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Introduction

Inflation is a complex economic phenomenon that has still extensive


attention of the macroeconomists, policymakers and the central bankers
from both developing and developed world. It is also a main subject of the
macroeconomics and one of the principal concerns of the policymakers and
the public. As per comprehensive definition we may assert that inflation is a
constant rise in commonly accepted price indices (Note 1) on account of
which broad spectrum of living cost has mounted up to the level where
general public feel relatively poorer. This could be easily stemmed out of this
definition that increase in prices should be so constant and permanent that it
may be alleged as inflation. There are two major determining factors of
inflation:
1) Demand-pull inflation (Note
2): It appears in an economy when aggregate demand is higher than
aggregate supply,
2) Cost push inflation: It emerges in an economy as a result of increase in
cost of basic inputs of the production process. There are number of factors
those affect cost push inflation such as wages, low productivity, erroneous
fiscal policy, and imported rising inflation. It is widely accepted that basic
factor for increase in inflation has been termed as enhanced level of
economic activity in a society. So, strengthening in economic activity leads to
high inflation and weak economic activity lowers the inflation. This
macroeconomic variable has very much importance in economic literature
because it has strong effects on economic stability of the country.
There is no controversy in literature upon association of inflation and
economic growth but serious debate arises when we talk about the sign of
relationship between the two. Evidence in this regard supports both the signs
of relationship either it is negative or positive. The controversy breeds two
main school of though in this regard i.e. Structuralists and Monetarists.
Structuralists considers inflation as a fundamental element for economic
growth of a country while as per Monetarists inflation has an ability to
determine economic progress (Malik and Chowdhry, 2001). Mundell (1965)
mentioned that inflation causes positive effects on capital formation and
capital information has a positive relationship with economic growth.
According to the work of Malik and Chowdhury (2001), inflation and growth
are positively related in India, Pakistan, Bangladesh and Sri Lanka. However,
existence of negative association between inflation and economic growth has
also been pointed out in so many other studies (Note 3) whether the studies
have been conducted on time series or cross-sectional data of developed or

developing country. After all this controversy leads the theorists upon a
consensus that if in a county there is stability in a low level of inflation (may
be a single digit inflation) than inflation may prove be helpful in promoting
economic growth of that country (Mubarik, 2005). Such an association
between the two further depends upon the economic environment of that
country and produce different results for different countries. Keeping in view
this perspective econometricians introduced a technique to investigate the
relationship between inflation and economic growth. As per this technique a
verge point regarding inflation has been utilized which differs the effects of
inflation on economic growth. Up to that verge point the inflation is helpful to
promotes economic growth and beyond that inflation affects economic
growth negatively (Sweidan, 2004).
Nepalko context
Nepal experienced uneven growth pattern throughout it history. The average
economic growth during last 45 years is around 5.5 percent. Nepal has been
facing lot of problems in macro economic management such as internal and
external threats. Internally not only there exists gaps between receipts and
public expenditures, savings and investments, population growth and capital
formation in Pakistan but success in establishing financial markets has also
not been achieved sufficiently. Externally Pakistan has to face imbalance
between exports and imports and has to face exchange rate problems.
Therefore, it looks impossible to achieve the task of sustainable growth
pattern in Pakistan. High inflation rate is also considered as an ill for
economic growth in Pakistan because it had witnessed high inflation since its
independence. The average inflation rate during last 45 years is around 8
percent.

However, as the empirical evidence by recent research work differs


substantially across the countries. There is no consensus over the point after
which the inflation is deterrent to economic growth. Fischer (1993) used a
spline regression and found a negative relationship at all levels of Inflation.
Barro (1996) found inflation harmful to growth but his findings were driven
by the observations where inflation exceeded 20%. Below that, the point
estimate was negative but statistically insignificant. Bruno and Easterly
(1998) found that countries ith annual inflation above 40% grows
significantly lower than countries with inflation rates below 40%. Using the
most advanced econometric techniques, Khan and Senhadji (2001) found 1%
threshold level of inflation for industrialized countries, which means above
1% it would have negative effects on growth. On the contrary, Burdekin

(2000) found a threshold level of 8% for the said countries. This result is also
consistent with the findings of Sarel (1996) which tested for a structural
break and found that inflation is negatively related to growth after 8%.
However, the point estimate for inflation below 8% was found positive but
statistically insignificant. Similarly, Ghosh and Phillips (1998) used 2.2%
threshold level of inflation in the analysis for industrialized countries while
Judson and Orphanides (1996) assumed 10% threshold level without
empirical testing. In the same way, Khan and Senhadji (2001) found 11%
threshold level of inflation for developing countries (including India & Nepal);
again below 11% the inflation-growth effect is positive but insignificant.
Another study found a threshold level of 3% or less for developing countries
(including India and Pakistan) (Burdekin, 2000)
The remainder of this paper is organized as follows: Section 2 reviews the
empirical literature on inflation and economic growth. Section 3 provides
information about the historical trends of inflation and economic growth in
Bangladesh. Section 4 discusses the model and methodology used to obtain
the empirical findings reported in this paper. Section 5 provides data sources
and estimated results on inflation and economic growth, and finally, section
6 presents a summary of the main conclusions, limitations of the paper, and
discusses a possible future extension.

Statement of problem
The impact of inflation on economic growth is one of the most central points
of macroeconomic issues that need to be resolved. Though there are
numerous studies carried out, the relationship between inflation and
economic growth is not well defined. As mentioned above, this is mainly due
to macro-economic and development conditions of the world, region or
country under study. Regardless of this, recently, there exists a high level of
consensus among - 20,000.0 40,000.0 60,000.0 80,000.0 100,000.0
120,000.0 140,000.0 160,000.0 180,000.0 1970 1975 1980 1985 1990 1995
2000 2005 2010 2015 RGDP RGDP 6 | P a g e researchers and economists
that positive and lower level of inflation is positively related to economic
growth while high and unstable level of inflation has negative impact on the
growth of an economy. Due to this reason economists and policy makers
largely aim for low and stable level of inflation with rapid rate of economic
growth (Bruno and Easterly 1996: 141) Maintaining price stability became
the leading objective of monetary policy of central banks in many countries.
This policy got extensive support after the high inflation period experienced
in the 1970s in various industrial economies. At present, a number of
countries adopted inflation targeting monetary policy giving priority to price

stability. This implies that high inflation is certainly a problem that causes the
economy not to operate at its optimal level (Palensuela, Mendez and Garcia
2003: 5-8). As described by Smal (1998) inflation causes harm to the
economy through the uncertainty it creates. Economic decisions such as
investing, borrowing, buying and selling are highly determined by the current
price and expected future price. High and unstable inflation causes
uncertainty about future prices. Due to this reason, economic decisions are
affected negatively harming the welfare in the economy. Smal (1998) also
has mentioned the negative effects of inflation on the well being of
individuals in the economy in the form of redistribution costs. The
redistribution cost occurs through economic agents such as lenders,
borrowers, fixed income earners and government by reducing the purchasing
power of money. Economic agents cannot totally stop holding hard cash for
transaction purposes and as a saving deposit. As inflation rises, a large
amount of money buys fewer goods and services and hence the purchasing
power of money declines. This reduces the welfare of firms and individuals
that hold money. 7 | P a g e On the other hand, the well-being of lenders and
borrowers is affected through a high inflation rate. Lenders are compensated
for the lost purchasing power of their principal loan by the nominal interest
rate, where it is determined by the level of the anticipated inflation. If the
anticipated inflation is less than the actual inflation, then lenders real return
declines causing redistribution of income from lenders to borrowers. If the
anticipated inflation is higher than the actual inflation, then the well-being of
borrowers declines. In most cases anticipated inflation is different from the
actual one and hence nominal interest rate favours either the lender or the
borrower (Smal 1998: 35 8). Inflation also increases the average weighted
tax rate of individuals. Without any increment of the purchasing power, an
increase in wage pushes wage earners to enter into high tax brackets. In
such cases the redistribution of income goes from wage earners to
government (Smal 1998:37-9). Inflation does not only have negative impacts
on welfare in the economy but it also negatively affects the long run growth
rate of the economy, through the distortion caused in the labour market,
capital market, saving, investment and international competitiveness. A high
and volatile inflation rate which is difficult to anticipate, leads workers and
employers to engage in short term contracts which again leads to
unproductive frequent renegotiations. A high rate of inflation also reduces
the international competitiveness of the country through depreciation of the
currency which negatively affects the traded goods sector and raises the
current account deficit. On the other hand, inflation also affects saving
negatively since it lowers its real return and savers are sensitive to the
changes to the after tax interest rate. The lower saving reduces the supply of
loanable funds and hence investment will be negatively affected. Mainly due

to these welfare and economic costs of inflation, a large number of countries


tackle inflation as the major objective of their monetary policy (Smal 1998:
41 -3). 8 | P a g e The stable macro-economic history of Ethiopia, especially
the single digit inflation (apart from the periods of drought) did not
encourage policy makers and researchers to consider inflation as a problem.
Due to this reason, the impact of inflation on the growth of the economy and
the relationship between the two macro-economic variables is not studied
well even though it is thoroughly discussed in international literature. This
state of affair motivates this study using the quarterly disaggregated data of
post socialist regime in Ethiopia. In addition to this, the stable macroeconomic condition in Ethiopia could not be observed since the year 2003/4.
Since then a high and sustained increase in the general price level became
the common feature of the macro-economic state of the country. For
instance, in the year 2007/08 the 12 months moving average of the overall
inflation was 25.3% while the 12 months moving average of inflation rate for
the year 2008/9 was 36.4%. This roaring inflation however is joined by the
double digit growth that astounded international economic observers. The
average GDP growth of the country for the same time period where there
was high inflation, say 2007/08, real GDP growth was 11.2% and in the year
2008/9 it was 11%. This recent high growth high inflation scenario in the
country is the other reason that drives the current study to formally observe
the relationship between the two variables (MoFED 2011: 4 - 12). As
mentioned above, there is a huge disagreement on the relationship between
inflation and growth both on theoretical and empirical basis. The existing
empirical divergence is mainly in the sign and significance of the linear
relationship between inflation and growth. Regardless of this divergence,
recent research findings agree on the non-linear relationship that positive,
low and stable inflation is positively related to growth while high and
unstable inflation has depressing effect on the growth of the economy. Still
the level of inflation that turns to be 9 | P a g e discouraging to growth is
indecisive and depends on the development condition of the specific country.
Since inflation has not been considered as a problem in Ethiopia, there was
no clear target level of inflation. Nonetheless, from the year 2010 onwards
following the five year development plan of the Growth and transformation
Plan (GTP), the monetary policy aims to keep inflation at 6%. This is because
of the belief that a level of inflation higher than 6% is considered to be
destructive to the economy (MoFED 2010: 15 16). However, this topic does
not seem to be discussed intensively in this regard and hence such a gap
inspires this study to provide policy implication regarding the target of
inflation that the central bank should focus on. In conclusion, this study tries
to fill the knowledge gap on four aspects. First it eliminates the problem data
mixing among different regimes. Other studies mix the data of the pure

communist regime where there was no private investment in the economy


with the current market oriented economy. An outcome with such mix of data
may lead to wrong conclusion and hence wrong policy implication. This
problem is eliminated in this study by just focusing on the period after the
post socialist regime. Second, the conflicting views on the relationship
between inflation and growth not only in global literature but also in Ethiopia
have motivated this paper and contributing to the knowledge in this area.
Third, is the inclusion and exclusion of variables in both growth and inflation
models given the characteristic of the Ethiopian economy. Fourth, the
methodology used in this study includes both single equation and VAR
system of long-run modelling..

Purpose of study
The main objective of this study is to empirically evaluate the relationship
between inflation and economic growth in Ethiopia. Given this, the study has
the following specific objectives:
The aim of the study is disaggregated into the following objectives:
To determine whether economic growth can lead to inflation.
To determine the impact of inflation on the economic growth.
To determine whether inflation targeting contribute to lower economic
growth
3. To estimate the threshold level of inflation for the Ethiopian Economy
Many empirical studies such as Barro (1995) and Ahmed and Mortaza (2005)
found out that inflation and growth are negatively related. Due to this
reason, this study hypothesizes that there exists a negative relationship
between inflation and economic growth. However, the positive relationship
cannot be rejected since a number of empirical findings such as (Ozdemir
2010) exist. These conflicting views on the relationship between inflation and
economic growth motivate this study. The study period covers from 1992
2010 on quarterly bases with 76 observations. The year 1992 is selected
because it marks the beginning of the market oriented economy in the
country after 17 years of the socialist regime. During the socialist period
there was no private sector in the economy but a command based monetary
policy with static and fixed exchange rate regime. The emergence of the
private financial institutions, foreign direct investment, market based sort
of monetary policy in the country and the implementation of managed
floating exchange rate system in 1992 has influenced the two
macroeconomic variables, inflation and economic growth, to be determined

from other sources such as real effective exchange rate and private
investment, 11 | P a g e respectively. On the other hand, the year 2010 is
selected as the latest period in which relevant variables such as GDP can be
obtained on quarterly basis.

Significance of study
This topic is relevant and timely given that the Ethiopian economy is
exhibiting double digit economic growth coupled with a high rate of inflation
that has never been witnessed in its history. The double digit growth is driven
by the ambitious five year development plans to reduce poverty as the
government focuses on achieving the Millennium development Goals (MDGs)
by the year 2015. The five year development plans namely Sustainable
Development and Poverty Reduction Program (SDPRP), Plan for Accelerated
and Sustained Development to End Poverty (PASDEP) and the current Growth
and Transformation Plan (GTP) are very ambitious in reducing poverty and
achieving rapid economic growth. These development plans largely deal with
heavy infrastructural projects such as hydro-electric power dams, road and
railway construction, building schools and health institutions in different
parts of the country. These large physical and social investments require a
large amount of money to be injected in the economy causing a high rate of
inflation (Geda and Tafere 2008: 5). However, this relationship between
inflation and growth should be studied using advanced and well structured
methods. In addition to this, there are conflicting theoretical and empirical
findings in the relationship between inflation and growth. Such state of
affairs makes this study important to find out the behaviour of the
relationship between the two macroeconomic variables. Since Ethiopia had
stable macroeconomic performance prior to the year 2002/3 the relationship
between the two variables in the country has not been studied well. Few
studies that are carried out in the Ethiopian context such as (Teshome 2011)
and Asaminew (2010) do not have a model that 12 | P a g e explains the
macro-economic condition of the country. They also do not have in-depth
analysis and they used a mix of data of different macro-economic systems of
different regimes. In this regard, this study fills the gap by analyzing the
relationship between inflation and economic growth with deep
methodological analysis that will be discussed in the next section. The study
also tries to use a model that can well explain the macro-economic condition
of the country both in growth and inflation models. Furthermore, the problem
of mixing data of different regimes is removed in this study by focusing only
on the post socialist Ethiopia. Though it is possible to identify the regime
change using dummy variable, this study focuses on the post socialist
Ethiopia with quarterly disaggregated data. Last but not least, the

importance of the study is to provide policy guidance for the monetary policy
makers with regard to the threshold level of inflation. As mentioned earlier,
there exists a wide range of consensus that stable and low inflation is
positively related to growth while high rate of inflation affects the growth of
the economy negatively. However, the question still remains on how low
should inflation be so that economic growth will not be affected negatively.
This threshold point differs based on the development position of each
country under study. Identifying this threshold point of inflation for the
Ethiopian economy provide possible policy.

Delimination
Due to the conflicting findings in the relationship between inflation and
economic growth several studies have analyzed this topic. Some studies use
panel data for several countries while others use time series data for a
specific country. In this study, the later one is in use since the study focuses
on the relationship between inflation and growth in a specific country,
Ethiopia. The scope of this study is to analyze the relationship between
inflation and growth in Ethiopia, limited to the period 1992 quarter one to
2010 quarter four. The main reason why the scope is limited to the year 2010
is due to the lack of data. Many of the variables used in the inflation and
growth models do not have adequate quarterly data. Due to this reason
different techniques of data disaggregation are used. These techniques are
discussed in section 3.1.3. Some of the techniques require data for the
subsequent Ethiopian fiscal year which is not yet published. Due to this
reason, the study is limited to analyze the issue up to the year 2010. In
addition, the disaggregation method of annual RGDP to quarterly RGDP is
driven from simple algorithm chosen by the National Bank of Ethiopia. The
fact that the natural data generating process is not applied can also be
stated as a limitation of the study. The other limitation of the study is the
lack of data on the consumer price index (CPI) at the national level for the
study period before 1998. Therefore, for the time period 1992-1998 the CPI
of the capital city, Addis Ababa, is used as a representative of the national
CPI since it is the only data available on CPI.

Literature reviews
2.1 Some Empirical Evidence on the Inflation-Growth Relationship
The investigations into the existence and nature of the link between inflation
and growth

have experienced a long history. Although economists now widely accept


that inflation
has a negative effect on economic growth, researchers did not detect this
effect in data
from the 1950s and the 1960s. A series of studies in the IMF Staff Papers
around 1960
found no evidence of damage from inflation (Wai, 1959; Bhatia, 1960;
Dorrance, 1963,
1966). Johanson (1967) found no conclusive empirical evidence for either a
positive or a
negative association between the two variables. Therefore, a popular view in
the 1960s
was that the effect of inflation on growth was not particularly important.
This view prevailed until the 1970s, when many countries, mainly in Latin
America,
experienced hyperinflation or chronic inflation. Numerous empirical studies
were
devoted to finding the effects of inflation in high-inflation countries. These
studies
repeatedly confirmed that inflation had a significant negative effect on
economic growth,
at least at sufficiently high levels of inflation. Therefore, today, the dominant
view
regarding the effects of inflation has changed dramatically. Fisher (1993)
found negative
associations between inflation and growth in pooled cross-section, time
series regressions
- 11 for a large set of countries. He argued that inflation impedes the efficient
allocation of
resources by obscuring the signaling role of relative price changes, the most
important

guide to efficient economic decision-making. Later, a famous paper by Barro


(1995)
more precisely examined the five-year average data of 100 countries over
the period of
1960-90 by using the Instrumental Variable (IV) estimation method. Using
different
instrumental variables, he obtained a robust estimation result showing that
an increase in
average inflation by 10 percentage points per year would slow the growth
rate of the real
per capita GDP by 0.2-0.3 percentage points per year. He argued that
although the
adverse influence of inflation on growth appeared small, the long-term
effects on
standards of living were actually substantial. Nevertheless, some other
empirical and
theoretical studies argued that the inflation-growth relationship is fragile.
Levin and
Zervos (1993) showed that the cross-section correlation between inflation
and growth
depends on extreme inflation observations with high-frequency data. Bruno
and Easterly
(1998) and Bullard and Keating (1995) found support for the notion that this
negative
relationship emerges only when rates of inflation exceed some threshold.
Levine and
Renelt (1992) and Clark (1997) also questioned whether a uniformly negative
relationship exists between inflation and real activity independently of the
prevailing rate
of inflation.
Recently, intensive research has focused on the nonlinear relationship
between these two

variables. That is, at lower rates of inflation, the relationship is positive or not
significant,
but at higher rates, inflation has a significantly negative effect on growth. In
terms of
nonlinearity, explaining why views on the inflation-growth relationship have
changed
- 12 dramatically over the past forty years is not difficult. Table 1 shows the
means and
medians across the countries of the inflation rates in five decades: 19601969, 1970-1979,
1980-1989, 1990-1999 and 2000-2002. The median inflation rate was only
2.6% per year
in the 1960s and rose rapidly to 9.2% per year in the 1970s, and then 10.3%
per year in
the 1980s. In addition, the median growth rate decreased dramatically from
8.8% per year
in the 1960s to 2.3% per year in the 1970s. The negative effects of inflation
on economic
growth are very clear. Therefore, since during the 1960s most countries
experienced low
inflation below the threshold level, it is not surprising that no evidence
supported the
negative inflation-growth relationship. As the median inflation rates rose
dramatically in
the 1970s, a significantly negative relation occurred between the two
variables.
The nonlinear view with respect to the inflation-growth relationship not only
can
convincingly explain the empirical findings but also has a strong policy
implication: keep
inflation below the structural break! This implication could be the reason
why, since the

1990s, numerous economists have been trying to find the exact threshold
level. Such a
nonlinear relationship was first detected by Fischer (1993). Sarel (1996) used
OLS with
fixed effects to examine a sample with 87 countries (including both industrial
countries
and developing countries) over the period 1970-1990. He specifically tested
the existence
of a structural break point and found evidence of a significant structural
break in the
relationship between the two variables. Moreover, he estimated the inflection
point, or
threshold, to be at an 8% annual inflation rate. Ghosh and Phillips (1998)
reexamined the
issue of the existence of threshold effects, using a larger sample than Sarel
(1996).
Surprisingly, they found a substantially lower threshold effect at a 2.5%
annual inflation
- 13 rate. Christoffersen and Doyle (1998) estimated the threshold level at 13%
for transition
economies. Khan and Senhadji (2001) used an unbalance panel with 140
countries for 40
years to estimate the threshold for industrial and developing countries. Using
the
nonlinear least squares (NNLS) estimation technique, Khan and Senhadji
(2001)
estimated that the threshold levels for industrial countries and developing
countries were
at 1-3% and 11-12%, respectively.
Literature review
This section contains different empirical studies that show the relationship
between inflation and economic growth. The concern of previous studies was

not only finding simple relationship between inflation and economic growth
but also finding whether the relationship holds in the long run or just a short
run phenomenon, causal direction of the relationship, whether the
relationship is linear or non linear and the like.
Empirical review for relationship between inflation and economic growth
Fisher (1993) has studied about the relationship between inflation and
economic growth entitled role of macroeconomic factor in growth. In this
paper, the data set consists of several macroeconomic variables including
inflation for 93 countries. He applied a simple alternative to mixed
regression. The result of the paper has shown that the channel through
which inflation affect economic growth and inflation negatively affects
growth by reducing investment, and by reducing rate of productivity growth.
Fisher also argues that inflation distorts price mechanism, and this will affect
the efficiency of resource's allocation and hence influence economic growth
negatively. Barro (1997) also studied the relationship between inflation and
economic growth. He used 30 years data from 1960 to 1990 of 100
countries. He included other determinants of economic growth additional to
inflation. To analyze the data, systems of regression equation were used. The
regression results indicated that an increase in average inflation by 10% per
year leads to a reduction of the growth rate of real per capita GDP by 0.2%
-0.3% per year and a decrease in the ratio of investment to GDP by 0.4%0.6%. But the result is becoming statistically significant only when high
inflation experiences are included in the sample. Moltey (1994) includes
inflation in his model to examine the effect of inflation on the growth rate of
real GDP. He extend the model of Mankiw, Romer and Weil (1992) which was
based on Solow growth model by allowing for the possibility that inflation
tends to reduce the rate of technical change. The result indicates a negative
relationship between inflation and the growth rate of real GDP.
Khan and Senhadji (2001) analyzed the relationship between inflation and
economic growth separately for industrial and developing countries. They
have used new econometric techniques
12
initially developed by Chan and Tsay (1998) and Hansen (1999), to show the
existence of threshold effects in the relationship between inflation and
economic growth. The authors have used unbalanced panels data containing
140 countries for the period 1960-1998. The estimated value of threshold is
1-3 percent and 11-12 percent for developed countries and developing
countries respectively. The result indicated that the threshold for
industrialized countries is lower than developing countries. It also indicated
that inflation level below the threshold level of inflation have no effect on

growth. But inflation rates above the threshold level have a significant
negative effect on growth.
Mubarik (2005) also tried to estimate threshold level of inflation for Pakistan.
He found 9 percent threshold level of inflation and inflation above this level
affect economic growth negatively. But inflation below the estimated level is
conductive for economic growth.
There are empirical evidences that support the findings of Mundell (1963)
and Tobin (1965) of a positive relationship between economic growth and
inflation. Mallik and Chowdhury (2001) are among the supporters of positive
relationships between the two variables. To reach this conclusion they used
co-integration and error correction model to analyze data collected from four
south Asian countries (Bangladesh, India, Pakistan and Sirlank) and found a
long run positive relationship between inflation and economic growth. They
concluded that moderate inflation is helpful to faster the economic growth.
Empirical literature also shows a positive relationship between inflation and
economic growth below threshold level of inflation. Ghosh and Phillips (1998)
found that at very low inflation rates (less than2-3 percent) inflation and
growth are positively related. Similarly Fabayo and Ajilore (2006) examined
the existence of threshold effect in inflation growth relationship on Nigeria
using data for the period of 1970-2003. They found 6 percent level of
inflation as a threshold. Inflation has a positive impact on economic growth
below the threshold level of inflation. Moreover, Wang Zhiyong (2008)
studies indicated that economic growth positively relates to inflation with
above three quarters lag. He used co integration and error correction model
to detect the result.
In the other hand, some empirical studies found that zero relationship
between inflation and economic growth. One study by Sidrauski (1967)
indicates that inflation has no relationship with
13
growth in the long run. Moreover, he testifies the super neutrality of money
in his model. In addition to Sidrauski, Bruno and Easterly (1995) have shown
insignificant relationship between inflation and economic growth. They found
this result after deleting high observation of inflation. There are also studies
that indicate insignificant relationship between the two variables below the
threshold level of inflation. For example Christoffersen and Doyel (1998)
detected 13 percent threshold level of inflation below which no significant
relationship between inflation and economic growth but above the level they
have a negative relation.

Empirical review for causality relationship between inflation and economic


growth
Mubarik (2005) analyzed the causal relationship between inflation and
economic growth. The test result indicated that the causality between the
two variables is uni-directional i.e. inflation is causing GDP growth but not
vice verse. Odhiambo (2011) also examined the short run and long run
causal relationship between inflation, investment, and economic growth in
Tanzania. He used ARDL-bounding testing approach and found that a
unidirectional causal flow from inflation to economic growth. By using VAR
granger causality test, Chimobi (2010) studied about inflation and economic
growth in Nigeria and found unidirectional causality from inflation to growth.
Another paper which is worked in case of Hungary and Poland by Gillman and
Nakov (2003) indicated that a causal relationship with direction from inflation
to growth and from money to inflation. Moreover, Erbaykal and Okuyan
(2008) analyzed the causal relationship between inflation and economic
growth in the framework of the causality test developed by Toda Yamamoto
(1995). The result indicated no causal relationship from economic growth to
inflation where as there is a causality relationship from inflation to economic
growth.
Chuan Yeh (2009) estimated the causal interrelationships between inflation
and economic growth within a simultaneous equation frame work. They used
cross sectional data of 140 countries over the 1970-2005 periods. The result
indicated that a bilateral causal relationship between growth and inflation. It
also showed that inflation is harmful to growth where as the effect from
growth to inflation is beneficial. In their analysis, they grouped the data set
into high income, low income and developing countries, and the results
indicated that the negative impact of inflation on growth in low income
countries is greater than in developing countries and high income countries.
14
In addition to unidirectional causality from inflation to economic growth and
bilateral causality, there are studies which indicated unidirectional causality
from growth to inflation. Gokal and Hanif (2004) studied about inflation and
economic growth in Fiji. They obtain that granger causality runs one way,
from growth to inflation but not from inflation to growth. It means that it is
unidirectional. Datta (2011) examined relationship between inflation and
economic growth in Malaysia with the data covering from 1971 to 2007. The
findings show that there exist short run causality between the variables and
direction of causality is from inflation to economic growth and in the long run
economic growth Granger cause inflation.

Finally there also studies which indicates, no causality relationship between


inflation and economic growth. Kigume (2011) studies about inflation and
economic growth in Kenya from 1963 to 200. The Granger causality test of
this study revealed that no causality relation between these two variables.

Methodology
Research design
The research study adopted the quantitative study design to be able to
determine the relationship between economic growth and inflation also to
explain variations between them.
Area of the Study
The area of study is the South African economy and the study sought out to
understand this important correlation between economic growth and
inflation. The study chose to use the sample period, 1993 to 2011 for which
data is collected, analysed and interpreted. Once the relationship is clarified
between these variable this can assist in policy formulation since the trends
of the variables will be known.
Data Collection
The current study relies mainly on the quarterly secondary data. The sample
size to be used is 18 years which is from 1993 to 2011 being quarterly data
which will be based on pre inflation targeting 1993 to 1999 quarterly data
and post inflation targeting 2000 to 2011 quarterly.
The current study also uses annual data for the period 1975 to 2010 for the
estimation of threshold level of inflation for Nepal. Data source on
consumers price index (CPI) and Gross domestic product (GDP) are taken
from different issues of Economic Surveys published by Government of Nepal
and Nepal Rastra Bank of Nepal.