Economic growth, inflation, and banking sector competition

Empirical findings suggest that inflation and economic growth are positively correlated when inflation is initially low. However, once inflation rises above a certain threshold level, the correlation becomes negative. Furthermore, the threshold is higher for developing than for advanced economies. Why does the inflation threshold vary across countries? Using an endogenous growth model, this paper demonstrates that the inflation-growth relationship is influenced by regulatory restrictions on banks’ balance sheets and the degree of competition in the banking sector. For example, in an economy with high restrictions on banks’ activities, the threshold inflation rate is high if the banking system is not competitive and hence not deep enough (i.e., banks are holding too much liquidity). As the financial sector around the world is becoming more concentrated and subject to tighter regulation, the analysis calls for the need for coordination between monetary and macroprudential policymakers.