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Inflation, growth, and central banks : theory and evidence

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  • De Gregorio, Jose

Abstract

The author reviews the theory and evidence on inflation and growth and provides additional empirical evidence for a large cross-section of countries. The evidence, he reports, suggests a robust negative relationship between inflation and growth. He argues that inflation limits growth mainly by reducing the efficiency of investment rather than its level. But this finding is difficult to explain using traditional theories that rely on the effects of inflation on employment, which are not supported by the data. Explanations focusing on the effects of inflation on the allocation of talents and the functioning of financial markets may help in understanding better the long-run relationship between inflation and growth. The author also reviews the theoretical and empirical literature on how central banks affect inflation and output growth. An independent central bank can be effective in reducing inflation if the public perceives that it is tough on inflation. But inflation persists because the cost of reducing it is high - the most evident cost being the loss of output from disinflation. The author concludes that although serious progress has been made in recent years in assessing empirically how central banks affect macroeconomic performance, the results are still inconclusive. The empirical evidence shows a negative correlation between inflation and central bank independence, especially in OECD countries, but the effects on growth are less conclusive. It is fair to say that the bulk of the evidence suggests that central bank independence produces lower inflation at no real costs.

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Bibliographic Info

Paper provided by The World Bank in its series Policy Research Working Paper Series with number 1575.

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Date of creation: 29 Feb 1996
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Handle: RePEc:wbk:wbrwps:1575

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Keywords: Environmental Economics&Policies; Economic Theory&Research; Payment Systems&Infrastructure; Banks&Banking Reform; Financial Intermediation; Economic Theory&Research; Environmental Economics&Policies; Banks&Banking Reform; Financial Intermediation; Inflation;

References

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  1. Benabou, Roland, 1988. "Search, Price Setting and Inflation," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 55(3), pages 353-76, July.
  2. Laurence Ball, 1994. "What Determines the Sacrifice Ratio?," NBER Chapters, in: Monetary Policy, pages 155-193 National Bureau of Economic Research, Inc.
  3. Bruno, Michael & Easterly, William, 1998. "Inflation crises and long-run growth," Journal of Monetary Economics, Elsevier, Elsevier, vol. 41(1), pages 3-26, February.
  4. Bertola, Guiseppe & Caballero, Ricardo J, 1994. "Irreversibility and Aggregate Investment," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 61(2), pages 223-46, April.
  5. Alesina, Alberto & Summers, Lawrence H, 1993. "Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 25(2), pages 151-62, May.
  6. Aizenman, Joshua & Marion, Nancy P, 1993. "Policy Uncertainty, Persistence and Growth," Review of International Economics, Wiley Blackwell, Wiley Blackwell, vol. 1(2), pages 145-63, June.
  7. Robert J. Barro, 2013. "Inflation and Economic Growth," Annals of Economics and Finance, Society for AEF, vol. 14(1), pages 121-144, May.
  8. R. Anton Braun, 1994. "Another attempt to quantify the benefits of reducing inflation," Quarterly Review, Federal Reserve Bank of Minneapolis, Federal Reserve Bank of Minneapolis, issue Fall, pages 17-25.
  9. Cooley, T.F. & Hansen, G.D., 1988. "The Inflation Tax In A Real Business Cycle Model," Papers, Rochester, Business - General 88-05, Rochester, Business - General.
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  15. Aghion, P. & Howitt, P., 1989. "A Model Of Growth Through Creative Destruction," UWO Department of Economics Working Papers, University of Western Ontario, Department of Economics 8904, University of Western Ontario, Department of Economics.
  16. Alex Cukierman & Sebastian Edwards & Guido Tabellini, 1989. "Seigniorage and Political Instability," NBER Working Papers 3199, National Bureau of Economic Research, Inc.
  17. Aghion, Philippe & Howitt, Peter, 1992. "A Model of Growth Through Creative Destruction," Scholarly Articles 12490578, Harvard University Department of Economics.
  18. Abel, Andrew B, 1983. "Optimal Investment under Uncertainty," American Economic Review, American Economic Association, American Economic Association, vol. 73(1), pages 228-33, March.
  19. Alesina, Alberto, 1987. "Macroeconomic Policy in a Two-Party System as a Repeated Game," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 102(3), pages 651-78, August.
  20. Barro, Robert J, 1991. "Economic Growth in a Cross Section of Countries," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 106(2), pages 407-43, May.
  21. Baumol, William J, 1990. "Entrepreneurship: Productive, Unproductive, and Destructive," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 98(5), pages 893-921, October.
  22. Alberto Alesina, 1988. "Macroeconomics and Politics," NBER Chapters, in: NBER Macroeconomics Annual 1988, Volume 3, pages 13-62 National Bureau of Economic Research, Inc.
  23. Ben S. Bernanke, 1980. "Irreversibility, Uncertainty, and Cyclical Investment," NBER Working Papers 0502, National Bureau of Economic Research, Inc.
  24. Alesina, Alberto & Gatti, Roberta, 1995. "Independent Central Banks: Low Inflation at No Cost?," American Economic Review, American Economic Association, American Economic Association, vol. 85(2), pages 196-200, May.
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Cited by:
  1. W. Adrián Risso & Edgar J. Sánchez Carrera, 2010. "Análisis de cointegración y valores umbrales entre la inflación y el crecimiento económico en México: 1970-2007," Ensayos Revista de Economia, Universidad Autonoma de Nuevo Leon, Facultad de Economia, vol. 0(2), pages 77-98, November.
  2. Hermes, Niels & Lensink, Robert, 2000. "Financial system development in transition economies," Journal of Banking & Finance, Elsevier, Elsevier, vol. 24(4), pages 507-524, April.
  3. Arbache, Jorge Saba, 2004. "Do Structural Reforms always Succeed? Lessons from Brazil," Working Paper Series, World Institute for Development Economic Research (UNU-WIDER) UNU-WIDER Research Paper , World Institute for Development Economic Research (UNU-WIDER).
  4. José De Gregorio & Jong-Wha Lee, 1999. "Economic Growth in Latin America: Sources and Prospects," Documentos de Trabajo, Centro de Economía Aplicada, Universidad de Chile 66, Centro de Economía Aplicada, Universidad de Chile.

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