Empirical studies for the industrial nations have generally confirmed the hypothesis that, owing, inter alia, to uncertainty effects, inflation has a negative impact ...
Applied Economics Letters, 1994, 1, 175–177
The effects of inflation on economic growth in industrial and developing countries: is there a difference? RI CH A R D C. K . BU R D E K I N , T H O M A S G O O D W I N * , S U Y O N O S A L A M U N ‡ A N D T H O M A S D . W I L L E T T§ Department of Economics, Claremont McKenna College, 850 Columbia Avenue, Claremont, California 91711-6420, USA, *Pitzer College, Claremont, California 91711, ‡ Government of Indonesia, Jakarta, Indonesia, § Claremont Graduate School and Claremont McKenna College, Claremont, California 91711 Received 19 July 1994
Using panel estimation for a large sample of industrial and developing countries we find significant negative effects of inflation on economic growth. The magnitude of these effects is, however, much larger for the industrial countries than for the developing countries
I. INTRODUCTION Empirical studies for the industrial nations have generally confirmed the hypothesis that, owing, inter alia, to uncertainty effects, inflation has a negative impact on economic growth. There is, however, less evidence on developing countries. 1 We find that, while high inflation is costly in terms of economic growth for developing as well as for industrial countries, this relationship appears to be considerably weaker for developing countries.
I I . E M P I RI CA L F I N D I N G S Following the approach used in Grimes’s (1991) study of 21 industrial countries, we regress output growth on the level of inflation, the first difference in the inflation rate, a time trend and oil prices for 23 industrial countries and 49 developing countries over annual data for the 1960-90 period. This formulation seeks to correct for short-run Phillips curve effects arising from changes in the inflation rate and from supply shocks as proxied by oil prices.
We have: GROWTH = b b
+ b 1 INF + b 2 CHINF + 3 TIME + b 4 OIL + e
0
(1)
where GROWTH = the growth rate of real gross domestic product INF = the rate of growth of the consumer price index (CPI) CHINF = the first difference of the CPI inflation rate TIME = a time trend OIL = oil prices2 e = a white-noise error term The results of panel estimation for industrial and developing countries taken together, and then for industrial and developing countries separately, are given in Table 1. The panel estimation technique pools the data from the different countries, and provides gains from increased degrees of freedom and increased efficiency relative to standard single-country regression analysis. 3 Each set of results reveals a significant negative effect of the oil price variable, suggesting the importance of supply shocks over this period. The effects of inflation on growth are also negative and significant throughout, while the change in inflation is insignificant
1 Exceptions
are Grier and Tullock (1989) and Cooper (1992). prices for Venezuela are used as a proxy for the world oil price as Venezuela is the only country to have oil price data for the full 1960-90 sample period. 3 Fixed-effects estimation is employed and the intercept is free to vary across countries. The assumptions of the fixed-effects method used to pool the data could not be rejected at the 5% level based on the critical values given by Leamer (1978, p. 114) that allow the nominal significance value to be a function of sample size. 2 Oil
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Table 1. Results of panel estimation Inflation
Change in inflation
Time
Oil price
Number of observations
Industrialized and developing countries Full sample (72 countries)
–0.001***
0.0005
–0.026
–0.029***
1977
Industrial countries Full sample (23 countries) Selective sample (15 countries)
–0.123*** –0.232***
0.004 0.093***
–0.032* –0.038**
–0.020*** –0.014***
680 444
Developing countries Full sample (49 countries) Selective sample (15 countries)
–0.001*** –0.030*
0.0005 –0.012*
–0.031 0.005
–0.029*** –0.033***
1297 415
Notes: ***significant at 1% level **significant at 5% level *significant at 10% level Selective samples pool the data only for those countries that have a negative and significant coefficient on inflation. In the case of the developing countries, Bolivia, a hyper-inflation country is also excluded.
in the full-sample results (the ‘selective sample’ results are discussed below). These regression results suggest that the recent aversion to inflation in the industrial countries is well-founded. Our estimates for the 23 industrial countries are in the same ball park as those of Grimes (1991). Here, a move from zero inflation to 10% inflation would reduce the growth rate of a typical industrial country by one to two percentage points. On the other hand, our results imply that only relatively high inflation rates typically have substantial negative effects on growth in developing countries. For the 49 developing countries in our sample, the coefficient estimates suggest that a 10% increase in the inflation rate would lower output growth by only a 100th of 1%. Hence, if inflation rates are reduced from triple digit annual rates or higher to the 20-50% range, the gains from further disinflation, based on these estimates, really do appear to be quite small. While perhaps, in part, reflecting problems with the data, this latter finding is nonetheless consistent with the behaviour of a number of Latin American countries that have successfully brought inflation down from very high levels but then allowed it to stick in the 20-40% range rather than pressing for the single digit inflation rates that are typical of the industrial countries. There is also evidence that the critical threshold at which inflation begins to exert negative effects on economic growth appears to be considerably higher for developing countries than for industrial countries (Burdekin et al., 1993). It is important to note, however, that the panel results cover a wide range of individual country experiences. For example, the set of developing countries includes Bolivia, which underwent 4 Bolivia
hyperinflation during the sample period, together with lowinflation countries like Malaysia and Thailand that had average inflation rates below 10% over the sample period (for full details on the countries included in the study, and individual country results, see Salamun, 1994). One method of discriminating between the different countries within each group is suggested by Alexander (1990), who proposes focusing on the sub-set of countries that evidence significant negative effects of inflation when the model is estimated for that country individually. The application of this procedure yields ‘selective samples’ of 15 industrial countries and 15 developing countries, the results for which are reported below the respective ‘full sample’ results in Table 1. 4 As expected, the selective samples yield larger negative coefficients on inflation than do the results for the full sample. For the industrial countries, the coefficient on inflation rises from 0.123 to 0.232 in absolute value. For the developing countries, the absolute value of the coefficient increases from 0.001 to 0.030. This latter result implies now that an increase in the inflation rate from 10% to 20% could lower economic growth three-tenths of 1%, an effect that is now much closer to the adverse effects of inflation in the industrial countries. Moreover, the selective sample results suggest that increases in inflation hurt economic growth in the developing countries. This implies that there is a price to be paid in the transition to higher levels of inflation and there is no evidence of any short-run boost to output arising from more inflationary policies. This contrasts with the positive coefficient on the change in the inflation rate in the case of the industrial countries. 5
is also excluded in order to avoid the excessive influence its very high inflation rates would have on the results for the smaller group of countries. 5 In the industrial countries, the change in inflation may have an expansionary effect on output both because, with lower average rates of inflation, it is less likely to be anticipated and because indexing is generally less prevalent than in the developing countries.
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I I I . C O N C L U S I O N S A N D P O L I CY IMPL ICATIONS
toward economic liberalization and more widespread use of the price system and financial markets should be quite cautious when considering whether it is safe to allow continuation of inflation rates in the double digit range.
Interestingly, the selective sample of developing countries, for which the negative effects of inflation are most apparent, includes Chile and Mexico. 6 These two Latin American countries have taken perhaps the greatest strides towards disinflating their economies, with inflation rates in Mexico falling to single digit levels in 1993. Our findings suggest that these countries are among those that had the most to gain from disinflating their economies. Further research is needed, however, to investigate the underlying reasons for the variations in the effects of inflation on economic growth. Certainly, even relative to the selective sample of developing countries analysed here, the magnitude of the effects of inflation on economic growth remains considerably smaller than for the industrial countries. More widespread use of formal and informal indexing may help insulate the real economy from fluctuations in inflation in the developing countries. Indexation itself can be a drag on economic growth, however. Even if indexing is successful in reducing the per unit costs of inflation for growth, it may induce other costs such as reduced flexibility of relative prices and reduced informational efficiency of the price system as well as increased tendencies to run higher rates of inflation. Another possible explanation for some of the different findings for the industrial and developing countries is that the costs of inflation may be higher for those economies that rely more heavily on financial transactions. It seems likely that the more widespread use of financial market mechanisms that contribute to the higher levels of productivity and income in the industrial countries also make them more vulnerable to the negative effects of inflation. If true, this suggests that the developing and formerly centrally planned economies which are making major strides
6
A CK N O W L E D G E M E N T S This study is a part of the Claremont Project on Economic Reform in former Communist countries coordinated by the Claremont Institute of Economic Policy Studies and the Lowe Institute of Political Economy. Financial assistance from the Lincoln Foundation is gratefully acknowledged.
RE F E R E N C E S Alexander, W. R. J. (1990) Growth: some combined cross-sectional and time series evidence from OECD countries, Applied Economics, 22, 1197–204. Burdekin, R. C. K., Goodwin, T., Salamun, S. and Willett, T. D. (1993) When does inflation hurt economic growth?, Paper presented at the 29 October Claremont workshop on currency policy issues in economies in transition. Cooper, R. N. (1992) Economic Stabilization and Debt in Developing Countries (MIT Press, Cambridge, MA). Grier, K. B. and Tullock, G. (1989) An empirical analysis of cross-national economic growth, 1951-80, Journal of Monetary Economics, 24, 259–76. Grimes, A. (1991) The effects of inflation on growth: some international evidence, Weltwirtschaftliches Archiv, 127, 631–44. Leamer, E. E. (1978) Specification Searches: Ad Hoc Inference with Nonexperimental Data (John Wiley, New York). Salamun, S. (1994) The effects of different levels of inflation on economic growth: an empirical study for industrial and developing countries, Unpublished PhD dissertation, Claremont Graduate School.
The other countries comprising this selective sample are Costa Rica, Dominican Republic, Guyana, Honduras, Jamaica, Myanmar, Philippines, South Africa, South Korea, Thailand, Tunisia, Turkey and Venezuela.
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