Inflation and Growth: An Estimate of the Threshold Level of Inflation in Pakistan

Transcription

1 SBP-Research Bullein Volume 1, Number 1, 2005 Inflaion and Growh: An Esimae of he Threshold Level of Inflaion in Pakisan Yasir Ali Mubarik This sudy esimaes he hreshold level of inflaion in Pakisan [à la Khan and Senhadji (2001)] using annual daase from 1973 o The esimaed model suggess 9 percen hreshold level of inflaion above which inflaion is inimical for economic growh. JEL Codes: E31, C13 Key Words: Inflaion, Growh, Threshold 1. Inroducion This paper aemps o esimae he hreshold level of inflaion for Pakisan. Following he work of Khan and Senhadji (2001), he sudy esimaes he hreshold model and suggess 9 percen as he hreshold inflaion level. Wih he passage of ime a general consensus developed ha he moderae inflaion helps in economic growh, unlike high price level ha may creae uncerainy and hamper economic performance. This consensus raises an ineresing policy issue of how much of inflaion is oo much; ha is, how much inflaion impedes economic growh? Alhough work on modeling he naure of relaionship beween inflaion and economic growh is under progress, a considerable amoun of lieraure on his issue is available. Several sudies address his issue for boh developed and developing counries. However, Khan and Senhadji s (2001) work is seminal in ha ha i acually calculaes he hreshold level of inflaion for boh developing and developed counries. For developing counries, including Pakisan, hey sugges a hreshold level range of 7-11 percen. This sudy follows Khan and Senhadji (2001) mehodology and exclusively focuses on Pakisan and suggess an exac hreshold level, as opposed o a range. The sraegy of his paper is as follows. Secion 2 presens a brief lieraure review The auhor [yasir.ali@sbp.org.pk] is Analys in he Economic Policy Deparmen of he Sae Bank of Pakisan. He wishes o hank he Edior, anonymous Referee, Axel Schimmelpfennig, Safdar ullah Khan, and Sadia Tahir for heir very helpful commens. Daa suppor by Fida Hussain is grealy acknowledged. All remaining errors are he responsibiliy of he auhor by he Sae Bank of Pakisan. All righs reserved. Reproducion is permied wih he consen of he Edior.

2 36 SBP-Research Bullein, Vol. 1, No. 1, 2005 on inflaion and growh. Secion 3 aemps o find some consisen observaions on inflaion and growh in Pakisan. Secion 4 oulines he hreshold model. Esimaion resuls of he hreshold model are presened in Secion 5. Concluding remarks follow in Secion Inflaion and Growh: A Brief Lieraure Review Several sudies have esimaed a negaive relaionship beween inflaion and economic growh. Neverheless, some sudies have accouned for he opposie. Thirlwall and Baron (1971), in one of he earlies cross-counry sudies, repor a posiive relaionship beween inflaion and growh in a cross secion of indusrial counries and a negaive relaionship in a cross secion of 7 developing counries. Gillman e al. (2002), based on a panel daa of Organizaion for Economic Cooperaion and Developmen (OECD) and Asia-Pacific Economic Cooperaion (APEC) counries, indicae ha he reducion of high and medium inflaion (double digis) o moderae single digi figures has a significan posiive effec on growh for he OECD counries, and o a lesser exen for he APEC counries. They furher add ha he effec of an expeced deceleraion of inflaion migh only be observed when he world economy is no facing a sudden growh rae deceleraion due o shocks. If here are no such shocks, a reducion in inflaion rae can produce considerably higher growh rae. Similarly, Alexander (1997) finds a srong negaive influence of inflaion on growh rae of per capia GDP using a panel of OECD counries. Fischer (1993) resuls indicae ha inflaion reduces growh by reducing invesmen and produciviy growh. He furher noes ha, low inflaion and small fiscal deficis are no necessary for high growh even over long periods; likewise, high inflaion is no consisen wih susained economic growh. Ghosh and Phillips (1998), using large panel daase, covering IMF member counries over 1960 o 1996, found ha a very low inflaion raes (less han 2-3 per cen) inflaion and growh are posiively correlaed. However, hey are negaively correlaed a high level of inflaion. Similarly, he empirical resuls of Nell (2000) sugges ha inflaion wihin he single-digi zone may be beneficial, while inflaion in he double-digi zone appears o impose slower growh. Bruno and Easerly (1996) find no evidence of any relaionship beween inflaion and growh a annual inflaion raes of less han 40 percen. They find a negaive, shorer o medium erm relaionship beween high inflaion (more han 40 percen) and growh. Furhermore, hey repor ha here was no lasing damage o growh from discree high inflaion crises, as counries end o recover back oward heir

3 Yasir Ali Mubarik 37 pre-crisis growh raes. Mallik and Chowdhury (2001) conduced coinegraion analysis of inflaion on economic growh for four Souh Asian counries (Bangladesh, India, Pakisan, and Sri Lanka) and repor wo ineresing poins. Firs, inflaion and economic growh are posiively relaed. Second, he sensiiviy of inflaion o changes in growh raes is larger han ha of growh o changes in inflaion raes. One recen analysis suggess ha here is a hreshold level of inflaion in he relaionship beween oupu growh and inflaion. In his conex, Khan and Senhadji (2001) have done he seminal work. They no only examine he relaionship of high and low inflaion wih economic growh bu also sugges he hreshold inflaion level for boh indusrialized and developing counries. They conduc a sudy using panel daa for 140 developing and indusrialized counries for he period of Their resuls srongly sugges he exisence of a hreshold beyond which he inflaion exers a negaive effec on economic growh. In paricular, he hreshold esimaes are 1-3 percen and 7-11 percen for indusrial and developing counries, respecively. 3. An Overview of Inflaion and Growh The lieraure review in he preceding secion does sugges a negaive relaionship beween inflaion and economic growh. However, as a moivaion, i is imperaive o observe he relaionship hrough visual examinaion. Figure 1 illusraes he Figure 1. Inflaion and Real GDP Growh Raes, inflaio n GDP growh Source: Economic Survey of Pakisan (various issues)

4 38 SBP-Research Bullein, Vol. 1, No. 1, 2005 Figure 2. Average GDP Growh and Inflaion 8 average GDP growh (Inflaion) (GDP Growh) rend in inflaion and GDP growh raes of Pakisan. 1 The figure somehow indicaes an inverse relaionship beween boh hese variables. As illusraed, growh raes remained below 5 percen unil lae 1970s during which inflaion remained mosly double digi. Anoher double-digi episode of inflaion was in 1990s during which he growh performance remained dismal. However, for a more precise picure, i is worhy o undersand he hisorical naure of relaionship beween he wo variables. For his purpose, whole sample ( ) is reduced ino nine observaions. How o arrive on nine observaions? Firs of all, he range of inflaion is chosen from he sample (minimum and maximum levels of inflaion in he given sample). Wihin his band of inflaion, average GDP growh raes are calculaed agains each linear level of inflaion; for example, wha is he average value of GDP when inflaion raes are 3 percen during he period ( ) and so on. Figure 2 shows ha GDP growh and inflaion have posiive relaionship up o 7 percen inflaion; and beyond ha level here is a negaive relaionship. This suggess ha he hreshold level is roughly around 7 percen ha may affec economic growh. This simple analysis suggess ha inflaion has a negaive effec on economic growh. Here, policymakers would be ineresed in a hreshold level of inflaion above which inflaion adversely affecs economic growh while below ha level inflaion is favorable for economic growh. Firs par of his policy issue can be addressed wih he help of a hreshold model for inflaion. However, he sudy is limied in he sense ha i does no esimae he lower level of inflaion favorable for economic growh. 1 Noe ha inflaion is growh in he log of CPI.

5 Yasir Ali Mubarik Threshold Model The model is developed by Khan and Senhadji (2001) for he analysis of hreshold level of inflaion for indusrialized and developing counries. Following he aforemenioned work, his sudy is based on four-variable model consising of economic growh, inflaion, populaion, and oal invesmen growh raes. 2 Threshold level of inflaion is based on he following equaion: GROWTH = β + β ( INF ) + β * D ( INF k) + β ( POP ) + β ( INVST ) + U (1) Economic growh and inflaion are compued as: GROWTH = 100* DLOG( Y ) INF = 100 * DLOG( P ). Y : real GDP GROWTH : growh rae of real GDP POP : populaion growh rae k : hreshold level of inflaion P : consumer price index INF : inflaion INVST : invesmen growh rae U : error erm Growh raes of populaion and invesmen are compued using similar mehod. Whereas, he dummy variable is defined as: 1:100* DLOGP > k D = 0 :100* DLOGP k The parameer k represens he hreshold inflaion level wih he propery ha he relaionship beween oupu growh and inflaion is given by: (i) low inflaion: β 1 ; (ii) high inflaion: β 1 + β 2. High inflaion means ha when long-run inflaion 2 Populaion and oal invesmen growh raes are used as conrol variables. The reason for choosing hese variables is heir auheniciy in empirical lieraure on growh. Solow (1956) and Swan (1956) who developed he firs neo-classical models of growh, ake he rae of growh of populaion as one of exogenous variables in heir model o show ha he faser he rae of populaion growh, he poorer he counry. Fischer (1993) includes invesmen in his model o show ha inflaion reduces growh by reducing invesmen and produciviy growh. Moreover, Mankiw e al. (1992) also include invesmen growh and populaion growh in heir growh model.

6 40 SBP-Research Bullein, Vol. 1, No. 1, 2005 esimae is significan hen boh ( β 1 + β 2 ) would be added o see heir impac on growh and ha would be he hreshold level of inflaion. While he value of k is given arbirarily for he esimaion, he opimal k is obained by finding ha value ha minimizes he residual sum of squares (RSS). Thus, he opimal hreshold level is ha which minimizes he sequence of residual sum of square (RSS). Inflaion a his level has a significan impac on economic growh. 5. Threshold Model Esimaion The sudy uses annual daase on Consumer Price Index (CPI based on ), real GDP (a consan facor cos of ), populaion, and oal invesmen for he period of 1973 o The daa is obained from Economic Survey of Pakisan (various issues). The growh rae of GDP, CPI, populaion, and oal invesmen are compued by using log ransformaion mehod ha eliminaes, a leas parially, he srong asymmery in inflaion disribuion. The log ransformaion also, o some exen, smoohed ime rend in he daase. Khan and Senhadji (2001) calculae growh raes of macroeconomic variables using log ransformaion, which provides bes fi in he class of non-linear models. Alhough he growh raes of all hese variables are calculaed using log ransformaion mehod, sill here is a lo of volailiy in he daa (Figure 1). Therefore, he daase is furher smoohed using Hodrick- Presco filer. Before esimaing he model, Granger Causaliy es is applied o measure he linear causaion beween inflaion and economic growh. Tes saisics in Table 1 show ha he null hypohesis is rejeced, which means ha inflaion is causing GDP growh. The causaliy beween wo variables is uni-direced. The second null hypohesis of oupu growh causes inflaion is no rejeced a 5-10 percen level of significance, which proves ha here is no feedback from oupu growh o inflaion. This resul helps in he choice of dependen and independen variable for he hreshold model specificaion. Table 1. Pair wise Granger Causaliy Tess Sample: Null Hypohesis: Observaions F-saisics Probabiliy INF does no Granger Cause GDP GDP does no Granger Cause INF The selecion of sample is based on daa availabiliy and o avoid he srucural shif in he series caused by he 1971 war.

7 Yasir Ali Mubarik 41 Table 2. Esimaion of non-linear Model a K= 7 o 11 (Dependen Variable: GDP growh) k Variable Coefficien Sd. Error -Saisic Prob. RSS INF (INF>7)*(INF-7) % Populaion growh Invesmen growh C INF (INF>8)*(INF-8) % Populaion growh Invesmen growh C INF (INF>9)*(INF-9) % Populaion growh Invesmen growh C INF (INF>10)*(INF-10) % Populaion growh Invesmen growh C INF (INF>11)*(INF-11) % Populaion growh Invesmen growh C The esimaion of Equaion (1) gives a precise value of hreshold inflaion level and also quanifies he impac of ha level on economic growh (Table 2). For his purpose Equaion (1) is esimaed and he residual sum of square (RSS) for hreshold level of inflaion ranging from k 1 percen o k n percen was compued. In Granger Causaliy analysis, inflaion is causing growh a lag wo (lag = 2) for he given period of ; herefore, inflaion is kep a lag wo in he esimae. The opimal hreshold level is he one ha minimizes he sequence of RSS (Table 2). The -saisics and heir p-vales of following esimaed equaion are given in Table 2. The p-values on ) β 1 sugges ha for low inflaion levels ( k 9) here is an insignifican relaionship beween oupu growh and inflaion. For higher inflaion level ( k > 9) here is a significan negaive relaionship beween oupu growh and inflaion. The insignifican relaionship is ranslaing ino significan one as he

8 42 SBP-Research Bullein, Vol. 1, No. 1, 2005 level of inflaion (k) increases above 7 percen. Finally, 9 percen inflaion level is a hreshold level, which is obained by finding ha value of k ha minimizes he residual sum of squares (RSS). If inflaion increases above hreshold level, growh is esimaed o decline by 0.08 percen. Beyond ha level, here migh be a significan shock o economic performance of he counry. Sensiiviy Analysis There could be a specificaion bias of he esimaed model [Equaion (1)]; ha is, exclusion of oher relevan variables for a growh equaion. 4 To check his bias, inflaion, real GDP growh, invesmen growh, and populaion growh are used as insrumens. 5 The resuls of 2SLS (Table 3) also sugges 9 percen hreshold Table 3. Esimaion of non-linear Model a K= 7 o 10 (Dependen Variable: GDP growh) k Variable Coefficien Sd. Error -Saisic Prob. RSS INF (INF>7)*(INF-7) % Populaion growh Invesmen growh C INF (INF>8)*(INF-8) % Populaion growh Invesmen growh C INF (INF>9)*(INF-9) % Populaion growh Invesmen growh C INF (INF>10)*(INF-10) % Populaion growh Invesmen growh C Insrumen lis: INF(-3) INVST(-3) POP(-2) GDP(-3) 4 Scope of he model and daa unavailabiliy is he main reason behind he exclusion of oher relevan variables. 5 Since he original model is based on wo lags, herefore all insrumens were defined wih hree lags excep for populaion ha was significan a wo lags. These insrumens are only valid if he error erm in Equaion (1) is no auocorrelaed (Boh Augmened Dickey-Fuller and Phillips Perron ess rejec auocorrelaion in he error erm a 5 percen level of significance).

9 Yasir Ali Mubarik 43 inflaion level (Table 3). The comparison of boh esimaed models [Table 2 (OLS) and Table 3 (2SLS)] show a similar hreshold level of inflaion and he values of esimaed coefficiens also remain close in boh he models. Boh resuls indicae 9 percen hreshold inflaion level for economic growh in Pakisan. 6. Concluding Remarks The esimaes of causaliy es, an applicaion of hreshold model and finally is sensiiviy analysis using home counry daase of inflaion and oupu growh sugges he following major findings. The Granger Causaliy es defines causaliy direcion from inflaion o economic growh and no vice versa (uni-direced). The hreshold model esimaion recommends 9 percen hreshold inflaion level for economic growh a which inflaion is red aler for economic growh. The sensiiviy analysis, conduced for he robusness of he model, also suggess he same level of hreshold inflaion. The empirical analysis suggess ha he inflaion below he esimaed level of 9 percen is conducive for economic growh. The resul migh be useful for policymakers in providing some clue in seing an opimal inflaion arge. However, his sudy does no esimae ha level of inflaion ha is oo low for economic growh; indeed, his calls for furher research on he opic. References Alexander, W. R. J. (1997). Inflaion And Economic Growh: Evidence from a Growh Equaion. Applied Economics, Vol. 29: Bruno, M. and W. Easerly (1996). Inflaion and Growh: In Search of Sable Relaionship. Federal Reserve Bank of S. Louis Review, Vol. 78, No.3. Fischer, S. (1993). The Role of Macroeconomic Facors in Growh. Journal of Moneary Economics, Vol.32: Ghosh, A. and S. Philip (1998). Inflaion, Disinflaion, and Growh. IMF Working Paper No.WP/98/68. Washingon, D.C.: IMF. Gillman, M., M. Harris, and L. Mayas (2002). Inflaion and Growh: Some Theory and Evidence. Berlin: 10h Inernaional Conference on Panel Daa. Khan, M.S. and S.A. Senhadji (2001). Threshold Effecs in he Relaionship beween Inflaion and Growh. IMF Saff Papers, Vol. 48, No. 1. Mallik, G. and Chowdhury A. (2001). Inflaion and Economic Growh: Evidence from Souh Asian Counries. Asian Pacific Developmen Journal, Vol.8, No.1.

10 44 SBP-Research Bullein, Vol. 1, No. 1, 2005 Mankiw, N., D. Romer, and D. Weil (1992). A Conribuion o he Empirics of Economic Growh, Quarerly Journal of Economics, Vol. 107: Nell, K.S. (2000). Is low Inflaion a precondiion for faser Growh? The case of Souh Africa. Working Papers in Economics. Deparmen of Economics, Keynes College, Universiy of Ken. Solow, R. (1956). A Conribuion o he Theory of Economic Growh. Quarerly Journal of Economics, Vol. 70: Swan, T. (1956). Economic Growh and Capial Accumulaion. Economic Record, Vol. 32: Thirlwall, A.P. and C.A. Baron (1971). Inflaion and Growh: The Inernaional Evidence. Banca Nazionale del lavoro Quarerly Review, Vol. 98: