The impact of inflation on economic growth evidence from a panel of selected asia countries

IVERSITY OF ECONOMICS
HO CHI MINH CITY
VIETNAM

THE HAGUE
THE NETHERLANDS

VIETNAM -NETHERLANDS
PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

HE IMPACT OF INFLATION ON ECONOMIC
GROWTH: EVIDENCE FROM A PANEL OF
SELECTED ASIA COUNTRIES
A thesis submitted in partial fulfilment of the requirements for the degree of
MASTER OF ARTS IN DEVELOPMENT ECONOMICS

By

VU DOAN THANH TIEN

Academic Supervisor:

Dr. LE CONG TRU

HO CHI MINH CITY, AUGUST 2012


-------.-- -

-

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DECLARATION
"I certify that the substance of this thesis has not already been submitted for any degree and
have not been currently submitted for any other degree.
I certify that to the best of my knowledge and help received in preparing this thesis and all
sources used have been acknowledged in this thesis."

ii


ACKNOWLEDGEMENTS
The first person I would like to send special thanks to is my supervisor- Dr. Le Cong Tru. I'm
grateful not solely his help throughout the thesis process, but also enthusiasm and many
lessons in an attempt to improve my knowledge and skills as well. He is usually ready to
assist me anytime, although he is bustling. The professor often keeps track of my work and
motivates me to finish the duty. To gain the result today, I cannot miss out his contributions.
Thanks so much, Dr.Tru!
Next, I'm happy to thank to Dr. Hoai, Dr. Ngai, and Dr. Nam. They tried their best to help me
select an appropriate topic for my thesis. When I confront to issues, they supported to find the
solution and give advice in hope that I might overcome the problems. Besides, I also thank to
the other professors ofVNP for lectures and precious materials.
At the same time, I also send thanks to VNP officials, especially Ms. Hong. They are very
nice in helping me when having troubles. They inform exactly and quickly to students. I enjoy
their enthusiasm. Additionally, I also send thanks to Mr. Quy - a librarian. He is nice to his
;

duty. I'm always welcomed by him.
Last but not least, I cannot forget sending thanks to my family and friends. I'm very grateful
them to take care of and encourage me while performing the thesis. Not only do they support

for finance, but also for mental. I always keep in mind devotion and sacrifice of all.
Thanks so much for everything!!!

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TABLE OF CONTENTS
TABLE OF CONTENTS ............................................................................................. IV

LIST OF FIGURES .................................................................................................... VII
LIST 0 F TABLES ..................................................................................................... VIII

ABSTRA.CT .................................................................................................................... 2
CHAPTER 1.................................................................................................................... 3
INTRODUCTION .......................................................................................................... 3

1.1 PROBLEM STATEMENT ..................................................................................... 3
1.2 RESEARCH OBJECTIVES AND RESEARCH QUESTIONS ........................... 5
1.3 STRUCTURE OF THE PAPER ............................................................................ 6
CHAPTER 2.................................................................................................................... 8

LITERATURE REVIEW ...........................•.................................................................. 8

2.1 THEORIES RELATED TO INFLATION AND GROWTH ................................. 8
2.1.1

Classical Theory ......................................................................................... 9

2.1.2

Neo-Classical Theory ................................................................................. 9

2.1.3

Endogenous Theory ................................................................................. 10

2.1.4

Keynesian Theory .................................................................................... 10

2.1.5

Nee-Keynesian Theory ............................................................................ 11

2.1.6

Monetarist Theory .................................................................................... 11

2.2 GROWTH MODELS .......................................................................................... 12
2.2.1

The Basic Growth Model ......................................................................... 13

2.2.2

Solow Model ............................................................................................ 13

2.2.3

Augmented Solow Model ........................................................................ 14

2.3 VARIABLE DEFINITION .................................................................................. 15
2.3.1

Growth Rate ............................................................................................. 15

2.3.2

Inflation .................................................................................................... l6

2.3.3

Cost of Inflation ......................................................•................................ 17

2.3.4

Control Variables ...................................................................................... IS

2.3.5

Threshold Concept ................................................................................... 21
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2.4 EMPIRICAL STUDIES ....................................................................................... 21
2.4.1

The Studies of 1960s-1980s ..................................................................... 22

2.4.2

The Studies of 1990s ................................................................................ 23

2.4.3

Recent Studies ............................................................... :.......................... 26

CHAPTER 3 .................................................................................................................. 31

ECONOMIC OUTLOOKS OF STUDIED COUNTRIES ....................................... 31
3.1 Economic Outlook of Vietnam ............................................................................ 32
3.2 Economic Outlook of Philippines ........................................................................ 34
3.3 Economic Outlook of Malaysia ........................................................................... 36
3.4 Economic Outlook oflndonesia .......................................................................... 39
3.5 Economic Outlook ofThailand ............................................................................ 42
3.6 Economic Outlook ofChina ................................................................................ 44
3.7 Economic Outlook of India.................................................................................. 46
CHAPTER 4 .................................................................................................................. 49

MODEL SPECIFICATION & RESEARCH METHODOLOGY ........................... 49
4.1 EMPIRICAL MODEL ......................................................................................... 49
4.2 MODEL SPECIFICATION ................................................................................. 50
4.2.1

Non-Linear Inflation-Growth Relationship ............................................. 50

4.2.2

Testing Thresholds in the Inflation-Growth Relationship ........................ 51

4.3 DATA ................................................................................................................... 52
4.4 . RESEARCH METHODS .................................................................................. 53
CHAPTER 5 .................................................................................................................. 57
EMPIRICAL RESULTS ............................................................ ~................................. 57

5.1 DESCRIPTIVE ANALYSIS ................................................................................ 57
5.1.1

China ........................................................................................................ 57

5.1.2

India ......................................................................................................... 60

5.1.3

Indonesia .................................................................................................. 62

5.1.4

Malaysia ................................................................................................... 64

5.1. 5

Philippines ................................................................................................ 66

5.1.6

Thailand ................................................................................................... 68

5.1.7

Vietnam .................................................................................................... 70

5.2 REGRESSION ANALYSIS ................................................................................. 72
5.2.1

China ........................................................................................................ 75
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5.2.2

India ......................................................................................................... 75

5.2.3

Indonesia .................................................................................................. 76

5.2.4

Malaysia ................................................................................................... 76

5.2.5

Philippines ......... , ...................................................................................... 77

5.2.6

Thailand ................................................................................................... 78

5.2. 7

Vietnam .................................................................................................... 78

5.3 INFLATION THRESHOLD ANALYSIS ............................................................ 79
5.3.1

Threshold Results ofChina ...................................................................... 79

5.3.2

Threshold results oflndia ........................................................................ 80

5.3 .3

Threshold results of Indonesia ................................................................. 81

5.3.4

Threshold Results ofMalaysia ................................................................. 82

5.3.5

Threshold Results of Philippines ............................................................. 84

5.3.6

Threshold Results of Thailand ................................................................. 85

5.3. 7

Threshold Results ofVietnam .................................................................. 87

CHAPTER 6 .................................................................................................................. 89

CONCLUSIONS, POLICY RECOMMENDATION, LIMITATIONS AND FUTHER
STUDY ........................................................................................................................... 89
6.1 CONCLUSIONS ................................................................................................. 89
6.2 POLICY RECOMMENDATIONS ...................................................................... 90
6.3 LIMITATIONS .................................................................................................... 92
6.4 FURTHER STUDY ............................................................................................. 92
REFERENCES ............................................................................................................. 93

APPEND IX A··················!'····························································································· 99
APPENDIX B .............................................................................................................. 101
APPEND IX C .............................................................................................................. 107
APPENDIX

»...............................................................................................................113

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LIST OF FIGURES
Figure 2-1: Analysis framework for the impact of inflation on growth and thresholds remained
in the relationship .................................................................................................. 30
Figure 3-1 A comparison between inflation and growth rate ofVietnam from 1990-2010 .... 33
Figure 3-2: A comparison of inflation-growth relationship of Philippines from 1990 to 2010
................... :........................................................................................................... 35

Figure 3-3 A comparison between inflation and growth rate of Malaysia in the period of years
1990-2010 .............................................................................................................. 38
Figure 3-4: A comparison between inflation and economic growth of Indonesia from
1990-2010 .............................................................................................................. 41
Figure 3-5: A benchmark between inflation and gro\\>1h of Thailand in the years of 1990-2010
............................................................................................................................... 43
Figure 3-6: A comparison between inflation and growth rate of China from 1990-2010 ....... 45
Figure 3-7: A comparison between inflation and economic growth rates of India in the period
1990-2010 .............................................................................................................. 47

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LIST OF TABLES
Table 2-1 Summary of the papers with thresholds found in the inflation-growth correlation .27
Table 4-1 Summary variables used in the models .................................................................... 52
Table 5-l Correlation matrix between variables (China) ......................................................... 58
Table 5-2: Summary Descriptive Statistics (China) ................................................................ 59
Table 5-3: Correlation matrix between variables (India) ......................................................... 60
Table 5-4: Summary Descriptive Statistics (India) .................................................................. 61
Table 5-7: Correlation matrix between variables (Malaysia) ................................................... 64
Table 5-9: Correlation matrix between variables (Philippines) ................................................ 66
Table 5-10: Summary Descriptive Statistics (Philippines) ....................................................... 67
Table 5-11: Correlation matrix between variables (Thailand ................................................... 68
Table 5-13: Correlation matrix between variables (Vietnam) .................................................. 70
Table 5-15 Regression Results with Fixed Effects Method ..................................................... 73
Table 5-16: Estimation Thresholds ofChina ............................................................................ 80
Table 5-17: Estimation Thresholds of India ............................................................................. 81
Table 5-18: Estimation Thresholds oflndonesia ...................................................................... 82
Table 5-19: Estimation Thresholds ofMalaysia .................................-...................................... 83

Table 5-20: Estimation Thresholds ofPhilippines .................................................. ,................ 85
Table 5-21: Estimation Thresholds of Thailand ....................................................................... 86
Table 5-22: Estimation Thresholds ofVietnam ........................................................................ 87

Vlll


The Impact of Inflation on
Economic Growth: Evidence from
a Panel of Selected Asia Countries


ABSTRACT
The objective of this paper is to ascertain whether inflation significantly impacts on economic
growth for the selected Asia countries. The study relied on macroeconomic theories, the
augmented Solow model, and empirical studies for seeking the key variables impacting
growth. Simultaneously the quadratic model is employed to find out the impacts of inflation
on growth, using a panel data of seven Asian countries in the period of 1990-2010. The
fixed-effect method was used for capturing the differences among the selected countries. The
results show that only China, India, Thailand, and Vietnam have a negative effect of inflation
on growth, and among the countries, Thailand and Vietnam have statistically significant
meaning at 1% and 5%. Meanwhile the rest of countries comprising Indonesia, Malaysia and
Philippines contain the positive effect of inflation on growth. Except for Malaysia, Indonesia
and Philippines have statistically significant meaning at 5%.

For estimating thresholds for the countries, the paper adopted several methods including
scatter diagrams, observing average inflation rates and the method of Khan and Senhadji. The
outputs indicate that only India has the threshold at 7% and statistically significant meaning at
5%. The rest of countries including China, Indonesia, Malaysia, Philippines, Thailand and
Vietnam also find out the levels of threshold in the relationship between inflation and

economic growth are 6%, 12-13%, 4%, 10-13%, 4.2-4.5% and 8%; however, all are not
statistically significant meaning.

2


Chapter 1
INTRODUCTION

1.1

PROBLEM STATEMENT

Theoretically speaking, rapid output growth and low inflation are the most common
objectives of macroeconomic policy. Along with monetary policy related to
interest rate or money supply, and the fiscal policy associated to taxes policy or
gr)Vernment expenditures are often applied in the macroeconomic stabilization. In
o her words, they assist to reduce inflation pressures and support the sustainable
g:·owth. Since inflation is known as a harmful factor for both firms and families.
Jvlany countries put the price stability into the first priority. While as some
researchers agree that the economy may get some beneficial effects at moderate
inflation rates. For instance, thanks to inflation, investors will reallocate their
p< 1rtfolios away from money and into capital, helping to decrease the real rate of
interest, encourage investment and rise labour productivity (Tobin, 1965). Also, in
1~172,

Tobin claimed that "a little inflation helps oil the wheels of the economy"

through assisting labour market adjustment. Furthermore, Jarret and Selody (1982)
argued that a steady growth in demand contributed to moderate rates of inflation; as a

consequence, it would promote productivity growth instead of reducing it. Hence, the
efforts to get zero inflation amount to a policy for "paying now for more pain later".

3


Nonetheless, in recent years, inflation has been a noticeable phenomenon in almost
countries; especially in developing countries. There are consequences that the world
i

has been suffering from the global economic crisis and dramatically affected all
countries over the world. The developing countries in Asia sector are not exceptional.
These countries must be struggling to increase in all commodity prices, resulting in a
difficulty in the people life. The energy and food prices raising many folds during the
crisis contributed to the soaring of the prices. Besides, a strong domestic demand and
rising wages are other drivers of inflation pressures. Immediately it pushes the prices
of all commodities to grow up. This causes the harness in all households and
companies in the economy; they must endure escalating of living and production costs.
Although, the governments have tried their best to show many strategies associated to
fiscal or monetary policies ·so as to decrease the inflation rate and help to stabilize the
macroeconomic, but we realize that the prices still continue to increase without the
end point. It is the disasters that the 'families and individuals in the poor countries have
to face.

Scientifically speaking, there are many studies involved in the relationship between
inflation and growth. Obviously many findings surrounding the correlation are not
similar. Some studies state that inflation has a positive effect on growth, in contrast to
this; other research find that inflation has a negative impact on the growth. While as
the recent studies mention that there is a nonlinear relationship between inflation and
growth, the authors point out the thresholds in the inflation-growth nexus. However,

the evidence is not clear for the developing countries and there is much less
agreement about the precise relationship between inflation and economic performance.
At the same time, base on many findings, the inflation has the effects on the economic
growth that are not similar from the developing countries to the developed countries.
Most of the developed economies are usually stable in growth and inflation rates.
They have low inflation rates while the developing countries have higher and unstable
inflation rates. This influences remarkably to the economy and the households' life as
a whole.

4


For this reason, it is necessary to make clear the relationship between economic
growth and inflation in the selected developing Asia countries including China, India,
Indonesia, Malaysia, Philippines, Thailand and Vietnam ofthe period 1990-2010. The
paper selects the countries since these are prominent in the speed of economic
development of Asia in recent years. Nevertheless, they have been bearing from the
consequences of the global economy depression, and particularly the inflation rates are
surging so high in these countries. In addition, the selected developing countries
virtually belong to A SEAN group, and my country-Vietnam is a member of this group;
therefore they are in common in many aspects of the economy such as structure,
natural conditions and the speed of growth, etc.

1.2

RESEARCH OBJECTIVES AND RESEARCH QUESTIONS
The core objective of the paper is examining the effects of inflation on economic
growth in the selected Asian countries. At the same time, the paper tries to
understand how inflation will affect economic growth differently between
developing countries in the sample. Furthermore, the study also tests whether

thresholds remain in the relationship between inflation and economic growth or not

and how the thresholds obtained in the relationship are different between the
countries. Last but not least, based on the results, the paper will recommend the
relevant policies for economic development in Vietnam.

There are four questions raised for the study, comprising the following questions:
(1) Does inflation impact the economic growth in the selected Asia countries?
(2) How are inflation effects on growth different from the countries?
(3) Are there thresholds in the nexus between inflation and growth of the
countries? And,
(4) How different are threshold levels captured by the countries?

5


1.3

STRUCTURE OF THE PAPER

The rest of this paper is divided into 5 chapters:

•

The second chapter reviews theories associated to the correlation between inflation
and growth. In addition, this chapter provides definitions of the variables used in the
model. The thesis also presents empirical studies for reinforcing the evidences of
existence the inflation-growth relationship

•

The third chapter discusses economic outlooks of the selected Asia countries
including various parts of economy contributing to GDP growth rate and inflation rate
through the period of 1990-2010. The statement of each country will be summarized
and captured through the figures in an attempt to expose partly the edge of economy
for each country

•

The fourth chapter presents specific theoretical and empirical research models on
purpose of employing the appropriate models for the research. Besides, the selected
research methodology and data source using for estimating the models will be
indicated in a detail way so as to catch the idea of the thesis.

•

The fifth chapter presents the empirical results of the study. Firstly, descriptive
statistics of each country will be pointed out as an overview about prediction of
regression results. Next, the results achieved from regression the models by using
Eviews 4.0 software will be showed and discussed for each country consisting of
influences of inflation on growth and thresholds obtained in the inflation-growth
relationship.

•

Finally, the last chapter will provide conclusions related to the results achieved in
the previous chapter.

Accordingly, the thesis

will

suggest some policy

recommendations in the hope to aid the countries solve their issues. At the same
time, the paper will indicate research limitations and further study.

6


The thesis also consists of four appendices:
•

Appendix A provides the regression result of the quc;tdratic model by using the
fixed-effect method of panel-data and treated by SUR in an attempt to reduce the
problems involved in regression .

•

•

Appendix B contains the scatter diagrams between two variables comprising
squared-inflation and growth of each country. The diagrams are showed for
supporting to find out thresholds

•

The results of testing Heteroscedastiscity via White-test approach for each country
will be contained in Appendix C

•

Appendix D consists ofthe scatter diagrams describing the correlation between the
variables in the model of each country.

7


Chapter 2

•

LITERATURE REVIEW
This chapter will review the literature related to the relationship between inflation and
growth, which are key issue in the research. Firstly, the theories of the inflation-growth
correlation will be addressed to give a foundation of the growth research. Secondly,
growth models are also indicated for the purpose of understanding the association
between the growth and other primary factors apart from inflation, particularly one of
the growth models will be employed for the study. Thirdly, the variables included in the
model will be clearly defined and described in details. Finally, the empirical studies
linked to the growth-inflation nexus will be mentioned as a prominent reference source.

2.1

THEORIES RELATED TO INFLATION AND GROWTH
Base on the quantity theory of money cited in Azar's paper (2009), a negative
relationship between output and the price level arises when there is a movement along
the aggregate demand (AD) curve. The derivation of the AD curve is from the
equation of exchange:

MV=PY
The equation indicates that if money supply (M) does not vary and velocity (V) is kept
constant, then an increase in real output (Y) would result in a decrease in the price
level (P) so as the equality held. Nonetheless, a movement in AD curve will only occur
when aggregate supply (AS) curve shifts (Azar, 2009).

According to Mishkin (200 1), four core factors decide to movement of aggregate
supply (AS) curve to the left, causing the price level grows up and conversely a fall in
8


the output. Firstly, when output is beyond the natural output rate, a pressure is boosted
in the labour market which increases in wages and obviously production costs. As the
result, the AS curve shifts to the left. And the second determinant is that when
expected inflation is not neutral and negative correlation with output. And the last
factor which is known as a negative supply shock such as an increase in oil price or
•

volatility in the commodity markets will give a rise a movement of the AS curve to the
left.

The below section presents the additional theories linked to both variables: inflation
and growth. They comprise the Classical, Neo-classical, Endogenous, Keynesian,
Neo-Keynesian and Monetarist theories. Not only do the theories support to gain more
understanding about the inflation-growth correlation, but also mention the impacts of
other factors on the growth in general.

2.1.1

Classical Theory

It is widely knovm that Adam Smith and David Ricardo are the prominent economists

for the classical theory. Their perspectives to the theory are that the economy is
self-regulating and always at full-employment. The technological changes are highly
assessed for impacts on the economic growth (Me Taggart et al., 1996)

Furthermore, the theory determines three factors having the effects on the economic
growth are capital, labour and technology. Among these factors, capital is embodied
by investment and saving, the target to mention the variable is its role to the
inflation-growth relationship. When inflation rate goes up, the real interest rate surely
goes down; and it means that saving rate will reduce, this does harm to investment as
saving is one of core sources facilitating to investment. Although the real interest rate
decreases, it is a chance for investors to increases in borrowing, the lack of capital is
restricted borrowings (Me Taggart et al., 1996)

2.1.2

Neo-Classical Theory

Solow (1956) and Swan (1956) are pioneers in indicating the neo-classical models.
9


Nonetheless, the

person who discovered a new mechanism

involving the

inflation-growth relationship is Mundell. Base on the model of Mundell (1963), the
affluent of people would decrease if the inflation or inflation expectations increase
(Gokal and Hanif, 2004). Cass (1965) and Koopmans (1965) developed neoclassical
growth model by comprising variables like investment and population growth in the
growth regression. The model estimates that a stimulus in economic growth is thanks
to an increase in investment rate and a combination to a reduction in population
growth rate.

For a New Classical theory, inflation puts a tax on money balances when the spending
purpose of the government is for promoting growth. Besides, high inflation often
combines with a rise in variability of inflation, which give way to increasing costs and
risks of capital and inversely influences resource allocation (Paul et al., 1997)

2.1.3

Endogenous Theory

The Endogenous theory is commonly so-called the new growth theory. The theory
comprises the main motivations in explaining differences of growth rate across
countries and a higher rate of the growth observed. The economic growth determined
in the Endogenous growth theory is generated by factors within the production process
(Todaro, 2000).

The theory identifies that inflation brings about the impacts on growth v1a two
channels are investment and capital accumulation. At the same time, with the help of
the Endogenous models, growth is explained further with human capital. And the
growth rate is expanded through depending on the return rates of both human capital
and physical capital (Gokal and Hanif, 2004)

2.1.4

Keynesian Theory

In contrast to the Classical theory, the Keynesian theory states that the economy
cannot be left alone and achieve full-employment without interventions of fiscal and
monetary policies. The Keynesian theory is one of the Aggregate Demand Theories,
10


thus the factors influence the growth in terms of the aggregate demand such as
consumption, investment, government expenditures and so on. Besides, the theory
assumes that fluctuations of aggregate demand depend on expectations which named .
as "animal spirits" 1•

According to the conventional Keynesian viewpoint, inflation is viewed as a stimulus
to economic growth. This is the view that is dominantly expressed via a short-run
Phillips curve arises in light of sticky prices and wages (Dornbusch et al., (1996) and
Mallik and Chowdhury* (2001)). Therefore, inflation is able to give rise to a faster
real growth in the short-run (Motley, 1998). Nonetheless, when economic agents are
likely to join in price changes, the Phillips curve trade-off maybe disappear. The
schools of thought were especially famous in the 1960's and still develop into the
1980's (Bruno et al., 1996). Also, Paul et al.( 1997) claimed that in a Keynesian theory,
inflation stimulates growth through redistributing income from labours to firms with
higher level of propensities to save and invest.

2.1.5
The original

Neo-Keynesian Theory

ofNeo-Keynes~an

theory is from the perspectives of the Keynesian theory.

The theory mentions that the level of real growth (GDP) and the natural rate of
employment are the main factors influencing inflation (Me Taggart et al., 1996)
According to New Keynesians, there is non-neutral in the relationship between
inflation expectations and money supply changes. In particularly, if inflation is higher
expected, money supply level would be expanded. As a consequence, AD curve will
shift to the right and promote to production a higher output.

2.1.6

Monetarist Theory

When it comes to the Monetarist theory, we cannot forget two representative

1

The expectations determined here are news or rumours about interest rate, tax rate, technological advances or world

economic events; whereas aggregate supply is in response to changes in money wage rate (Me Taggart et al., 1996)

11


economists for the theory, they are Milton Friedman and Brunner. The theory agrees
with the Classical theory that the economy is self-regulating and at full-employment.
And the fluctuations in the aggregate demand .rely on the quantity of money. In
opposite to this, the factor which affects the aggregate supply is the money wage rate

as mentioned at the Keynesian theory.

The Monetarist theory focuses on fiscal policy like reducing taxes, this resembles to
the policy used by the Classical theory. Moreover, the Monetarism convinced that the
economic growth will be stable if the money supply increases steadily. To be updated
by the Quantity theory, the Monetarism reconfirms the important role of monetary
growth in affecting inflation (Me Taggart et al., 1996)

2.2

GROWTH MODELS
Base on many studies, the negative effects of inflation on economic growth have been
estimated in the context of the economic growth models. The models show that the
outcome of capital accumulation along with technological progress results in the
continuous increase of per capita income. And the uncertainty of rate of return of
capital and investment is caused by a high and volatile unanticipated inflation.
Nonetheless, even inflation is totally anticipated, also it may reduce the rate of return
of capital (Bruno and Easterly (1998), Pindyck and Solimaoo(1993)).

Besides, inflation causes the negative effects on human capital or investment in
research and development, and indirectly affects economic growth. But the most
significant impact of inflation leads the long-run macroeconomic performance of
market economies to worsen via depreciating the total factor productivity (TFP). That
is known as the efficiency channel and difficult to set up in a theoretical model.
i

Nevertheless, the channel plays a core role in the transmission mechanism from
inflation towards a lower economic growth, thus it cannot be rejected in the
estimation the effects of inflation on growth.

12


This part will review the main growth models like the basic growth model, the Solow
and augmepted Solow growth models. The models are coherently described the

•

effects of determinants to growth. According to the growth theory, growth bases on
three core processes: the first one is the accumulation of assets like capital, labour and
land; the second one is making the assets more productive, especially saving and
investment; and the last one is technological progress. The premise of showing the
models is to determine other main factors affecting on the GDP growth apart from
inflation. At the same time, one of the models will be applied as a basic model for the
paper.

2.2.1

The Basjc Growth Model

The most fundamental models of economic growth are based on a small number of
equations that relate saving, investment, and population growth to the size of the
workforce and capital stock and, in tum, to aggregate production of an individual good.
These models initially focus on the levels of investment, labour, productivity, and
output (Todaro, 2000)

As we have stressed, the aggregate production function is at the heart of every model
of economic growth. This function can take many different forms, depending on what
we believe is the true relationship between the factors of production (capital and
labour) and aggregate output. Standard growth models are known to have had one or

many production functions. And at the national level, the production functions present
the association of both the size of total labour force and the value of capital stock of a
country with the scale of total output of that country (Todaro, 2000)

2.2.2

Solow Model

By virtue of the limitations in the Harrod-Domar model, Solow replied by eliminating
the fixed-coefficients production function and superseding it with a neoclassical
production function that helps to induce more flexibility and substitution between the
factors of production. The capital-output and capital-labour ratios in the Solow model
13


are not be fixed, instead they will change, and the variation will depend on the
comparative endowments of capital and labour in the economy and the production
process. The model of Solow states that a production function with the same assets of
diminishing returns to capital. And the Solow model is known as the key of most
theories of economic growth and having considerable influences in developing
countries (Todaro, 2000)

For Solow model, decreasing marginal returns to capital is a core assumption which
contributes an economy in the growth process to achieve the steady state where all
factors output per capita, capital stock and consumption increase at a same rate
equalling to the exogenously indicated rate of technological development.

2.2.3

Augmented Solow Model

Base on Solow's suggestion, the economic growth is studied through decreasing
returns to capital of a standard neoclassical production function. He points out that the
rates of saving and population gro\\-1h resemble exogenous, and they are responsible to
show the steady state level of income per capita. An advantage of Solow model is
giving simple testable predictions in terms of how the saving rates and population
growth affect the steady state level of income. In details, the country is to be the richer
if having a higher saving rate. While the country will become the poorer if the rate of
population growth is higher (Mankiw et al., 1992)

Nevertheless, the Solow model's assumptions are not completely right; the model has
no accurate prediction about the magnitudes of the saving rates and population growth.
As a consequence, the augmented Solow model is suggested in order to help us
understand clearly the relationship between saving, population growth and income.
The model comprises accumulation of human and physical capital. It is realized that
eliminating human capital from the Solow model is main reason to explain why saving
and population growth have a large effect on income. Besides, the augmented Solow
model confirms that accumulation of human capital is associated with the rates of
saving and population growth, thus the estimated coefficients on saving and
14


population growth will be biased if we omit building up of the human capital (Mankiw
et al., 1992)

The augmented Solow model adding human-capital accumulation to the textbook
Solow model (Mankiw et al., 1992) is given as follows:

Where:

Y denotes for the total output, K is the physical capital, H is the stock of

human capital, A is technology level and L represents for labour force.

2.3

VARIABLE DEFINITION

2.3.1

Growth Rate

There are many definitions related to the growth rate. According to Blanchard (1997),
the measure of aggregate output in the national income accounts is kno-wn as gross
domestic product, or GDP. He shows three ways of thinking about GDP of an economy.
The first definition is defined that GDP is the value of the final goods and services
produced in the economy during a given period. Secondly, GDP is indicated as the sum
of value added in the economy during a given period. Lastly, GDP is the sum of
incomes in the economy during a given period.

In macroeconomic theory, the economic growth is visualized as an outward shift in the
production possibilities frontier (PPF). According to Me Taggart et al. (1996), the real
gross domestic product or GDP will be employed for measuring the economic growth.
There are two approaches used to determine GDP: the first one is the total expenditure
on goods and services. It is explained that for the real GDP demanded (Y), it is the
sum of consumption expenditures (C) by households, real investment (I) by firms,
government expenditures (G) and net exports (X-M) (Me Taggart et al., 1996)

Y=C+I+G+X-M
15

And the second one is the total income earned through producing goods and services
or the real GDP supplied. It is the total amount of the factors including wages, interest,
rent and profit which are paid for production (Me Taggart et al., 1996). While the real
GDP supplied is measured by the aggregate production function as follows:
Y= F (L, K, T)
Where: L is labour, K denotes for capital, and T stands for technology

2.3.2

Inflation

Inflation rate is determined as the per cent change per year in a price index, especially
the consumer price index. It is also known as the increase in the average level of prices.
Inflation is a process of rising prices and measures as the percentage change in the
average level of prices and the price level. Thirlwall (1974) defines that inflation as a
"rise in the general price level whatever its cause". According to the view of Mishkin
(200 1) inflation is "a continual increase in the price level". In the paper of Dornbusch

et al.( 1999), inflation is defined as ''the rate of change in prices". There are many
various definitions about inflation, but it has a common point related to changes in
price.

The Consumer Price Index (CPI) is a common measure of the price level. It is a signal
of how the average prices of goods and services bought by the specific household
change from one period to the next (Gerber, 1999). Economically speaking, two key
purposes of CPI consist of measuring variations in the cost of living and changes in
the value of money. And computing the inflation rate will meet these changes. The
following formula is used for calculating the inflation rate:

.
t
I n fl awn
rae=
t

(CPlt:hisy~rar-CPllasey~rar)

X lOO

CPI lcut year

It is commonly known that besides CPI, there are two alternatives employed to measure
the inflation rate. The first one is the producer price index or PPI, obtained to compute
changes in the input prices purchased by producers. And the GDP deflator is a second
one; it is calculated by multiplying the nominal GDP rate to real GDP of a given year for
16


100. Nonetheless, CPI has many advantages and common in use rather than PPI and
GDP deflator. According to many studies, CPI is used to reduce the negative impacts of
inflation on growth, but is not caused by inflation. Besides, CPI is a better choice in
comparison to GDP deflators since the growth rates are negatively associated with the
changes in GDP deflators (Gerber, 1999).

2.3.3

Cost of Inflation

Although theoretical models clearly indicating the long-run impacts of inflation are

shortage, this has not deprived many researchers from attempting to assess the costs of
inflation. There are many ideas surrounding that inflation is harmful to economic
growth. Indeed, inflation causes difficulties for economic agents to make accurate
decisions because fluctuations in relative prices become difficult to anticipate
(Harberger, 1998). Furthermore, Feldstein (1982) found that inflation is detrimental to
economic growth through imposing many substantial costs, resulting in distorting
relative prices and so investment decisions and resource allocation.

Additionally, inflation leads to erode tax reduction for depreciation and to push up the
rental price of capital, as a result of a deduction in capital accumulation and hence in
production growth (Clark, 1982). Friedman (1977) indicates that at a higher inflation
rate leads to a higher volatility of inflation, then affects seriously to growth. The
expectations-augmented Phillips curw shows that expected inflation is equal to actual
inflation in the long-run, and the unemployment rate is at its natural level. Hence, in
the long-run, a nominal variable like inflation does not have an effect on real variables
like unemployment rate or growth; in contrast, there are other nominal variables having
a negative impact on the real variables.

When it comes to the impacts of inflation, we are familiar with the views of menu
costs2 , and shoe-leather costs 3 . Especially, inflation attributes many forecast errors by
biasing the information contents of market prices, and compelling economic agents to
2

At a high level of inflation gives rise to a gradual change in prices is costly for companies

3

Decreases the efficiency level of cash holdings by consumers
17