Relationship Between Inflation And Economic Growth Economics Essay

The relationship between inflation and economic growth, from diverse direction, it is stayed for long period in debating. But, now a days, most scholars agreed its harmfulness beyond some threshold. The threshold size is different among the developed economies and developing nations. Even, in the developing nations the size is very different. For example, Ghosh and Philips(1998) estimated 2.5% threshold rate while Burno and Easterely (1998) estimated 40% threshold rate that doesn’t affect economic growth in developing countries. In addition, different regions estimated different threshold such as from Asian region: Bangladesh (6%), Pakistan (9%), Indonesia(8.5-11%), from Latin American countries: Mexico(9%), from African countries: Nigeria(8%), S.Africa(8%), Ghana(11%), and Egypt(15%). Hence, from this threshold concept and such divers results , one can judge that before estimating the threshold it is difficult to say that the inflation rate is harmful or not.

Further, this controversy was started from classical to endogenous growth economic theories. Classical economists believe that inflation at any rate is harmful, monetarists believes as no relationship, and neoclassical economists argued in three ways: positive, negative and no relationship. This similar as indicated in the above.

However, recent Ethiopia inflation and the economic growth relationship is similarly a controversial issue. According to IMF(2008) report, the existing inflation rate is very overheated so that it is harmful for economic growth. Another auther Teshome(2011), indicates that the existing inflation rate is helpful for economic growth. Others like Desta(–) and, Geda and Tafere(2008) research finding report, from multiple regression analysis, the main determinants of inflation was not found economic growth but import, domestic currency depreciation, declined domestic interest rate and broad money supply are the main drivers.

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Despite these, there are also other facts, challenges and prospects indicated by different authors. For example, in the last seven years (2003/04 to 2009/10), Ethiopia’s annual economic growth was 11 % and GDP per capita growth was also 8%. In addition, in the last 15 years period(1994/95 to 2009/10), the size of poverty or people living below poverty line has reduced from 49.5%(1994/95) to 29%(2009/10)(MoFED, 2010: 5-6). Similarly, in the last 12 years period (2000 to 2011), HDI is increased from 0.274(2000) to 0.363(2011). That is, life expectancy in the last 31 years period(1980-2011) is increased by 35% or from 43.9 age (1980) to 59.3 age (2011), GNI per capita(ppp us dollar) is increased from 539(1985) to 971(2011)(MoFED, 2010/11 : 9).

On other hand, according to different research reports such as Alem and Sederbom(2010), Headey et al (2012), IFPRI(2009), and Jeni and Jose(2007) reports, inflation has affected both rural and urban households.

Finally, this report presentation is mainly organized in three sections such as: introduction, analysis and conclusion. The first part, introduction, introduces: objectives, methodology and data sources. The second part, discussion, which is the main part of the report, investigates the core issues associated with the thematic area. This part entertains different ideas (theoretical views, other researchers conclusions, facts, challenges, prospects, etc) from different angles so that it is essential and core part of the report. The third part, conclusion, is the summary of all the observation in condensed form with the group members final inclined remarks.

Objective

The objectives of this report are to investigate the relationship between inflation and economic growth in Ethiopia. In addition, other facts, challenges, and prospects about the relationship inflation and economic growth globally, and also in case of Ethiopia. Next, after all observation, group member’s final remarks all about Ethiopia’s inflation and economic growth will be presented.

Methodology and data sources

The sources of data used for this analysis includes secondary data from : research papers, books, journals, and empirical/statistical figures from government and Non Governmental Organizations. The method used for analyzing the paper is descriptive analysis.

Analysis : The relationship between inflation and economic growth

Definitions and concepts

Before we start to our analysis about inflation and economic growth relationships, it needs some descriptions, as to what inflation is and what economic growth, as the starting point. Different scholars defined both inflation and economic growth in some different ways but all have the same meanings. Let us see them as follows:

a). Inflation: is a price rise while inflation rate is the percentage rate of change in the price index over a given period, and this rate can be measured through consumer price index(Froyen, 1993: 8-9). Inflation is an increase in the average price of goods and services in terms of money (Romer, 2012 :514). Inflation is the overall increase in prices (Mankiw, 2010). Inflation is general level of prices increase of goods and services in an economy over a period of time (www.en.wikipedia.org, 02/10/12). Inflation is a sustained increase in the average price level of the entire economy while deflation is a sustained decrease in the average price level of an entire economy (Mankiller W., 1995). Inflation rate is the percentage change of price index. The most important issue here is the rate of change of prices, inflation rate, as per unit of time (Sullivan and Sheffrin, 2006: 131-32).

b). Economic growth: is the expansion of nation’s output, or, the expansion of nation’s capability to produce the goods and services its people want, or, the expansion of an economy’s output( Agarwal, 1998: 904). Similarly, economic growth is generally defined as a sustained increase in per capita national output or net national product over a long period. Further, to say there is an economic growth, there should be continuous increase growth rate for a long period, and also this economic growth rate should be greater than the population growth rate. Another qualification of economic growth is that the national output should be composed of such goods and services which satisfy the maximum number of wants of the people. Short- increase in output in one period followed by a similar decrease in it in the next period does not mean an economic growth (Dwivedi,1995: 570).

The relationship

Theoretical view

The different school of thought economists (classical, neoclassical, monetarist and neoclassical) theoretical views are different about the relationship between inflation and economic growth. For example, classical economists argue implicitly that the relationship between inflation and economic growth is negative because inflation raises wage so that this reduces firms profit and less investment. The other economist class, Keynesian economists argue as in the short run inflation affect economic growth, ie, both have positive relationship, while in long run inflation doesn’t affect output so that inflation and economic growth have negative relationship. Another group, the monetarists, argues that the sources of inflation will associate with money supply growth. That is, if the growth of money supply is higher than the economic growth rate, inflation will result. Hence, according to monetarist view, inflation and economic growth have no relationship but money supply and inflation have positive relationship. The rest economists group, neoclassical, arguments are also by themselves different. For example, Tobin(1965) and Mundell(1963), neoclassical economists, argue that inflation and economic growth has positive relationship because, when inflation increases individuals substitutes fiat money in to high interest earning assets, which leads to generate capital intensity so that this promote economic growth. Another neoclassical economist, Sidrauski(1967), argued that inflation doesn’t affect economic growth, ie, both didn’t have any relationship. Other neoclassical economist, Stockman(1981), developed a model and finally concluded that inflation erodes purchasing power of money balances this leads cutting people their goods purchases so that reduces output or discourages economic growth. Cooley and Hansen (1989) concluded that output permanently falls when inflation rate rise up. In general, by different neoclassical economists, the relationship between inflation and economic growth concluded different results such as: when inflation rise up can result in higher output (Tobin effect) or lower output (stockman effect) or no change in output(Sidrauski). From endogenous growth theory argument, inflation assume as capital tax, then, inflation decreases rate of return, which in turn reduces capital accumulation and decreases the growth rate(Gokal and Hanif, 2004: 4-18).

Other researchers conclusion

In many ways, the relationship between inflation and economic growth is controversial issue. Generally, we can group the arguments in to four types: one group argues that both of them have positive relationship, others also argue that they have negative relationship, others set threshold and the rest argue no relations. For example, De Gregorio (1993) has studied the relationship among inflation and economic growth on 12 Latin American countries, by using data from 1950-1958, and conclude that inflation detrimental (harmful) for economic growth. Others like Barro(1995), Bullard and keating (1995), Burno and Easterly (1998) on their own study conclude that inflation is related to economic growth negatively(Bittencourt, 2010:3).

Similarly, others also Gillman et al (2002), Swedian (2004), Thrilwall and Barton (1971), Mallik and Chowdhury (2001) are found a positive relationship between inflation and economic growth (Ahortor, Adenekan and Ohemeng, 2011:159).

However, currently, most of researchers are coming agreement on positively relationship below some threshold. But, the level of this threshold is still controversial. Because, the level of the threshold for developing and developed economies findings are so different. Even, for developing economies, researchers’ conclusions are unsimilar. Some of them are calculated high rate of threshold and others are low rate of threshold. For example, Sarel(1996) found annual threshold rate 8%, Ghosh and Philips (1998) found annual threshold rate 2.5%, Christiferson and Doyle(1998) found annual threshold rate 13% , Burno and Easterly (1998) found annual threshold rate 40%, and above these rate they conclude that it switches negatively (Khan and Senhadji, 2001:2).

Moreover, other researchers also found the relationship between inflation and economic growth is linear and non-linear. For example, Fischer(1993) has studied on 93 developing and industrialized countries using both cross-sectional and panel data , and found that strong relationship between 15-40% annual threshold rate, ie, above 40% it is negatively related and below 15% no relationship. Similarly, Dornhusch and Fischer(1993) found 15-30% as moderate rate, Burno(1995) has also studied on 127 countries and found that growth is accelerated in 15-20% annual rate while growth is decelerated in 20-25% annual rate, Khan and Senhadji(2001) have studied on 140 countries (developing and developing) from 1960-1998 and found that threshold level of inflation above which inflation significantly slow growth is estimated at 1-3 percent for developed countries and 11-12 percent for developing countries, Sepheri and Moshiri(2004) have studied by using panel data from developed and developing countries and found that the estimated threshold varied widely from as high as 15 percent per year for the lower -middle-income countries to 11 percent for the low – income countries, and 5- percent for the upper middle- income countries , Polin and Zhu(2006) have studied on 80 countries during 1961-2000 data and found that moderate threshold inflation rate estimated to 15-18 percent, Kremer, Bick and Nautz(2009) have studied on 124 countries using panel data during the period from 1950-2004 and found the threshold rate 17.2 percent for developing countries , and Brito and Bystedt(2010) have studied on 46 developing countries(13 IT countries) using panel data during the period 1980-2006 and found that IT actually result in lower output growth during adoption (Anuwar and Isiam, 2011: 7-8).

Further, this threshold level estimate is studied by researchers at individual country level especially on developing country and they have calculated different results for each country. For example, Singh and Kalirajan(2003) have studied India threshold by using annual data, during the period 1971-98, and found no threshold level of inflation for India; however, their findings clearly suggested that an increase in inflation from any level has negative effect on economic growth. Similarly, Ahmed and Mortaza(2005) have studied Bangladesh threshold using annual data, during the period 1980-2005, and found 6% rate threshold, ie, above 6% rate inflation adversely affect economic growth, Mobarik(2005) has studied Pakistan threshold using annual data , during the period 1973-2000, and found 9% rate threshold, ie, above 9% rate it is detrimental for economic growth, Kheir-El-Din and Abou-Ali(2005) have studied Egypt using annual data for 25 years, and found 15% threshold, ie, above 15% rate it has negative effect on economic growth , Salami and Kelikume(2009) have studied Nigeria threshold using annual time series data, during 1970-2008, and found 8% rate threshold, Risso and Sanchez Carrera(2009) have studied Mexico, and found 9% rate threshold, Chowdhury and Ham(2009) have studied Indonesia, and found 8.5-11% rate threshold, Phiri(2010) has studied South Africa by using quarterly data, during from February 2000-july 2010, and found 8% rate threshold, Frimpong and Oteng-Abayie(2010) have studied Ghana by using 1960-2008 data, and found 11% rate threshold , ie, at 11% rate and above inflation would adversely affect economic growth . In addition to these, countries targeted inflation rate is found much lower than country level and cross -countries level threshold studies findings. Recent cross-countries studies (2001-present) suggest inflation rates between 8 and 17 percent whereas country level studies suggest slightly lower thresholds ranging from 6 to 15 percent(Anuwar and Isiam, 2011: 9-10).

Furthermore, Latin American countries in 1980s and early 1990s experienced hyperinflation due to debt crisis, and this created macroeconomic instability, highly deteriorated welfare of poors , higher unemployment, aggravated poverty and inequality, political transition, impediment for economic growth and prosperity(Bittencourt, 2010: 16-18).

Ethiopia’s debating position

From above countries experiences, we have seen that different relationships among inflation and economic growth. Recently, most researchers agreed on under some limit threshold rate of inflation both inflation and economic growth has positive relationship whereas beyond this threshold they are negatively related.

However, in case of our country, Ethiopia, the current inflation rate and the economic growth relationship is like above a controversial issue. Because, scholars are arguing differently. Let us see these arguments as follows. For example, Teshome(2011), from descriptive analysis, both inflation and economic growth are increased from 2004 to 2010, then, the author conclude that both inflation and economic growth related positively ,ie, between 2004 to 2010 inflation facilitated economic growth through high spending on consumption. In addition, according to the author, the sources of inflation during this period justified as demand pull-inflation that means aggregate demand was highly increased from 7 billion gap (2004) to 181 billion gap(2008). During this period, the aggregate demand (AD) and aggregate supply gap was 19.7% , which is the highest and this gap is coming at large. Hence, this demand gap is supplied by through foreign trade of import and this high demand of foreign product aggravated the currency devaluations so that domestic prices are forced to be shooting up .

On other hand, there are some groups which did not believe on the above argument ( Teshome, 2011). One of such group is IMF team that prepared country report about Ethiopia’s recent inflation problem. According to this group report (country report No.08/259, July 2008), Ethiopia’s economic growth did not have as such a significant role for the incidence of escalation of the inflation. But, the causes, according to their believe, are generally internal and external factors. The internal factor are: the role of large money supply growth starting from 2005( unlimited domestic public credit increase), the supply shock(due erratic rainfall problem), excess demand increased(donors shifted from food aid to cash aid so that this affected the domestic market), the devaluation of domestic currency, volume of import increased, the influences of expectation of inflation and export price influences(due to some agricultural price increased in international markets this has played a significant role in driving up domestic prices). The external factors as they mentioned are : world nonfood items price increment , especially, petroleum oil price rise up has attributed some limited effect. Whereas the contribution of economic growth for the escalation of current inflation is not that much significant ( Honda,Zhan andThomas, 2008).

According to Yonas and Soderbon(2011) on the effect of a large food price shock study report, they have mentioned the driving forces of Ethiopia’s inflation are such as : excess aggregate demand, increase in international commodity prices including oil, structural change and continued good economic performance, increase supply of money and injection of cash in to rural economy, increase local purchase by government food security institution, agricultural cooperatives, and relief agencies, and agricultural supply shock.

According Desta(–) research finding report, from multiple regression analysis, the main determinants of inflation was not found economic growth but import, domestic currency depreciation, declined domestic interest rate and broad money supply are the main drivers.

According to Geda and Tafere(2008) research finding report, the sources of Ethiopia’s inflation, in short run, have found as : wages, international prices, exchange rate and inflation expectation but not economic growth.

Reviewing Ethiopia’s general existing situation

Some pieces facts/indicators

positive side indicators/facts

economic development as one indicator

In the last seven years (2003/04 to 2009/10), Ethiopia’s annual economic growth was 11 % and GDP per capita growth was also 8%. In these year period the highest economic growth was 12.6%(2004/05) and the lowest economic growth was in 9.9%(2008/09). The reason for these highest and lowest achievement are agriculture and service sector contribution was better and in agriculture the weather condition was not favorable(for the lowest case) respectively(MoFED, 2010 : 5). Detail data are presented on table-1 below.

Table- 1 Macroeconomic indicators

Sector/indicator

(%)

2003/04

2004/05

2005/06

2006/07

2007/08

2008/09

2009/10

Average

(2004/05-09/10)

GDP growth

11.7

12.6

11.5

11.8

11.2

9.9

10.1

11.0

agriculture and allied activities

16.9

13.5

10.9

9.4

7.5

6.4

6.0

10.1

industry

11.6

9.4

10.2

9.5

10

9.9

10.2

10.1

service

6.3

12.8

3.3

15.3

16

14

14.5

13.2

GDP per capita growth

10.7

9

7.9

7.8

7.1

6.0

8.3

8.1

Source : Ethiopia: 2010 MDGs report by MoFED, September 2010, Addis Abeba, Ethiopa

Poverty as the second indicator

In the last 15 years period(1994/95 to 2009/10), the size of poverty or people living below poverty line has reduced from 49.5%(1994/95) to 29%(2009/10). In addition to this , the trends inequality or Gini coefficient indication was improved from 0.29(1995/96) to 0.304(2004/05) at national level and also improved for urban and rural positions from 0.34(1995/96) and 0.27(1995/96) to 0.44(2004/05) and 0.26(2004/05) respectively(MoFED, 2010: 6). Details are presented in table-2 below.

year

Poverty head count ratio, Po(%)

Trends of inequality(Gini coeffifient)

Total

Rural

Urban

1994/95

49.5

1995/96

0.29

0.27

0.34

1999/00

0.28

0.26

0.38

2000/01

42.8

2001/02

43.1

2002/03

44.2

2003/04

43.9

2004/05

38.0

0.304

0.26

0.44

2005/06

36.6

2006/07

34.6

2007/08

32.7

2008/09

30.6

2009/10

29.0

Source : Ethiopia: 2010 MDGs report by MoFED, September 2010, Addis Abeba, Ethiopa

Human development index as the third indicator/fact

In the last 12 years period (2000 to 2011), HDI is increased from 0.274(2000) to 0.363(2011). That is, life expectancy in the last 31 years period(1980-2011) is increased by 35% or from 43.9 age(1980) to 59.3 age(2011), GNI per capita(ppp us dollar) is increased from 539(1985) to 971(2011)(MoFED, 2010/11 : 9). Details are presented in table-3 below.

year

Life expectancy at birth

Expected years of schooling

GNI per capita (ppp us dollar)

HDI

1980

43.9

2.5

–

–

1985

44.4

3.0

539

–

1990

47.0

3.1

588

–

1995

49.2

2.6

522

–

2000

51.4

4.4

567

0.274

2005

53.8

6.7

683

0.313

2010

56.1

8.3

992

0.358

2011

59.3

8.5

971

0.363

Source : MoFED 2010/11 annual report

Negative side indicators/ black spots

Welfare problem as negative fact

As we have seen above, the other countries experiences, inflation is hurting all rural and urban household but the level of hurt is different in area location, ie, urban households and especially the poor households are the most victims of inflation. Our country, Ethiopia, such experience has started from 2004, then, the realities could not be out of the other countries experienced realities. By 2010, to understand such impact of inflation in some urban areas such as Addis Abeba, Dessie, Awassa and Mekelle research was carried by some group. Then, by this research it is found that urban households, especially, those with low level of assets have been particularly adversely affected and deteriorated their way of living by the food price inflation ( Alem and Soderbom, 2010: 22-23).

Another research study by Headey, et.al (2012) findings report indicates that urban poor person’s food CPI trend from 2001-2011, in eleven year periods, is much higher (at least 40% higher) than the nominal wage index so that urban poor consumption is deteriorated at least by 40% or more(Headey et al, 2012:9).

From international food policy research institute (IFPRI) research finding February 2009 report, due to food price inflation in Ethiopia annual household welfare loss in birr and calorie intake deterioration amount is estimated. That is, annual loss amount(in birr) from different food items is such as : from cereals for urban(birr 616.4) and for rural(birr 764.2), from pulses and legumes for urban(birr 95.7) and for rural(birr 102.1), from meat for urban(birr 214.5) and for rural(birr 161.3), from sugar and honey for urban(birr 66.9) and for urban(birr 36.1), from vegetables for urban(birr 109.7) and for rural (birr 74.00). Further, annual calorie intake is decreased in all regions such as : A.A rural(-15.7%) and urban (-12.3%), Afar rural(-24.8%) and urban(-12.5%), Amhara rural(-18.8%) and urban(-12.1%), B.Gumuz rural(-14.8%) and urban(-8.4%), D.D rural(-22.1%) and urban(-12.9%), Gambella rural(-15.6%) and urban(-11.4%), Harari rural(-14.9%) and urban(-10.9%), Oromia(-13.5%) and urban(-11.8%), SNNPR rural(-6.9%) and urban(-9.8%) , Somale rural(-15.0%) and urban(-11.8%) and Tigray rural(-24.1%) and urban(-16.1%). From all rural areas Afar region (by 24.8%) and from all urban areas Tigray region (by 16.1%) affected higher than the other regions (Ulimwengu, Workneh and Paulos, 2009: 13-15).

Other research finding also indicates that the recent inflation in Ethiopia affected the urban household in such a way that cost of living is increased at least by 8-12 % , income inequality gap much widened and household consumption pattern (substituting teff by wheat) is increased(Jeni and Josef, 2007: 41).

However, national aggregate wealth is in increasing very well. Some rich people are building sky towers while 29%(2009/10) poor citizens are living in absolute poverty in our country. That is, income distribution in our country is quite unfair. This is undeniable fact. Policies are most likely in favor of riches. Unless somebody accumulates or save some amount of money on his own hands it is impossible to get land for investing home. The policy discourages the poor not be the owner of home. Urban land tenure systems together with its hung-over corruption standing in favor of riches but not for poor. On the hands of the riches, there is an excess money which is collected through in favor of the country polices that aggravating inflation through different meanness (speculative hoardings) in addition to the unbalanced situation.

Hence, in our country, Ethiopia, there is surely economic growth together with its inflation but the benefit is most likely on the hands of the few riches and a little drop rages may spillover or trickle down to the mass of the population. From, the international experiences, according to Kuznets’s theory, the higher gap income distribution among the riches and the poor is the behavior of the early economic growth but this notion is today highly criticized, even in United States and Europe, liberal economic system promoters.

Challenges

From different sectoral development issues, different writers identify different challenges. Some of them are included as follows. According to African development bank group report(2011), Ethiopia developmental challenges are : Macroeconomic fragility in the context of high growth( due weather shock and inflation, vulnerability and poverty are aggravating), low agricultural productivity(both labor and land), and weak institutional capacity(particularly lower level of government)(ADBG, 2011: 10-9).

Another writer (Teshome, 2011: 9) identified some challenges of ethiopian economic growth are : the lower agricultural productivity, slow sectoral transformation, higher consumption spending, high inflation expectation, high foreign trade imbalance, market imperfection, low tax collection capacity, supply side constraint and external shocks. Another writer, Schafer et al(2007), includes poverty, vulnerability and unemployment as critical challenges for the country. Tewfik(2010: 25) also raises the issue of public capacity as the critical problem. That is, in over all the country technical know-how, financial and material resources and technical facilities are in short supply.

In addition to these, from our observations, there are other challenges that need to include are: corruption and inefficiency of good governance, incomplete, non enforceable and rigid institutions, political ambition (the ruling party and its opponents), inequality democratization process and speculative pressures can be mentioned.

Future prospects

The most important potential factors that are essential for economic growth for a given country are: natural resources, capital, labor, entrepreneurship/technology(—–). But, out of all these determinant elements of production, capital, especially human capital is the engine of the economic growth. Because, human mind is the major actor that has a potential in steering economic growth. That is, either to exploit the natural resources, to invent technology or to manage the capital and labor, knowledge or human capital is crucial element. However, we cannot deny others factors of production significant role in production. Output can be generated only through all these factors of production in integrated and cumulated effects, ie, they are none- separable elements for productions.

Hence, having this fact in mind, we can evaluate our current position and imagine the future. In our country, Ethiopia, human capital development is not that much qualified. That is, its technical capacity is still weak. But, the initiation to improve the quality seems a good and promising. This can be attached with the expansion of post graduate studies, giving attention and strengthening research centers in different disciplines. Government interest and its effort in such lines seems a growing opportunity and can be taken as strong interaction.

Moreover, other opportunities such as economic development pubic interest and driving policies and strategies, at macro level, are other including strong positions. And practical efforts in agriculture, education, health and infrastructures sectors could not be ignored. The investment to raise the existing low capacity of electric power generation, a great bottle neck problem in industry sector development, can create a good opportunity for fostering economic growth. Another important issue is our country international acceptances in increasing so that it is a good opportunity.

Hence, by now, it is possible to recognize that there is a little luminous candle flashing few radius, then, if other disturbances remained constant, the bright future can be imagined.

Conclusion

Summary

From theoretical view or different researchers recent findings, inflation and economic growth has both relationships, positive and negative. There is a limiting point for their relationship. That is, beyond a threshold, inflation affect or harm the economic growth and below the threshold most of the scholars agree in that inflation facilitate economic growth. The size of this threshold is different for different countries and estimated by researchers between 2.5% and 40% . For example, Ghosh and Philips(1998) estimated 2.5% threshold rate(for developed economies) while Burno and Easterely (1998) estimated 40% threshold rate that doesn’t affect economic growth in developing countries.

Our country position cannot be far from these international experiences. There economic growth and inflation. But, from different researchers argument the current economic growth is aggravating inflation so that this may hurt the economic growth soon later. Because, most of individuals income is not in increasing so that inflation is deteriorating saving and this can affect investments.

Hence, to reconcile this situation, macroeconomic policy (mone