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1、Copyright 2013 SciRes. ME Modern Economy, 2013, 4, 87-92 http:/dx.doi.org/10.4236/me.2013.42011 Published Online February 2013 (http:/www.scirp.org/journal/me) Testing the Link between Inflation and Economic Growth: Evidence from Asia Pradana M. Bandula Jayathileke1, Rathnayaka M. Kapila Tharanga Ra
2、thnayake2 1School of Management, Wuhan University of Technology, Wuhan, China 2School of Science, Wuhan University of Technology, Wuhan, China Email: , Received December 4, 2012; revised January 5, 2013; accepted February 6, 2013 ABSTRACT The link between inflation and economic growth is one of the
3、 most important controversies in the economic literature. This paper investigates the short-run and the long-run relationship between the economic growth and the inflation of three Asian courtiers over the period 1980-2010. The methodology used in the study is cointegration and causality test. Johan
4、sens cointegration test and bound test approach were performed on the variables which have been tested for the stationary property using Augmented Dickey-Fuller and Phillips and Perron tests in order to examine the cointegration between the economic growth and the inflation. Vector error correction
5、and Granger Causality test were further per- formed to discover the short run dynamics of the relationship between the variables and identify the direction of causal- ity. The results reveal that there is a long run negative and significant relationship between the economic growth and inflation in S
6、ri Lanka. Whereas no statistically significant relationships were found between the variables in China and in India, a negative and significant short run relationship was found for China. The causality results reveal that there is a unidirectional causality that runs from the economic growth to the
7、inflation in China. The paper discusses the important policy implications of the results. Keywords: Inflation; Economic Growth; Cointegration; Causality 1. Introduction The relationship between inflation and economic growth is one of the most important economic controversies among the economists, po
8、licymakers and monetary au- thorities in the last few decades. In particular, the core of argument is that whether inflation is necessarily for eco- nomic growth or it is harmful to economic growth. Al- though the relationship between inflation and economic growth has been widely examined and invest
9、igated over the years the relationship is being debated in economic literature. The empirical and theoretical evidences pro- vide basically three types of relationship between the inflation and the economic growth, positive, negative and none. Early of the twentieth century, where the Keynes- ian po
10、licies predominated, inflation was not regarded as a problem and considered it has a positive effect on the economic growth. Phillips Curve has taken more atten- tion in the same period and hypothesizes that high infla- tion positively affects the economic growth by creating of a low unemployment ra
11、te. Subsequently, a series of studies found no conclusive empirical evidence for either a positive or a negative association between inflation and economic growth 1,2. The studies which based argu- ments on the real business cycle theories and based on cross countries have later demonstrated that th
12、ere is a negative correlation between inflation and growth in the long run due to the influence of the former on reducing investment and productivity growth. Nevertheless, a re- cent study of Reference 3 analyzes the inflation-growth dynamics in four South Asian countries finds a signifi- cant posit
13、ive relation between two variables in the long run. These divergent results confirm that there is a debate yet on the relationship between inflation and economic growth in the literature. This controversial condition en- courages for further studies in examining the dynamics of the relationship betw
14、een inflation and economic growth. On the other hand, it is the general consensus that the developing countries are more susceptible to supply shocks causing high variability in inflation and disturb the consumption, investment and production behavior. Moreover, more government interventions in fina
15、ncial and goods markets and macro economics behavior cause economic instability and market failure. Therefore, prices do not give correct signals about the policies and the course of actions of the economy agents in the most of developing countries. In this context, the examination of inflation-grow
16、th relationship with respect to developing Copyright 2013 SciRes. ME 88 P. M. B. JAYATHILEKE, R. M. K. T. RATHNAYAKE countries is imperative. Thus, this paper seeks to exa- mine the relationship between the inflation and the eco- nomic growth in three developing countries in Asia; China, India and S
17、ri Lanka. The rest of this paper is organized as follows. The next section reviews the literature with relevant empirical studies. Section three describes the methodology used in the study. Next two sections are devoted to present and discuss the results of the present study in order to con- clude t
18、he paper. 2. Literature Review The existence and nature of the link between inflation and economic growth have extensively been investigated in the economic literature. Some economic theories ex- plain that inflation is conducive to economic growth and there is a positive relationship between inflat
19、ion and economic growth 1. Keynesian Model explains that there is a short run tradeoff between output and the change of inflation, but no permanent trade-off between output and inflation. The concept of Phillips Curve also hypotheses that high inflation is positively affected eco- nomic growth by co
20、ntributing creation of a low unem- ployment rate. The Tobin Effect suggests the inflation causes individuals to substitute out of money into interest earning assets, which leads to greater capital increasing and promotes economic growth. In effect, inflation ex- hibits a positive relationship to eco
21、nomic growth 4. However, the validity of the positive relationship was questioned in the 1970s. During the period, numerous studies have been devoted to finding of effect of inflation on economic growth since the economies around the world have experienced hyper-inflation and massive un- employment.
22、 Those studies showed that sustained high rates of the inflation can have an adverse consequence on real economic growth even in the long run and repeatedly confirm that inflation has a considerable negative effect on economic growth, at least at sufficiently high level of inflation 5-7. Reference 8
23、, among others, helped to shift the conventional empirical wisdom about the effects of inflation on economic growth from a positive one to a negative one. 2.1. Relationship between Inflation and Economic Growth: Empirical Studies Examination of the inflation-growth relationship has been a major issu
24、e in economic research. Earlier works on that fail to establish any meaningful relationship be- tween inflation and economic growth 9,10. Later on, a number of studies have attempted to identify the dynamic of relationship between inflation and economic growth. Reference 9 shows that inflation has n
25、o impact on eco- nomic growth except the situation where the inflation rate is over 40% that has negative impact on economic growth. Similarly, Reference 10 found no evidence to establish any meaningful relationship between inflation and economic growth by studying 70 countries for a pe- riod of 196
26、0-1989. However, some studies found that inflation has a negative and significant impact on real economic growth 5,6,9. The studies based on cross country data show the evidence that long term growth is adversely affected by inflation 6,11,12. Reference 13 reports that countries which experienced hi
27、gh inflation rates have also witnessed lower long term growth. The studies based on multi country panel data show that the rate of inflation has an adverse impact on investment that creates macroeconomics stability and growth 14. Ref- erence 6 examines the role of macroeconomics factors in growth an
28、d finds that growth is negatively associated with inflation and positively associated with good fiscal performance and undistorted foreign exchange markets. Fischer further suggests that, since there are no good arguments for very high rate of inflation, a government that is producing high inflation
29、 is a government that has lost control. The inflation rate thus serves as an indicator of macroeconomics stability and the overall ability of the government to manage the economy. Reference 5 vali- dates the positive relationship between inflation and economic growth using a large sample in relation
30、 to more than 100 countries for 1960-1999. His finding shows that even though for adverse influence of inflation on growth appeared small, the long term effects on standard of liv- ing are really sizeable. Reference 13 finds a significant negative relationship between inflation and growth by studyin
31、g 12 Latin American countries. He shows that both inflation and its variance have negative effects on growth, since they are highly correlated in cross country evidence. Reference 15 shows the evidence that the cross sectional correla- tion between inflation and growth depends on severe inflation ob
32、servations with high frequency data. Refer- ence 9,16 found support for the view that the negative relationship emerge only when rates of inflation exceed some threshold. Reference 15,17 also questioned whe- ther a uniformly negative relationship exists between inflation and real activities independ
33、ently of the previous rate of inflation. Paul et al. (1997) examined a multi country empirical investigation of the patterns between inflation and growth in a sample of 70 industrial econo- mies and developing countries. They conclude that the relationship between inflation and growth is non-uniform
34、 across countries and a vast majority of countries show either uniform or bilateral causality over the selected period. A series of recent studies provide the evidences to support the argument that inflation has a negative effect on inflation. In fact, Reference 18 studied inflation and Copyright 20
35、13 SciRes. ME Country & Statistics GDP Growth (%) Inflation Rate (%) China Mean 10.02 5.61 td. Deviation 2.81 6.49 Mean 6.27 8.12 td. Deviation 2.18 3.23 Mean 4.90 11.42 td. Deviation 1.88 5.60 S India S P. M. B. JAYATHILEKE, R. M. K. T. RATHNAYAKE 89 growth relationship in Turkey over 20 years and
36、found a negative short term relationship between the variables. Similarly, Refernce 19 found a strong long term inverse relationship between CPI and GDP in Kuwait from the data covering 20 years. Reference 20 found a long term negative relationship between inflation and economic growth in Bangladesh
37、. Conversely, Reference 20 estab- lished divergent results, a long term positive relationship between inflation and economic growth, by studying the long term and short term dynamics of the relationship for four south Asian countries; Bangladesh, India, Pakistan and Sri Lanka. On the other hand, cro
38、ss country evidences show that countries which experienced higher growth are those with lower inflation rates and higher inflation has an ad- verse impact on long run economic growth. A study car- ried out by World Bank states that the high performing East Asian countries had a sustainable high econ
39、omic growth in the last three decades since a stable macro- economics environment that fostered high rates of in- vestment and economic growth 21. Some of studies argue that negative relationship between inflation and economic growth may be varied between opened and closed economies whereas the rela
40、tionship is expected to be stronger in opened economies which rely on foreign direct and domestic investment. 3. Methodology The study uses the annual time series data of real GDP growth rate and inflation rate of the three countries from 1980 to 2010. Since the study focuses the Asian region, three
41、 developing countries namely China, India and Sri Lanka were selected. China and India being the two big developing nations in the region have shown remarkable development in the recent years. Although Sri Lankan economy is too small compared to these two countries it has shown invariable growth in
42、the past years and is con- sidered as an emerging economy in the region. The data were obtained from the online publication base of the World Bank Indicators. The unit roots test is initially performed to find the stationary properties of the each time series. Augmented Dickey-Fuller Test (ADF) and
43、Philips and Perron (PP) unit root tests are used for that purpose 22,23. In the testing, if any variable does not show stationary at level then stationary property will be test on its first difference. If variables are stationary at their first difference long run association of the variable can be
44、tested by using multivariate cointegration tech- nique. This paper employs a testing procedure for coin- tegration projected by 24 which is known as bounds test approach to cointegration and Johansens cointegra- tion test. The most important advantage of this procedure is that this method does not d
45、epend on whether variables are stationary at I(0) or I(1). To test the long run rela- tionship F-test is used. If estimated F statistics comes above the upper level at integrated order one, which suggest a relationship between the variables. If F statis- tics comes at bottom level which signs for no
46、 long run relationship between the variables. If there is a case in which computed value of Statistics lies within the top and bottom, no conclusion can be made from the result. Vector error correction and Granger causality test are further employed and performed to investigate the short run dynamic
47、s of the relationship between inflation and economic growth. 4. Results and Discussion Table 1 shows the average inflation rate and real GDP growth rate for the period of 1980-2010. China, among others, has experienced an immense average economic growth while keeping average inflation below 10% in t
48、he period. The lowest average GDP growth was recorded in Sri Lanka which experienced the highest average infla- tion rate in the period. However, India was succeeded to keep modest economic growth rate while keeping aver- age inflation below 10% over the period. 4.1. Stationary Test ADF t-tests and
49、PP tests were performed on each of the time series to examine the stationary properties. The re- sults reproduced in Table 2. Although ADF test results shows that growth rate of China is stationary at its level I(0), PP test results does not support that and indicates that the growth rate of China is stationary at its first dif- ference I(1). However, both test results show that infla- tion rate of China is stationary at its first difference I(1). With respect to India, both test