Historical and comparative studies have provided no clear empirical conclusions about the relationship between inflation and growth. Some have argued that price stability is a prerequisite for rapid and sustainable growth, whereas others have maintained that – especially in economies faced with supply bottlenecks and weak export markets – the pursuit of price stability will lead only to unemployment and, hence, slower growth. In Discussion Paper No. 1503, Thorvaldur Gylfason and Tryggvi Thor Herbertsson claim that more recent econometric evidence suggests an inverse relationship across countries, and they investigate the relationship further using a model of simultaneous determination and interaction of inflation and growth.

Allowing for money to enter into an optimal growth framework with increasing returns to scale, the authors examine different channels through which inflation can affect growth. These include reduced saving (via lower real interest rates), the income velocity of money, the government budget deficit (through the inflation tax and tax erosion), and productive efficiency (through the wedge between the returns to real and financial capital). The results suggest that inflation and growth are generally negatively correlated for reasonable values of the structural parameters in the model. Using panel data derived from both the Penn World Tables and the World Bank and covering 170 countries from 1960 to 1993, the authors test the growth equation derived from their model. They find that the adverse effect of inflation on growth was both significant and sizeable at all income levels, both across countries and over time, and that their results are statistically and economically robust.

Does Inflation Matter for Growth?
Thorvaldur Gylfason and Tryggvi Thor Herbertsson