Anda di halaman 1dari 27

This article was downloaded by: [University of Cambridge]

On: 01 January 2015, At: 00:58


Publisher: Routledge
Informa Ltd Registered in England and Wales Registered Number: 1072954 Registered
office: Mortimer House, 37-41 Mortimer Street, London W1T 3JH, UK

Journal of the Asia Pacific Economy


Publication details, including instructions for authors and
subscription information:
http://www.tandfonline.com/loi/rjap20

Inflationgrowth relationship in
selected Asian developing countries:
evidence from panel data
a

bcd

Ahmed Taneem Muzaffar & P.N. (Raja) Junankar


a

School of Business, University of Western Sydney, Sydney,


Australia
b

Industrial Relations Research Centre, University of New South


Wales, Sydney, Australia
c

University of Western Sydney, Sydney, Australia

Click for updates

IZA Institute for the Study of Labor, Bonn, Germany


Published online: 30 May 2014.

To cite this article: Ahmed Taneem Muzaffar & P.N. (Raja) Junankar (2014) Inflationgrowth
relationship in selected Asian developing countries: evidence from panel data, Journal of the Asia
Pacific Economy, 19:4, 604-628, DOI: 10.1080/13547860.2014.920594
To link to this article: http://dx.doi.org/10.1080/13547860.2014.920594

PLEASE SCROLL DOWN FOR ARTICLE


Taylor & Francis makes every effort to ensure the accuracy of all the information (the
Content) contained in the publications on our platform. However, Taylor & Francis,
our agents, and our licensors make no representations or warranties whatsoever as to
the accuracy, completeness, or suitability for any purpose of the Content. Any opinions
and views expressed in this publication are the opinions and views of the authors,
and are not the views of or endorsed by Taylor & Francis. The accuracy of the Content
should not be relied upon and should be independently verified with primary sources
of information. Taylor and Francis shall not be liable for any losses, actions, claims,
proceedings, demands, costs, expenses, damages, and other liabilities whatsoever or
howsoever caused arising directly or indirectly in connection with, in relation to or arising
out of the use of the Content.
This article may be used for research, teaching, and private study purposes. Any
substantial or systematic reproduction, redistribution, reselling, loan, sub-licensing,
systematic supply, or distribution in any form to anyone is expressly forbidden. Terms &

Downloaded by [University of Cambridge] at 00:58 01 January 2015

Conditions of access and use can be found at http://www.tandfonline.com/page/termsand-conditions

Journal of the Asia Pacific Economy, 2014


Vol. 19, No. 4, 604628, http://dx.doi.org/10.1080/13547860.2014.920594

Inflationgrowth relationship in selected Asian developing countries:


evidence from panel data
Ahmed Taneem Muzaffara* and P.N. (Raja) Junankarb,c,d
School of Business, University of Western Sydney, Sydney, Australia; bIndustrial Relations
Research Centre, University of New South Wales, Sydney, Australia; cUniversity of Western Sydney,
Sydney, Australia; dIZA  Institute for the Study of Labor, Bonn, Germany

Downloaded by [University of Cambridge] at 00:58 01 January 2015

We question the empirical foundation of keeping inflation at 5% or below in


developing economies. Using System Generalized Method of Moments we investigate
the issue in the context of 14 Asian developing countries for the period 19612010.
We find no robust empirical justification for targeting inflation at such a low level.
The inflation threshold for these countries is found around 13% and it may range
between 7% and 14% depending on the level of development. The findings suggest
that developing countries can gain from moderate levels of inflation and should not be
alarmed when inflation crosses the 5% benchmark.
Keywords: Threshold level of inflation; growth; developing countries in Asia; panel
estimation
JEL Classifications: E31, O40

1. Introduction
Macroeconomic policies in developing countries, in recent decades, put strong emphasis
in attaining price stability by keeping inflation low. This follows episodes of high and
accelerating inflation accompanied by growth stagnation during the 1970s and the 1980s,
especially in Latin American countries. There seems to be a strongly held belief by the
mainstream economics profession that targeting low inflation is good for achieving macroeconomic stability and therefore beneficial for long term economic growth. The experiences of stagflation of the 1970s and the Great Moderation during 19932007 have led
to a growing consensus on this view.1 Founded on this belief, policies targeting low inflation have been spearheaded by international financial institutions such as the International
Monetary Fund (IMF). The IMF strongly advises the developing countries to pursue macroeconomic policies targeted at keeping inflation rates within 5%. In response to why
inflation should be kept within 5% the IMF notes:
Inflation is the most pernicious tax on low-income households that lack the means to protect
their salaries and scant savings against inflation . . . a large body of empirical evidence has
established that when (annual) inflation passes the 5 percent mark investment and economic
activity also suffer . . . [therefore] the Fund supports policies aimed at achieving or maintaining low inflation.2

As a result, central to the economic management of some of these countries, compelled to embrace IMF suggested economic reforms, has been to restrain inflation at 5%.
Typically, these policies include tight monetary policy and reining in fiscal deficits
*Corresponding author. Email: t.muzaffar@uws.edu.au
2014 Taylor & Francis

Downloaded by [University of Cambridge] at 00:58 01 January 2015

Journal of the Asia Pacific Economy

605

because of their supposed link to inflationary pressure. This policy of fighting inflation
first, keeping it as low as 5%, is suggested even at the expense of immediate adverse
impacts on growth on the ground that this would foster sustained growth in the future 
supposedly short term pain for long-term gain.
This paper questions the empirical validity of this conventional wisdom that inflation
beyond 5% is detrimental to economic growth in the case of developing countries. We
provide an empirical investigation on a sample of 14 Asian developing countries over the
period 19612010 and show that inflation above 5% is not necessarily harmful for economic growth. Moreover, our findings reveal that the inflation threshold, the level beyond
which it starts having a negative effect on growth, is not fixed at a particular level. It
varies according to the level of economic development with poorer countries tending to
have a higher inflation threshold. To the best of our knowledge, empirical analysis on this
issue with particular emphasis on developing countries of Asia is absent. Our contribution, as such, is twofold. First, the study adds to the literature pertaining to the
growthinflation nexus by providing econometric evidence on panel data from Asian
developing countries. Second, our findings have profound implications for macroeconomic policies in developing countries, in terms of policy space and dealing with
the IMF. There is evidence that despite the policy application suggested by the IMF
based on this conventional wisdom, economic performance failed to improve and
poverty remained high in many countries, even though inflation fell (see e.g. Wilkinson
2000, 643).
The rest of paper is organized as follows. Section 2 discusses the issue that leads us to
this investigation  the problem of keeping inflation at a low single-digit level and crosscountry evidence on inflation threshold. Section 3 describes the data and selection of variables as well as summary statistics. Sections 4 and 5 provide the empirical model and
findings from the analyses on inflation threshold, respectively. Section 6 examines variations in inflation threshold according to levels of development. Section 7 provides concluding remarks.
2. The low-inflation trap and cross-country evidence on inflation threshold
In recent years, a number of leading economists have put forward strong theoretical arguments and empirical evidence against a very low inflationary environment. Nobel Laureate in Economics, Paul Krugman in his opinion page of The New York Times in 2011
calls this the low-inflation trap.3 When inflation falls it creates a deflationary expectation and thus even if nominal interest rate is kept at a very low level,4 real interest rate
continues to rise. This leads to a higher real cost of borrowing and eventually depresses
the economy.5 A couple of decades ago, another Nobel Laureate economist James Tobin
also pointed out the danger of paying too much attention to inflation control (see Tobin
1987). The Economist notes that [e]conomists of highly divergent stripes. . .[such as]
Kenneth Rogoff, Greg Mankiw, Scott Summer, Paul Krugman, Brad DeLong  all have
indicated that higher inflation would be a boon to the economy.6 Criticisms also came
within the IMF. In 2011, Dominique Strauss-Kahn, the then Managing Director of the
IMF, argued the need for a wholesale re-examination of macroeconomic policy
principles and questioned the pre-crisis7 advice that keeping inflation low and stable
was the best way to secure optimal economic performance.8 A number of studies (see
e.g. Anwar and Islam 2011; Chowdhury 2006; Epstein and Yeldan 2008) in recent
years have argued against low-inflation targeting policies, both empirically and analytically, in developing countries. Chowdhury (2006, 409) argued that pursuing a very low

Downloaded by [University of Cambridge] at 00:58 01 January 2015

606

A.T. Muzaffar and P.N. (Raja) Junankar

single-digit inflation rate in developing countries may create a stabilization trap, a situation characterized by low inflation and insufficient growth for poverty reduction.
On the empirical side, a classic example of a developing economy trapped in a stabilization trap could be Argentina9 (see Chowdhury 2006, 426427). In the 1980s, hyperinflation in the country (average annual inflation rate of around 391%) had led to a crisis
and the IMF stabilization programme brought down inflation to a single-digit level, 1.5%
annually. However, as Chowdhury (2006, 427) notes that the continuation of the tight
macroeconomic policies created a deflationary-spiral and the economy plunged into
recession, causing unemployment rate to rise from 6.5% in 1991 to 17.5% in 1996. This
had dire consequences for the poverty rate (head-count ratio) as well  about 13 percentage point rise in a decade, from 21.8% in 1993 to 34.3% in 2002. Referring to the experience of Argentina, the author alerts that while inflation needs to be kept under control,
too much emphasis on a very low inflation rate may lead to an inadvertent consequence
that exacerbates poverty. Studies such as Epstein and Yeldan (2008) and Anwar and Islam
(2011) also observe the sacrifice made in terms of growth and employment in developing
countries in pursuit of a low inflationary environment. The latter study argues that low
inflation is not translated into benefits of reduced cost of borrowing, because such costs
are likely to be determined by structural factors of the economy. Contrary to the mainstream view, nominal borrowing interest rates lagged behind inflation resulting in higher
real interest rates.
Despite the findings that targeting inflation at a very low level may be detrimental to
economic growth, the IMF policy guideline, explicitly or implicitly, tends to suggest a
target of 5% or below irrespective of country-specific circumstances. For instance, an
inflation target of 5% or less was suggested to 22 out of 32 programme countries between
1995 and early 2007 (Goldsbrough, Adovor, and Elberger 2007, 5). According to the
IMFs Independent Evaluation Office (IEO 2007), an inflation target of less than 5% was
suggested to 29 Sub-Saharan African countries during the 2000s.
To examine IMFs position on inflation we now look at the empirical findings on
inflation threshold from some selected cross-country studies. A list of such studies and
their findings in relation to developing countries is provided in Table 1 followed by
discussion.
Empirical literature, both recent and relatively old, provides strong evidence of a nonlinear relationship between growth and inflation. The question of interest, therefore, is at
what level the inflation threshold occurs for the developing countries. Bruno and Easterly
(1998) find robust evidence that growth falls sharply at discrete high-inflation (which
they propose to be 40% per annum) crises, then recovers rapidly and strongly after inflation falls. They argue that the correlation between growth and inflation only exists in the
case of extreme inflation observations. However, Sarel (1996), a study carried out at the
IMF, finds evidence of a structural break of inflation at a much lower rate of 8%. He uses
annual data for 87 countries over 19701990 but does not differentiate between developed and developing countries. Amato and Gerlach (2002, 788), in this connection, state
that there is little hard evidence to suggest that the level of inflation targets [in developing countries]. . .should be much different than in more advanced economies. However,
not differentiating between developed and developing countries leads to potential bias in
the estimation due to combining various countries at different levels of development.
Sepehri and Moshiri (2004) support that the inverted U-shaped relationship between inflation and growth vary across countries of various stages of development. As a result of
such degree of heterogeneity across countries in terms of development, the authors suggest that it is inappropriate to set a single numerical policy target uniformly for all

19652004

19612007

19602004

19602007

19612000

19502000

19601996

19651992 and
19671992 for
developed and
developing
countries,
respectively

Lopez-Villavicencio
and Mignon (2011)

Bick (2010)

Espinoza et al. (2011)

Pollin and Zhu (2006)

Drukker et al. (2005)

Sepehri and
Moshiri (2004)

Burdekin et al. (2004)

Period

Yilmazkuday (2013)

Study

92 countries with 26 lowermiddle-income and 28


low-income countries.
21 industrial and 51
developing countries.

138 countries

80 middle-income and
low-income countries

165 countries

40 developing countries

44 countries

84 countries

Number of countries

Table 1. Selected cross-country studies on the threshold effect of inflation on growth.

Generalized least-squares (GLS)


estimator with fixed effects.

Generalized panel threshold


model.
Logistic smooth transition
regression model.
Pooled OLS, Fixed effects,
Random effects, and Between
effects panel estimation
models.
Non-dynamic, fixed effects panel
data models.
Spline regression technique.

Panel smooth transition model


(PSTR) and dynamic
generalized method of
moments (GMM)

Rolling-window two-stage-leastsquares method.

Method

Downloaded by [University of Cambridge] at 00:58 01 January 2015

(continued)

15% and 11% for lower-middleincome and low-income


countries, respectively.
Higher inflation threshold for
more advanced countries; 8%
and 3% for industrial and
developing countries,
respectively.

Around 19% in the full sample.

Inflation threshold is between


8% and 15%. A positive effect
of trade and human capital on
growth is significant when
inflation is below 8% and
15%, respectively.
Threshold inflation differs
strongly between developed
and developing countries. For
developing countries it is
17.5%, below which the
relationship is non-significant.
12% and 19% with and without
regime intercept, respectively.
Between 7% and 13% for
developing countries.
Between 15% and 18%.

Findings on inflation threshold

Journal of the Asia Pacific Economy


607

19601996
19611992

19701990

Ghosh and Phillips (1998)


Bruno and Easterly (1998)

Sarel (1996)

Source: Adapted from Muzaffar (2013, 4749).

19601998

Period

Khan and Senhadji (2001)

Study

Table 1. (Continued )

87 countries

145 countries
26 countries

140 countries

Number of countries

Spline regression

Binary recursive trees method.


Descriptive analysis

Conditional least-squares

Method

Downloaded by [University of Cambridge] at 00:58 01 January 2015

1%3% and 11%12% for


industrial and developing
countries, respectively. The
positive effect of inflation on
growth is present up to 18%
for developing countries.
2%3%.
No cross-sectional correlation
between long-run averages of
growth and inflation below
inflation rate of 40%.
8%.

Findings on inflation threshold

608
A.T. Muzaffar and P.N. (Raja) Junankar

Downloaded by [University of Cambridge] at 00:58 01 January 2015

Journal of the Asia Pacific Economy

609

developing countries (202). Their basic model is based on Solows augmented production
function which is estimated using Sarels (1996) spline regression technique. In general,
for developing countries the study finds a threshold at a double-digit level and higher
than that of advanced economies. Another study by Ghosh and Phillips (1998, 709), also
carried out at the IMF such as Sarel (1996), believes that the threshold level of inflation is
expected to differ, at least somewhat, across countries.
An influential study, carried out at the IMF, which finds substantially different
threshold levels for developed and developing countries is Khan and Senhadji (2001).
They find a double digit inflation figure at around 11%12% for developing countries
as opposed to 1%3% for developed ones. More importantly the sensitivity analysis,
performed to see the effect of inflation on growth when threshold varies from 1% to
50%, shows a positive effect of inflation on growth up to 18% for developing countries
(16). In a more recent study (outside the IMF), Lopez-Villavicencio and Mignon (2011)
also find a wide difference between the threshold figures for developed and developing
countries, 2.7% and 17.5%, respectively. The study shows that for developing countries
the relationship between inflation and growth is non-significant when inflation is below
17.5%. The results are consistent using both panel smooth transition (PSTR) model and
Generalized Method of Moments (GMMs). Findings of Burdekin et al. (2004) are at
odds with the results of these major studies. According to them the inflation threshold
for developing countries is 3%, significantly lower than 8% found for the advanced
economies. Perhaps a rationale behind this result by Burdekin et al. (2004) can be found
in the explanation by a much earlier study by Dorrance (1964). Prices are more inflexible downwards as a result of more organized trade unions in rich countries compared to
poor countries. Developing economies are also mostly dependent on a few primary products for exports and agricultural products. Therefore, Dorrance (1964) argues that the
appropriate rate of inflation needed to achieve relative price flexibility in advanced economies is higher than that of developing countries. One serious limitation of the study by
Burdekin et al. (2004) is that it uses previous period real GDP per capita as a regressor.
The level of real GDP per capita is likely to be non-stationary and thus may lead to a
spurious relationship.
Broadly, results from other panel studies on inflation threshold provide estimates
between 7% and 19%. The study by Espinoza, Leon, and Prasad (2011) at the IMF revisits the issue within a nonlinear framework and argues that the threshold level lies in the
range of 7% to 13% for developing countries. Pollin and Zhu (2006) estimate the inflation
threshold for 80 countries over the period 19612000. The authors, in addition to entire
sample period, consider four separate decades and consistently find that higher inflation
is associated with moderate gains in growth up to around 15%18% inflation. Based on
their results, they question the justification of inflation targeting policies to keep inflation
at 3%5% levels. There are, however, several limitations of this study. First, panel estimation models  pooled OLS, fixed effects, random effects, and between effects  used
are not appropriate in a dynamic setting and fail to take care of the issue of endogeneity
problem. Such problems can be taken care of by using methods such as GMMs estimations which some of the other studies relied on. The study also does not include variables
relating to money as a control variable in the model.10 Money is an important covariate in
explaining the growthinflation relationship. Moreover, in the case of regression by decades, estimates of the threshold are weak on a number of cases because the linear and
squared terms of inflation are not significant at 5%.
Drukker, Gomis-Porqueras, and Hernandez-erme (2005), using an unbalanced panel
dataset covering 138 countries spanning over 19502000, find a well-defined threshold

Downloaded by [University of Cambridge] at 00:58 01 January 2015

610

A.T. Muzaffar and P.N. (Raja) Junankar

level at 19.16% for the full and non-industrialized samples.11 One limitation of this study
is that the inference made is based on a non-dynamic fixed effects model instead of more
appropriate dynamic models such as GMM. Bick (2010) also finds a similar result, but
argues that the inclusion of regime intercept, used in his study, lowers the threshold from
19% to 12%. Inflation rates less than 12% are associated with a significant positive effect
on growth. Bicks (2010) study consists of a balanced panel dataset12 of 40 developing
countries covering the period 19602004.
Taken together, the review of the existing literature on cross-country panel studies,
carried out both within and outside the IMF, provides strong evidence that inflation
threshold in developing countries is well above 5% level. Broadly, the threshold varies
between 7% and 19% with majority of the studies supporting a double-digit level for
developing countries. Moreover, most studies including the influential ones carried out
at the IMF suggest that the threshold for developing countries is significantly higher
than that of advanced economies. Higher inflation tolerance of developing countries
might be due to a number of reasons such as the BalassaSamuelson effect, indexation
systems, exchange rate policies, and experience of high bouts of inflation in these countries (see Lopez-Villavicencio and Mignon 2011, 462). In short, inflation threshold at
5% may be applicable for developed countries, but certainly not for developing countries. The implication of this finding is that developing countries can gain from moderate
levels of inflation and should not be alarmed when inflation crosses the 5% benchmark
set by the IMF.
3. Data, variables, and summary statistics
We now turn to examine the empirical foundation of IMFs policy prescription for
developing countries to keep inflation within 5% level. We gather a panel dataset of 14
Asian developing countries for the period 19612010 from standard and most widely
used sources  the World Banks World Development Indicators (WDI); the IMFs
International Financial Statistics (IFS) and World Economic Outlook (WEO). The selection of country is based on the availability of data on real Gross Domestic Product
(GDP), Consumer Price Index (CPI), and other control variables. The countries are
Bangladesh, Cambodia, India, Indonesia, Lao PDR, Malaysia, Pakistan, The Philippines,
Thailand, Vietnam, Kazakhstan, Kyrgyz Republic, Papua New Guinea, and Tajikistan.
The dataset is unbalanced because information on variables for the 14 countries is not
available for all years.
Our sample includes a longer time-frame (19612010) compared to the previous
studies and, therefore, contains more information about the growth effects of low inflation. Moreover, we use annual data in our panel estimations in order to maximize sample
size and to measure the parameters of interest more precisely. This empirical approach
differs from most frequent practice in the literature  smoothing data using 510 year
averages. There are two main arguments in favour of using annual observations. First, the
relationship between inflation and growth is more evident in the case of higher frequency
of the data as noted by Bruno and Easterly (1998). They state, [the] results get stronger
as one goes from the cross-section to ten year averages to five year averages to annual
data (4). Khan and Senhadji (2001, 16) also note that high-inflation effect [on
growth] . . . is more powerful for yearly data. The second reason is based on the argument
set forth in Baltagi, Demetriades, and Law (2009). The study states that averaging out
annual data over, for instance, five year periods results in reduction in sample size thereby
raising the possibility of making most of the variables statistically insignificant. The

Downloaded by [University of Cambridge] at 00:58 01 January 2015

Journal of the Asia Pacific Economy

611

Figure 1. Relationship between real GDP growth and inflation.


Sources: Authors calculations using data from World Bank, WDI and IMF, IFS, and WEO.

authors explain that smoothing out of time series data removes useful variation from the
data, which could help to identify the parameters of interest with more precision (286).
Apart from these two reasons we also believe that taking 56 10-year averages to smooth
out business cycle fluctuations is not appropriate because such data-smoothing technique
assumes a uniform business cycle pattern for all countries in the panel. It is unlikely that
the business cycle pattern is homogenous for all countries in the sample.
Our empirical approach, in essence, involves regressing real GDP growth on CPI
inflation, conditioned upon other variables suggested by the related literature. Growth
and inflation are derived by taking the first difference of the natural logarithm of level
variables, real GDP (constant $2000) and CPI, respectively. To preview, Figure 1
attempts to capture the relationship between real GDP growth and inflation following
Khan and Senhadji (2001, Figure 1, 4) who smoothed out data by reducing the full sample to five observations. The arithmetic mean of real GDP growth is taken for five
equal subsamples corresponding to increasing levels of inflation (see Khan and Senhadji
2001, 3). The observation from our sample differs from what was noticed by Khan and
Senhadji (2001). In both cases the relationship between inflation and growth is positive
for low levels of inflation. However, unlike Khan and Senhadji (2001) we do not see, in
our sample, growth to decline drastically when inflation moves to a moderately high
level. This also does not corroborate the findings of Ghosh and Phillips (1998) who
warn of a danger of a steep drop in growth beyond the threshold level of inflation. The
findings of Khan and Senhadji (2001) also show that the negative effect of inflation on
growth weakens at very high inflation rates, supporting Fischers (1993) findings. Our
findings, however, are different and more in line with what Bruno and Easterly (1998)
suggested. Figure 1 shows that growth declines gradually when inflation starts to move
towards a higher level. It is at a very high level of inflation that growth falls sharply.
The differences between the findings are perhaps obvious. Khan and Senhadji (2001) in
their analysis, displayed in Figure 1 (4), did not differentiate between industrial and
developing countries. Our analysis consists of a much smaller group of developing countries. This reiterates the importance of making the distinction between advanced and
developing countries while performing the analysis as pointed out by studies such as
Sepehri and Moshiri (2004).
Apart from inflation, a number of control variables which might influence the
growthinflation relationship are considered as regressors. They are as follows.

612

A.T. Muzaffar and P.N. (Raja) Junankar

Downloaded by [University of Cambridge] at 00:58 01 January 2015

Lagged growth. Growth lagged one period is taken on the right hand side to reflect the
dynamic nature of the relationship and to capture the possibility of partial adjustment
towards the steady state. Greene (2003, 307) explains that incorporating dynamics in this
way allows us to consider the entire history of the right hand side variables, so that any
measured influence is conditioned on this history. The coefficient of this variable is
expected to be positive and lie between 0 and 1.
Real household consumption per capita (HCONPC). To measure the effect of aggregate demand, real household consumption per capita measured in constant $2000 is
included as a control variable. The inclusion of this variable is justified since consumption
is assumed to be the largest component of aggregate demand. Besides, higher household
consumption per capita is assumed to be growth enhancing and an indication of poverty
reduction. The expected sign of its coefficient is positive.
Financial deepening (FD). Broad moneyGDP ratio is taken as a control variable to measure the effect of financial deepening. The expected sign of FD could be either positive or
negative. Earlier studies such as McKinnon (1973), Shaw (1973), and Kapur (1976) argue
that financial development has a positive impact on growth. If the ratio of broad money to
GDP is growth enhancing, money supply is expected to have a greater impact on growth
and less impact on inflation. This is because a developed financial system absorbs the
money supply and diverts it to the real sector, thus generating growth. Therefore, the sign
is positive. On the other hand, Robinson (1952) and Lucas (1988) doubt the role played by
financial development in promoting growth. Bangake and Eggoh (2011, 178) points out the
empirical example of the Asian economies which grew fast in the 1970s and 1980s without
a developed financial system. The sign of FD could be negative if an increase in M26 GDP
implies pressure on inflation and, therefore, negative impact on growth. Moreover, monetary expansion may lead to bubbles (which might result into an inflationary situation) in
the financial system if monetary transmission mechanism is not effective enough to channel
the funds from the financial system to the real sector.
Government consumption expenditure (GOVCON). Government consumption (% of
GDP) is taken to determine the effect of fiscal policy. The sign of GOVCON could be
either positive or negative. A negative sign might indicate that higher government spending is inflationary (fiscal theory of price level) that is bad for growth. In addition,
increased size of the government may crowd out private sector, thus adversely affecting
growth. On the other hand, when fiscal deficits correct a deficiency in private demand the
argument of crowding out is not valid (Arestis and Sawyer 2003). Hemming, Kell, and
Mahfouz (2002) identify a number of reasons why the effect of fiscal policy tends to be
positive and quite large. These conditions include a demand constrained economy with
excess capacity; a closed economy or an open economy with a fixed exchange rate; and
households with limited horizons or liquidity constraints. Therefore, we can also expect a
positive sign of GOVCON when government spending is beneficial in raising the productive capacity of the economy and thus growth inducing.
Trade openness (OPEN). Summation of export and import as a percent of GDP is
taken as a control variable to measure the trade openness. A more open economy is subject to shocks which could be either positive or negative. Therefore, the sign of this coefficient in the growth regression is uncertain.
Agricultures share of GDP (AGR). Since agriculture is still the mainstay of the economy in most of the developing countries, the share of agriculture output (% of GDP) is
considered as a control variable. We expect that AGR would help us capture the structural
changes in the economy and any impact on growthinflation nexus as a result of the

Downloaded by [University of Cambridge] at 00:58 01 January 2015

Journal of the Asia Pacific Economy

613

change. A greater level of development would mean that economic transformation is taking place and economies are less dependent on the primary sector. A negative sign of
AGR, therefore, is expected which would indicate that such transformation is taking place
and is beneficial for economic growth. However, we do not rule out the possibility of a
positive sign of the coefficient of AGR either. As Chenery (1960) observes that this overall relationship may not necessarily apply to every individual country. He argues that
within limits, the changing composition of domestic demand for food can be offset
through foreign trade. A country having a continuing comparative advantage in primary
production, he points out, may, therefore, reach a high level of income without an
increase in the share of industry in total output.
Oil and commodity price shocks. Developing countries are prone to supply shocks
caused by oil and commodity prices in the international markets. Fluctuations in the oil
and commodity prices may act as an incentive or disincentive for domestic production
and therefore affect growth. We create two dummy variables to assess such impacts. The
oil dummy, DUMOIL, takes the value 1 for the years 1971, 1974, 1979, 1999, 2000,
2004, 2005, and 2008 and the value 0 otherwise. In these years, growth rate of oil price
index is 20% above its historical mean that is 7.44%. The commodity price dummy,
DUMCOMPR, is constructed in a similar fashion and takes the value 1 for years 1973,
1974, 2004, and 2006 (and 0 otherwise) when growth rate of commodity price index is
above 20% of its historical mean at 3.85%. Here we are only interested to see the influence of negative supply shocks as a result of rising oil and commodity prices and therefore the expected signs of these dummies are negative.
We present time series graphs of the variables in Figure 2. Mean growth rate in the
sample countries shows major declines in the early 1970s and 1990s. There was one

Figure 2. Mean (unweighted) of cross-country data for each year, 19612010.

Downloaded by [University of Cambridge] at 00:58 01 January 2015

614

A.T. Muzaffar and P.N. (Raja) Junankar

major hyperinflationary period in the 1960s and one inflationary spike during the Asian
Financial Crisis 19971998. These episodes are mostly driven by the experiences of
Indonesia around that time. Apart from growth and inflation experiences, one revealing
fact is that real household consumption per capita shows a significant upward trend since
the early 2000s. Financial deepening shows more or less an upward trend with some setbacks in the 1990s. On the other hand, government consumptionGDP ratio shows a
more restrained trend. It peaks in the late 2000s perhaps due to the expansionary policy to
help recover the economies from the Great Recession of 20092010. Trade openness
shows a significant upward trend in the 1990s perhaps due to globalization policies dominant around that time. The mean of agricultureGDP ratio shows a continuous decline
over this period of time.
Inspection of the time series graphs of the control variables reveals that taking the control variables in their first differenced form is appropriate to avoid spurious regression.
Although theoretically ratio variables such as M2-GDP and government consumptionGDP
should show mean reversion process and therefore should be stationary, the visual inspection of the time series casts doubt on this. Therefore, following Kwon, Mcfarlane, and Robinson (2009), in our regression analyses we use the variables in their first differences.
We provide summary statistics of the growth rates of the above variables for the
period 19612010 in Table 2. In general, long-run average (unweighted) economic
growth in the sample countries is below 5%. The average inflation is around 17% and it is
significantly more volatile (as evident from the standard deviation) than economic growth
over this long period. Real household consumption per capita has registered less than 2%
average growth over this period. Mean growth rates in financial deepening and government consumption (both% of GDP) are less than 5% and 1%, respectively. The latter
shows that the size of the government proportional to GDP has not grown much over the
long period. Average growth rate in trade openness is around 2%, reflecting the fact that
the countries in the sample are becoming more open economies. It is also important to
note that average growth of share of agriculture to GDP is around negative 2%, revealing
a declining trend in the primary sector of the economies. This is an indication that structural transition is taking place in these traditional agro-based economies. In the international markets, oil price on average has increased more and remained more volatile
compared to commodity prices (Table 2).

Table 2. Summary statistics of growth rates of selected variables, 19612010.


Variable
Economic growth
CPI inflation
Real household
consumption per capita
Broad money-GDP ratio
Government
consumption-GDP ratio
Trade openness
Agriculture-GDP ratio
Oil price index
Commodity price index

Observations

Mean

Standard deviation

Minimum

Maximum

538
465
470

4.63
17.64
1.81

5.35
103.42
7.88

33.64
7.63
31.12

19.57
1877.37
53.96

435
513

4.23
0.55

10.35
13.47

87.44
65.10

64.17
152.59

529
507
50
50

2.05
2.14
7.43
3.84

16.90
7.39
27.50
13.57

107.95
42.23
64.86
23.22

114.99
47.22
111.20
42.46

1
0.237

0.122
0.048

0.046
0.019
0.115
0.071

1
0.277
0.493

0.02
0.016

0.011
0.139
0.122
0.232
0.028
0.069
0.131
0.187

0.093
0.086

Real household
consumption
per capita

0.032
0.004
0.119
0.127

1
0.266

Broad
money-GDP

Note: Bold faced figures refer to correlation significant at 5% level of significance.

Growth
CPI inflation
Real household
consumption per capita
Broad money-GDP
Government
consumption-GDP
Trade openness
Agriculture-GDP
Oil price
Commodity price

Growth

CPI
inflation

Table 3. Correlation matrix of growth variables.

0.147
0.05
0.079
0.134

Government
consumption-GDP

1
0.102
0.3
0.259

Trade
openness

Downloaded by [University of Cambridge] at 00:58 01 January 2015

1
0.126
0.066

Agriculture-GDP

1
0.449

Oil
price

Commodity
price

Journal of the Asia Pacific Economy


615

616

A.T. Muzaffar and P.N. (Raja) Junankar

Downloaded by [University of Cambridge] at 00:58 01 January 2015

The correlation matrix of the growth variables, presented in Table 3, also provides
some interesting facts about the possible long run relationship amongst the variables.
These associations, however, do not provide an understanding about the direction of causality. There exists a moderate negative association between inflation and GDP growth
and it is significant at 5% level.
In summary, the selection of variables to examine the growthinflation relationship is
done with a view to incorporating economic factors relating to structural, demand and
supply side shocks, and macro policies affecting the issue. From an analytical point of
view the aim is to create a parsimonious model in explaining the relationship between
inflation and growth.
4. Empirical model
To investigate the potential nonlinearity of the relationship between inflation and growth,
we develop the following panel model:
yit mi bt b1 pit b2 p2it

n
X
j3

bj Zit eit

(for country, i D 1, . . . , N and time, t D 1, . . . ,T), where yit is the real GDP growth, mi is
an unobservable time invariant country-specific effects to capture heterogeneity in the
growthinflation relationship across countries, bt is a time-specific effect incorporating
dummies for different time periods, pit is the CPI inflation rate, Zit is a vector of control
variables, and eit is the classical error term, assumed to be independent and identically
distributed with mean 0 and variance s 2e , which varies with countries and time in the
regression. The country-specific effects, mi, and the error term, eit, have the standard error
component structure:
Emi  Eeit  Emi eit  0

and the transient errors are not serially correlated:


Eeit eis  0 for s 6 t:

The above general version of the model can be rewritten as follows:


Growthit mi bt b1 D lnCPIit b2 D ln CPIit 2 b3 Growthit1
b4 D lnHCONPCit b5 D lnFDit b6 D lnGOVCONit b7 D lnOPENit
b8 D ln AGRit b9 DUMOILt b10 DUMCOMPRt eit ;

where the notation is explained above.


The inclusion of time-fixed effects requires some explanations. We use time-fixed
effects in our model to make the estimations more robust. As Kumar and Woo (2010)
explain that this is to account for the possibility of any structural changes over the sample period, including changes in trends in global growth or global risk factors. Besides,
in the autocorrelation tests and robust standard errors reported later, we assume absence

Downloaded by [University of Cambridge] at 00:58 01 January 2015

Journal of the Asia Pacific Economy

617

of autocorrelation across countries in the error term. Thus, including time dummies
increases the chances of this assumption to hold (see Kathavate and Mallik 2012;
Roodman 2006). In all our estimations, the time-fixed effects are found to be significant. We also use robust standard errors in all our estimations to take care of the
heteroscedasticity.
To empirically estimate the above model using annual data, our concern is the presence of outliers  very high observations of inflation for few countries  which may
have strong influence on the results. To avoid problems due to the outliers in our model,
we include cases where inflation rate is less than 40%, practised similarly by Pollin and
Zhu (2006) and de Mendoca and de Guimaraes e Souza (2012) among others. This elimination of high-inflation cases is done in line with the observation made by Bruno and
Easterly (1998) that inflation beyond 40% is indeed harmful for economic growth.
Finally, the threshold level of inflation is measured by the turning point of inflation:
coefficient of linear term of p=2coefficient of squared term of p100:

5. Empirical results
5.1. Static panel estimation results
This section presents results based on fixed effects (FE) and random effects (RE) models, the two most common models used in panel data estimations. Such panel estimations are superior to simple OLS estimations as they can capture the country
heterogeneity more efficiently. We estimate the model within a static framework by
not incorporating the lagged dependent variable on the right hand side of the regression
as it may cause bias in the estimators. Kumar and Woo (2010, 12) state that in the
dynamic panel setting, the within transformation in the estimation process of FE introduces a correlation between transformed lagged dependent variable and transformed
error,. . .[making] FE inconsistent. In the case of RE models, it is assumed that the
observable regressors are uncorrelated with the unobservable characteristics in both
country-specific effects and error term. This assumption is somewhat relaxed in the
case of FE model which does not impose that country-specific effects and observable
regressors are uncorrelated.
Table 4 presents the results from the FE and RE estimates. Our main interest is in the
measure of inflation turning point which is around 13% and 14% according to FE and
RE, respectively. We would consider results from FE estimates since the Hausman test
shows that the FE model is preferable to the RE one. In the case of 13% inflation threshold, coefficient of the squared term of inflation is significant but the linear term is not.
Coefficients of other covariates, except for government consumption expenditure and
trade openness, are significant. They also show the expected signs, apart from
DUMCOMPR.
5.2. Dynamic panel estimation results
Estimations within a dynamic setting allow us to incorporate a lagged dependent variable
as a regressor, thus overcoming the problem of FE and RE estimates. We now face the
difficulty of finding an appropriate external instrument for inflation and other economic
variables to overcome the endogeneity problem. We use system generalized method of

618

A.T. Muzaffar and P.N. (Raja) Junankar

Table 4. Fixed and random effects panel regressions.


Dependent variable is real GDP growth
(1)
FE3

Downloaded by [University of Cambridge] at 00:58 01 January 2015

Inflation

(2)
RE3

0.163
(0.093)
0.622
(0.246)
13.10
0.232
(0.074)
0.0835
(0.0364)
0.0188
(0.0266)
0.00338
(0.016)
0.0649
(0.0335)
0.0303
(0.0104)
0.0637
(0.0218)
380
14
0.31
0.36
0.004

0.0751
(0.0759)
Inflation 2
0.267
(0.245)
Turning point
14.06
Dln HCONPC
0.282
(0.0729)
Dln FD
0.0238
(0.0353)
Dln GOVCON
0.0217
(0.0317)
Dln OPEN
0.00388
(0.0181)
Dln AGR
0.0869
(0.0382)
DUMOIL
0.0217
(0.0202)
DUMCOMPR
0.0144
(0.0163)
Observations
380
Number of countries
14
R-squared overall
0.35
Within
0.33
Between
0.61
Hausman test:
45.07
Chi-square6 (p-value)
(0.00)
Countries
Bangladesh, Cambodia, India, Indonesia, Lao PDR, Malaysia, Pakistan,
The Philippines, Thailand, Vietnam, Kazakhstan, Kyrgyz Republic, Papua
New Guinea, and Tajikistan.
Notes: Estimation is based on annual observations and all cases of inflation greater than 40% are excluded to
avoid the outlier effect of inflation. All standard errors are robust and reported below coefficient estimates. ,

, and , denote significance at 1%, 5%, and 10% respectively. In Hausman test the null hypothesis is that Random Effect model is preferable to Fixed Effect model. Constant terms and time dummies are not reported to conserve space.

moment (SGMM) approach arising from the work of Arellano and Bover (1995) and
Blundell and Bond (1998) to take care of this endogeneity issue. This approach uses suitable lagged levels and lagged first differences of the regressors as their instruments. It has
recently gained popularity and is extensively used in applied economic research
(see Kumar and Woo 2010). The estimator also helps eliminate any endogeneity that
may arise because of the correlation of country-specific, time-invariant, factors, and the
right-hand side variables. Moreover, in this type of regression, lagged values of the

Journal of the Asia Pacific Economy

619

regressors are used to prevent simultaneity or reverse causality. We also use the one-step
estimator as opposed to the two-step estimator since the latter does not produce any meaningful result.
Table 5 provides results by regressing real GDP growth on different regressors.
Adding different regressors changes the threshold levels of inflation. This reveals
that the relationship between economic growth and inflation is not simple and it is

Table 5. Impact of inflation on growth, dynamic panel estimations.

Downloaded by [University of Cambridge] at 00:58 01 January 2015

Dependent variable is real GDP growth

Growth (1)
Growth (2)
Inflation
Inflation 2
Turning point
D ln HCONPC

(1)
SGMM1

(2)
SGMM2

(3)
SGMM3

0.131
(0.0857)
0.141
(0.05)
0.0158
(0.0465)
0.0345
(0.0336)
22.89

0.152
(0.0719)
0.0967
(0.0534)
0.0504
(0.042)
0.0488
(0.0267)
51.63
0.208
(0.0552)

0.15
(0.0733)
0.0483
(0.0736)
0.167
(0.0562)
0.645
(0.115)
12.94
0.237
(0.0673)
0.0596
(0.0203)
0.0524
(0.0168)
0.0128
(0.0195)
0.0267
(0.0124)
0.0154
(0.0189)
0.075
(0.0397)
0.0565
(0.0319)
0.089
(0.0349)

D ln FD
D ln FD (1)
D ln GOVCON
D ln GOVCON (1)
D ln OPEN
D ln OPEN (1)
D ln AGR
D ln AGR (1)
DUMOIL
DUMCOMPR
Observation

435

396

370

(4)
SGMM4
0.15
(0.0733)
0.0483
(0.0736)
0.167
(0.0562)
0.645
(0.115)
12.94
0.237
(0.0673)
0.0596
(0.0203)
0.0524
(0.0168)
0.0128
(0.0195)
0.0267
(0.0124)
0.0154
(0.0189)
0.075
(0.0397)
0.0565
(0.0319)
0.089
(0.0349)
0.0202
(0.0078)
0.057
(0.0155)
370
(continued)

620

A.T. Muzaffar and P.N. (Raja) Junankar

Table 5. (Continued )
Dependent variable is real GDP growth
(1)
SGMM1
Number of countries
SGMM estimation method
AR (1) test (p-value)

Downloaded by [University of Cambridge] at 00:58 01 January 2015

AR (2) test (p-value)


Sargan test (p-value)
Countries

(2)
SGMM2

(3)
SGMM3

(4)
SGMM4

14
14
14
14
One step
One step
One step
One step
2.98
2.83
2.9
2.9
(0.00)
(0.00)
(0.00)
(0.00)
0.24
0.58
0.31
0.31
(0.80)
(0.55)
(0.75)
(0.75)
353.18
432.82
537.81
537.81
(0.14)
(0.14)
(0.87)
(0.87)
Bangladesh, Cambodia, India, Indonesia, Lao PDR, Malaysia,
Pakistan, The Philippines, Thailand, Vietnam, Kazakhstan,
Kyrgyz Republic, Papua New Guinea, and Tajikistan.

Notes: Estimation is based on annual observations and all cases of inflation greater than 40% are excluded to
avoid the outlier effects of inflation. All standard errors are robust and reported below coefficient estimates. ,

, and , denote significance at 1%, 5%, and 10%, respectively. Regressions use the Blundell and Bond (1998)
system GMM (SGMM) estimator. AR (1) and AR (2) tests are Arellano-Bond first and second order serial correlation tests respectively. The null hypothesis is that residuals show no serial correlation. Sargan test is for over
identifying restrictions. The null hypothesis is that over-identifying restrictions are valid. Time dummies are not
reported to conserve space. Variables lagged in one period are represented by 1 within parentheses after the
variable.

necessary to take into account the effects of other variables into this relationship.
The results showing a threshold level at 12.94%, in columns 3 and 4, seem to be a
good estimate as both the inflation coefficients are significant at 1% level. The
results are robust since post-regression diagnostic tests are satisfactory showing that
the underlying assumptions of the model are valid. For instance, AR (1) and AR (2)
tests are performed to test first- and second-order serial correlation in the disturbances. One should reject the null hypothesis of the absence of first order serial correlation and not reject the absence of second order serial correlation (see Baltagi,
Demetriades, and Law 2009). Our tests satisfy these conditions. The other important
diagnostic test, Sargan test, does not reject the null hypothesis that over identifying
restrictions are valid.

6. The level of development and inflation threshold


The panel estimations, above, suggest that the inflation threshold for Asian developing
countries is at around 13%. We now want to examine if this threshold varies according to
the level of economic development. Table 6 shows the findings from subsamples based
on different regions and income groups. There is strong evidence from the results that
poorer countries have a higher threshold level of inflation. For instance, in column 1,
when we drop relatively richer East Asian countries, we find the threshold at around 14%.
The threshold reduces, in columns 2 and 3, to around 11% and 8% as the mean real GDP
per capita and mean real household consumption per capita increase. This result

Journal of the Asia Pacific Economy

621

Table 6. Impact of inflation on growth, the regional effect.


Dependent variable is real GDP growth

Downloaded by [University of Cambridge] at 00:58 01 January 2015

(1)
SGMM5
Excluding East
Asia
Inflation
Inflation 2
Turning point
Number of
countries
Countries dropped
from the sample
of 14 countries
Mean real GDP per
capita
Mean real
household
consumption per
capita

0.216
0.756
14.28
10

(2)
SGMM6
Excluding South
Asia
0.132
0.596
11.07
11

Bangladesh, India, and


Indonesia, Malaysia,
Pakistan
The Philippines, and
Thailand

(3)
SGMM7
Excluding Former
Command Economies
0.094
0.571
8.31
8

534.24

1099.92

Cambodia, Lao PDR,


Vietnam, Kazakhstan,
Kyrgyz Republic, and
Tajikistan
1268.83

385.9

682.1

724.15

Notes: Estimation is based on annual observations and all cases of inflation greater than 40% are excluded to
avoid the outlier effect of inflation. , , and , denote significance at 1%, 5%, and 10%, respectively. Regressions use the Blundell and Bond (1998) system GMM (SGMM) estimator. Control variables, time dummies, and
post estimation tests (AR test and Sargan test) are not reported to conserve space. Unweighted mean values of
real GDP per capita and real household consumption per capita within each group over the period 19902010
are reported.

convincingly proves that threshold varies according to economic circumstances of groups


of countries.
To further strengthen our claim, we examine how the inflation threshold might vary
according to changes in agricultural dependence, financial deepening, and trade openness.
First, Table 7 groups the countries according to above and below sample mean based on
these three criteria.
We now present the regression results in Table 8, based on the above criteria. The
results are consistent with what we have argued so far. The threshold varies according to
the levels of economic development, and less-developed countries tend to have a higher
inflation threshold. For instance, in the case of agro-dependence, countries more dependent on agriculture appears to have a higher turning point, at 13.51%, compared to that of
countries relatively less dependent on agriculture (turning point at around 10.7%; see columns 1 and 2 in Table 8). We find similar evidence in the case of financial deepening and
trade openness. The findings on threshold vary, but remain within the range between 7%
and 14%.
Taken together, our empirical investigation finds an inflation threshold at around 13%
for a sample of 14 Asian developing countries over the period 19612010. Moreover, the
threshold varies between 7% and 14% depending on the level of development. Although,
our sample size is much smaller, our finding on inflation threshold echoes findings from

622

A.T. Muzaffar and P.N. (Raja) Junankar

Downloaded by [University of Cambridge] at 00:58 01 January 2015

Table 7. Averages of selected variables in the sample countries, 19902010.


Agriculture share of GDP: sample mean
Countries below sample mean

24.63

Country

Mean

Kazakhstan
Thailand
Malaysia
Indonesia
The Philippines
India
Bangladesh
Pakistan
Financial deepening: sample mean
Countries below sample mean

10.28
10.44
11.1
16.18
16.28
23.28
23.89
24.07
45.25

Country

Mean

Malaysia
Thailand
The Philippines
India
Vietnam

114.37
97
52.34
52.03
47.6

Countries above sample mean


Country
Lao PDR
Cambodia
Kyrgyz Republic
Papua New Guinea
Tajikistan
Vietnam

Mean
47.01
38.91
35.88
34.74
27.55
25.85

Countries above sample mean

Trade openness: sample mean


Countries below sample mean

88.08

Country

Mean

Malaysia
Papua New Guinea
Vietnam
Thailand
Tajikistan
Cambodia
Kyrgyz Republic
Kazakhstan

188.57
113.91
113.57
111.71
108.1
104.72
96.13
89.37

Country
Tajikistan
Lao PDR
Cambodia
Kyrgyz Republic
Kazakhstan
Papua New Guinea
Bangladesh
Pakistan
Indonesia

Mean
9.9
14.29
15.52
15.66
19.83
34.4
37.3
41.65
42.98

Countries above sample mean


Country
India
Bangladesh
Pakistan
Indonesia
Lao PDR
The Philippines

Mean
30.23
33.23
34.61
58.04
67.33
86.09

major recent studies such as Bick (2010), Espinoza, Leon, and Prasad (2011), Lopez-Villavicencio and Mignon (2011), and Pollin and Zhu (2006). Our results, in short, help to
conclude that empirical basis for maintaining inflation within 5% in developing countries
of Asia is weak.

Malaysia, Thailand,
Tajikistan, Lao PDR,
The Philippines, and
Cambodia, and
India
Kyrgyz Republic

Lao PDR, Cambodia,


Kyrgyz Republic,
and Papua New
Guinea

Kazakhstan,
Thailand,
Malaysia,
and Indonesia

0.651
2.34
13.91

0.0903
0.576
7.83

0.635
2.35
13.51

0.0764
0.357
10.7

Malaysia, Papua New


Guinea, Vietnam,
and Thailand

0.114
0.719
7.92

Most

Trade openness

(5)
SGMM12

India, Bangladesh,
Pakistan, and
Indonesia

0.171
0.763
11.2

Least

(6)
SGMM13

Notes: Estimation is based on annual observations and all cases of inflation greater than 40% are excluded to avoid the outlier effect of inflation. , , and , denote significance at 1%,
5%, and 10%, respectively. Regressions use the Blundell and Bond (1998) system GMM (SGMM) estimator. P-value for the linear term of inflation in column (5) is 0.153 and therefore
the estimate is significant at 16% significance level. Control variables, time dummies, and post estimation tests (AR test and Sargan test) are not reported to conserve space. 4 least and
most agro-dependent, financial deepening, and trade open countries are selected from Table 7 for each group of estimation.

Inflation
Inflation 2
Turning
point
Number of
countries
Countries

Least

Most

Most

(4)
SGMM11

Least

(3)
SGMM10
Financial deepening

(2)
SGMM9

Agro dependence

(1)
SGMM8

Dependent variable is real GDP growth

Table 8. The impact of inflation on growth based on structural characteristics of the countries.

Downloaded by [University of Cambridge] at 00:58 01 January 2015

Journal of the Asia Pacific Economy


623

624

A.T. Muzaffar and P.N. (Raja) Junankar

Downloaded by [University of Cambridge] at 00:58 01 January 2015

7. Conclusion
We question the validity of the conventional wisdom that inflation beyond 5% is harmful for
economic growth in the case of developing countries. First, we critically review the existing
literature to find support for this view. We, then, provide an empirical investigation, using
panel estimation techniques such as System GMM, on a sample of 14 Asian developing
countries over the period 19612010. Findings from both critical reviews and econometric
analyses show that the empirical justification to keep inflation as low as 5% is weak. Our
empirical evidence suggests that inflation threshold for these countries is around 13%, well
above the level, 5%, advocated by the IMF. Besides, we show that poorer countries tend to
have a higher threshold, providing convincing evidence against one size fits all policy and
that country-specific circumstances matter. Our results reveal that inflation threshold may
vary within the range of 7%14% depending on the level of development. The implication
of this finding is that developing countries can gain from moderate levels of inflation and
should not be alarmed when inflation crosses the 5% benchmark set by the IMF.
The policy implications arising from this study are straightforward. The IMF should
rethink its macroeconomic policy advice to developing countries and governments in
these countries should highlight their country-specific circumstances during the negotiation with the IMF officials to access IMFs support facilities. The findings also help
rethink macroeconomic policy making in developing countries that still follow a lowinflation targeting policies. Macroeconomic policies require a broader perspective, creating a balance between the need for stabilization and development. The study suggests
that the developing countries should give priority to poverty reduction and employment
creation instead of pursuing a restrictive policy of low inflation.
Acknowledgements
We thank Anis Chowdhury, Ron Ratti, Gerald Epstein, Malcolm Treadgold, Geoffrey Harcourt, and
participants at the 11th Annual Society of Heterodox Economists Conference held at the University
of New South Wales, Australia for very helpful comments on an earlier draft. An earlier version of
the article was written as a background paper for the United Nations Economic and Social Survey of
Asia and the Pacific 2013. Usual caveats apply.

Notes
1.

2.
3.
4.
5.

6.

The 1970s was a period of high inflation and stagnation, caused mainly by commodity price
shocks and the breakdown of the Bretton Woods system as a result of high US inflation. The
Great Moderation was characterized by an unusually high degree of macroeconomic stability,
with steady growth and low and stable inflation in most of the advanced economies since
1993 until the Great Recession hit in 2008.
Source: IMF-Supported Programs  Frequently Asked Questions, available at http://www.
imf.org6 external6 np6 exr6 faq6 progfaqs.htm#q4.
Paul Krugman, The Low Inflation Trap (Slightly Wonkish), The New York Times
(23 September 2011), available at http:6 6 krugman.blogs.nytimes.com6 20116 096 236
the-low-inflation-trap-slightly-wonkish6 .
It cannot go below zero.
The Japanese economy is a classic example in this regard. This idea is also captured in the
Keynesian Liquidity Trap. There is however an opposing view which considers higher inflation rate to cause higher cost of borrowing. Rising inflation leads to higher inflation expectations. Fishers equation explains that this would lower the real return for lending and hurt
lenders. As a result lenders tend to charge higher nominal interest rates.
The Economist (15 February 2010), Monetary policy: a healthy dose of inflation. Available
at http://www.economist.com6 blogs6 freeexchange6 20106 026 monetary_policy_1 (this is
because of the problem of the zero bound to nominal interest rate).

Journal of the Asia Pacific Economy


7.
8.
9.

Downloaded by [University of Cambridge] at 00:58 01 January 2015

10.
11.
12.

625

The Global Financial Crisis of 20072008 and the Great Recession of 20092010.
See the opening remarks by Dominique Strauss-Kahn, at the IMF conference on Macro and
Growth Policies in the Wake of the Crisis, Washington D.C., March 7, 2011, available via
the internet at http://www.imf.org6 external.
Developing countries are defined according to their Gross National Income (GNI) per capita.
Countries with a GNI per capita of US$ 11,905 and less are defined as developing. In 2012,
Argentinas GNI per capita was around US$ 11,572. The World Bank classifies Argentina as
an upper middle income country.
The article by Khan and Senhadji (2001) also suffers from the same problem.
They also find two but lower threshold levels, 2.57% and 12.61%, for industrial countries.
One may question this aspect of the dataset as it is difficult to create a balanced dataset for
developing countries due to poor availability of data.

Notes on contributors
Ahmed Taneem Muzaffar holds a PhD in economics from the University of Western Sydney, New
South Wales, Australia. He also studied financial economics and obtained an MSc from the University
of Essex, UK. His key research interests include macroeconomic policies and economic development.
P.N. (Raja) Junankar (BSc (Econ), MSc (Econ), LSE; and Ph.D., University of Essex.) is an Emeritus Professor (University of Western Sydney); Honorary Professor (University of New South
Wales); and Research Fellow at the IZA in Bonn, Germany. He has consulted for the OECD, ILO,
ESCAP, and several other organizations.

References
Amato, J.D., and S. Gerlach. 2002. Inflation Targeting in Emerging Market and Transition Economies: Lessons After a Decade. European Economic Review 46: 781790.
Anwar, S., and I. Islam. 2011. Should Developing Countries Target Low, Single Digit Inflation to Promote Growth and Employment? ILO Employment Sector Employment Working Paper 87: 135.
Geneva: International Labour Office.
Arellano, M., and O. Bover. 1995. Another Look at the Instrumental Variables Estimation of
Error-Components Models. Journal of Econometrics 68: 2951.
Arestis, P., and M. Sawyer. 2003. Reinventing Fiscal Policy. Journal of Post Keynesian Economics 26 (1): 325.
Baltagi, B.H., P.O. Demetriades, and S.H. Law. 2009. Financial Development and Openness:
Evidence from Panel Data. Journal of Development Economics 89: 285296.
Bangake, C., and J.C. Eggoh. 2011. Further Evidence on Finance-Growth Causality: A Panel Data
Analysis. Economic Systems 35: 176188.
Bick, A. 2010. Threshold Effect of Inflation on Economic Growth in Developing Countries. Economic Letters 108: 126129.
Blundell, R., and S. Bond. 1998. Initial Conditions and Moment Restrictions in Dynamic Panel
Data Models. Journal of Econometrics 87: 11543.
Bruno, M., and W. Easterly. 1998. Inflation Crises and Long-Run Growth. Journal of Monetary
Economics 41: 326.
Burdekin, R.C.K., A.T. Denzau, M.W. Keil, T. Sitthiyot, and T.D. Willett. 2004. When Does Inflation Hurt Economic Growth? Different Nonlinearities for Different Economies. Journal of
Macroeconomics 26: 519532.
Chenery, H.B. 1960. Patterns of Industrial Growth. American Economic Review 50 (4): 624654.
Chowdhury, A. 2006. The Stabilisation Trap and Poverty Reduction  What Can Monetary
Policy Do? Indian Development Review 4 (2): 407432.
de Mendonca, H.F., and G.J. de Guimaraes e Souza. 2012. Is Inflation Targeting a Good Remedy
to Control Inflation? Journal of Development Economics 98 (2): 178191.
Dorrance, G.S. 1964. The Effect of Inflation on Economic Development. In Inflation and Growth
in Latin America, edited by W. Baer and I. Kerstenetzky, 3788. New Haven: The Economic
Growth Center, Yale University.

Downloaded by [University of Cambridge] at 00:58 01 January 2015

626

A.T. Muzaffar and P.N. (Raja) Junankar

Drukker, D., P. Gomis-Porqueras, and P. Hernandez-erme. 2005. Threshold Effects in the


Relationship Between Inflation and Growth: A New Panel-Data Approach. MRPA Paper.
Munich: University Library of Munich.
Epstein, G., and E. Yeldan. 2008. Inflation Targeting, Employment Creation and Economic
Development: Assessing the Impacts and Policy Alternatives. International Review of Applied
Economics 22 (2): 131144.
Espinoza, R., H. Leon, and A. Prasad. 2011. When Should We Worry About Inflation? The World
Bank Economic Review 26 (1): 100127.
Fischer, S. 1993. The Role of Macroeconomic Factors in Growth. Journal of Monetary
Economics 32 (3): 485512.
Ghosh, A., and S. Phillips. 1998. Warning: Inflation May Be Harmful to Your growth. IMF Staff
Papers 45 (4): 672710.
Goldsbrough, D., E. Adovor, and B. Elberger. 2007. Inflation Targets in IMF-Supported Programs. Center for Global Development Working Group on IMF Programs and Health Expenditures Background Paper March: 19. Washington, DC: Center for Global Development.
Greene, W.H. 2003. Econometric Analysis. 5th ed. Upper Saddle River, NJ: Prentice Hall.
Hemming, R., M. Kell, and S. Mahfouz. 2002. The Effectiveness of Fiscal Policy in Stimulating
Economic Activity  a Review of the Literature. IMF Working Paper 026 208. Washington,
DC: International Monetary Fund.
IEO. 2007. The IMF and Aid to Sub-Saharan Africa. Washington, D.C: Independent Evaluation
Office, International Monetary Fund.
Kapur, B.K. 1976. Alternative Stabilization Policies for Less Developed Countries. Journal of
Political Economy 84: 777795.
Kathavate, J., and G. Mallik. 2012. The Impact of the Interaction Between Institutional Quality and
Aid Volatility on Growth: Theory and Evidence. Economic Modelling 29: 716724.
Khan, M.S., and A.S. Senhadji. 2001. Threshold Effects in the Relationship Between Inflation and
Growth. IMF Staff Papers 48 (1): 121.
Kumar, M.S., and J. Woo. 2010. Public Debt and Growth. IMF Working Paper WP6 106 174: 1-46.
Washington, DC: International Monetary Fund.
Kwon, G., L. Mcfarlane, and W. Robinson. 2009. Public Debt, Money Supply, and Inflation: A
Cross-country Study. IMF Staff Papers 56 (3): 476515.
Lopez-Villavicencio, A., and V. Mignon. 2011. On the Impact of Inflation on Output Growth:
Does the Level of Inflation Matter? Journal of Macroeconomics 33: 455464.
Lucas, R.E. 1988. On The Mechanisms of Economic Development. Journal of Monetary Economics 22: 342.
McKinnon, R.I. 1973. Money and Capital in Economic Development. Washington, DC: Brookings
Institution.
Muzaffar, A.T. 2013. Macro Policies Targeting Low Inflation: Revisiting the Conventional Wisdom in Selected Developing Countries of Asia. PhD diss., University of Western Sydney.
Pollin, R., and A. Zhu. 2006. Inflation and Economic Growth: A Cross-country Nonlinear Analysis. Journal of Post Keynesian Economics 28 (4): 593614.
Robinson, J. 1952. The Rate of Interest and Other Essays. London: Macmillan.
Roodman, D. 2006. How to Do xtabond2: An Introduction to Difference and System GMM in
Stata. Center for Global Development Working Paper 103. Washington, DC: Center for
Global Development.
Sarel, M. 1996. Nonlinear Effects of Inflation on Economic Growth. IMF Staff Papers 43: 199215.
Sepehri, A., and S. Moshiri. 2004. Inflation-growth Profiles Across Countries: Evidence from Developing and Developed Countries. International Review of Applied Economics 18 (2): 191207.
Shaw, E.S. 1973. Financial Deepening in Economic Development. New York, NY: Oxford University Press.
Tobin, J. 1987. Policies For Prosperity: Essays in a Keynesian Mode. Brighton: Wheatsheaf Books.
Wilkinson, F. 2000. Inflation and Employment: Is There a Third Way? Cambridge Journal of
Economics 24: 643670.
Yilmazkuday, H. 2013. Inflation Thresholds and Growth. International Economic Journal 27 (1):
110.

WDI

WDI

Broad money is the sum of currency outside banks; demand deposits other than those of the
central government; the time, savings, and foreign currency deposits of resident sectors other
than the central government; bank and travellers checks; and other securities such as
certificates of deposit and commercial paper.
General government final consumption expenditure (% of GDP).

GOVCON

WDI, IFS,
WEO, SDBS

WDI

WDI

WDI

Source

Inflation is measured by the consumer price index.


Broad money (% of GDP); M2 Nominal GDP ratio.

GDP (constant $2000).


GDP, gross domestic product, at purchasers prices is the sum of gross value added by all
resident producers in the economy plus any product taxes and minus any subsidies not
included in the value of the products. It is calculated without making deductions for
depreciation of fabricated assets or for depletion and degradation of natural resources. Data
are in constant 2000 US dollars. Dollar figures for GDP are converted from domestic
currencies using 2000 official exchange rates. For a few countries where the official exchange
rate does not reflect the rate effectively applied to actual foreign exchange transactions, an
alternative conversion factor is used.
GDP per capita (constant $2000).
GDP per capita is gross domestic product divided by midyear population. Data are in constant
US dollars.
Consumer price index (2005 D 100).
Consumer price index reflects changes in the cost to the average consumer of acquiring a basket
of goods and services that may be fixed or changed at specified intervals, such as yearly. The
Laspeyres formula is generally used.
Inflation, consumer prices (annual%).

Variable description

M2GDP (FD)

INFCPI

CPI

RGDPCAP

RGDP

Mnemonic

Table A1. List of variables and sources.

Appendix

Downloaded by [University of Cambridge] at 00:58 01 January 2015

(continued)

NE.CON.GOVT.ZS

FM.LBL.BMNY.GD.
ZS

FP.CPI.TOTL.ZG

FP.CPI.TOTL

NY.GDP.PCAP.KD

NY.GDP.MKTP.KD

Indicator code

Journal of the Asia Pacific Economy


627

HCONPC

AGR
OIL
COMPR

OPEN

General government final consumption expenditure (formerly general government consumption)


includes all government current expenditures for purchases of goods and services (including
compensation of employees). It also includes most expenditure on national defence and
security, but excludes government military expenditures that are part of government capital
formation.
Household final consumption expenditure per capita (constant $2000).

Household final consumption expenditure per capita (private consumption per capita) is
calculated using private consumption in constant 2000 prices and World Bank population
estimates. Household final consumption expenditure is the market value of all goods and
services, including durable products (such as cars, washing machines, and home computers),
purchased by households. It excludes purchases of dwellings but includes imputed rent for
owner-occupied dwellings. It also includes payments and fees to governments to obtain
permits and licenses. Here, household consumption expenditure includes the expenditures of
nonprofit institutions serving households, even when reported separately by the country. Data
are in constant 2000 U.S. dollars.
Trade (% of GDP)
Trade is the sum of exports and imports of goods and services measured as a share of gross
domestic product.
Agriculture value added as a% of GDP
UK Brent crude oil index (2005 D 100)
Non-energy commodity price index by the World Bank for low and middle income countries
(2005 D 100)

Variable description

Mnemonic

Table A1. (Continued )


Source

WDI
IFS
IFS

WDI

WDI

Downloaded by [University of Cambridge] at 00:58 01 January 2015

NV.AGR.TOTL.ZS

NE.TRD.GNFS.ZS

NE.CON.PRVT.PC.
KD

Indicator code

628
A.T. Muzaffar and P.N. (Raja) Junankar