Relation between Economic Growth and Inflation
What is the theory and empirical evidence on the relationship between economic growth and inflation.
Economic growth and inflation are both positively correlated. This means that inflation is one of the inherent economic growth’s features. Along. Hamilton (1952) claimed that inflation is an important stimulant for creating growth and Rostow (1960) also argued that inflation is necessary for developing industrial take-offs. The great support of inflationary policy is came from Keynes, compare to deflation Keynes is more tolerable to inflation he described both of inflation and deflation in negative term one is unjust and the other is inexpedient, but to have inflation is preferable because to provoke unemployment is worse than to disappoint the rentier.
Keynes argued that investment can generate its own saving by raising the level of income when the economy is not performed, and inflationary policy can redistribute income from wage earners with low propensity to save to profit earner with high propensity to save when economy perform at full capacity. The second argument of Keynes is, the inflation can encourage investment by raising the nominal rate of return on investment and reduce the real rate of interest.
However, there are some dangers of inflation that need to be considered. Just to mention one of them is that inflation can reduce the purchasing power of money if it is reaching excessive level. And it can put the society in a real resource costs and welfare losses.
Numbers of empirical studies show that inflation has a non-linier relationship with growth. Bruno (1995), at World Bank, who observe annually on 127 countries over the year 1960-1992 shows that inflation and growth are positively related up to 5 per cent inflation and then start to declining to inflation set. And it comes to negative relationship when the inflation rate reaching 30 per cent. The other study by Sarel (1996) at the IMF shows the similar result when he examined 87 countries over the period 1970-1990 and divide the observation into twelve inflation group using inflation of group 6 as reference show that in the inflation take a positive effect on growth for group 7 (averagely 8%) and start toward negative relationship when inflation is very high. The evidence of non-linearity and growth is also found by Stanners (1993) he studied 9 countries over the period of 1948-1986 and 44 countries over 1980-1988 that after divide the 44 countries into four groups the growth is highest for the second group.
The lesson from empirical data is, it is okay to have inflation an moderate level since it is an inherent feature of growth but what is need to be aware is when inflation rate reaches an excessive level which could create hyperinflation.