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1517 Public Disclosure Authorized POLICY RESEARCH WORKING PAPER 1517 Public Disclosure Authorized Inflation Crises After excluding countries with high-inflation crises - periods and Long-Run Growth when annual inflation is above 40 percent - the data reveal no evidence of a Public Disclosure Authorized Michael Bruno William Easterly consistentrelationship between growth and inflation, at any frequency. But growth does tend to fall sharply during discrete crises of high inflation and to recover surprisingly strongly after inflation falls. Perhaps inflation crisesare purely Public Disclosure Authorized cyclical, or perhaps in the long run they have a favorable purgative effect. The World Bank Office of the Vice President Public Disclosure Authorized Development Economics and Policy Research Department Macroeconomics and Growth Division September 1995 IPOLICY RESEARCH WORKING PAPER 1517 Summary findings Recent literature suggests that long-run averages of strongly after inflation falls. The fall in growth during a growth and inflation are only weakly correlated and that crisis and the recovery of growth after the crisis tend to such correlation is not robust to the exclusion of average out to nearly zero (even slightly above zero); observations of extreme inflation. Including time series hence no robust cross-section correlation. panel data has improved matters, but an aggregate Their findings could be consistent either with trend parametric approach remains inconclusive. stationarity of output (in which inflation crises are purely Bruno and Easterly propose a nonparametric definition cyclical phenomena) or with models in which crises have of high-inflation crises as "periods when annual inflation a favorable long-run purgative effect. is above 40 percent." Excluding countries with high- Their findings do not support the view that reducing inflation crises, they find no evidence of a consistent high inflation carries heavy output costs in the short to relationship between growth and inflation, at any medium run. frequency. They do find that growth falls sharply during discrete crises of high inflation, then recovers surprisingly This paper - a joint product of the Office of the Vice President, Development Economics, and the Macroeconomics and Growth Division, Policy Research Department - is part of a larger effort in the Bank to examine the determinants of economic growth. Copies of the paper are available free from the World Bank, 1818 H Street NW, Washington, DC 20433. Please contact Rebecca Martin, room Nll-059, telephone 202-473-9120, fax 202-522-3518, Internet address [email protected]. September 1995. (48 pages) The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about developmentissues. An objectiveof theseries is to get the findingsout quickly, evenif the presentationsare lessthan fully polished.The paperscarry the namesof the authorsand should be usedand cited accordingly.The findings, interpretations,and conclusionsare the authors' own and shouldnot be attributed to the World Bank, its ExecutiveBoard of Directors,or any of its membercountries. Produced by the Policy Research Dissemination Center INFLATION CRISES AND LONG-RUN GROWT]H Michael Bruno World Bank and NBER William Easterly World Bank 'We are gratefulfor commentsto M.K.Anyadike-Danes, Mark Baird, RobertBarro, Zeljko Bogetic, Philip Brock,Erwin Diewert,Allan Drazen,Theo Eicher,Stanley Fischer, Alan Gelb, RossLevine, Norman Loayza, Peter Montiel, Lant Pritchett, MichaelSarel, Klaus Schmidt-Hebbel, Luis Serven,Carlos Vegh, Jaume Ventura, Steven Webb, Holger Wolf,and to participants in seminarsat the NBER MonetaryEconomics Summer Institute, the World Bank,the Universityof Washington,the University of BritishColumbia, the Bankof Italy, the InteramericanDevelopment Bank, the LatinAmerican Conference on Economic Growthin Bogota,and the New Schoolof Economicsin Moscow.We are indebtedto Giuseppelarossi for researchassistance. The dataset for this papercan be downloadedon the Intemetat the web site: hItp://www. worldbank org/html/research/prdmg/grthweb/growth_rop.html Abstract Recent literature suggests that long-run averages of growth and inflation are only weakly correlated and such correlation is not robust to exclusion of extreme inflation observations; inclusion of time series panel data has improved matters but an aggregate parametric approach remains inconclusive. We propose a nonparametric definition of high inflation crises as periods when inflation is above 40 percent annual. Ercluding countries with high inflation crises, wefind no evidence of any consistent relationship between growth and inflation at any frequency. However, we find that growth falls sharply during discrete high inflation crises, then recovers surprisingly strongly after inflation falls. The fall in growth during crisis and recovery of growth after crisis tend to average out to close to zero (even slightly above zero), hence the lack of a robust cross-section correlation. Our findings could be consistent either with trend stationarity of output, in which inflation crises are purely cyclical phenomena, or with models in which crises have a favorable long-run purgative effect. Our findings do not support the view that reduction of high inflation carries heavy short-to-medium run output costs. Michael Bruno William Easterly Room N-6043 Room N- 11069 World Bank World Bank 1818HSt.NW 1818 H St. NW Washington DC 20433 Washington DC 20433 Email: MBruno@WorldBank Email: WEasterly(WorldBank.Org. Phone: (202) 473-3774 Phone: (202) 473-8965 Fax: (202) 522-1158 Fax: (202) 522-3518 L Introduction Is inflation harmful to growth? The ratio of fervent beliefs to tangible evidence seems unusually high on this topic, despite extensive previous research. In this paper, we address the simpler problem of the growth effects of high inflation crises. We propose a nonparametric definition of high inflation crises, and show unambiguous results for the growth outcome during an inflation crisis and for the surprisingly fast recovery afterward. Our approach is purely empirical, and even then we do not resolve the difficult causality issues. Our aim is to make progress on stylized facts that can be used for further theorizing. Our nonparamnetricapproach is simple - we will define a country as in a high inflation crisis when it is above some threshold level of inflation -- 40 percent is what we choose as explained later. We will then calculate how that country's growth performs before, during, and after its high inflation crisis. We will examine the robustness of the results to controlling for other factors. The advantage of this approach over the conventional estimation of a linear relationship between growth and inflation, both averaged over some period, is as follows: (1) The case study literature on inflation experiences suggests that countries can manage to live with moderate - around 15-30 percent -- inflation for long periods. Colombia is the classic example. But case studies make clear that no countries manage to keep stable or otherwise live with higher rates of inflation. Case studies suggest that high inflation is a different animal than low or moderate inflation. (2) Assuming a linear or log-linear functional form for inflation and growth is implausible - it is unlikely that the marginal effect of 100 additional percentage points of inflation is the same when one goes from 0 to 100 as it is when one goes from 1000 to 1100. Conventional tests of the inflation-growth relationship are jointly testing the hypothesis that inflation matters for growth with the hypothesis that an a priori implausible functional form holds between the two. Nor is it obvious what functional form should replace the implausible linear or log-linear form. The advantage of a nonparanetric form is that it is robust to any monotonic functional relationship between inflation and growth, as well as to threshold functions in which only high inflation matters. 2 (3) The distributionof inflationis skewed to the right, with a small number of extremepositive values. Estimatedrelationships between growth and inflationaverages depend on a small number of these extremneobservations, as previouslypointed out by Levine and Zervos 1993.This problem is even more severewhen one tries to addressthe issues in (1) and (2) by estimatingspline relationshipsbetween growth and inflation. Shiftsin the coefficienton inflationare even more sensitivethan the coefficientitself to the tiny number of observationsin the higher inflationranges over which the shifts are being calculated.The definitionof discreteepisodes of high inflationwith a non-parametricdefinition gives a more robust test of the averagegrowth associated with high inflationcompared to low inflation. (4) Cross-sectionaverages for growthand inflationdiscard the informationabout what happensto growth before and after the crisis. The case study literatureon high inflationsmake clear that they are discreteevents with well-deftnedbefore, during, and afters. Modelsranging from the neoclassicalmodel to endogenousgrowth modelsof cleansingrecessions would predict that growth will not be the same after a discreteepisode of high inflation,even if inflationreturns to its originallevel. A nonparametricdefinition of discretehigh inflationepisodes will allow us to addressthe before-and-afterissue. The rest of the paper proceedsas follows. Section11 discusses some of the previousliterature, the lack of robustnessof conventionalgrowth-inflation associations, and the choiceof
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