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Inflation-Economic Growth Relationship

Introduction
Countries objectify to achieve rapid and sustainable economic growth. However,
achieving such objective is difficult for most countries because of various aspects that impact
economic growth. According to Barro (1995), inflation is one of the several variables that
determine economic growth. As such, most countries pay more attention to dealing with
inflation-related effects on economic growth. The efforts to deal with inflation effects are
informed by the perception that price stability in a critical determinant in not only economic
growth but also in sustainable development. The mandate behind the establishment of central
banks is maintaining price stability and promoting high economic growth rates. People’s
confidence in money as a medium of exchange declines whenever the value of money
deteriorates. The consequence is reduced savings, investment, and a reduction in economic
growth (Tutor2u, 2009).
There are various theories and empirical studies regarding inflation-economic growth
through their findings are not conclusive. According to Li (2006), the nature of the relationship
that exists amid inflation and economic growth and the avenues via which inflation implicates
actual economic activities is surrounded with controversy. From the previous studies, the
inflation-economic growth relationship may not exist (Sidrauski, 1967), it might have a negative
correlation (Fisher, 1993), or it might have a positive correlation (Mallik & Chowdhury, 2001).
Additionally, existing literature indicates different channels via which inflation impacts
economic growth with Capital accumulation being the most significant channel.
The existing literature on the relationship between inflation and economic growth have
emphasized only the availability of the connection and the inception impact amid the two
variables and overlooked the avenues through which inflation severely affects growth. As the
focus on capital accumulation as an essential way through which inflation impacts economic
growth is emphasized, the current study sought to fill the existing literature gap by investigating
the kind of relationship that exists among inflation and capital accumulation as well as economic
growth. The study tried to respond to the concerns on whether inflation is related to capital
accumulation and whether the inflation impact on capital accumulation has a similar trend to that
of inflation effect on economic growth.

2.0 Background on Inflation-Economic Growth Relationship

Sustainability of economic growth and price stability are core goals of macroeconomic
policies in most world countries in modern day society. According to Umaru and Zubairu (2012),
the focus on monetary policy is on price stability with the standpoint to ensure sustainable
economic growth and to enhance the domestic currency’s purchasing power. The issue of
whether inflation is harmful or helpful in economic growth is hugely debatable amongst the
policymakers as well as the macro-economists. Many studies allude that inflation is negatively
correlated to economic growth. Notably, the contentious issue is if inflation is essential for
economic growth or it has a detrimental effect on growth.
Fundamentally, the economic growth rate relies mostly on the capital formation rate
which is also dependent on the savings and investment rates (Datta & Kumar, 2011). Economic
growth, as well as levels of inflation across the world, have been fluctuating. According to
Madhukar & Nagarjuna (2011), the dominance of inflation rates has been above that of
economic growth over the years. The dominating effect of inflation rates have made the
inflation-economic growth one of the serious macroeconomic problems. Ahmed (2010) indicates
that the inflation-economic growth relationship has been debated across many pieces of literature
and the debates depict variations that are in line with the world economic order. The policies
hold that an increase in total demand attracts increased production as well as inflation. However,
in the past, inflation was regarded as positive and accepted as a contributor to economic growth.
An argument was put across that inflation had the effect of reducing unemployment rates and
hence spurring economic growth. In the 1970s, areas with high inflation rates such as the
countries in Latin America started recording a reduction in economic growth rates, and this gave
birth to the views that the effect of inflation had severe negative impacts on economic growth.
Evidence on inflation-economic growth relationship in different countries shows that
GDP varied with a variation in the inflation rate. For instance, in India, the GDP increased from
3.5 percent to 5.5 percent in the 1970-1980 period while inflation rose from 1.7 percent to 6.4
percent in the 1960-1970 timeframe and later to 8 percent in the 1970-1980 timeframe (Prasanna
& Gopakumar, 2010). In Tanzania, for the 1952-1970 period, the rate of economic growth was
5.2% while the official inflation rate was a single digit. During the 1966-1970 period, the official
inflation rate was 11.7%. Ndyeshobola (1983) shows that in 1964-1969 timeframe, inflation on
the National Consumer Price Index (NCPI) was 0.3 percent. The NCPI increased by averagely
16 percent in the 1973-1975 period causing serious food problems in Tanzania. The results were
different in different countries but portrayed a similar trend regarding the inflation-economic
growth relationship.
The link regarding inflation and economic growth has been a theme of argument despite
the primary goal of macroeconomic policies being the promotion of economic growth as well as
a reduction in inflation. Scholars allied to the Structural and Keynesian viewpoints argue that
inflation does not harm economic growth while scholars allied to monetarist perspectives hold
the view that inflation has adverse effects on economic growth. Other scholars hold the belief
that there exists a link amid inflation and economic growth, though short-term (Datta & Kumar,
2011). The divergent perspectives and the controversies surrounding them motivated the research
inquiry on the inflation effect on economic growth across countries.

3.0 Discussion
There are both theoretical and empirical foundations regarding the relationship between
inflation and economic growth.

3.1 Theoretical provisions on Inflation-Economic Growth relationship

Many economic theories have extensively handled the subject of inflation. Different
economic theories explain inflation and its implication on economic growth.
3.1.1 Keynesian Theory
John Keynes, in his book, presents what is commonly considered Keynesianism
perspective and modern microeconomics. Keynesianism postulates that on a macro-economic
scale, it is difficult to achieve full production as well as full employment due to market
adjustment. Keynesianism highly regards the government’s economic interventions through
economic policies to boost investment and increase demand to realize total production. Effective
demand maximizes the utilization of limited resources and upon achievement of the full output,
further demand becomes excess demand. In Keynesian Theory, the Aggregate Demand and
Aggregate Supply (AD-AS) curves are used to illustrate how inflation and production, as well as
employment, are related.

Figure 1: A Graph of AD-AS Curve based on Keynesianism

In the graph above, P is the nominal price while Y is the output.
In the event current resources are underutilized, government interventions promote
effective demand which penance output and employment with no generation of inflation till full
production in output (Y2) are attained. From the AD graph above, the AD curve at AD1 position
representation a situation where total output, as well as full employment, are not achieved.
Efforts to increase effective demand cause an outward shift of the AD curve from AD1 position
to AD2 making the production to reach full level while the price remains at position P1. A
further rise in demand causes a shift in the curve from AD2 to AD3, but there will be no change
in output as full output shall have been achieved at Y2 under AD2 position. The excess demand
results to increase in the price from P1 to P2. The increase in price brings in the issue of inflation
which is commonly termed as demand-pull inflation as it emerges due to excess demand.
Nonetheless, Figure 1 shows that demand-pull inflation has no long-term impact on the output.

3.1.2 Monetarism Theory

Keynesian Theory fails to explain nor give resolutions to the incorporation of high
inflation, excess unemployment, and stagnating growth that existed in many developing states in
the 1970s. The failure of the Keynesian theory gave birth to Monetarism theory which postulates
that money supply is the single-most component that dictates price levels in any economy and
any government intervention should be focused on management of rate of growth of money
supply so that there is harmony between money supply and long-run rate of growth of output.
Equation (i) is used in monetarism, and it depicts the Quantity Theory of Money transformation
showing an unequivocally negative inflation-economic growth relationship.
Π=( ΔM/M)-( ΔY/Y)-------------------------------Equation (i)
Where is Π inflation, ΔM/M is the money supply growth rate and ΔY/Y is the output
growth rate
Additionally, the Phillips Curve presents the tradeoff relationship involving inflation and
unemployment. Monetarism explains ‘stagflation’ as a consequence of high government
intervention in the marketplace and its associated distorting effect on the market mechanism.
Considering this believe, Philips Curve shows an upwards sloping trajectory pointing to a
positive inflation-unemployment relationship.
 Figure 2: A graph Showing Philips Curve
Phillips Curve is divided into short-run and long-run under monetarism. In the short-run,
projected inflation that is below actual inflation will result in actual wages that are lower than
nominal wages. Increasing profits of firms will have a boosting effect on investment which will
eventually reduce unemployment. However, in the long-run, real wages and nominal wages are
identical with expected and actual inflation showing inevitable consistency. The situation is
regarded as neutrality/superneutrality of money. Neutrality applies when equilibrium values of
the actual variables are independent on the money supply level on the long-run basis while
superneutrality is applicable where real variables are involved (Gokal & Hanif, 2004).
3.1.3 Neo-classical Growth Theory
The theory considers saving rate and population growth rate as well as technological
progress as exogenous. The level of capital moves and stabilizes at a constant level where the
output will remain steady at existing exogenous variables. A disturbance on the existing balance
due to alteration in exogenous variables results in the establishment of a new steady state.
According to the theory, channels through which the effect of variables influence economic
growth include Total factor productivity and growth in the capital as well as labor. Tobin (1965)
have tried to explain the inflation influence on the growth of the economy based on the neo-
classical growth theory. According to Tobin (1965), inflation-caused increase in nominal interest
compels people to prefer investment to consumption. The result of such is increased capital
accumulation that will fuel economic growth. Such argument alludes to a positive association
amid inflation and growth of the economy. On the contrary, Stockman (1981) presumes cash-in-
advance constraint in which actual money balances and investments are complementary.
Stockman’s model maintains that inflation will lower real money balances as well as investment
and hence a negative effect on economic growth.
3.1.4 New Growth Theory
According to the theory, development in technology has an internal cause. Additionally,
the theory considers marginal product of capital as being constant. The New Growth Theory
argues that the effect of inflation on the returns on capital is dependent on the relation amid
investment and the amount of goods and services that a given amount of money can purchase. In
cases where the actual amount of money that can buy a given level of goods and services can be
substituted with investment, inflation will lower return rate on the actual amount of money
available. In the same situation there will be an increase in return on investment. The two
situations above which involve substitution relationship between investment and available
money for buying goods and services point to the existence of a positive inflation-economic
growth relationship. On the other hand, a complement relationship between real money balances
and investment result in an adverse effect of inflation on economic growth. The latter situation
point to a negative relationship regarding inflation and growth of the economy.
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3.2 Empirical evidence on Inflation-Economic Growth Relationship
Theoretical conceptions show different arguments on inflation and its influence on the
growth of the economy. In the actual world, the postulations and limitations of theoretical
underpinnings regarding inflation and growth of the economy help in explaining an already
complicated issue. Previous studies have thrown weight into the complexity of the subject as
there exist inconclusive debate regarding the nature of the association between inflation and
growth of the economy in past empirical studies.
Fischer (1993) used empirical data and growth accounting method to study the
relationship between inflation and growth. He calculated Solow residuals and made regression of
productivity residual and an increase in capital accumulation among other components of
economic growth with a consideration of inflation. The results of Fischer’s study indicate that
inflation affects economic growth via capital accumulation and total factor productivity. The
study concludes that the effect of inflation is negatively related to economic growth.
Nevertheless, the study cautions that direct evidence showing direct inflation-growth relationship
is non-existent.
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Furthermore, Fischer (1993) argues that inflation has a detrimental effect on investment.
Fischer explains that inflation is having a distorting impact on price mechanism which then
distorts price levels affecting the efficiency of resource allocation. The negative influence
cascades down to affect economic growth adversely. Other supportive studies show that inflation
has a changing effect on money and capital returns that changes the choice by consumers and
enterprises, and there can be a diversion to economic activities because of adverse-risk. Such
changes have impacted the influence of price mechanism distorting the initially effective
resource allocation.
Buerdekin et al., (2000) state that the relationship between inflation and growth of the
economy is non-linear. They argue that breakpoint levels for estimation should be different and
unique between develop and emerging economies. The study found an 8 percent threshold in the
relationship between the two variables in developed countries while the limit in emerging
economies was 3 percent. According to Khan & Senhadji (2000), a 1-3 percent threshold of the
relationship exists in developed countries while in developing countries the limit is 7-11 percent.
The evidence, in this case, is that beyond the breakpoints, there is a negative correlation between
inflation and economic growth. The level of inflation is a reflection of the structural features of a
country and hence different threshold levels are likely to exist in different countries
(Christoffersen & Doyle, 1998).
Mallik and Chowdhury (2001) adopted co-integration as well as error-correction models
in their study of inflation-economic growth relationship and discovered that inflation is
positively related to economic growth in the long-run. Ahmed and Mortaza (2005) also used the
two models in studying inflation in Bangladesh, and the results showed that negative inflation-
economic growth exists when inflation is above the structural breakpoint and there does not exist
a statistically significant relationship between the two variables when inflation does not exceed
the breakpoint.
Bruno and Easterly (1995) find no relationship between inflation and growth in the
economy. The study on Brazil, an economy known with high inflation over time, showed non-
relationship between the two variables on the long-run but found a negative relationship in the
short-run (Faria & Carneiro, 2001). Contrary to the conclusion by the two studies, Faria &
Carneiro (2001) while studying on inflation in countries based in Latin America discovered a
negative inflation-economic growth relationship in the long-run. Gregorio (1996) emphasize the
crucial role of central banks in controlling inflation and concludes that inflation negatively
affects economic growth.
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Previous studies have depicted divergent views regarding the relationship between
inflation and growth of the economy. Although there is evidence in empirical literature that
inflation above the threshold level negatively affects growth, positive relationship, as well as
non-relationship, also exist. Lack of conclusive results points to the complexity of the
relationship between the two variables.

4.0 Conclusion
The study sought to determine the nature of the relationship that exists between inflation
and growth of the economy. Different theoretical underpinnings show different arguments
regarding the association between the two variables. Equally, past empirical studies have
depicted the complexity of the matter, and presently there is no unambiguous and conclusive
finding. Previous literature indicates that structural attributes of a country have a direct influence
on the way inflation relates to economic growth in that particular country. Perhaps, a variation in
structural characteristics in different economies is the reason behind many studies with mixed
results about the relationship between the effects of inflation and the growth of the economy.
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Both theoretical and empirical findings point to a significant effect of macro-economic
policies in a country. Different studies show that there is a level beyond which the impact of
inflation become detrimental to the economy. Macro-economic policies should always ensure
that inflation rates are kept below the threshold levels to avoid adverse effects on economic
growth. Equally, there are studies and theoretical arguments that have shown the positive impact
of inflation on the growth of the economy. Such finding implies that some level of inflation is
necessary for the growth of the economy. Therefore, macro-economic policies should be
designed in a way that they allow for the existence of an acceptable level of inflation to trigger
economic growth.
Evidence shows that inflation cannot be eliminated or an economy cannot exist without
inflation. The point of departure is on the level of inflation in a country. There are levels of
inflation that do not affect economic growth, and their existence cannot be felt. Acceptable levels
of inflation motivate economic growth and hence they should be adopted due to their positive
relationship with economic growth. Inflation levels that exceed breakpoints are detrimental
because they lower savings and investments which are the key drivers of the economy. There
should be a fight against excess inflation because it adversely impacts the growth of the
economy. As such, inflation is a central issue in any economy, and its impact is relative
depending on the structural features of the particular economy and the inflation threshold level in
that economy. Therefore, there is no conclusive and definitive nature of the inflation-economic
growth relationship as the association is dependent on the particulars of a specific economy.

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