They argue that inflation reduces real interest rates, creating imbalances in the capital market. This leads to a decrease in the supply of capital, so private investment will decrease due to limited sources of borrowing. A decrease in positive real interest rates reduces investment and economic growth.
High inflation and strong fluctuations make non-state sector investment, although having excess capital, not invest in long-term due to high risk but switch to short-term investment, therefore, investment quality is not high.
If the exchange rate is fixed or slow to adjust, higher domestic inflation will reduce the relative profits of enterprises producing and trading in tradable goods, increase the demand for imports and reduce the supply for exports, thus worsening the trade balance and exacerbating the foreign currency shortage. This will reduce the effectiveness of the process of opening up and integrating with the region and the world, negatively affecting the country's overall macroeconomic achievements.
Through the above analysis, we see that there are two opposing views on the impact of inflation on economic growth. Currently, most economists believe that the structuralist view of a positive correlation between inflation and unemployment is basically appropriate when inflation is low, while the opposing view is appropriate when inflation is high.
1.1.5. Studies testing the relationship between inflation and economic growth in monetary policy management
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1.1.5.1. Linear form [ 13, 87] [ 20, 74]
In some analyses, the inflation variable is presented in a linear form. In this particular type, the empirical relationship depends largely on the statistical results of the association between the inflation variables. As a result, the relationship may be positive, negative, or insignificant.
Mundell (1965) established an aggregate model of inflation to show the relationship between inflation and development: [ 13, 87]
In there:
g y : growth rate,
g y
1
v 1
(1.9)
: inflation rate
v : velocity of money which is assumed to be constant
: reserve ratio in the banking system
: capital/output ratio.
Through this model Mundell (1965) showed a positive relationship between inflation and growth.
To find a significant positive relationship between inflation and growth, using a bivariate approach, Thirwall and Barton (1971) selected countries with per capita income above $800, regressed growth (Y) on inflation (X) and obtained the following results: [ 13, 87]
Y 2.793 6.612
And note that “for average inflation in the countries studied, a 1 percentage point change in the average inflation rate tends to be associated with 0.6 percentage points of growth above average.”
Kormendi and Meguire (1985) investigated 47 countries over the period 1950 - 1977 with the following regression equation to find a significant negative relationship between inflation and growth.
MDY j 0 1 YPC j 2 MDPOP 3 SDY j
SRM MDM MDGX MDEXX MDINF
(1.10)
4 j 5 j 6 j 7 j 8 j
MDY j : median growth in real aggregate output of the country
YPC j : initial per capita income
MDPOP j : median population growth rate
SDY j : standard deviation of real output growth
SRM j : standard deviation of money supply shock
MDM j : median of money supply growth
MDGX j : median growth rate of government consumption as a share of output
MDEXX j : median growth of exports as a share of output
MDINF j : median inflation rate growth
The regression results show that the coefficient of inflation impact on growth is -0.84. Grier and Tullock (1989) implemented the study of Kormendi and
Meguire, when conducting a survey in 115 countries including OECD countries in the period 1950 - 1981 with an average of 5 years. Grier and Tullock regressed real economic growth on 7 regressors including: (1) initial real GDP per capita, (2) share of government spending in GDP, (3) standard deviation of GDP growth, (4) population growth, (5) inflation, (6) change in inflation, (7) standard deviation of inflation. The results showed that inflation had a negative impact on growth for developing countries, and had no impact in OECD countries.
Burdekin (1994) processed annual data of 23 industrial countries and 49 developing countries for the period 1960 - 1990 using the regression function:
GROWTH 0 1 INF 2 CHINF 3 TIME 4 OIL ( 1.11)
GROWTH : growth rate of real GDP
INF : CPI inflation
CHINF : first difference of CPI inflation index
TIME : time trend
OIL : oil price
: allowable error limit
And concludes that “inflation has a negative and significant effect on growth.” He also notes that the inclusion of oil prices in the regression is to control for external price shocks.
1.1.5.2. Nonlinear form [ 13, 89] [ 20, 77]
In fact, inflation has been widely viewed as a negative factor affecting economic growth. However, this negative effect was not found in the data from the 1950s and 1960s. Until the 1970s, many studies showed that the effect was insignificant, or even positive. The change in opinion came only after many countries experienced severe periods of high and persistent inflation in the 1970s and 1980s. With more data available for these periods, studies have reaffirmed that inflation has a significant negative effect on economic growth. The sudden change in views on the impact of inflation on economic growth raises the question: Since the estimated effects of inflation on growth are quite small, should the results of these studies influence policy and institutional priorities, and if we accept a particular range of inflation values, what should that range be?
To answer these questions, studies have investigated the possibility of a nonlinear effect of inflation on economic growth and found evidence of the existence of a structural change in the relationship between growth rate and inflation. When inflation is low, it does not have a significant negative effect on economic growth. But when inflation is high, it has a negative effect on growth. The existence of a structural change may explain why the negative effect of inflation on economic growth has not been detected.
over a long period of time: before the 1970s there were not many periods of high inflation.
In 1971, Mundell abandoned the assumption of constant velocity of money, presenting a case where the velocity of money is positively related to inflation:
In there:
v v 0
(1.12)
v 0 : velocity of money when inflation is 0
: coefficient showing the effect of inflation on the velocity of money Mundell gives the equation:
g
y
v 0 1
(1.13)
This model shows the non-linear effect of inflation on growth.
growth. In particular, the first derivative of g y is given by:
v 0 1
g y
v 2
0 1
(1.14)
This derivative is a bell-shaped model of the denominator that shows a nonlinear relationship between inflation and growth. However, over the entire range of inflation values, the expression of the partial effect of inflation on growth is consistent. In addition, the inflation threshold, an important point at which the partial effect of inflation on growth changes direction, is calculated as follows:
1 v 0 /( )
/( )
(1.15)
There are several methods used to identify the non-linear relationship between inflation and growth. These methods use quadratic functions, partitioning the data on the basis of arbitrary thresholds, and symmetrical positioning of the thresholds.
Thirwall and Barton (1974, 1978) modified their earlier studies by introducing a quadratic function:
y ˆ / p ˆ
a bp ˆ
(1.16)
Or
y ˆ p ˆ p ˆ 2
(1.17)
The use of quadratic functions encounters a fundamental obstacle in not being able to achieve the asymmetry in the relationship between the two sides of the midpoint.
Stanners (1993) uses a quadratic function to show that the relationship between growth and inflation is U-shaped or inverse U-shaped. In addition, there are some cases of concave and convex negative relationships. However, many cases do not show a statistically significant relationship.
Another approach is to divide the sample data by arbitrarily chosen thresholds. Fischer (1993) divided the data into three ranges of inflation, below 15%, 15% - 40%, and > 40%. Through this approach, Fischer (1993) found a negative relationship between inflation and growth in all three ranges. Furthermore, he concluded that “.. the effect of inflation is nonlinear but with each percentage point of inflation, the relationship between inflation, growth, and its determinants weakens on average as inflation increases ”.
Bruno's (1995) research results show that growth declines sharply during periods of high inflation (about more than 40%/year) and in general, growth recovers quickly after inflation is stabilized.
Sarel's (1996) study used data on population, GDP, consumer price index, terms of trade, real exchange rate, government expenditure and investment ratios. The two databases are PWT 5.5 and World Table. [ 20, 77]
CPI and trade data are used to reduce the negative correlation between inflation and growth rates that is not directly caused by the impact of inflation on growth.
These two databases are combined into a common database that includes annual information for 87 countries from 1970 to 1990. The 20-year sample period is divided into four periods (5 years/period) consisting of a total of 248 observations. In each 5-year period, between years t and t+5, the growth rate of output per capita, the population growth rate, the inflation rate, and the rate of change in terms of trade are calculated as logarithmic averages of the annual changes during that period: [ 20, 77]
Growth (t, t +5)
log (
=
y t 5 )
medical
5
(1.18)
n (t, t +5) =
log (
pop t 5 )
pop t
5
(1.19)
π (t, t +5) =
log ( T t 5 )
P t
5
(1.20)
∆TOT (t, t +5) =
log ( TOT t 5 )
TOT
5
(1.21)
To find the inflation threshold, he used a simple estimation method, first he introduced the inflation variable:
*
β 1 log (π) + EXTRA (1.22)
EXTRA
2 D [log(
)
log( * )] ,
Or:
1 log(
)
2D
* [log(
)
log(
* )]
π : inflation rate
π * : inflation threshold
D: dummy variable, takes the value 1 if π > π * ,
takes the value 0 if π < π * ,
µ, β: parameters of the equation
He then conducted OLS regressions on two variables log (π) and EXTRA combined with the variables income per capita (LY); government expenditure (GOV), population growth rate (N) and the rate of change in terms of trade, he found empirical evidence for a threshold level of inflation rate of 8% per year. Below that rate, inflation has an insignificant effect on growth, or may have a slight positive effect on growth. At inflation rates higher than 8%, this effect is inverse and significant. According to him, if we ignore this important fact, we will certainly draw misleading conclusions about the effect of inflation on economic growth.
Using Sarel's method, in the study of Khan and Senhadji (2001), the study was based on the data set of 140 countries in the period 1960 - 1998, to test the existence of an inflation threshold according to the model:
d log (y) = µ + β 1 log (π) + β 2 D π* [ log (π) – log (π * )] + θ ' X + ε
(1.23 )
In there:
d log( y ) : GDP growth rate
X: includes independent variables such as investment/GDP ratio; population growth rate; first-year per capita income; rate of change in terms of trade. X includes only some of the most important variables.
The impact of inflation on growth is expressed as β 1 in countries where inflation is less than or equal to π * , and (β 1 + β 2 ) in countries where inflation is higher than π * .
To find the inflation threshold, he estimated a series of different values of π. The optimal value π * corresponds to the case where the squared deviation of the estimator is minimum.
The results show that there exists a threshold below which inflation and growth are positively correlated and above which inflation has a negative impact.