From Raj Nallari and Breda Griffith's lecture notes
Inflation and Economic Growth
While inflationary policies can provide a short-run stimulus to economic growth, the economic literature suggests that, over the medium and long term high rates of inflation are bad for economic growth. Cross-country studies show that those countries with consistent positive growth records have on average much lower rates of inflation.
Why might this be? The basic reason is that prices perform a critical signalling mechanism in any market economy, with resources allocated based on prevailing relative prices. If inflation is high these price signals become distorted – it becomes difficult to distinguish between relative and ongoing secular price changes – and resources end up not being allocated efficiently. Moreover, high inflation encourages consumption instead of saving. Higher prices induce people to purchase more products now (before they become more expensive) and discourage people from saving, because money saved for future use will have less value. Too much consumption discourages savings needed for investments in capital goods and technology, the real causes of wealth. Thus investment ends up being curtailed and productivity growth stunted. This in turn impedes overall growth.
In a seminal article, Fischer (1993), while noting a positive relationship between growth and low levels of inflation, showed that economic growth is negatively associated with higher levels of inflation (and also large budget deficits and distorted foreign exchange markets). Subsequent studies have examined the relationship in depth and confirm a non-linear relationship between inflation and economic growth that is negative once a certain threshold (of the level of inflation) is reached. The threshold effect depends on the country context. The threshold level of inflation above which inflation acts as a brake on economic growth is estimated at 1 to 3 percent for industrial countries and between 7 to 11 percent for developing countries (Khan and Senhadji, 2000). Above these threshold levels, there is a robust negative relationship between economic growth and inflation, i.e. the negative relationship is not affected by the estimation method, where the threshold level is located, the exclusion of high-inflation observations, data frequency or other model specifications.
More generally, high rates of inflation are associated with poor macroeconomic performance. The typical goal of macroeconomic policy is a high and sustained growth of output alongside with low and stable inflation. As noted by Fischer (1993) inflation serves as ‘an indicator of the overall ability of the government to manage the economy.’ Inflation control is essential for macroeconomic stability and has formed a central component of the macroeconomic policy of government and the structural adjustment programs suggested by the IMF. Many African countries have succeeded in bringing down inflation with annual average inflation on the continent dropping from 17 percent in 1990 to 10 percent in 2003 (in SSA from 20 to 12 percent) (Rogoff, 2003).
Inflation and the Poor
Above we have noted the negative relationship between economic growth and inflation. Given the positive impact of economic growth on poverty reduction, it is unsurprising that many studies find that the costs of inflation are borne most heavily by the poor. For example, a 2001 polling survey by Fischer and Easterly showed that inflation was more likely to be rated a top national concern by the poor than the rich. The polling survey showed that improvements in the share of per capita income for the poor were negatively correlated with the rate of inflation, as was the percentage decline in poverty and the percentage change in the real minimum wage (Fischer and Easterly, 2001).
On a more practical level, the poor and, in particular, the rural poor suffer disproportionately from inflation. They lack the wealth that would enable them to diversify into inflation-proof assets. Furthermore, it is likely that they have no access to the financial system and hold their balances in cash that quickly erode in value as a result of inflation. The poor, lacking any assets have only their labor to offer. They are therefore overly dependent on wage labor. Given that wages and prices are sticky in the short run, the poor also suffer disproportionately when inflation is increasing rapidly. High inflation tends to lower the share of the bottom quintile and the real minimum wage - and tends to increase poverty.
Next week: exchange rate policy