The relationship between inflation and growth has remained a controversial one in both theory and empirical findings. Over the past couple of years, a lot of economists have claimed that an increase in economic growth leads to an increase in inflation and that decreased growth reduces inflation. There are several theories to explain the nature and existence of the inflation-economic growth with the theories suggesting that variety of possible conclusions. These include: Classical, Keynesian, Neo-Keynesian, Monetarist, Neo-classical and Endogenous growth theories. Studies have shown that inflation and its variability have significant real costs to the economy with several of the ...view middle of the document...
Economic growth is measured as the annual change (%) of the Gross Domestic Product (GDP) or Gross National Product (GNP). It is important to distinguish between economic growth and economic development… while economic growth is concerned with market productivity and changes in the Gross Domestic Product (GDP); economic development is concerned with economic and social well-being of the people through policy intervention.
Inflation and Economic Growth
The relationship between inflation and growth has remained a controversial one in both theory and empirical findings. Over the past couple of years, a lot of economists have claimed that an increase in economic growth leads to an increase in inflation and that decreased growth reduces inflation. At the same time, a lot of papers have been written in an attempt to assess the impact of inflation on economic growth. The general idea is, however, that individuals and economic agents have lower economic performances when the inflation is high and unpredictable and that an efficient control of inflation brings higher benefits in terms of a higher sustainable economic growth in the future (Birman, 2011).
The negative and positive effects of inflation have been studied in the context of economic growth. The high costs associated with high and variable inflation have often been emphasized by with Governments and monetary institutions, with specific focus on the negative externalities imposed by inflation through interference with the economy’s efficiency (Gokal & Hanif, 2004).
Another impact of inflation on the economy is the uncertainty it can cause in relation to the future profitability of investment projects. This is more so when increased price variability is attributed to high inflation, thus leading to lower investment and economic growth as a result of more conservative/cautious investment strategies.
A country’s competitiveness can also be impacted by high inflation results in more expensive exports, thus an impact on the balance of payments.
Borrowing and lending decisions can also be distorted by inflation and tax systems interactions with firms devoting more focus and resources on competitive activity to identify general inflationary trends vs. industry specific causes.
One of the key challenges in the measurement of economic growth using GDP or GNP is the impact of inflation or deflation. It becomes difficult to distinguish whether the increase (or decrease) in GDP was due to a rise in prices (drop in prices) or due to a higher (or lower) production and saving of goods and services.
Studies have shown that inflation and its variability have significant real costs to the economy with several of the studies indicating that a 10% inflation rate can cause up to 3% loss in the GNP. Such losses would occur due to savings and investment misallocations or due to real balances value (Antonio Moreno , 2004). In view of this, many governments have adopted inflation targeting as a dominant...