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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


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


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


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


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


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 non-

linear 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 (non-

linearity), 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 inflation-

growth 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


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


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