Some Empirical Aspects regarding the Relationship between Inflation and Economic Growth in Romania - the Speed Limit Effect

By Birman, Andrei | European Journal of Interdisciplinary Studies, December 2011 | Go to article overview

Some Empirical Aspects regarding the Relationship between Inflation and Economic Growth in Romania - the Speed Limit Effect


Birman, Andrei, European Journal of Interdisciplinary Studies


1. Inflation and the Economic Growth

Recent work on the design of monetary policy reflects a general consensus on the appropriate objectives of monetary policy; the monetary authorities as well as the majority of observers, and even politicians, perceive the stability of prices as the main goal to be achieved, as inflation is a very costly phenomenon. A part of the costs of inflation relate to its nominal level while other costs are due to the variability and the uncertainty of the inflation. The general idea is, however, that individuals and economic agents have lower economic performances when the inflation is high and unpredictable and that an efficient control of inflation brings higher benefits in terms of a higher sustainable economic growth in the future.

The conventional view in the academic literature holds that permanent and predictable changes in the rate of inflation are neutral: in the long run, they do not affect the real activity. However, empirical evidence suggests that sustained high rates of inflation have adverse consequences for real economic growth in the long run, although it is much less agreement about the precise relationship between inflation and economic performance, and about the mechanism by which inflation affects economic activity. In a survey article on the costs of inflation, Briault (1992) says that there are many well-established theoretical reasons why inflation and uncertainty about future inflation may reduce economic welfare. Among these, he includes, at a very general level:

* The unplanned redistribution of income and wealth;

* Additional uncertainty about future prices introduced in the decisions about consumption, saving, borrowing, and investment; and,

* The higher costs of identifying changes in relative prices and allocating resources accordingly.

In the context of economic growth models, in which the continuous growth of the per capital income is the result of the capital accumulation and technical progress, the negative effects of inflation have been indicated as being significant. The uncertainty related with an unanticipated and volatile inflation has been accepted as one of the main factors that determines the return on capital and on investments (Pindyck and Solimano, 1993).The perfectly anticipated inflation may also reduce the rate of return on capital giving the non-neutrality of money that is embedded in the fiscal systems of most developed countries (Jones and Manuelli, 1993). Apart from these reasons, inflation weaknesses the trust of the resident and non-resident investors in the future monetary policy decisions and impacts other determinants of economic growths, such as human capital and research & development.

Also, inflation reduces the long term economic performance of market economies by lowering the productivity of the economic factors (the efficiency channel). The higher level of inflation produces frequent and costly changes in the prices shown on the shelves (menu costs) and reduces the optimal level of cash to be had by the consumers (shoe- leather costs). Inflation generates high forecast errors, through the distortion of the informational content of prices, making economic agents to spend more time and resources to gather relevant information about the relative prices and to protect themselves against price instability, impairing the efficient allocation of resources.

Another cost of inflation, at least on short term, is that associated with the disinflation process, estimated through the sacrifice ratio which indicates how much output is lost as a result of the restrictive monetary policy measures implemented in order to reduce inflation. Hence, to the extent that there is cost push inflation, there is a short term trade off between the variability of inflation and that of the output (Taylor, 1979). It is important to mention, however, that this trade off arise only for cost push inflation while for demand-pall inflation (in which the inflation depends only on current and future demand) the central banks are able to achieve both the inflation target and the output target by manoeuvring the interest rates. …

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