Relationship Between Inflation and Economic Growth

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Inflation and Economic Growth in India –An Empirical Analysis

Prasanna V Salian1, Gopakumar. K2

Abstract This paper seeks to examine the relationship between inflation and GDP growth in India. An empirical evidence is obtained from the cointegration and error correction models using annual data collected from the Reserve Bank of India. The result shows that there is a long-run negative relationship between inflation and GDP growth rate in India. Inflation is harmful rather than helpful to growth. These results have important policy implications.

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Indian Economic Service , New Delhi Faculty, BIET-MBA Programme, Davangere, Karnataka.

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I. INTRODUCTION The relationship between inflation and growth remains a controversial one in both theory and empirical findings. Originating in the Latin American context in the 1950s, the issue has generated an enduring debate between structuralists and monetarists. The structuralists believe that inflation is essential for economic growth, whereas the monetarists see inflation as detrimental to economic progress. There are two aspects to this debate: (a) the nature of the relationship if one exists and (b) the direction of causality. Friedman (1973: 41) succinctly summarized the inconclusive nature of the relationship between inflation and economic growth as follows: ―historically, all possible combinations have occurred: inflation with and without development, no inflation with and without development‖.

The impact of inflation on growth, output and productivity has been one of the main issues examined in macroeconomics. Theoretical models in the money and growth literature analyze the impact of inflation on growth focusing on the effects of inflation on the steady state equilibrium of capital per capita and output (e.g., Orphanides and Solow, 1990). There are three possible results regarding the impact of inflation on output and growth: i) none; ii) positive; and iii) negative. Sidrauski (1967) established the first result, showing that money is neutral and superneutral1 in an optimal control framework considering real money balances (M/P) in the utility function. Tobin (1965), who assumed money as substitute to capital, established the positive impact of inflation on growth, his result being known as the Tobin effect. The negative impact of inflation on growth, also known as the anti-Tobin effect, is associated mainly with cash in advance models (e.g., Stockman, 1981) which consider money as complementary to capital. Following Friedman‘s (1977) Nobel Lecture the theoretical and empirical research on the relationship between inflation and output growth has progresses along two distinct lines. The first line of research starting with Friedman‘s hypothesis that higher nominal inflation raises inflation uncertainty, has tended to investigate the relationships among inflation, inflation uncertainty, growth and growth uncertainty. The second line of research has tended to remain within the traditional macroeconomics and investigate the relation between inflation and growth without reference to inflation uncertainty and growth uncertainty.

This study follows the second line and examines the nature of the relation between inflation and growth in the Indian economy. Within the second line of research two distinct camps, with 2

opposite predictions on the relation between inflation and growth, have distinguished themselves. Researchers of the first camp base their arguments on the Phillips curve and output gap, defined as the difference between actual and potential output and assert a positive relation between inflation and growth. The underlying reasoning is that if actual output rises above potential output, this will create an upward pressure on wages in the labor market. Higher wages, in turn, will lead to higher production costs and hence higher prices. This conclusion has been supported by empirical findings. Gerloch and Smets (1999), for instance, show that 1%...
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