What is inflation? Inflation stems from the rise of general price level of goods and services in the economy. This is the general explanation for the term known to several economists, demographers and other experts in several fields alike. This explanation links to when an apple’s price increases fo
r $2 to $5 and this leads to a rightward lift in supply, thus boosting production and output. This is what we all know as inflation. Economic growth on the other hand is the general improvement of the economy as a result as a rise in output and production resulting from several factors. Economic growth is closely link to GDP because it deals with the accumulation of monetary value of output of an economy has within a given year. Furthermore, some economists see inflation as a function of the demand and supply of money: I=f (Dm, Sm), where I=Inflation, f is function, Dm=Demand of money and Sm= Supply of money. This means the production of more money (e.g.: Naira), its value declines, driving price up. Thus, in the context money supply is the major determinant of inflation therefore, inflation and money supply has a direct relationship. This view is linked to the monetarist view of economic growth which focuses mainly on the relationships, causations and correlations between inflation and money supply. Therefore, inflation can be seen through many viewpoints. One of the arguments that considers inflation’s effects on economic growth are detrimentally or positively, while another arguments believes in a non-existent relationship between the two variables. These arguments are based on empirical findings and evidence from experimentations. The use of scientific economic thought to reach these conclusions are based on appropriate deductions. Each of these views are valid in their own domain and represent a different thought process on the same argument. One of these argument is the structuralist view which presents a positive outlook on the argument that inflation positively affects economic growth (Mallik & Chowdhury, 2001). On the other hand, the monetarist view suggests that inflation negatively affects economic growth and go against inflation as a method to drive economy up as it would simply end up doing the opposite (Fisher, 1993). While another group of economists with a radical view on the argument proposed that inflation and economic growth doesn’t even have any form of relationship (Sidrauski, 1967).
Structuralist View
This perspective of the argument is based on empirical analysis from experimentations on multiple economies around the world to reach the conclusion that inflation does in fact positively affect the economic growth rate of a country. Among the supporters of this view include neo-classists who point out that inflation may increase economic growth by shifting the income distribution in favour of higher saving capitalists and in conjunction, more saving leads to investments which leads to economic growth. They concluded that because inflation drives people to save more rather than spending due to the raising prices unlike in deflation, they end up saving more money in order to invest in productive activities which will in turn contribute to the employment of resources and increased output leading to economic growth. Keynesians also proposed that inflation may increase economic growth due to rises in profit leading to higher private investment thus resulting in economic growth due to higher output. It can be deduced from this that due to higher prices, producers will not only be inclined to produce more in concordance with the law of supply but due to higher profits and revenue they will reinvest in order to further maximise profit leading to an increase in private investments which leads to higher output in overall and thus economic growth. This view is so popular that it is used by Central Banks around the world. For example, in the US, the Fed (Federal Reserve) usually targets a yearly inflationary rate. They believe that a slow rise in price levels keeps businesses profitable and prevents deflation from driving demand. The central bank of the US, the Fed sees inflation as a driver of economic growth as a below the threshold inflationary rate of about 2-3% usually promotes and instigates economic growth due to higher profits, greater production and higher income levels leading to higher demand which will in turn drive demand leading to higher economic growth and development. It is a wonder to see the mechanics of Economics work in such a way. Theoretically, when an economy is not at an optimum level or production, inflation helps drive production. More money leads to more spending which results in higher demand which in turn pushes production to meet consumer demands thus resulting in economic growth. This is in relation to money supply being a major cause of inflation.
Monetarist View
This view is closely linked to the economic concept of monetarism which is bound by the principle of the relationship that exists between money supply and inflation. According to them, money supply is an independent variable that influences and is responsible for the fluctuations in price I=f (Dm, Sm). Here, I=Inflation is a function of the changes in Dm=Demand of money and Sm=Supply of money. Thus, Inflation is dependent on the changes of the endogenous variables demand and supply of money, especially supply of money, which in this context plays a major role in determining the level of inflation in the economy. This concept was proposed by Milton Friedman where inflation is directly tied to money supply as a result of government intervention. They argue that inflation occurs as a result of a higher rise of money supply in relation to the growth in national income. In the short run it may have effect on real variables such as real GDP and price level negatively but in the long run the influence only spreads to price level and other nominal variables but not real variables such as real output (Richard Froyen, 1998). Monetarists believe that due to the increase in money supply which leads to inflation, this will in turn lead to difficulty in investment opportunities as inflation causes the value of the money to drop. When this happens people will be discouraged to spend more, interest rates for loans will be spiked and investments will reduce due to low profitability expectation of it. This will lead to a reduction in output or production and a decline in economic growth. Other views that support this proposition like Baro (1995) believe that high inflation stunts investment adversely affecting growth negatively. Another proponent of this view is Fisher who was at the forefront of this perspective. He argued that inflation distorts the price mechanism which causes inefficiency in resource allocation leading to a decline in economic growth. This was backed by economists using data drawn from 30 years from 1960 to 1990 of 100 countries to reach a conclusion about the relationship between inflation and economic growth. This was reached through the regression equation- it is an equation which is used to determine the relationship that exists between any set variables or data. It is given as Yi=f (Xi, β) +ei, where Yi is the dependent variable and it is a function of Xi =the dependent variable, β=unknown parameters and ei =error terms. The regression equation via econometric analysis and modelling brought about statistical evidence and valid proof to support their claims. The regression equation can be seen below:
GGDPit = b0 + b1INVTit + b2GPOPit + b3 ln INFit + b4 ln GDP0i + eit (1)
(Where; GGDP is growth rate of GDP in year t at country i, INF is inflationary rate at time t at country i, INVT is investment rate at time t at country i.)
The calculation using this regression equation resulted in a reduction in real GDP per capita by 0.2%-0.3% per year as a result of the 10% inflation rate per year. This empirical finding solidified this view and it held a lot of prominence in the economic world as it has a strong statistical evidence as proof.
In another study, it was deduced by a group of economists such as Bhatia that inflation and economic growth in fact does not have any significant relationship. A study by Sidrauski (1967) shows no relationship between the two in the long run furthermore, he testifies the super neutrality of money in his model. This super neutrality of money indicates that real variables including the GGDP (Growth of GDP) are independent of the GMS (Growth of Money Supply) in the long run. Inflation is thus harmless to economic growth. This again is linked to monetarism in the sense that money supply has to be the major cause of inflation for this view to hold true. In this study, inflation has no relations with economic growth. This is due to the super neutrality of money as the GGDP is independent and is not influenced by the GMS of an economy, thus GGDP≠f (GMS). Moreover, Bruno and Eastely (1995) after deleting observation of high inflation from some data discovered the insignificant relationship between the two variables below the threshold level of inflation. However, it was noted that above this threshold a negative relationship was observed. Therefore, it is dependent on the period, whether short or long run when the relationship was being observed and if it is above or below the threshold of inflation. If below the threshold, it will have no effect but above it will incur negative effects. In the long run, there is no effective relationship between the two variables but there seems to be a possible relationship between the two during the short run.
Personal view
Apparently, there seems to be a lot of debate surrounding the kind of relationship that exists between the two variables. “Achieving sustainable rapid economic growth is the objective of most countries” (Södertörns University: Economic Growth and Inflation). However, it has been an issue to achieve this due to the numerous variables that affect economic growth in one way or the other. One of these factors include inflation, for some economists. All the divergent views stated above hold validity in their respective standpoints. Some observed a positive relationship, others a negative one and other economists descried that the two variables have no relationship whatsoever. According to sources from the IMF, it was concluded that the relationship between the two variables were matched according to the economic state of the specific countries as well as influences from other exogenous variables. Thus, it is not a simple matter to demystify. Either way, considering what has been discussed above, I support the monetarist view. This is because money supply does seem to have a direct relationship with inflation. With more money in circulation, currency will be devalued and this will restrict demand as people will struggle to get enough money to buy products. This is in conjunction to the consensus understanding of the value of money as when the amount of money in circulation increases, the prices will be driven up causing inflation, leading to a decrease in the value of money, thus reducing its purchasing power. Therefore, people will be unable to fully invest in investable opportunities because of the likely crash of the currency, resulting in not being able to maximize profit and utility. This will lead to a decline in output and production resulting in a drop in GDP causing a plunge in economic growth. Conclusively, inflation does not have a good effect on economic growth but a negative one; even though it is a possibility that inflation below threshold level may hold positive effect for economic growth, it is too big a risk and inflation is usually characterized by “high inflation” which can result in unsavory economic repercussions.
References
Södertörns University: Economic Growth and Inflation (A Panel Data Analysis); Fikirte Tsegaye Mamo and supervisor: Xiang Lin
Investopedia: When Is Inflation Good for the Economy? By Sean Ross
IMF e-Library: Inflation and Growth: The Statistical Evidence by Graeme S. Dorrance
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