Inflation and Growth: An Inverted-U Relationship

He, Qichun and Zhang, Zhixiang (2019): Inflation and Growth: An Inverted-U Relationship.

Abstract

This study explores a novel channel for monetary policy to impact growth and welfare---a cash-in-advance constraint on R&D combined with R&D subsidies by seigniorage tax. In a scale-invariant Schumpeterian growth model, growth is an inverted-U function of the inflation rate. Friedman rule is suboptimal (optimal) when the elasticity of labor supply is low (high). By contrast, the inverted-U relation does not exist when R&D is subsidized by other taxes or in an AK model. Calibration confirms our prediction and finds that the growth and welfare effects of inflation are large. Using panel data for 154 countries during 1970--2014, both non-parametric cubic spline and parametric regressions show that growth is an inverted-U function of the inflation rate in samples with an annual inflation rate below 30%. The cutoff point for inflation to have a zero marginal effect on growth is around 5% in ordinary least squares estimation and 3% in instrumental variables (IV) estimation. We also find that the share of labor employed in R&D---rather than the physical capital investment rate---is an inverted-U function of inflation in IV estimation. Our empirical evidence provides support for our theory.

• Item Type: MPRA Paper
• Language: English
• Keywords: cash-in-advance constraint on R&D; government subsidies of R&D with seigniorage; inflation; growth; welfare; inverted-U; panel data
• Subjects: E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E51 - Money Supply ; Credit ; Money Multipliers; O - Economic Development, Innovation, Technological Change, and Growth > O3 - Innovation ; Research and Development ; Technological Change ; Intellectual Property Rights > O31 - Innovation and Invention: Processes and Incentives; O - Economic Development, Innovation, Technological Change, and Growth > O4 - Economic Growth and Aggregate Productivity > O42 - Monetary Growth Models

References

Acemoglu, D., Naidu, S., Restrepo, P., and Robinson, J. 2019. "Democracy Does Cause Growth." Journal of Political Economy 127(1): 47-100.

Aghion, P., Akcigit, U. and Fernández-Villaverde, J. 2013. "Optimal Capital versus Labor Taxation with Innovation-Led Growth." NBER Working Paper No. 19086.

Aghion, P., Bacchetta, P., Ranciere, R., and Rogoff, K. 2009. "Exchange rate volatility and productivity growth: The role of financial development," Journal of Monetary Economics 56(4): 494--513.

Aghion, P., and Howitt, P. 1992. "A Model of Growth Through Creative Destruction," Econometrica, 60(2): 323-351. Aghion, P., and Howitt, P. 1998. Endogenous Growth Theory, Cambridge, Mass.: MIT Press.

Ahmed, S. and Rogers, J. 2000. "Inflation and the Great Ratios: Long Term Evidence from the U.S.," Journal of Monetary Economics, 45: 3--35.

Alesina, A., and Summers, L. 1993. "Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence." Journal of Money, Credit and Banking 25(2): 151--62.

Almus, M., and Czarnitzki, D. 2002; "The Effects of Public R&D Subsidieson Firms' Innovation Activities: The Case of Eastern Germany." ZEW Discussion Paper No. 01-10, Centre for European Economic Research.

Arawatari, R., Hori, T., and Mino, K., 2018. "On the nonlinear relationship between inflation and growth: A theoretical exposition." Journal of Monetary Economics 94, 79-93.

Bade, R. and Parkin, M. 1988. "Central Bank Laws and Monetary Policy." mimeo, University of Western Ontario.

Baglan, D., and Yoldas, E. 2014. "Non-linearity in the inflation--growth relationship in developing economies: Evidence from a semiparametric panel model." Economics Letters 125: 93--96.

Barro, R. 1991. "Economic Growth in a Cross Section of Countries," Quarterly Journal of Economics 106(2): 407--443. Barro, R. 1995. "Inflation and Economic Growth," Bank of England Quarterly Bulletin (May): 166--76.

Baum, C., Schaffer, M. and Stillman, S. 2007. ivreg2: Stata module for extended instrumental variables/2SLS, GMM and AC/HAC, LIML, and k-class regression. Boston College Department of Economics, Statistical Software Components S425401. Downloadable from http://ideas.repec.org/c/boc/bocode/s425401.html.

Bick, A., 2010. "Threshold effects of inflation on economic growth in developing countries." Economics Letters 108: 126--129.

Boeing, P. 2016. "The Allocation and Effectiveness of China's R&D Subsidies: Evidence from Listed Firms." Research Policy 45(9): 1774--89.

Bruno, M., and Easterly, W. 1996. "Inflation and Growth: In Search of a Stable Relationship," Review of Federal Reserve Bank of St. Louis working paper.

Booth, G., and Ciner, C., 2001. "The relationship between nominal interest rates and inflation: International evidence." Journal of Multinational Financial Management, 11, 269--280.

Bullard, J. and Keating, J. 1995. "The Long-run Relationship Between Inflation and Output in Postwar Economies," Journal of Monetary Economics, 36: 477--96.

Checherita-Westphal, C., and Rother, P. 2012. "The impact of high government debt on economic growth and its channels: An empirical investigation for the euro area." European Economic Review 56(7): 1392--1405.

Chu, A. and Cozzi, G. 2014. "R&D and economic growth in a cash-in-advance economy." International Economic Review, 55: 507--524.

Chu, A., Cozzi, G., Fan, H., Furukawa, Y., and Liao, C.H. 2019. "Innovation and Inequality in a Monetary Schumpeterian Model with Heterogeneous Households and Firms." Review of Economic Dynamics 34: 141-164.

Chu, A., Cozzi, G., Furukawa, Y., and Liao, C.H. 2017. "Inflation and economic growth in a Schumpeterian model with endogenous entry of heterogeneous firms," European Economic Review 98(C): 392--409.

Chu, A., Cozzi, G., Lai, C.C., and Liao, C.H. 2015. "Inflation, R&D and growth in an open economy." Journal of International Economics, 96, 360--374.

Chu, A., Cozzi, G., and Galli, S. 2014. "Stage-dependent intellectual property rights," Journal of Development Economics, 106(C): 239-249.

Chu A., and Lai, C.C. 2013. "Money and the welfare cost of inflation in an R&D growth model." Journal of Money, Credit and Banking, 45: 233--249.

Chu, A., Ning, L., and Zhu, D. 2019. "Human Capital and Innovation in a Monetary Schumpeterian Growth Model." Macroeconomic Dynamics 23(05): 1875-1894.

Cozzi, G., Giordani, P. and Zamparelli, L. 2007. "The refoundation of the symmetric equilibrium in Schumpeterian growth models." Journal of Economic Theory 136, 788--97.

Czarnitzki, D., and Hussinger, K. 2004. "The Link Between R&D Subsidies, R&D Spending and Technological Performance." ZEW Discussion Paper No. 04-56, CEER.

Dincer, N.N. and Eichengreen, B. 2014. "Central Bank Transparency and Independence: Updates and New Measures," International Journal of Central Banking 10(1): 189-253.

Dotsey, M., and Sarte, P. 2000. "Inflation uncertainty and growth in a cash-in-advance economy." Journal of Monetary Economics 45: 631-655.

Drukker, D., Gomis-Porqueras, P. and Hernandez-Verme, P. 2005. "Threshold Effects in the Relationship Between Inflation and Growth: A New Panel-Data Approach," Working Paper.

Feenstra, R., Inklaar, R. and Timmer, M. 2015. "The Next Generation of the Penn World Table," American Economic Review 105(10): 3150--3182.

Fischer, S. 1993. "The Role of Macroeconomic Factors in Growth," Journal of Monetary Economics (Dec.): 485--512.

Friedman, M. (1969) The Optimum Quantity of Money. Macmillan. Funk, P. and Kromen, B. 2010. "Inflation and innovation-driven growth." B.E. Journal of Macroeconomics, 10(1): 1--52.

Gomme, P., 1993. "Money and growth: Revisited," Journal of Monetary Economics, 32: 51--77

Grilli, V., Masciandaro, D. and Tabellini, G. 1991. "Political and Monetary Institutions and Public Finance Policies in the Industrial Countries." Economic Policy, 341--92.

He, Q. 2015. "A Monetary Variety-Expanding Growth Model with a Cash-in-Advance Constraint on Manufacturing." Economics Bulletin 35(1): 571-579.

He, Q. 2018a. "Inflation and Fertility in a Schumpeterian Growth Model: Theory and Evidence." International Review of Economics and Finance 58: 113-126.

He, Q. 2018b. "Inflation and Health in a Schumpeterian Growth Model: Theory and Evidence." Economic Modelling 75: 159-168.

He, Q. 2018c. "Inflation and Innovation with a Cash-in-Advance Constraint on Human Capital Accumulation." Economics Letters 171: 14-18.

He, Q., and Zou, H-F. 2016. "Does Inflation Cause Growth in the Reform-era China? Theory and Evidence" International Review of Economics and Finance 45: 470--484.

Jones, L. and Manuelli, R. 1995. "Growth and the effects of inflation." Journal of Economic Dynamics and Control, 19: 1405--1428.

Khan, M., and Senhadji, A. 2001. "Threshold Effects in the Relationship Between Inflation and Growth." IMF Staff Papers 48(1).

Kormendi, R. and Meguire, P. 1985. "Macroeconomic determinants of growth: Cross-country evidence." Journal of Monetary Economics 16: 141--63.

Kremer, S., Bick, A., and Nautz, D. 2013. "Inflation and growth: new evidence from a dynamic panel threshold analysis." Empirical Economics 44: 861--878.

Laincz, C. and Peretto, P. 2006. "Scale effects in endogenous growth theory: An error of aggregation not specification," Journal of Economic Growth, 11(3): 263--88.

López-Villavicencio, A., and Mignon, V., 2011. "On the impact of inflation on output growth: Does the level of inflation matter?" Journal of Macroeconomics, 33, 455--464.

Mankiw, G., Romer, D. and Weil, D. 1992. "A Contribution to the Empirics of Economic Growth." Quarterly Journal of Economics 107: 407--37.

Marquis, M. and Reffett, K. 1994. "New technology spillovers into the payment system." Economic Journal, 104, 1123--1138.

Mishkin, F., 1992. "Is the Fisher effect for real? A reexamination of the relationship between inflation and interest rates." Journal of Monetary Economics, 30, 195--215.

Obstfeld, M. and Rogoff, K. 1996. Foundations of International Macroeconomics, Cambridge, MA: the MIT Press.

Peretto, P. 1998. "Technological change and population growth." Journal of Economic Growth 3, 283--311.

Peretto, P. 1999. "Cost reduction, entry, and the interdependence of market structure and economic growth." Journal of Monetary Economics 43, 173--195.

Persson, T. and Tabellini, G. 2009. "Democratic Capital: The Nexus of Political and Economic Change," American Economic Journal: Macroeconomics, 1(2), 88--126.

Romer, P. 1990. "Endogenous Technological Change." Journal of Political Economy 98 (October): S71-102.

Segerstrom, P., 1998. "Endogenous growth without scale effects." American Economic Review, 5, 1290--1310.

Segerstrom, P., 2000. "The Long-Run Growth Effects of R&D Subsidies." Journal of Economic Growth 5(3): 277-305.

Sidrauski, M. 1967. "Inflation and economic growth." Journal of Political Economy 75: 796--810.

Staiger, D., and Stock, J. 1997. "Instrumental Variables Regressions with Weak Instruments," Econometrica, 65, 557--586.

Stockman, A. 1981. "Anticipated inflation and the capital stock in a cash-in-advance economy." Journal of Monetary Economics 8: 387--393.

Tobin, J., 1965. "Money and economic growth." Econometrica 33: 671--684.

Walsh, C. 2010. Monetary Theory and Policy (3rd edition). Cambridge: The MIT Press.

Wei, S., Xie, Z. and Zhang, X. 2017. "From "Made in China" to "Innovated in China": Necessity, Prospect, and Challenges," Journal of Economic Perspectives, 31(1): 49--70.

Zheng, Z., Huang, C., and Yang, Y. 2018. "Inflation and Growth: A Non-Monotonic Relationship in an Innovation-Driven Economy." MPRA paper No. 84768.