Monetary Policy

The Continuing Puzzle of the Inflation-Growth Relationship

The inflation-growth relationship has attracted much attention from economists, both in academia and in the world of central banking, for good reason. If reducing the average rate of inflation can be expected to increase a country's average annual growth rate of output by even one-tenth of a percentage point, it is a policy worth considering. Although one-tenth of a percentage point in an annual growth rate seems very small, over a period of many years even such small variations can translate into significant changes in the level of income. Consider, for example, a country that has per capita income today equal to 100 and an annual growth rate of 1.5 per cent. After 30 years, income will have grown to 156. Now imagine increasing that growth rate to 1.6 per cent; after 30 years, income will have increased to 161. Going another 30 years further into the future, the lower-growth level of income will be 244, whereas the level of income in the (slightly) higher-growth world will be 259. These may seem like small differences, but they should not be ignored. Who wouldn't want to increase their income by even a few percentage points?

As important as the possible link between inflation and growth may be, Ragan's (2000) review of the research demonstrates the difficulty in finding clear and convincing evidence that such a relationship exists. What is clear is that, in countries that have experienced very high ("hyper") inflation, there is a significant and negative effect on growth. This is not surprising. When inflation becomes very high, money is losing its value so quickly that it soon ceases to be useful as either a medium of exchange or as a store of value. In such an environment, firms and workers, borrowers and lenders are led to conduct their transactions without money—we typically observe a re-emergence of barter economies. But barter is so inefficient relative to money that, not surprisingly, the output generated by such economies, and thus the real income accruing to their residents, typically plummets.

What is much less clear from the empirical research is any relationship between inflation and real output growth in countries that already have low, or even moderate, inflation. For example, in a country with inflation of, say, 5 per cent per year, it is not clear from the data that a policy decision to reduce inflation to 4 per cent or 3 per cent would have any impact on that economy's long-run rate of output growth. This is not to say that there would be no benefits from the lower inflation—including the benefits that would stem from the reduced uncertainty of inflation—only that the evidence does not clearly identify a higher rate of output growth among those benefits. This is an important enough topic, however, that researchers will continue to re-examine the data in different and better ways until there appears to be a clear answer to the question.