The Relation between Growth and Inflation Rates in Latin America

Beginning of article

ABSTRACT

Inflation has long been a problem for countries in Latin America. While some countries have made progress in addressing the problem, other countries have not been able to achieve sustained economic growth. Keynesian thought posits the notion that inflation and growth can be positively related, while other theories suggest that inflation is detrimental to long-run growth. Various empirical studies yield conflicting results. This study applies two Granger causality tests to seventeen Latin American countries in order to determine possible long-run relations. For most of the countries, no causality is found, while unidirectional causality and bi-directional causality is found in a limited number of countries.

INTRODUCTION

Historically, many Latin American countries have been plagued by inflation problems though the problem has not been universally severe. During the past few decades, some of the countries have made considerable progress toward controlling inflation while others still struggle in the battle against inflation. Some countries in the region have also encountered difficulties in maintaining respectable economic growth rates. The purpose of this paper is to explore the relations that appear to exist between inflation and economic growth in selected Latin American countries and to note some of the econometric problems that exist in analyses of this nature.

There is far from universal agreement regarding the relation between inflation and economic growth, and this relation has long held a central position in macroeconomics. The traditional Keynesian view would hold that inflation can act as a stimulus to economic growth. This view is typically expressed through a short run Phillips curve tradeoff (Paul, Kearney & Chowdhury, 1997) that arises due to sticky prices and wages. Thus, in the short run, faster real growth may be associated with inflation (Motley, 1998). However, the Phillips curve tradeoff tends to disappear as economic agents are able to anticipate price changes. These views were especially prominent in the 1960's and continued into the 1980's (Bruno & Easterly, 1996).

There are strong arguments that inflation is detrimental to economic growth, especially in the long run. Inflation makes it difficult for economic agents to make correct decisions since changes in relative prices become obscured (Harberger, 1998). Inflation imposes variable costs, especially menu costs. If inflation is high, the variability of inflation may also be high and this complicates the task of forecasting inflation. If inflation cannot be correctly anticipated, both savers and investors may be lead to make decisions that are detrimental to economic growth. This view is traditional and, in spite of the Keynesian views promulgated in the 1960's and thereafter, this view is incorporated into models of the new-growth literature (Bruno & Easterly, 1996).

The empirical evidence regarding the inflation-growth relation is mixed. Fischer (1993) found that real GDP growth is negatively related to inflation in cross sectional regressions and that low inflation is not necessary for growth. Using extreme bounds analysis, Levine and Zervos (1993) found that there is not a significant negative correlation between growth and inflation. They suggest that if inflation persists over a long time period, economic agents find mechanisms to adjust so that growth is not affected. However, cross-country regressions involving socio-economic variables often produce fragile results (Levine & Renelt, 1992).

Grier and Tullock (1989) found that the average level of inflation had a neutral effect on growth in the OECD countries but for the remainder of the world, inflation had a significant negative effect on growth. For Latin America, they found no statistical relation between inflation and growth. Barro (1997), in a world wide cross sectional analysis, found a negative relation between inflation and growth, though the effect could not be isolated for inflation rates below 20 percent. Other research by Barro (1996) indicates that the experiences of high inflation have adverse effects on investment and growth. Kocherlakota (1996) supports Barro's findings of a negative slope coefficient between growth and inflation and further shows that high growth tends to generate low inflation.

Until the 1970's, many studies found the negative effect of inflation on economic growth to be statistically insignificant, and in some instances, the effect was found to be positive (Sarel, 1996). The high and persistent inflation rates experienced by some countries during the 1970's and 1980's brought about a rethinking of the inflation-growth link.

The preceding review of cross-sectional studies, while not exhaustive, does not provide clear evidence of the growth-inflation relation. There are numerous problems associated with the use of cross-country regression analysis. Levine and Renalt (1992) and Temple (1999) review some of the methodological problems. Pooled cross-country data sets tend not to be informative regarding what happens in the lower ranges of inflation (Bruno & Easterly, 1998). The empirical relation between growth and inflation appears to be different for Africa and Latin America (Ericsson, Irons & Tryon, 2001).