Investment, inflation and economic growth nexus.
Iqbal, Nasir ; Nawaz, Saima
The paper has twofold objectives. Firstly, the impact of the
inflation rate on economic growth with the possibility of two threshold
levels for Pakistan using annual data from 1961 to 2008 is examined and
secondly, nonlinear relationship between inflation and investment has
been investigated. Inflation and growth models support the existence of
a nonlinear relationship with two thresholds (6 percent and 11 percent).
Inflation below the first threshold affects economic growth positively
but insignificantly; at moderate rates of inflation, between the two
threshold levels, the effect of inflation is significant and strongly
negative and at high rates of inflation, above the second threshold, the
marginal impact of additional inflation on economic growth diminishes
but is still significantly negative. Investment is one of the possible
channels through which inflation influences economic growth and the
analysis indicates the nonlinear relationship between these two
variables with only one threshold at 7 percent. Rate of inflation below
the threshold level has positive but insignificant impact, while above
the threshold it has strong negative and significant impact on the
investment. Therefore, it is desirable to keep the inflation below 6
percent because it may be helpful for the achievement of robust economic
growth and investment.
JEL classification: E22, E31, O40
Keywords: Investment, Inflation, Economic Growth, Nonlinear,
Pakistan.
1. INTRODUCTION
High and sustainable economic growth and low inflation are the two
main objectives of policy-makers and the central bank. It is generally
believed that inflation has negative and significant impact on economic
growth in medium- and long-run [Khan and Senhadji (2001)]. However, the
existence and nature of relationship between inflation and economic
growth and the channels through which it affects real economic
activities has been the subject of considerable interest and debate due
to inconclusive results. Recent literature on this issue has uncovered
some important findings.
Empirical literature on inflation growth nexus is divided into two
main strands. One strand of literature has found negative and
significant relationship between inflation and economic growth [Fisher
(1993); Barro (1995); Bullard and Keating (1995); Malla (1997); Bruno
and Easterly (1998) and Faria and Carneiro (2001)] while other has
confirmed positive and significant association between inflation and
economic growth [Lucas (1973); Mallik and Chowdhury (2001) and Gillman
and Nakov (2004)]. These strands of literature highlight the possibility
of non- linear relationship between inflation and economic growth.
Several recent empirical studies have explored that the relationship
between inflation and economic growth is in fact nonlinear. They are
trying to support the hypothesis that low and stable inflation promotes
economic growth and vice versa.
Fischer (1993) explored this possibility and noted the existence of
nonlinear relationship between inflation and economic growth. He found
that there was a positive association between inflation and economic
growth at low rate of inflation, and a negative one as inflation rose.
Findings of Fischer (1993) generate new debate among the economists to
determine precisely the level of inflation that promotes economic
growth.
In this context, various empirical studies are conducted. Sarel
(1996) found that before 1970s inflation rates were modest in most
countries and empirical studies during this period show the evidence of
a positive relationship between inflation and economic growth while
after 1970s inflation rates started to be high and a negative
relationship between these variables, beyond that time period, was
observed. Bruno and Easterly (1998) examine the determinants of economic
growth using annual CPI inflation of 26 countries which experienced
inflation crises during the period between 1961 and 1992. Their
empirical analysis predicts that inflation rate of 40 percent and over
is considered as the threshold level of inflation.
Khan and Senhadji (2001) explored the inflation and growth
relationship separately for industrial and developing countries and
re-examined the issue of the existence of "Threshold" effects.
Their results show that the threshold rate of inflation is 1-3 percent
for industrial countries and 7-11 percent for developing countries. Lee
and Wong (2005) estimated the threshold levels of inflation for Taiwan
and Japan using quarterly data set from the period between 1965-2002 for
Taiwan and 1970-2001 for Japan. Their estimation of the threshold models
suggests that an inflation rate beyond 7.3 percent is detrimental for
the economic growth of Taiwan. On the other hand, they found two
threshold levels for Japan, which are 2.5 percent and 9.7 percent. They
suggest that inflation rate below the estimated level of 9.7 percent is
favourable to economic growth and beyond this threshold value it is
harmful for the economic growth in Japan. Munir and Mansur (2009)
investigate the non linear relationship between inflation rate and
economic growth during the period of 1970-2005 for Malaysia. They found
that threshold level of inflation is 3.9 percent and support the view
that the relationship between inflation rate and economic growth is
nonlinear. Inflation rate above the threshold level significantly
retards growth rate of GDP and below the threshold level, it promote
economic growth significantly. Sergii (2009) investigate the
growth-inflation interaction for CIS countries for the period of
2001-2008 and found that when inflation level is higher than 8 percent
economic growth is slowed down, otherwise, it is promoted.
How then inflation affect growth and more particularly, what do
gives rise to the so-called threshold effect in the relationship? What
is the channel through inflation can affect growth in nonlinear
settings? Recent literature highlights that investment might be consider
as an important channel through which the impact of inflation is
transmitted nonlinearly in economic growth. Investment, inflation and
economic growth non linear nexus can be explained by using financial
market development. Nonlinearity between inflation and financial
development is well documented in literature [Boyd and Smith (1998);
Huybens and Smith (1998, 1999); Boyd, et al. (2001); Khan, et al.
(2001)]. A predictable increase in the rate of inflation can slow down
financial market development. Inflation, a tax on real balance, reduces
real returns to savings which in turn causes an informational friction
afflicting the financial system. These financial market frictions
results in credit rationing and thus limit the availability of
investment and finally this reduction in investment adversely impacts
economic growth. In endogenous growth literature, economic growth is
dependent on rate of return and inflation decreases rate of return
[Nelson (1976); Fama and Schwert (1977); Gultekin (1983) and Boyd, et
al. (1996)], which leads to reduction in capital accumulation and hence
decrease the growth rate. Inflation creates uncertainty in the financial
market and increases the risk associated with the investment which
translated into reduction in economic activities [Hellerstein (1997)].
Inflation can discourage investors by reducing their confidence in
investments that take a long time to mature in stock market. There are
few studies that explored the investment inflation relationship and
hence its impact on growth. According to Barro (1995) reduction is
economic growth is occurred due to reduction in the propensity to
investment that is outcome of inflation. He further shows that an
increase in average inflation by 10 percentage points per year cause
reduction in the ratio of investment to GDP by 0.4-0.6 percentage points
and this reduction in investment reduces the real per capita GDP by
0.2-0.3 percentage points per year. Therefore, inflation reduces the
level of investment and hence reduction in investment adversely affects
economic growth. Li (2006) estimates relationship between inflation and
investment for 27 developed and 90 developing countries over the period
1961-2004 and found that relationship is nonlinear for both developed
and developing countries.
Pakistan's economy has lost significant momentum in last few
years. Deteriorated economic growth coupled with high inflation and low
investment is major problems of Pakistan's economy. The growth rate
of real GDP has gone down to 1.2 percent in 2008-09 from 9 percent in
2005-05. Investment is a key determinant of growth and its fluctuation
reflects the intensification of economic activities. The total
investment has declined form 22.5 percent of GDP in 2006-07 to 19.7
percent of GDP in 2008-09 and private sector investment was decelerating
persistently since 2004-05 and its ratio to GDP has declined from 15.7
percent in 2004-05 to 13.2 percent in 2008-09. The inflation rate,
measured as Consumer Price Index (CPI), has climbed to 22.3 percent
during 2008- 09 over the corresponding increase of 10.3 percent
[Pakistan (2010)].
These statistics reveals that it is important to investigate the
nexus among inflation, investment and economic growth. Few studies, in
Pakistan, envisage the existence of non linear relationship between
inflation and economic growth [Mallik and Chowdhury (2001); Mubarik
(2005) and Hussain (2005)]. Mubarik (2005) estimates the threshold level
of inflation for Pakistan using an annual data set from the period
between 1973 and 2000. He found that an inflation rate beyond 9-percent
is detrimental for the economic growth while inflation rate below this
level is favourable for the economic growth. Hussain (2005) empirically
estimates the threshold level of inflation using standard econometric
technique used for estimations of threshold effect for the period of
1973-2005 in Pakistan. He found no threshold level of inflation for
Pakistan. These results are in sharp contrast to the findings of Mubarik
(2005) where threshold level for Pakistan is at 9 percent. He suggests
that targeting inflation exceeding a range of 4-6 percent will be a
deterrent to economic growth and this range of inflation is tolerable
for Pakistan.
Our study is different in three respects from other studies that
have been conducted for Pakistan. First, we focus on a more recent and
long time series (1961 to 2008). Secondly, these studies focus on the
existence of only one threshold level between these two variables by
ignoring the possibility of second threshold in the relationship of
inflation and growth. Thirdly, these studies have not examined the role
of investment as a channel through which inflation affects economic
growth.
The paper has twofold objectives. Firstly, the impact of the
inflation rate on economic growth with the possibility of two threshold
levels for Pakistan using annual data from 1961 to 2008 is examined and
secondly, nonlinear relationship between inflation and investment has
been investigated. Following questions are analysed in this context:
(1) Does a second threshold level exist in the inflation-growth
relationship?
(2) What is the relationship between inflation and investment? Does
the effect of inflation on investment show a similar pattern to that
inflation on economic growth?
The remainder of paper is organised as follows: Model specification
is discussed in Section 2. Data and descriptive statistics are explained
in Section 3. Results are presented in Section 4 while conclusion and
policy recommendation are in last section.
2. THE MODEL SPECIFICATION
The relationship between inflation and economic growth can be
derived using the standard growth equation [Barro (1991) and
Sala-i-Martin (1997)]:
d log Y = X[beta] + [epsilon] ... ... ... ... ... ... ... (1)
Where Y is real output, X is a set of explanatory variables, [beta]
is slope coefficients attached with explanatory variables and [epsilon]
is the error term. This basic growth equation is extended to captures
the link between inflation and economic growth by using following
equation:
d log Y = [[alpha].sub.0] + [[alpha].sub.1] Inf + X[beta] +
[epsilon] ... ... ... ... ... (2)
Where d log Y is growth rate of real GDP, Inf is growth rate of CPI
and X is matrix of other explanatory variables, [beta] matrix of slope
coefficients and [epsilon] is the error term.
Neoclassical growth model uses investment and population growth in
the growth analysis. Increase in investment together with a decrease in
population growth rate promotes economic growth. International trade
theory proposes to include openness of the economy in the growth
regression which is positively related to growth. Money supply is
important indicator for financial development. Development in financial
sector is positively linked with economic growth. Finally, our empirical
analysis uses the following explanatory variables: investment,
population growth, M2 and openness of the economy. Choice of variables
is consistent with the choice made by other researchers [Khan and
Senhadji (2001); Drukker, et al. (2005); Mubarik (2005); Hussain (2005);
Li (2006) and Sergii (2009)].
So, our final regression model is as follow:
d log Y = [[alpha].sub.0] + [[alpha].sub.1] (Inf) +
[[beta].sub.1](P) + [[beta].sub.2](INV) + [[beta].sub.3](F) +
[[beta].sub.4](O) + [epsilon] ... ... (3)
Where d log Y is growth rate of real GDP, Inf is growth rate of CPI
and P is population growth rate, INV is investment to GDP ratio, F is M2
to GDP ratio, O is openness ((Export + Import)/GDP) and [epsilon] is the
error term.
Theoretical as well as empirical debate predicts that threshold
effects are associated with a rate of inflation exceeding some
"critical value" or below some "critical value".
Threshold Model was developed by Khan and Senhadji (2001) for the
analysis of threshold level of inflation for industrialised and
developing countries. Mubarik (2005) and Hussain (2005) use the same
model for the estimation of threshold level of inflation in Pakistan. In
this model only one threshold level was captured. We extend this model
with the possibility of two threshold level in inflation growth nexus.
By introducing two threshold level of inflation; following final
regression model is designed:
[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] (4)
Where dependant variable and the control variable are defined as
the same as in Equation 3 while [[pi].sub.1] and [[pi].sub.2] are two
threshold level of inflation. I(Inf < [[pi].sub.1]), I([[pi].sub.1]
[less than or equal to] I([[pi].sub.1] [less than or equal to]
[[pi].sub.2) and I(Inf < [[pi].sub.2]) are indicators functions which
take the value of one if the term between parentheses is true and are
zero otherwise. This model specifies the effects of inflation with three
coefficients: [[alpha].sub.2], [[alpha].sub.3], and [[alpha].sub.4],
[[alpha].sub.2] denotes the effect of inflation below the first
threshold level [[pi].sub.1], [[alpha].sub.3] denotes the effect of
inflation on economic growth between and [[pi].sub.1] and [[pi].sub.2],
[[alpha].sub.4] denotes the effect of inflation on economic growth
exceeding the second threshold level [[pi].sub.2].
Identification of threshold is based on the methodology defined by
Khan and Senhadji (2001). Regression equation is estimated for different
values of threshold which is chosen in an ascending order (i.e., 1, 2
and so on), the optimal value threshold is obtained by finding the value
that maximises the [R.sup.2] from the respective regressions. This also
implies that the optimal threshold level is that which minimises the
residual sum of squares (RSS). This procedure has become widely accepted
in the literature on this topic. Search of optimal threshold for wider
range of threshold is very tedious. Moreover, Hansen (2000) proposed to
search optimal value only in the region where do expect the threshold
should be.
Theoretical literature indicates that investment might be the
channel through which inflation hits economic growth. Following linear
model specification is used to measure the relationship between
investment and inflation:
INV = [[delta].sub.0] + [[delta].sub.1] Inf +
[[delta].sub.2][INV.sub.t-1] + [epsilon] ... ... ... ... ... (5)
Where INV is the gross fixed capital accumulation as share of GDP
and first lag of INV is included to control the economic conditions in
the last period. With the possibility of two thresholds in investment
inflation nexus, following model is designed:
[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] (6)
Selection of threshold level is based on the similar procedure
explained for inflation and economic growth
3. DATA AND DESCRIPTIVE STATISTICS
The data are taken from Economic Survey of Pakistan (Various
Editions) and Fifty Year Economy of Pakistan (SBP). Data are ranging
from 1961 to 2008. Following variables are used in analysis. Growth of
real GDP is measured as annual percentage growth rate of GDP at constant
prices based on 2000 prices. Inflation is measured as annual percent
change of average consumer price index. Data for inflation are averages
for the year and index is based on 2000=100. Growth rate of population
is measured as annual population growth rate. Investment is measured as
gross capital formation as percent of GDP. Openness of the economy is
measured as share of export plus import in GDP.
Descriptive statistics of sample data shows that the average value
of growth rate of output is 5.5 percent, and growth rate of population
has the average value of 2.7 percent, investment has average value 18.1
percent and openness of the economy has average value 35.4 percent.
Inflation has mean 7.8 percent while M2 as share of GDP has average
value of 34.7 (Table 1).
The stationarity of the series is confirmed by applying Augmented
Dickey-Fuller (ADF) test. Table 2 gives the result of ADF for all
series. Real GDP growth rate and openness are stationary at level while
Investment to GDP ratio, Inflation, Population Growth rate and M2 as
percent of GDP are non stationary at level and become stationary at
first difference.
4. MODEL ESTIMATION
4.1. Inflation and Economic Growth Nexus
The simple linear model of economic growth and inflation as defined
in Equation 3 has been estimated. The basic purpose of simple linear
regression is to reveal the shape of the growth function relating the
inflation with economic growth. Result indicates that inflation has
significant negative impact on economic growth at second lag. (1) One
percent increases in inflation causes 0.2 percent reduction in growth
rate of GDP. Investment has positive and significant impact on economic
growth while population growth also has positive and significant impact
on economic growth (Table 3). The coefficient of investment / GDP ratio
is 0.65 which indicates that a 1 percentage point increase in investment
will cause a 0.65 percentage pint increase in growth. Other variable
like M2 to GDP ratio and openness was also used in the regression
equation and finally both variables were drop due to their insignificant
relationship with economic growth.
Nonlinear model has been estimated using Equation 4. For estimation
of [[pi].sub.1], and [[pi].sub.2],, we apply the methodology given in
Section 2. First, we estimate the Equation 3 with one threshold level.
With the possibility of one threshold level, we reformulate Equation 3
as follow:
d log Y = [[alpha].sub.1] + [[alpha].sub.2][(Inf).sup.*]I(Inf [less
than or equal to] [[pi].sub.1]) + [[alpha].sub.3] [(Inf).sup.*]I(Inf
> [[pi].sub.1]) + [[beta].sub.1](P)+ [[beta].sub.2](I) + [epsilon]
(7)
We apply a range of threshold level ranging from 1 to 8 and choose
the value that minimises the error sum of square as mention by Hansen
(2000). Finally, result indicates that the value of [[pi].sub.1], is 6
and inflation below 6 percent has positive but insignificant impact on
economic growth (Appendix Table 1-A and Table 1-B). Then, we carry out a
significant test of no threshold against one threshold [[pi].sub.1],.
The null hypothesis is [H.sub.0] = [[alpha].sub.2] = [[alpha].sub.3]
against the alternative of [H.sub.0] = [[alpha].sub.2] [not equal to]
[[alpha]sub.3]. The result indicates that null hypothesis is rejected at
5 percent level of significance which confirms the existence of one
threshold level in inflation data.
The existence of second threshold in the relationship between
growth and inflation is tested by using Equation 4. By using same
process we find the second threshold level which is 11 (Table 4). Then,
we carry out a significant test of one threshold against two thresholds.
The null hypothesis is existence of only one threshold against the
alternative of existence of two thresholds. The result supports the
existence of two thresholds against one at 5 percent level of
significance.
Our findings show that for the low inflation below the fist
threshold level, the coefficient of inflation (0.18) is positive which
implies that I percentage increase in inflation will cause a 0.18
percentage point increase in economic growth. However, this positive
impact is not significant. This indicates that, in Pakistan, low
inflation upto 6 is not harmful for the country. (2) In the middle range
of inflation i.e. between two threshold level (inflation between 6 and
12), the coefficient of inflation (-0.32) is negative and significant at
one percent level. Results show that an increase in one percentage point
inflation per year is associated with a reduction of the growth rate of
real GDP by 0.32 percentage point. When inflation rate is exceeding the
11 percentage point i.e. above the second threshold level, the
coefficient of inflation (-0.06) is still negative and significant.
However, this negative effect is smaller than that when inflation is in
the range of o to 11. A one percentage increase in inflation, when
inflation rate is more than eleven percentage point, a reduction of 0.06
percentage point is occur in real GDP growth rate.
The existence of two threshold levels implies that inflation can be
divided into three parts. As inflation rises from zero to six percentage
point, the effect on economic growth is negligible or even positive. As
inflation crosses the low threshold level, it has significant and
negative impact on the GDP up to a certain level. When inflation crosses
second threshold level, the marginal adverse impact of inflation on
growth diminishes. The smaller negative coefficient illustrate that the
inflation growth relationship flattens when the economy has high
inflation. Intuitively, we can say that once inflation exceeds a
threshold level, all of the damage to the financial system has already
been done, and then perfect foresight dynamics comes into being. When
these occur, further increases in inflation have no additional
detrimental effects on economic growth. (3)
4.2. Inflation and Investment Nexus
Theoretical literature has suggested that investment might be the
channel that link inflation to economic growth. The linear model is
estimated by using Equation 5 to uncover the relationship between
inflation and investment. Results indicate that inflation has
significant and negative impact on investment/GDP ratio. The coefficient
of inflation (-0.08) shows that a 1 percentage point increase in
inflation will cause a 0.08 percentage point reduction in investment.
The first lag of investment is used to control the economic conditions
in the last period which has significant and positive impact on current
investment (Table 5). This linear analysis confirms the
inflation-investment/GDP nexus like inflation and GDP growth. A dummy
variable ranging from 1973 to 1981 is used to make data stable and
normal.
Nonlinear model of investment and inflation is estimated using
Equation 6. By applying same process as given for inflation and growth,
a single threshold at 7 percent is estimated because we cannot reject
the null hypothesis of one threshold against 2 thresholds. Table o
presents the estimation results of the inflation-investment relationship
with threshold effects. The coefficient of inflation (0.05) is positive
but insignificant when inflation is below the threshold level. However,
as inflation rates exceed the threshold level, the effect of inflation
on the level of investment is negative and significant. The coefficient
of inflation (-0.07) shows that a 1 percentage point increase in
inflation will cause a 0.07 percentage point reduction in investment as
inflation rose from threshold level. These evidences suggest that during
a period of high inflation, the level of investment be adversely
affected by inflation.
5. CONCLUSION AND POLICY OPTIONS
The objective of the present study has been twofold. Firstly, the
impact of the inflation rate on economic growth with the possibility of
two threshold level for Pakistan using annual data from 1961 to 2008 has
been examined and secondly, nonlinear relationship between inflation and
investment is also explored.
Inflation and growth models support the existence of a nonlinear
relationship with two thresholds. Existence of a double threshold
divides the inflation into three categories i.e. low inflation, moderate
inflation and high inflation. Inflation, below the first threshold (6
percent), affects economic growth positively but insignificantly; at
moderate rates of inflation, between the two threshold levels (between 6
percent and 11 percent), the effect of inflation is negative and
significant; and at high rates of inflation, above the second threshold
(above 11 percent), the marginal impact of additional inflation on
economic growth diminishes but it is still negative and significant.
The second objective of the study is to explore the mechanism
through which inflation affects long-run economic growth in nonlinear
settings. Investment is one of the possible channels through which
inflation affects economic growth. The analysis indicates the nonlinear
relationship between these two variables with only one threshold at 7
percent. Rate of inflation below the threshold level has a positive but
insignificant impact on investment, while above the threshold it has
strong negative and significant impact on the investment.
These findings provide some important policy implications. The
analysis shows that it is desirable to keep the inflation below than 6
percent and therefore central bank should concentrate on those policies
which keep the inflation rate below the first threshold because it may
be helpful for the achievement of robust economic growth. Higher
inflation than the threshold would have adverse consequences for growth.
Monetary policy must be designed to stabilise the prices and curb
inflation. Low inflation is also helpful for minimising the
uncertainties in the financial market which in turn boost investment in
the country. Better coordination between monetary and fiscal polices is
required to achieve both objectives, i.e., high and sustain economic
growth and low inflation.
Appendices
Appendix Table 1-A
Estimation of One Threshold Level (Dependant Variable
is GDP Growth Rate)
Variable Coefficient t-Statistic
Constant -13.94929 -2.110006
Inflation <6 0.240981 0.924573
Inflation >=6 -0.203435 -3.087819
Investment 0.639304 3.232172
Population 0.035727 2.572852
R-Squared = 0.32; DW = 2.14; Jarque-Bera = 0.1 1; Ramsey RESET
Test (1, 40) = 1.19 [0.28].
Appendix Table 1-B
Estimation of One Threshold Level (Dependant Variable is
GDP Growth Rate)
Variable Coefficient t-Statistic
Constant -10.90925 -1.748677
Inflation <=6 -0.561443 -2.596820
Inflation > 6 -0.249473 -3.786838
Investment 0.515003 2.651303
Population 0.035711 2.725498
R-Squared = 0.3G; DW = 2.01; Jarque-Bera = 0.08; Ramsey
RESET Test (1, 40) = 1.08 [0.30].
REFERENCES
Barro, R. (1991) Economic Growth in a Cross-section of Countries.
Quarterly Journal of Economics 106:2, 407-443.
Barro, R. J. (1995) Inflation and Economic Growth. National Bureau
of Economic Research. (Working Paper, No. 5326).
Boyd, J. H. and B. D. Smith (1998) Capital Market Imperfections in
a Monetary Growth Model. Economic Theory 11, 241-273.
Boyd, J. H., R. E. Levine, and B. D. Smith (1996) Inflation and
Financial Market Performance. Federal Reserve Bank of Cleveland.
(Working Paper 9617).
Boyd, J. H., R. Levine, and B. D. Smith (2001) The Impact of
Inflation on Financial Sector Performance. Journal of Monetary Economics
47, 221-248.
Bruno, M. and W. Easterly (1998) Inflation Crises and Long-run
Growth. Journal of Monetary Economics 41:1, 3-26.
Bullard, J. and J. Keating (1995) The Long-run Relationship between
Inflation and Output in Post-war Economies. Journal of Monetary
Economics 36, 477-496.
Drukker, D., P. Gomis-Porqueras, and P. Hernandez-Verme (2005)
Threshold Effects in the Relationship between Inflation and Growth: A
New Panel-Data Approach. (IMF Staff Papers).
Fama, E., and G. Schwert (1977) Asset Returns and Inflation.
Journal of Financial Economics 5, 115-146.
Faria, J. and F. Carneiro (2001) Does High Inflation Affect Growth
in the Long and Short Run? Journal of Applied Economics 1.
Fisher, S. (1993) The Role of Macroeconomic Factors in Growth.
Journal of Monetary Economics 32, 485-512.
Gillman, M. and A. Nakov (2004) Granger Causality of the
Inflation-Growth Mirror in Accession Countries. Economics of Transition
12:4, 653-681.
Gultekin, N. (1983) Stock Market Returns and Inflation: Evidence
from Other Countries. Journal of Finance 38, 49-65.
Hansen, B. (2000) Sample Splitting and Threshold Estimation.
Econometrica 68:3, 575-603.
Hellerstein, R. (1997) The Impact of Inflation. Regional Review
7:1.
Hussain, M. (2005) Inflation and Growth: Estimation of Threshold
Point for Pakistan. Pakistan Business Review 7:3.
Huybens, E. and B. Smith (1998) Financial Market Frictions,
Monetary Policy, and Capital Accumulation in a Small Open Economy.
Journal of Economic Theory 81, 353-400.
Huybens, E. and B. Smith (1999) Inflation, Financial Markets, and
Long-run Real Activity. Journal of Monetary Economics 43, 283-315.
Khan, M. S., A. S. Senhadji, and B. D. Smith (2001) Inflation and
Financial Depth. (IMF Working Paper, WP/01/44).
Khan, M. S. and S. A. Senhadji (2001) Threshold Effects in the
Relationship between Inflation and Growth. IMF Staff Papers 48:1, 1-21.
Lee, C. C. and S. Y. Wong (2005) Inflationary Threshold Effects in
the Relationship between Financial Development and Economic Growth:
Evidence from Taiwan and Japan. Journal of Economic Development 30,
49-69.
Li, M. (2006) Inflation and Economic Growth: Threshold Effects and
Transmission Mechanisms. University of Alberta. (Working Papers).
Lucas, R. (1973) Some International Evidence on Output-Inflation
Tradeoffs. America, Economic Review 63, 326-334.
Malla, S. (1997) Inflation and Economic Growth: Evidence from a
Growth Equation. Department of Economics, University of Hawai'i at
Monoa. (Mimeographed.).
Mallik, G. and A. Chowdhury (2001) Inflation and Economic Growth:
Evidence from South Asian Countries. Asian Pacific Development Journal
8:1, 123-135.
Mubarik, Y. A. (2005) Inflation and Growth: An Estimate of the
Threshold Level of Inflation in Pakistan. State Bank of Pakistan
Research Bulletin 1:1, 35-44.
Munir, Q. and K. Mansur (2009) Non-linearity between Inflation Rate
and GDP Growth in Malaysia. Economics Bulletin 29:3, 1555-1569.
Nelson, C. (1976) Inflation and Rates of Return on Common Stocks.
Journal of Finance 31, 471-483.
Pakistan, Government of (2010) Pakistan Economic Survey (2009-10).
Islamabad: Economic Advisor's Wing, Ministry of Finance.
Sala-i-Martin, X. (1997) I Just Ran Two Million Regressions.
American Economic Review 87, 178-183.
Sarel, M. (1996) Nonlinear Effects of Inflation on Economic Growth.
IMF Staff Papers 43, 199-215.
Sergii, P. (2009) Inflation and Economic Growth: The Non-Linear
Relationship. Evidence from CIS Countries. MA Thesis in Economics, Kyiv
School of Economics.
(1) Mubarik (2005) and Hussain (2005) also found that inflation
effect economic growth at second lag.
(2) Mubarik (2005) found that in Pakistan, inflation up to 9
percent is not harmful while Hussain (2005) found that inflation between
4 percent to 6 percent is feasible.
(3) Li (2006) also found a similar result for developing countries.
Nasir Iqbal <nasir@pide.org.pk> is Staff Economist at the
Pakistan Institute of Development Economics, Islamabad. Saima Nawaz
<saimanawaz-2006@yahoo.com> is PhD Student at the Pakistan
Institute of Development Economics, Islamabad.
Authors' Note. The authors thank to Dr Musleh ud Din Joint
Director at the Pakistan Institute of Development Economics, Islamabad
for their valuable suggestions and Muhammad Javid Staff Economist al the
Pakistan Institute of Development Economics, Islamabad for help in
estimation. The authors also wish to thank Dr Mohsin S. Khan, Dr Waqar
Masood Khan and Dr Wasim Shahid Malik for their useful comments on an
earlier version.
Table 1
Descriptive Statistics
Variables N Mean SD Min Max
GDP Growth Rate 48 5.48 2.09 1.20 9.80
Investment as % of GDP 48 18.08 2.15 12.93 22.95
Inflation 48 7.81 5.29 -0.52 26.66
Growth Rate of Population 48 2.67 0.33 1.78 3.19
M2 as % of GDP 48 34.76 4.89 24.28 46.69
Openness 48 35.39 3.19 28.85 42.62
Table 2
Test for Non-stationarity of Variables
Level
Variables No Trend With Trend Result
GDP Growth Rate -5.73 -6.01 Stationary
Investment as % of GDP -2.12 -2.39 Non-stationary
Inflation -2.15 -2.86 Non-stationary
Growth Rate of Population -0.25 -2.44 Non-stationary
M2 as % of GDP -0.73 -1.44 Non-stationary
Openness -3.62 -3.76 Stationary
First Difference
Variables No Trend With Trend Result
GDP Growth Rate -- -- --
Investment as % of GDP -6.98 -6.99 Stationary
Inflation -4.60 -3.89 Stationary
Growth Rate of Population -3.77 -4.28 Stationary
M2 as % of GDP -5.92 -3.75 Stationary
Openness -- -- --
Note: 5 percent critical value is -2.87 for the case of no-trend,
and -3.42 when a trend is included. AIC is used for lag selection.
Table 3
Linear Estimation Results (Dependant Variable is GDP Growth Rate)
Variable Coefficient t-Statistic
Constant -14.35769 -2.368223
Inflation -0.198856 -3.274821
Investment 0.651056 3.573079
Population 0.036202 2.696865
R-Squared = 0.31; DW = 2.12; Jarque-Bera = 0.12; Ramsey RESET Test
(1, 41) = 1.11 [0.30].
Table 4
Estimation with Thresholds Effect (Dependant Variable is
GDP Growth Rate)
Variable Coefficient t-Statistic
Constant -10.16507 -1.596767
Inflation <6 0.183643 0.517296
Inflation>=6 and Inflation <=11 -0.322854 -2.611079
Inflation > 11 -0.056985 -3.827330
Investment 3.449236 2.593579
Population 0.512724 2.622883
R-Squared = 0.37; DW = 2.02; Jarque-Bers = 0.09; Ramsey RESET
Test (1, 39) = 0.34 [0.56].
Table 5
Linear Estimation Results (Dependant Variable is
Investment/GDP Ratio)
Variable Coefficient t-Statistic
Constant 7.682031 3.179267
Inflation -0.084268 -1.940828
Lag of Investment 0.589304 4.515194
Dummy from 1973 to 1981 -0.945999 -1.699239
R-Squared = 0.55; DW = 1.80: Jarque-Bera = 0.08; Ramsey RESET
Test (1. 40) = 1. 13 [0.32].
Table 6
Estimation with Thresholds Effect (Dependant Variable
is Investment/GDP Ratio)
Variable Coefficient t-Statistic
Constant 7.878550 3.277259
Inflation <7 0.047665 0.608740
Inflation >=7 -0.067759 -1.949206
Lag of Investment 0.579052 4.459827
Dummy from 1973 to 1981 -0.991533 -1.795522
R-Squared = 0.57; DW = 1.81; Jarque-Bera = 0.06; Ramsey
RESET Test (1, 40) = 0.11 [0.74].
