Monetary Economics in Developing Countries (FE3178), 2009-2010 Lecture 4

Money, inflation and growth

Chapter 4, GSF



The lecture introduces theories linking money and growth, starting with James Tobin’s 1965 neo-classical monetary growth model.

The lecture also explains the empirical relationship between money, inflation, and growth.

A key controversy is over the threshold level of inflation at which economic growth begins to slow down

Is the level different for developed and developing economies?


Tobin’s neo-classical model of money and growth

An increase in the money supply will increase inflation and reduce the real interest rate. That could ultimately lead to an increase in aggregate economic activity.

The Tobin effect



Complementarity hypothesis

The demand for money is complementary to the demand for physical capital.

So money is positively related to the propensity to invest (save) given the prevalence of ‘self-finance’.

Liberalising interest rates will probably have a positive effect on economic performance.



• All economic agents are restricted to self-finance;

• There are important indivisibilities in investment activities.

Before undertaking actual investment, the potential investors must accumulate money balances.

The higher the real interest rate, the greater will be the accumulation of money balances.



The Structuralists

The structuralists argue that financial liberalisation polices may increase the marginal cost of funds in the ‘unorganised money market’ by taking resources away from it (van Wijnbergen, 1982; Taylor, 1983)

Those unable to access the formal loans market suffer from the contraction of funds.

Thus the structuralists predict that a monetary policy tightening, i.e. reduced credit availability, and corresponding higher interest rates and costs of financing working capital, leads to contracting output and to an increasing rather than to a decreasing inflation rate.


The effect is equivalent to an adverse supply shock leading to stagflation.

A further prediction from the approach is that, if effective in reducing real aggregate demand, a contractionary monetary policy works by reducing investment and not consumption, with negative consequences for an economy’s growth prospects.



Recent empirical evidence on the complementary hypothesis

Thornton and Poudyal (1990) investigate McKinnon’s hypothesis for Nepal. They model the demand for money and the savings functions applying the two-stage least squares econometric technique and using data from 1974 to 1987.

Thornton and Poudyal’s results support McKinnon’s hypothesis for Nepal.

Demetriades and Luintel (1996) also investigate Nepal, and find that financial deepening and economic growth are jointly determined.


Ghatak (1997) further examines the theory in question, and he focuses on Sri Lanka’s experience with financial liberalization.

The paper investigates the invariance of the structural parameters and the model’s robustness in the light of Lucas’s critique -stating that a model’s structure is likely to be affected by agents’ expectations.

Ghatak finds no evidence of Lucas’s critique in his exercise. His results do unveil a positive and significant effect of financial liberalization on economic growth in Sri Lanka between 1950 and 1987.


Demetriades and Luintel (1997) study India’s experience with financial repression policies. Interestingly, they not only focus on investigating McKinnon and Shaw’s benchmark postulates on financial repression’s adverse impact via the real interest rate.

They also look into the policy’s effect on financial depth.

Demetriades and Luintel develop an index of financial repression based on several indicators –like interest rate controls, reserve requirements, and direct credit programmes- employing the principal components approach.


They study the link between the financial repression index and financial depth using annual time series data spanning 32 years, and employ competing single equation cointegration techniques.

Demetriades and Luintel’s key finding is that financial repression policies had a negative effect in India over and above the traditional real interest rate effect widely investigated in the literature.

Demetriades and Luintel (2001) also investigate financial repression policies in South Korea. In so doing they employ some of the empirical techniques featuring in Demetriades and Luintel (1997).


The authors show that financial deepening will not improve as a result of increasing the administered deposit rates. In contrast, financial repression (i.e. government intervention) policies seem to have been positive for financial development and for South Korea’s overall economic growth and development process.

Thus Demetriades and Luintel’s findings contrast with a large literature investigating financial liberalisation and their impact on financial development.

Some studies focus on using a technically compelling approach in testing the complementarity hypothesis. In this regard Pentecost and Moore’s (2006) contribution is testing McKinnon’s complementarity hypothesis specifying a system of equations comprising investment and money equations.


They apply Johansen’s (1988) multivariate cointegration technique and the vector error correction (VECM) model, and perform exogeneity tests. The authors contend that using such an approach is important. That is the case because the previous literature has focused on estimating stand-alone investment (or savings) and money demand functions, and that may lead to calculating biased coefficients.

Pentecost and Moore also perform structural break tests around India’s financial liberalization reforms between the end of the 1980s and the beginning of the 1990s. Using annual data on India ranging from 1951 to 1999, they find support for the complementarity hypothesis.


That is chiefly reflected in positive real interest rate coefficients affecting the investment and the money demand functions. However, they also find that investment’s and money demand’s sensitivity to interest rates has not significantly changed following financial liberalisation in India.



Much evidence arises from models assuming that there is a linear relationship between money and growth, and there is somewhat firm evidence that high inflation is bad for growth (e.g. De Gregorio, 1992; Barro, 1995).

However, an influential paper by Levine and Zervos (1993) reveals that inflation’s effect on output does not pass Leamer’s extreme bounds tests in growth regressions (see also Sala-i-Martin, 1997).

That is, inflation is not robustly associated with economic growth in a statistical sense.


Also, Bruno and Easterly (1998) show that after excluding countries with inflation rates above 40 percent from growth regressions inflation’s statistical significance diminishes.

Modelling the relationship amongst these variables has recently considered the relevance of considering nonlinear and threshold effects. That is, whether or not there is a certain level (threshold) of inflation beyond which it actually matters more, say than at lower levels (nonlinearity), in determining economic growth.

Sarel (1996) is amongst the first contributions along these lines. His main contribution is acknowledging the importance of allowing for a ‘kink’ in the inflationgrowth nexus at low levels of inflation, and he estimated it to be at around 8 percent inflation. That is, according


to his findings, inflation’s adverse impact on growth is significant when inflation rates climb above 8 percent per annum.

Following this line of inquiry, Ghosh and Phillips (1998) run regressions using panel data ranging from 1960-1996 and covering 145 countries. Their results show that there is a negative link between inflation and growth at all but the lowest levels of inflation.

More precisely, they estimate that at inflation rates of, say, 2-3 percent per annum or lower there is a positive relationship between inflation and growth. They also estimate that inflation’s negative impact on growth displays a significant non-linear pattern.


In this regard, Ghosh and Phillips reckon that an increase in inflation from 10 to 20 percent results in a larger reduction in output than an inflation rate moving from, say, 40 to 50 percent. Importantly, their results appear to be quite robust to alternative specifications and sample periods.

Khan and Senhadji (2001) further examine threshold effects in the inflation-growth link. The study employs data on 140 countries for the period 1960-1998. Importantly, their analysis distinguishes between the relevant thresholds for developed and for developing economies, which seems quite sensible.


Khan and Senhadji estimate that inflation’s negative impact on growth in developed economies becomes significant for rates beyond the 1-3 percent rate. In contrast, for developing economies that seems to happen for inflation rates exceeding 11-12 percent.

Gillman and Kejak (2005) explain the non-linearity between inflation and growth consistently present in empirical.

They achieve that result by considering a money demand function with an interest elasticity that is an increasing function of the inflation rate.

Their proposed mechanism implies that credit is used for substituting away from real money balances as inflation rises.

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