MAY/ J U N E 1 9 9 6 Michael Bruno is vice president and chief economist and William Easterly is a principal economist at the World Bank. We are grateful for com- ments from participants in the 20th Annual Policy Conference at the Federal Reserve Bank of St. Louis, in particular our discussants Kenneth D. West and Jon Faust. Correspondence may be addressed to either author at World Bank, 1818 H Street, NW, Washington, DC 20433; (202) 473-8965; fax:(202) 522-3518. Inflation and ingless; and the process of wealth-getting degenerates into a gamble and a lottery.”1 Growth: The emphasis on information and the fi- nancial system has returned to the litera- In Search of ture today.2 But inflation and growth rela- tionships have looked very different over a Stable time. We take snapshots of the literature in the 1960s and then in the 1980s. Relationship The View from the 1960s Michael Bruno and In the high-growth, low-inflation William Easterly 1960s, the traditional view that inflation was destructive no longer seemed so com- re inflation and growth inversely as- pelling. It was the Golden Age of the sociated, directly associated, or not Phillips Curve, in which inflation and A associated? Is the empirical inflation- growth were positively related in the short growth relationship primarily a long-run run. Even in the long run, Tobin and relationship across countries, a short- Sidrausky suggested a positive effect on run relationship across time, or both? Like growth from higher inflation. When infla- a bickering couple, inflation and growth tion was high, wealth would be reallocated just cannot seem to decide what their rela- away from money and into physical capital. tionship should be. Similarly, some development theories In this article, we characterize the lit- suggested that inflation was as good a way erature on inflation and growth. Aware of as any to mobilize resources for capital the limits of our comparative advantage, accumulation. There was little in the early we do not intend to do a general survey of experience of developing countries to con- the literature. Instead, we look at the tradict this view. Israel’s economy, for aspects of the literature that motivated us example, grew at around 10 percent per to pursue one particular angle in our own annum between 1948 and 1973, with an recent work: the behavior of growth inflation rate of around 6 percent to 7 per- before, during, and after discrete high cent per annum. Both of these figures were inflation crises. double the Organization for Economic Cooperation and Development (OECD) numbers for the same period. The higher, INFLATION AND GROWTH: largely anticipated inflation was a price A TOUR ACROSS THE considered well worth paying, especially as DECADES widespread indexation of wages, exchange Observers of extreme inflation have rates, and savings minimized the never had much doubt that inflation was distortionary costs of inflation. Israel was bad for the economy. Keynes, as usual, no exception—several growing economies gave the most eloquent statement, “As the in Latin America and Asia seemed to be inflation proceeds and the real value of the following the same strategy. currency fluctuates wildly from month to The early empirical studies of inflation 1 Keynes (1920), p. 220. month, all permanent relations between and economic development were as am- 2 See, for example, Ball and debtors and creditors, which form the ulti- biguous as the theory set forth in the pre- Cecchetti (1990), Tommasi mate foundation of capitalism, become so ceding paragraph. Harry G. Johnson in (1994), and De Gregorio and utterly disordered as to be almost mean- 1967 suggested that there was no conclu- Sturzenegger (1994). F E D E R A L R E S E RV E B A N K O F ST. L O U I S MAY/ J U N E 1 9 9 6 Figure 1 inflation rates greater than 20 percent, esti- mated relationships were sensitive to Inflation and Per Capita which observations were included—a Growth (1960–72*) problem that recurred in the 1980s. Per Capita Growth Rate (Percent) In sum, the view from the 1960s on inflation and growth was surprisingly ambiguous. Theory presumed that the short-run relationship was definitely posi- tive, whereas the long-run relationship could go either way. Empirical studies usu- ally found nothing. The View from the 1980s Because research on growth went into % hibernation in the 1970s, we jump next to the 1980s and new waves of research. The 1970s and 1980s had provided a Inflation Range % 0-5 5-10 10-20 20-40 40+ new set of extreme inflation experiences, Number of Observations 415 194 88 29 19 which were investigated by an interesting case study literature after the 1980s. 6 This literature’s treatment of output behavior sive evidence one way or the other. The usually focused on the short-run output International Monetary Fund (IMF) was costs of stabilization of high inflations. certainly no hotbed of inflationists, but The consensus was that stabilization of hy- studies in the IMF Staff Papers around that perinflation had little or no output costs, time could detect no relationship between whereas stabilization of mere high infla- growth and inflation.3 Latin America had tions was indeed costly. double-digit inflation rates in the 1950s Thus the presumption remained in the and 1960s, but economic growth was re- 1980s that there was a positive short-run spectable.4 Brazil was often cited as a high- relationship between growth and inflation. inflation, high-growth counterexample to This presumption in case studies of high the antiquated notion that inflation was inflation in developing countries was prob- bad for the economy. ably inspired in part by the industrial One interesting exception to this lack country literature, which continued to of findings in the literature was Wallich’s confirm that stabilization of low inflation (1969) pooled time series, cross-section was costly. Ball (1993), to take one recent (43 countries) study, using two five-year example, calculated large sacrifice ratios averages over the period 1956-65. Typical for foregone growth in inflation stabiliza- 3 Wai (1959), Dorrance (1963 of the literature of the time, he had postu- tions in OECD countries. and 1966), and Bhatia lated a positive relationship between The case study literature pointed (1960). inflation and growth. But he found instead out that high inflation was inherently a significant negative relationship. unstable. Once inflation got above a 4 Pazos (1972). We can see why the 1950s and 1960s certain range, it was prone to sudden ac- 5 The figure is from Bruno and yielded ambiguous findings when we look celerations. Increased indexation of the Easterly (1995). at the data for that period. Figure 1 shows economy weakened the nominal anchor 6 See, for example, Bruno et al. that the per capita growth rate actually that tied down the price level. Countries (1991); Dornbusch, rose as one went from single- to double- cannot tolerate such high and unstable 5 Sturzenegger, and Wolf digit inflation. Only when the annual inflations, so they pursue stabilization (1990); Kiguel and Liviatan inflation rate exceeded 20 percent did the fairly quickly after such inflations de- (1988, 1992a and b); and relationship seem to turn negative. Since velop. Hence high inflation was not so Calvo and Vegh (1994). there were not many observations with much a steady-state phenomenon as a F E D E R A L R E S E RV E B A N K O F S T. L O U I S 140 MAY/ J U N E 1 9 9 6 discrete burst of inflation followed by literature were from pooled time-series, stabilization. cross-section samples using decade In contrast, case studies pointed out averages, five-year averages, or even that there was an intermediate range of annual data. moderate inflations around 15 percent to Cross-section inflation and growth 30 percent.7 These moderate inflations can equations just did not work. Levine and be sustained for long periods without dis- Renelt (1992) and Levine and Zervos aster—Colombia is the archetypal (1993) used Leamer’s extreme bounds example. analysis to study how inflation entered into Inflation was slow in attracting atten- cross-section growth regressions. Not only tion as a key policy variable in the new was inflation not robustly significant in growth literature. Barro and Sala-i-Martin’s Levine and Renelt (1992), it was not ever 1995 survey of the empirical growth litera- significant in their many combinations of ture discusses 10 right-hand-side variables variables in growth regressions. Levine and for a basic growth regression. Inflation is Zervos (1993) found that any cross-section not among them. They then mentioned relationship that did show up depended on 14 other possible right-hand-side variables. a couple of influential points—Nicaragua Inflation was not among them either. Infla- and Uganda. In tests we ran with our data tion is not mentioned anywhere in the set, we found the significance of the cross- Barro and Sala-i-Martin text except in one section relationship to depend entirely on of the end-of-chapter problem sets. Nicaragua. Nicaragua and Uganda, both of But inflation gradually attracted atten- which had discrete bursts of extreme infla- tion from new-growth theorists. Theorists tion during civil wars, do not form much of postulated mechanisms by which inflation a basis for anti-inflation counsels to, say, might affect growth adversely. Authors the Bank of Canada. such as Jones and Manuelli (1993) and De The cross-section relationship was not Gregorio (1993) pointed out that inflation working in part because it had a number was a tax on capital in models with cash- of high- inflation, high-growth outliers off- in-advance requirements for investment.