Analyzing relationship between inflation rate and per capita GDP growth

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Student number: 0903642

Program: Financial and Economic Sector Policies

Course title: International Macroeconomics and Policy

Assignment title: Analyzing relationship between inflation rate and per capita GDP growth

INTRODUCTION

There have been different theories for explaining crucial relationship between inflation and per capita GDP growth. In this paper we will consider the neoclassical model and wage equation. This approach is very useful in terms of flexibility to understand underlying assumptions behind the theory. Along with this, this model does include the adjustments in real wages, which is very important while determining relationship between unemployment, inflation and growth. To prove that this theory holds in practice we will examine a country based example. For this purpose we will analyze some macroeconomic data of Azerbaijan and try to link them to see how the theory works in reality.

In the first part we will have a look at some theoretical issues and describe the relationship between inflation and unemployment, and then inflation and per capita GDP growth. The second part deals with economic processes that have been happening in Azerbaijan during last few years. Obviously, to understand the essence of macroeconomic statistics and some correlations and deviations from theory it is very important to know some key facts about economy. And finally, in the third part, we will look through some statistics and figures and try to observe theoretical issues in practice.

NEOCLASSICAL WAGE EQUATION, PHILIPS CURVE AND OKUN'S LAW

The following equation is called neoclassical wage equation:

(1)

Where, left hand indicates wage inflation, and right hand holds two variables: expected price inflation and difference between natural and actual unemployment rates. If we consider expected price inflation constant (because, it is usually hard to measure), from this equation, we can see that wage inflation is negatively related to unemployment _(Farmer, 2002)._ We will come back to this issue when we start analyzing data from Azerbaijan. This idea is the basic assumption behind Philips curve, which implies negative relationship between inflation and unemployment.

Now, let's have a look at other law, called Okun's law. According to this law, deviations between potential and actual GDP are proportional to difference between natural and actual unemployment (Gartner, 2003):

Y*-Y= A (U*-U) (2)

So, Philips curve shows negative relationship between inflation and unemployment and Okun's law describes relationship between unemployment and GDP. Thus, if we consider equations (1) and (2) together, we can see a correlation between GDP growth and inflation rate, i.e., both inflation and GDP growth is negatively correlated to unemployment. So, there is a positive relationship between inflation and GDP growth.

For now, it is enough with theoretical part. Now, let's see what is going on in practice.

AZERBAIJAN: KEY FACTS ABOUT GROWING ECONOMY

Due to huge oil revenues, country's GDP growth rate was enormous in last few years. Azerbaijan held 1st place in the world economy for its GDP growth rate from 2006 to 2009. In 2007 GDP growth rate was 34.50%. Baku-Tbilisi-Ceyhan pipeline that started operational phase in 2006 is expected to bring the country $160 billion during next 30 years.

Huge revenues brought about implementation of huge projects in Azerbaijan. This in turn resulted in more governmental spending and thus more aggregate demand. The latest factor pushed pressure on inflation rate. Therefore, inflation was upward in Azerbaijan parallel to increasing oil revenues. Along with this, governmental program aimed to development of non-oil sector is being implemented successfully. New plants and factories have been built during last decade to decrease economy's dependence on oil. As a result, unemployment rate is downward slopping.

Country's currency was re-denominated in 2006. This was very...
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