Growth inflation trade-off

A recent paper by IMF economists said inflation damages growth only beyond a certain level. So, central banks could move to a higher inflation target so that zero lower bound does not impact as severely as it has in this crisis. In one of the interviews on the paper:

The most striking suggestion you make is that nations should consider aiming for a higher rate of inflation,  

Blanchard: Before the crisis, if you talked to policy makers, the idea of being stuck at zero interest rate would have struck them as very unlikely. That happened in Japan. But most people convinced themselves that the Japanese didn’t know what they were doing.

Now we realize that if we had a few hundred extra basis points to rely on, that would have helped. We would have had to rely less on fiscal policy. So it would have been good to start with a higher nominal rate. The only way to get there is higher inflation.  

Policy makers have generally chosen a 2% (inflation rate target). But there was no  very good reason to use 2% rather than 4%. Two percent doesn’t mean price stability. Between 2% and 4%, there isn’t much cost from inflation.

As expected, this proposal was thrashed by most central banks/economists and some even called it the worst suggestion they have heard.

Anyways, this growth-inflation trade-off is always an interesting empirical question. How much inflation can an economy tolerate? After what level of inflation does growth start to decline?

Another set of IMF economists have released a paper looking at this relationship.  

Research on the inflation-growth nexus have addressed three key questions: (i) is there a robust negative relationship between inflation and growth? (ii) is there a “kink” in the relationship such that at very low levels of inflation the relationship is positive (perhaps due to Phillips curve effects), but at higher levels of inflation the relationship is negative? and (iii) does inflation have to reach some minimum “threshold” before the growth effects become serious?

A starting point to answering these questions is the identification of the threshold  optimal, tolerable) beyond which inflation has a negative effect on growth. Empirical studies have found a significant statistical relationship between inflation and growth, even after controlling for fiscal performance, wars, droughts, population growth, openness, and even human and physical capital, and allowing for simultaneity bias.

Measuring the threshold level of inflation in a cross-country framework runs the risk of being influenced by extreme values since samples typically include countries with inflation as low as 1 per cent and as high as 200 per cent. Ideally, inflation thresholds should be estimated for each country separately, allowing the incorporation of country specific characteristics. Nevertheless, since the relationship between inflation and growth is likely to be stronger at low frequencies, and the data rarely cover more than 40 years, the literature has mostly relied on panel techniques.

The authors point to number of empirical studies. For India some studies have shown it is around 5-7%.  In this paper authors increase the number of countries. The findings are:

Using a panel of 165 countries covering the period 1960–2007, we estimate that for emerging market economies inflation above a threshold of about 10 percent quickly becomes harmful to growth, suggesting the need for a prompt policy response to inflation at or above that threshold. For the advanced economies, the threshold is much lower. For oil exporting countries, the estimates are less robust (there are two potential modes for the bootstrapping distribution, reflecting some heterogeneity among oil producers), but we estimate the threshold to be again about 10 percent. The effect of higher inflation for oil producers is also stronger than for the rest of the countries.

I thought 10% threshold for emerging economies is on the higher side. Anyways, that is what this research paper shows. 

4 Responses to “Growth inflation trade-off”

  1. Kurt Streich Says:

    I think this statement that inflation brings little disruption of growth is only true sometimes. This would be in times of recession when we at within the Keynesian range with a horizontal supply curve. But, in good times, increase in aggregate demand can’t always lead to economic growth; it will lead to a huge inflation bubble. I don’t know in what times of economic prosperity these researchers did their studies, but if they were in relatively good times, perhaps we are learning that short run aggregate supply is more horizontal than we think near full employment. If so, the fed could buy up more securities, increase the money supply, cause lower interest rates, increase investment, and raise investment demand, which, according to this theory, would work harder to moving our economy toward full employment than to hurting us with inflation.

  2. Growth inflation trade-off « Mostly Economics « Rubber Tyres –> Smooth Rides Says:

    […] Growth inflation trade-off « Mostly Economics Blogged with the Flock Browser ▶ No Responses /* 0) { jQuery('#comments').show('', change_location()); jQuery('#showcomments a .closed').css('display', 'none'); jQuery('#showcomments a .open').css('display', 'inline'); return true; } else { jQuery('#comments').hide(''); jQuery('#showcomments a .closed').css('display', 'inline'); jQuery('#showcomments a .open').css('display', 'none'); return false; } } jQuery('#showcomments a').click(function(){ if(jQuery('#comments').css('display') == 'none') { self.location.href = '#comments'; check_location(); } else { check_location('hide'); } }); function change_location() { self.location.href = '#comments'; } }); /* ]]> */ Click here to cancel reply. […]

  3. unicon india Says:

    The most striking suggestion you make is that nations should consider aiming for a higher rate of inflation.

    Before the crisis, if you talked to policy makers, the idea of being stuck at zero interest rate would have struck them as very unlikely.

  4. select your broker Says:

    Now we realize that if we had a few hundred extra basis points to rely on, that would have helped. We would have had to rely less on fiscal policy. So it would have been good to start with a higher nominal rate. The only way to get there is higher inflation.

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