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Does Inflation Really Lower Growth? Does Inflation Really Lower Growth? MICHAEL BRUNO of the last bastions of very high inflation 20-25 percent. But growth rates decline more IN THE 1950s and 1960s, in Latin America, has recently joined the steeply as inflation rates approach 25-30 per- region's other successful stabilizers (Bolivia, cent, and growth rates become increasingly the growth costs of Chile, Mexico, and, more recently, Argentina negative at higher rates of inflation. inflation were not consid- and Peru); even in Eastern and Central The picture changes when we look at differ- Europe, the number of countries stabilizing ent subperiods. During 1960-72, per capita nI ered a serious issue. The from the post-collapse, hyperinflation explo- growth on average increased as inflation rose surge in inflation in the 1970s sion is gradually increasing. from negative or low rates to the 15-20 per- Why is it that the prevailing view in the cent range, suggesting that, at inflation rates and 1980s changed views on this 1950s and 1960s, that the growth costs of below 20 percent, inflation and growth may issue radically. Large growth inflation are not serious and, indeed, that some even have been positively related (Chart 2). costs surface only at higher rates inflation is good for growth, has today been In the 1950s and 1960s, low-to-moderate infla- discarded? It could be simply that after two tion went hand in hand with very rapid of inflation, but the upward bias decades of rampant and often persistent infla- growth because of investment demand pres- of inflationary persistence tion and growth crises, and the painful lessons sures in an expanding economy. (There were, of stabilization, we are much wiser than however, few cases of inflation in excess of 25 argues for keeping the inflation before. Or, it may be that the growth costs of percent per annum.) In contrast, the 1970s and genie tightly in the bottle. inflation and the importance of keeping it in 1980s were marked by supply shocks. check only become significant beyond a cer- Inflation and growth were negatively related tain inflation threshold. If so, it may be that during the 1973-92 subperiod, at least in part the underlying mechanism for low inflation because supply shocks affected both variables The last quarter of this century has witnessed is inherently different from that for much simultaneously. But for higher inflation fre- a prolonged and rather unique spurt of world- higher inflation. quencies, causality also ran from inflation to wide inflation amid lower growth. After a tur- Why worry about low or moderate inflation lower growth. bulent two decades, this period now seems to if the growth costs seem to be less pronounced A striking picture emerges when we look at be coming to an end. Very low inflation is at those rates? The answer lies in the dynam- the transition from the 1970s into the 1980s again becoming the norm, not only in the ics of inflation itself. If not held in check, (Chart 3). The industrial countries that had industrial world but also in developing a little inflation can lead to higher inflation, maximum inflation rates below the 20 percent regions that had long been plagued by chronic and eventually also to the inevitable costs of range during the 1970s all stayed below that inflation rates of three digits and more. In the low growth. level during the 1980s. In contrast, those coun- industrial countries, growth seems to have tries with inflation rates in the 20-40 percent permanently dropped. However, in some Studying the evidence range during the 1970s experienced higher developing countries that suffered from very A recent World Bank study of inflation and inflation in the 1980s, although they still did high inflation, the reform process may be growth in 127 countries, from 1960 to 1992 not go into extreme inflation. The 40 percent yielding post-crisis growth rates that are shows a close association between rising infla- inflation rate appears to be a threshold: those higher than before the crisis. tion and diminishing growth rates across a countries that crossed it in the 1970s were The transition from high inflation to rela- variety of inflation ranges (see Chart 1). Over almost certainly on their way to extreme infla- tive price stability, while not yet universal, has this period, average growth rates seem to fall tion rates in the 1980s. This experience sug- been widespread and dramatic. Brazil, one only slightly as inflation rates move up to gests that relatively low-to-moderate inflation Michael Bruno, an Israeli national, is Vice President, Development Economics, and Chief Economist of the World Bank. Finance & Development / September 1995 35 ©International Monetary Fund. Not for Redistribution Chart 1 Chart 2 Inflation and per capita growth, 1960-921 Inflation and per capita growth, 1960-722 Source: Michael Bruno and William Easterly, "Inflation Crises and Long-Run Growth," unpublished, World Bank, 1995. 1 Inflation and growth rates for a sample of 127 countries over the period 1960-92. For example, inflation rates of 5-10 percent are associated with growth rates of just over 2 percent. 2 Inflation and growth rates for a sample of 127 countries over the period 1960-72. (20-40 percent) may not lead to immediate average for the period and below the country's the sub-period 1950-65, all of these countries growth reductions, but it is very likely to lead growth prior to the outbreak of the crisis. The had an average per capita growth rate that to much higher inflation. The truly dangerous magnitudes of the growth depressions during was higher than any of a comparator group of inflations occur at 40 percent and above. the crisis were large. In some countries with 26 countries that did not have serious inflation Does high inflation cause low growth, or repeated inflation crises, like Brazil, Somalia, after World War II. low growth cause high inflation—or is most and Zaire, the growth crises matched the infla- Finally, the dramatic output collapse in of what we observe due to other factors (bud- tion crises exactly. By contrast, when all infla- Eastern Europe and the Baltic countries, get deficits, debt rescheduling, and supply tion crises (above 40 percent) were excluded Russia, and the other countries of the former shocks) that affect inflation and growth simul- from the international data set, there was no Soviet Union (BRO) has occurred simultane- taneously? One relevant bit of evidence is that evidence of a growth-inflation relationship. ously with high rates of inflation in many there is a significant effect from past inflation The study found surprising uniformity in countries. There is a correlation between the to current growth but no evidence for a feed- the response of growth after the crisis for two. Output has been recovering mainly in back from past growth to current inflation. those countries that had brought inflation those economies that have stabilized inflation, Once the supply shocks of the 1970s set in, the down by the end of the 1980s. The post-crisis while output continues to drop in economies negative relationship between inflation and growth rate was also above the pre-crisis where inflation remains high. Also, the most growth was at least partly a simultaneous growth rate and above the world average in recent successful Latin American stabiliza- response to these shocks. But at higher rates most cases. This growth acceleration suggests tions, in Argentina and Peru, have been of inflation (certainly at those experienced by a strong return to trend after the collapse accompanied by vigorous and immediate out- many non-industrial countries in the 1980s), of output during the crisis; it could indicate put recoveries. the evidence is consistent with causality also a change for the better in long-run growth Both the various historical episodes and running from high inflation to low growth. after the crisis. the recent data on crisis and recovery sug- The experience of countries that suffered gest—though they are far from conclu- Inflation crises the great hyperinflations in the period after sive—that something more than reversion to The World Bank study examined what hap- World Wars I and II is also illustrative. All of trend could be occurring. A high-inflation cri- pened to per capita growth (compared with the European countries that experienced sis may shock policymakers into instituting the world average) before, during, and after a hyperinflation in the 1920s (Austria, Germany, productivity-enhancing reforms that would high-inflation crisis. The threshold for defin- Hungary, Poland, and Russia) had higher- not have taken place if the country had just ing an inflation "crisis" was set at an annual than-average growth from the ends of their muddled along without severe crises. Inflation rate of consumer-price inflation of 40 percent inflation crises to 1938, the last year before may be but a barometer of a more general gal- or higher, prevailing for two consecutive years World War II broke out. Likewise, the recovery vanizing crisis. or more. The study found no uniform pattern from the post-World War II inflation crises is for countries' growth rates before the inflation extremely strong for the affected countries, Roots of high inflation crisis—some were above average and some, which include the East Asian tigers Japan, High inflation is always associated with below average. That is, there is no evidence Korea, and Taiwan Province of China), the large fiscal deficits. Detailed country compar- that countries that have inflation crises are fastest-growing industrial countries (Greece isons show that in all cases of inflation crisis, those that have subnormal growth before- and Italy), and three of the fastest-growing countries had large fiscal deficits before the hand.
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