Wallich, 1969 pp. 302).
Dornbusch and Frenkel (1973) adopted a new approach to evaluate the effect of inflation on growth. The main objective was to analysis the channels through which inflation affect the real variables. The conclusion of his findings was ambiguous and did not specify the effective correlation between inflation and growth. Brock (1974) studied the relationship of money and growth as an endogenous approach by using firms and consumer’s maximization behaviour to analysis the long-term perfect foresight. The conclusion of his research achieved the underlying objectives. First, an equilibrium model approach where expectations were analysed endogenously. Second high inflation horizon created marginal disutility for households. When the rate of nominal transfers was increasing then the steady state level declined and finally the welfare cost of inflation create a Pareto notion of optimum. Harkness (1978) evaluated the effect of money on real balances. He suggested that any kind of expectation on transfer and inflation rate can affect the steady state rate of return on real balances and this can generate the phenomenon of non-neutrality of money (P. 711)
Stockman’s Negative Effect
Stockman (1981) developed a model to evaluate the relationship between inflation and economic growth. His model was based on cash-in-advance constraint. It means cash is held in advance before investing in capital. He suggested that an increase in the rate of inflation causes a reduction in the real wealth of money holder. Hence, investment in consumption and capital goods also come down (Stockman 1981, pp. 393). Stockman in his model assumed money and capital as complementary goods, referring only to goods sector. The stockman’s effect is referred to a negative relationship between inflation and economic growth. Carlson (1980) carried an empirical research and his findings suggested a weak negative relationship between monetary growth and economic growth. He said that the real economic gain can be achieved by reducing the trend of monetary growth (Carlson 1980, pp. 19)…
Michael (1989) developed a model to evaluate inflation and the variance of inflation as well as the relationship between inflation variance and output variance. The study suggested that inflation variance can predict the real output variance. Though there was no bidirectional causal relationship yet, it predicted positive relation from inflation to real output. Cooly and Hansen (1989) introduced money into real business cycle with cash-in-advance economy. His result suggested that there is negative relation between high inflation and investment consumption. Furthermore, his findings also showed that there is a negative relation between the rate of inflation and the rate of employment; conforming the result of Friedman analysis in 1977 (Cooly and Hansen 1989, pp. 745)
Endogenous Growth Theory
In late 1980s with the development of “Endogenous Growth Theory”, the study of inflation and growth got another turn. Endogenous growth theory explains growth by the factors within the production function. In new growth model, the rate of growth is dependent on the rate of return on capital therefore extending endogenous growth model with monetary analysis will tell us how inflation affects the rate of return on capital (01 Gokal & Hanif, 2004, p. 16). The relationship of inflation and economic growth has been studied within endogenous growth theory.
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Wang and Yip (1992) reassessed the differences of three approaches of endogenous models; i.e. MIU function, CIA and TC models. They suggested that TC (Transaction Cost) model gives different result than other two approaches. Ploeg and Alogoskoufis (1994) extended endogenous monetary growth model, showing the non-neutrality of money in the long run, they concluded that money may affect growth either positively or negatively, depending on the accompanying monetary and fiscal policies. Jones and Manuelli (1995) also presented no growth effect of inflation within endogenous growth model. He found no difference between endogenous and exogenous models. He also analyzed the welfare cost of inflation. The effect of inflation on the welfare was marginal. Gillman and Kejak (2003) in recent paper analysed the theoretical models of inflation and endogenous growth models. He found significant negative relation. He further classified the underlying three models according to Tobin’s Type effect of inflation. They found negative and positive type Tobin effect in Ak and Ah models respectively. However, combing both the models Ak*h model presented a positive Tobin type effect.
Empirical Literature
Paul Gomme (1991) revisited the relationship of inflation and growth under the endogenous growth model with utility and production functions. The objective of his paper was to underline the relation between inflation and growth, at the same time to analyze the welfare cost of inflation. The result of his paper suggested a negative effect of inflation on growth but the welfare cost of inflation was slightly lower. Jose De Gregorio (1991) conducted a research on Latin American countries and the result suggested a negative relationship between inflation and growth. His study was based on the endogenous growth model in order to analyse the channels through which inflation affects growth. He emphasised that inflation is to be stopped however; this will still not guarantee the quality growth (Gregorio 1991; pp. 8-9). Frenandez Valdovinos (2003) empirically found negative relation between growth rate and the level of inflation for eight latin american countries.
Stanely Fischer (1993) carried out a cross-sectional and panel regression to evaluate the relationship between inflation and economic growth. He used regression analogue of growth accounting, initiating from the production function and extending to endogenous variables to the model. The result suggested that growth in negatively related with inflation. He identified the channel through which inflation affects growth. Channels through which inflation affects growth are; reduction in investment expenditures and productivity growth.
Stanners (1993) presented statistical and empirical evidence in order to answer if low or zero inflation rates is an essential condition for growth. He presented number of countries with time series data within an individual country and different panel countries. He found that empirical evidence does not support the idea that low or zero inflation is associated with the growth rate of countries (Stanners 1993, p. 106).
Barro (1996) presented empirical evidence in a panel of 100 countries while using regression analysis. He includes number of determinants of growth with inflation rate. The study suggested that there is significant negative relation between inflation and growth. One of the very important channel through which inflation does affect growth is the investment. However the conclusion of Barro was argued by Stanners (1996) that in fact there is no empirical correlation between the level of inflation and growth rate. Hence, econometric analysis may be misleading.
De Gregerio (1996) added further insight to theoretical and empirical literature of inflation and growth. He extended his study to the role of central bank policy, the way it affects the inflation and output. He particularly focused how the change of inflation rate affects the level of investment and the efficiency of investment. He found a robust negative relationship between inflation and growth through investment. Inflation negatively affects the efficiency of investment rather than it level. He suggested that central bank policy can stabilize the price level and can produce less inflation trend with no real cost. Patnaik & Joshi (1995) found similar empirical result for India. They studied the effects of inflation on output through investment decisions. They concluded a negative long-run relationship between high inflation and investment. It was also suggested that low inflation will be conducive for long-run growth and stability of economy.
Jones, Manuelli and Chari (1995) did an empirical research with the money demand under three different models i.e cash in advance or (CIA) in consumption model, shopping time model and third CIA (Cash in advance) with differential productivity between investment and purchases. They suggested a negative relation between inflation and growth. However, they also studied this relation with the extension of banking, growth and inflation which also suggested a negative relationship.
Alexander (1997) did an econometric empirical research to investigate the trade-off of inflation and growth within a growth equation. He adopted a model under production function by modifying the growth equation with the possibility of addition variables. He selected a pool of time series in a cross section fashion of 11 countries. He suggested that inflation negatively affects the profitability of investment which further affects the output level in the economy. Therefore by lowering the inflation rate, the growth rate is improved. Statistically if inflation is lowered from 6% to 2%, the growth rate will be improved about 1% (Alexander 1997, p. 237-238). With response to this paper, Stanners (1997) opposed Alexander’s work by arguing that growth rates are not related with the inflation rate. Furthermore, he argued that the extension of additional variables in Alexander’s work is not justified and explained within the growth equation model.
Bruno and Easterly (1996) figured the problems with regard to non-linear relationship of inflation and growth within a pooled cross-country datasets. They argued that the relation of inflation and growth is sometimes puzzled if it is studied in a pooled data set. Their study was based on an assumption that highly inflation crisis is more than 40%. They found no correlation for the countries with less than 40% inflation annual rate but above this level there was negative relation for short and medium run (Bruno & Easterly 1996, p. 145). Bruno and Easterly (1997) once again examined the relation under extreme discrete inflation prices (Period in which inflation is above some threshold level; i.e. 40 % annually). They found a significant negative relation between inflation and growth in the short and medium run. However, as the inflation continues to fall below the threshold the growth rate quickly recovers (Bruno & Easterly 1997, p. 3).
Ahmad and Rogers (1998) studied inflation, output, consumption and investment relationship within an econometric empirical analysis for US data. Their cointegration result showed a contradictory view to endogenous negative relation between inflation and other real variables in long run, while supporting the Tobin’s type effect of inflation (Ahmad & Rogers 1998, p. 24-25). Shi (1999) extended AK Cobb-Douglas model within divisible goods and money under the Household preferences and utility. He assumed that capital does not depreciate and the consumption utility to be linear with marginal utility. His findings in a neoclassical monetary growth model suggested that the rate money growth increases the level of tradable transactions by increasing the number of agents in the market. Hence, there is a positive relation between the rate of money growth and capital accumulation (Shi 1999, p. 98). Faria (2001) used econometric analysis of bivariate time series model for Brazil. Unlikely the result supported Sidrauski’s approach of super neutrality of money. It means inflation does not have long-run effect over real growth (Faria 2001, p.100).
Ghosh and Phillips (1998) followed the empirical literature. They found a negative relation between inflation and growth in a penal regression analysis and non-linear specification. However, binary recursive tree methodology was used which suggested inflation is one of the key elements of economic growth. This study was further extended to know the cost of disinflation. They concluded that there are short-run costs of disinflation. Malik and Chowdhury (2001) studied inflation and growth nexus for four South Asian (Bangladesh, India, Pakistan and Srilanka) countries using econometric analysis. They found long-run positive relation between inflation and growth for these countries (Malik & Chawdury 2001p. 123). Gyllapson and Herbertsson (2001) in cross-country panel data of 170 countries found a negative effect if inflation is in excess to 10-2-% annually. They used simple production function model incorporating money and finance in optimal growth with constant returns to capital. Arai et al (2002) focussed on the cyclical and causal relation between inflation and GDP growth with regression analysis for 115 countries. Empirical result showed no evidence that inflation is harmful, except for countries where inflation was caused by oil price shocks (Arai et, 2002, p. 15).
Gillman and Kejak (2002) in a penal study to assessed the effect of inflation on growth within three sector economy with a human and physical capital model under the endogenous utility function. They found a significant negative relation for the penal data. Gillman and Cziraky (2004) constructed a model of non-market sectors with cash in advance and human capital model. In non-market sector transaction takes effect with cash only therefore inflation tax cannot be avoided. Their empiric was based on underground economies of Bulgaria, Croatia and Romania. The result of theory and econometric analysis varied with negative and positive relation for individual countries (Gillman & Czirky 2004, p. 39).
Guerrero (2004) empirically with econometric analysis found significant negative relation for cross countries data. He also suggested that countries that have experienced hyperinflation have turned to low inflation trend than those who have not. Hanif and Gokal (2004) in the case of Fiji found once again significant negative relation between inflation and GDP growth. Boyed and Champ (2006) in a cross country empirical analysis with a banking approach, suggested that countries with 5 or 10 % inflation rate, a reduction in inflation should enhance economic performance. Fountas et al (2002) used GARCH model, the empirical work in the case of Japan showed that high variability of inflation causes inflation uncertainty therefore affecting the output growth negatively (Fountas (82), 2002, p. 293). In similar way, Hwang (2007) tested the causality of inflation and growth in econometric analysis, using VARMA and GARCH Asymmetric modelling,. The results showed that period of high volatility in inflation are followed by increased fluctuation in real growth. Hu-Qin and Zhen-Yu (2006) empirically showed a negative relation between inflation and real growth for china, using econometric analysis (81). Naryana et al (2009) likewise, found that high inflation volatility affects output growth negatively.
The mix theoretical and empirical literature also motivated the non-linear or threshold effect study of inflation and growth. For example, Sarel (1995) in a Penal dataset of 87 countries examined the nonlinear effects of inflation and growth. The result found a structural break. The study explained the reasons of structural break. The positive effect of inflation on growth was found empirically before 1970s, it is just because there were not many episodes of high inflation but during and after 1970s the high inflation trend showed a significant negative effect of inflation on growth. The non-linear effect also found that inflation below 8% has no significant negative effect over growth but above this rate there is a negative effect (Sarel 1995, p. 13). Khan and Sanjida (2001) estimated 1% for industrial countries and 11% for developing countries. Beyond these rates inflation affects growth negatively. Mubarik (2005) showed 9 % threshold effect for Pakistan where as the causality effect was from inflation to growth.
Once of the most concerning issue is the welfare effect of inflation which is striking issue is most of the developing countries. Some papers have exclusively focussed on the welfare effect of inflation through growth model. Rogers and Wang (1993) conducted their research paper understanding the relationship of inflation and growth by putting forward few questions and answering them empirically. They argued; first what is the cost of inflation with comparison to the cost of lowering inflation. Second, why is inflation chronically high in most of the Latin American countries? Third, what are the core reasons of highly inflation episode and finally what is the cost of stabilizing inflation? (Rogers and Wang 1993, pp. 37) By answering these questions, they replied with the result of paper that inflation causes resource misallocation and welfare cost of inflation even if it is moderate but other adverse effects of inflation on the economic activities are moderate. The second answer for high inflation for most Latin American countries was that high Government deficit and monetary expansion leads to inflation trap. Third the reason of high inflation episode was due to fiscal and monetary expansionary policy. Finally the cost of stabilizing would require programs and effective policies and that is why few o
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