Inflation and Growth: Analysis of the Relationship

Are inflation and growth inversely associated, directly associated, or not associated? In this paper we attempt to analyze the relationship of inflation and growth and how it affects an economy specifically in the context of Pakistan. This type of analysis being made by many economists around the globe here we will try to use their approaches and methodology on our economy and then compare the results. As per past studies we can say that the increase of the inflation rate would increase the nominal growth rate of industries, but it would decrease the real growth rate of industries; the inflation would stimulate the growth of primary, whole and retail industries; for maintaining the economic growth steady, the inflation rate should not exceed 3%. There are many other variables which can be used to strengthen this analysis would be, Consumers Price Index (CPI), Monetary Policy, Unemployment etc. furthermore, we would also throw light on wage inflation, cost-push inflation, pricing power inflation, and sectoral inflation individually and as whole.

1. Introduction
Maintaining the price stability is the responsibility of a central banks and it is accountable for achieving it. It is argued that sufficiently tight monetary policy maintained for sufficiently long time could halt even the most deeply rooted inflation. The price stability is obtained when economic agents such as households and business stop to take inflation at the time of decision-making. In the words of Blinder, prices are stable when ordinary people in their ordinary course of business stop talking about inflation. Observers of extreme inflation have never had much doubt that inflation was bad for the economy. Keynes, as usual, gave the most eloquent statement, As the inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealthgetting degenerates into a gamble and a lottery. 1 The emphasis on information and the financial system has returned to the literature today.2 But inflation and growth relationships have looked very different over time. We take snapshots of the literature in the 1960s and then in the 1980s. Macroeconomic policymakers focus on improving the health of the economy. The goals by which they gauge the health of the economy are high and sustainable rates of the economic growth, low unemployment, and low inflation.

Current Scenario The most well known indicator of inflation is the Consumer Price Index (CPI) which measures the average price of consumer goods and services purchased by households. In sum, Inflation is the rate at which the general level of prices is rising. High rates of inflation are often associated with fast growing economies where the demand for goods and services is higher that the countrys productive capacity. The fight against inflation is done by central banks which control the money supply by increasing or decreasing short term interest rates. For instance, the Governing Council of the European Central Bank aims at keeping annual inflation under 2% to promote price stability and sustainable growth. Diagrammatic representation of Inflation Rates of some major economies.

The number-one challenge identified for the year ahead is that of price volatility of raw materials and other inputs. Selected by 44 percent of firms globally, ahead of any other issue, price volatility is especially acute for Asian firms, selected by 54 percent of respondents. Unfortunately, executives do not anticipate much relief. A majority of survey respondents expects price increases on raw materials, energy, and transport and distribution. Some could be steep. One in five respondents expect transport costs to increase by at least 20 percent in the next one to two years, while 16 percent think the same of primary raw materials. However, the greatest fear of price increases relates to energy costs with nearly one in four executives expecting them to rise at least 20 percent. Such sentiment may be due to the fact that manufacturers are in the center of a price storm in 2011: industrial raw materials prices are expected to rise nearly 30 percent, according to the Economist Intelligence Unit, on the back of a 44.5 percent increase last year. Some relief is forecast for 2012. These cost concerns are exacerbated by intense competition and pressure to keep prices down, the second-biggest challenge, cited by 40 percent of survey respondents. For many, price increases will be unavoidable: 63 percent of executives agree that they will be forced to pass on higher costs to their clients in the year ahead. Rounding off the trio of challenges is uncertain demand (35 percent).

2. Scope of Study
3. 4.

5. 2.1 Estimating Global Ination

6. In what follows, we briey describe and compare results for four alternative measures of Global 7. Ination, namely: 8. 1. a cross-country average, 9. 2. the aggregate OECD ination, published by the OECD, 10.3. a measure based on static factor analysis, and 11.4. a measure based on dynamic factor analysis.

Literature Reviews
Nadia Saleem, (2010) examined the Adopting Inflation Targeting in Pakistan she has done an empirical analysis and applied vector autoregressive (VAR) model for this purpose, data used in this study comprises from 1970 to 2009, the she concluded that GDP growth and inflation during 1970-2009 are found to be negatively related, and recommend that Pakistan should adopt flexible inflation targeting, which means that it can manage the exchange rate in addition to the interest

rate, depending on the priorities emerging from inflation. SBP needs to win credibility by adopting aggressive monetary policy to monitor the future inflation rate.

David Drukker, et al (2005) explained their work with the name of Threshold Effects in the Relationship Between Inflation and Growth and applied new econometric methods for estimation and inference in non-dynamic, fixed-effects, panel-data models that may contain threshold effects. Data used in this study consists from 1950 to 2000, with having a full sample of 138 countries, they concluded that there is one threshold that is well identified by the data; the estimated value of the threshold is 19.16%. For the industrialized sample, results indicate that there are two threshold points at 2.57% and 12.61%. In the full sample, if the initial inflation rate is below 19.16%, increases in inflation do not have a statistically significant effect on growth. In contrast, when the initial inflation is above 19.16%, further increases in inflation will decrease long-run growth.

Yasir Ali Mubarik, (2005) has conducted his research to analyze Inflation and Growth: An Estimate of the Threshold Level of Inflation in Pakistan, and used the work of Khan and Senhadji (2001) the dataset used for this purpose is from 1973 to 2000. Yasir Ali Mubarik concluded and suggested that, the threshold model estimation recommends 9 percent threshold inflation level for economic growth at which inflation is red alert for economic growth. Furthermore, empirical analysis suggests that the inflation below the estimated level of 9 percent is conducive for economic growth.

Yan Hu-Qin, et al. (2005) conducted research on Analysis on Chinas Economic Growth and Inflation, during the period of 1953-2004, they used empirical analysis for this purpose and their main variables are mainly consists on prices indexes such as, urban consumer price index (UCPI), rural consumer price index (RCPI), overall retail price index (ORPI), investment price index (IPI), export price index (XPI), and import price index (MPI). They concluded that the inflation had positive influence on the primary industry and the whole and retail industry. If the inflation rate exceeded 3%, the economic growth would become much more unstable.

Abdul Qayyum, (2006) investigates the relationship between Money, Inflation, and Growth in Pakistan, he use quantity theory of money to formulate the determination of inflation (prices), money supply (M), velocity of money (V), and real income (Y), the data he used consist of four decades from 1960 to 2005, the result shows that there is a strong relationship between the money growth and inflation furthermore at first round it effect real GDP and at second round the money growth effects the inflation in Pakistan.

Bruno and Easterly (1996) examined the Inflation and Growth: In Search of a Stable Relationship, for this purpose they used the dataset from 1960 to 1995 and have find no evidence of any relationship between inflation and growth at annual inflation rates of less than 40 percent. They also find a negative, shorter to medium term relationship between high inflation (more than 40 percent) and growth. Furthermore, they report that there was no lasting damage to growth from discrete high inflation crises, as countries tend to recover back toward their precrisis growth rates.

Erman Erbaykal, et al (2008) conducted an analysis namely Does Inflation Depress Economic Growth? they used the Bound Test developed by Pesaran et al. (2001), and the existence of a co-integration relationship between the two series. The framework of data covering 1987:12006:2 period in Turkey. They concluded that there is a negative and statistically significant short term relationship has been found. The causality relationship between the two series has been examined in the framework of the causality test developed by Toda Yamamoto (1995). Whereas no causality relationship has been found from economic growth to inflation, a causality relationship has been found from inflation to economic growth.

Girijasankar Mallik, et al. (2001) conducted studies namely Inflation and Economic Growth: Evidence from Four South Asian Countries (Bangladesh, India, Pakistan, and Sri Lanka), and applied co-integration and error correction model, for this purpose they used annual data collected from IMFs international financial statistics. They concluded with two interesting points. First, inflation and economic growth are positively related. Second, the sensitivity of inflation to changes in growth rates is larger than that of growth to changes in inflation rates.

Francis Vitek, (2002), examined An Empirical Analysis of Dynamic Interrelationships among inflation, Inflation Uncertainty, Relative Price Dispersion, and Output Growth, conducts an empirical investigation of dynamic interrelationships among inflation, inflation uncertainty, relative price dispersion, and output growth, and selected a unified framework of data from 1961 to 2001, the main focus of this study is on the Canadian industrial sector, this study finds weak evidence that inflation uncertainty rises with the level of inflation, with short-run inflation uncertainty minimized at a trend inflation rate of approximately 3 per cent. Furthermore, the primary result is that across a variety of different model specifications, inflation uncertainty significantly lowers output growth, an effect of considerable size and duration.

Asif Idrees Agha, et at (2006) they examined an Empirical Analysis of Fiscal Imbalances and Inflation in Pakistan, he used Vector Error Correction Mechanism (VECM) model and applied Johansen co-integration analysis, the data used in this study comprises from fiscal year 1973 to 2003, the author concluded that, the long-run inflation is not only related to fiscal imbalances but also to the sources of financing fiscal deficit, assuming the impact of real GDP and exchange rate as exogenous. Furthermore, In VECM model, inflation has significant error correction coefficients that implicitly conclude that inflation is affected by governments bank borrowing for budgetary support as well as fiscal deficits. Therefore, in Pakistan, fiscal sector is dominant in explaining price movements.

Mohsin S. Khan, et al (2006) in this paper they examines the factors which affect Inflation in Pakistan, A simple inflation model is used that includes standard monetary variables (money supply, credit to the private sector), an activity variable, the interest and the exchange rates, as well as the wheat support price as a supply-side factor. The data framework for this model is estimated for the period January 1998 to June 2005 on a monthly basis. The results indicate that monetary factors have played a dominant role in recent inflation, affecting inflation with a lag of about one year. Private sector credit growth and broad money growth are also good leading indicators of inflation which can be used to forecast future inflation developments.

Testing the Link Between Inflation and Growth There is a large and growing body of empirical literature on the relationship between economic growth and inflation. The goals of this literature are twofold. The first is to identify a stylized fact and answer the following questions: What is the empirical relationship between growth and inflation? Is the relationship statistically significant? Is the relationship stable across countries and across time periods? The second goal is to interpret the relationship and to answer these questions: Is the relationship structural? Does the empirical relationship show that there is an exploitable trade-off by monetary policymakers? If there is an exploitable trade-off, what are the welfare implications of that trade-off and what is the optimal rate of inflation?

RELATIONSHIP BETWEEN INFLATION AND ECONOMIC GROWTH Like many countries, industrialized and developing, one of the most fundamental objectives of macroeconomic policies in Fiji is to sustain high economic growth together with low inflation. However, there has been considerable debate on the nature of the inflation and growth relationship. In this paper, we have reviewed several different economic theories to ascertain consensus on the inflation growth relationship. Classical economics recalls supplyside theories, which emphasis the need for incentives to save and invest if the nation's economy is to grow. Keynesian theory provided the AD-AS framework, a more comprehensive model for linking inflation to growth. Monetarism re-emphasized the critical role of monetary growth in determining inflation, while Neoclassical and Endogenous Growth theories sought to account for the effects of inflation on growth through its impact on investment and capital accumulation. The paper also reviews recent empirical literature. This includes studies by Sarel (1996), Andres & Hernando (1997) and Ghosh & Phillips (1998) and Khan & Senhadji (2001) amongst others. Ultimately, we tested whether a meaningful relationship held in Fijis case. The tests revealed that a weak negative correlation exists between inflation and growth, while the change in output gap bears significant bearing. The causality between the two variables ran one-way from GDP growth to inflation.

Hypothesis Testing
HO Null Hypothesis: Statement of theory: Inflation significantly & negatively impact on growth and investment.

Mathematical representation: Ho: > o H1 Alternative Hypothesis: Statement of theory: Inflation insignificantly & positively impact on growth and investment.

Mathematical representation :( 1 ) H1: < o ( 2 ) H1: = o ( 3 ) H1: o

Research Model

The research model which has been selected for this purpose is as follows:

Growth (GDP) = 1 + 2 Inflation + 3 Investment +

The terms mentioned in research model signifies the following. Dependent Variable: Independent Variables: : Growth (GDP) Inflation & Investment Error Term (Which includes other factors which may affect GDP).

Date Sources
The Pakistan Development Review, 2006 Asia Pacific Development Journal, June 2011 State Bank of Pakistan, Research Bulletin, 2005 & 2006 International Research Journal of Finance and Economics, Issue 17 (2008) 5. The Lahore Journal of Economics, 2010 6. United Nations Trade and Development Report, 2008 7. South African Reserve Bank (SARB) Conference, 2006 8. The Federal Reserve Bank of St. Louis, 20th Annual Policy Conference, 1996 9. Bank of Canada, Working Paper, 2002 10. The Institute of Chartered Accountants of Pakistan, Post Budget Seminar, 2010 11. 12. 13.
1. 2. 3. 4.

Objective

References
David Drukker Pere Gomis. And Paula Hernandez (2005) Threshold Effects in the Relationship Between Inflation and Growth: A New Panel-Data Approach, 11th International Conference, February 9, 2005 Abdul Qayyum (2006) Money, Inflation, and Growth in Pakistan, The Pakistan Development Review 45: 2 (Summer 2006), pp. 203212 Yan Hu-Qin and Liu Zhen-Yu (2009) Analysis on Chinas Economic Growth and Inflation during 1953-2004, (School of Management, Xiamen University, Working Paper) Bruno, M. and W. Easterly (1996). Inflation and Growth: In Search of Stable Relationship. Federal Reserve Bank of St. Louis Review, Vol. 78, No.3. Yasir Ali Mubarik (2005) Inflation and Growth: An Estimate of the Threshold Level of Inflation in Pakistan, SBP-Research Bulletin Volume 1, Number 1, 2005 Nadia Saleem (2010), Adopting Inflation Targeting in Pakistan: An Empirical Analysis, The Lahore Journal Of Economics 15: 2 (Winter 2010): pp. 51-76 Francis Vitek (2002) An Empirical Analysis of Dynamic Interrelationships Among Inflation, Inflation Uncertainty, Relative Price Dispersion, And Output Growth, Bank Of Canada Working Paper 2002-39 December. Mohsin S. Khan and Axel Schimmelpfennig (2006) Inflation In Pakistan, The Pakistan Development Review 45: 2 (Summer 2006) pp. 185202 Girijasankar Mallik and Anis Chowdhury (2001) Inflation and Economic Growth: Evidence from Four South Asian Countries, Asia-Pacific Development Journal Vol. 8, No. 1, June 2001 Erman Erbaykal and H. Aydn Okuyan (2008) Does Inflation Depress Economic Growth? Evidence from Turkey, International Research Journal of Finance and Economics ISSN 1450-2887 Issue 17 (2008) Euro Journals Publishing, Inc. 2008 Steve Ambler and Emanuela Cardia, Testing The Link Between Inflation And Growth, Journal Of Economic Dynamics And Control 20 (JanuaryMarch): 237-56. Vikesh Gokal and Subrina Hanif (2004) Relationship Between Inflation And Economic Growth, Working Paper 2004/04, Reserve Bank Of Fiji.