Growth and Inflation: A Cross-Country Study

This paper examines the effect of inflation on real growth in a Solow growth model using data from a cross section of countries over a 30-year period. The advantage of using a theoretical model is that it reduces the risk that the results will reflect data-mining. The results suggest that the 5 percentage point reduction in inflation from the 1970s to the 1980s would increase the growth rate of real GDP per head by between 0.1 and 0.5 percentage point. This effect would be worth between 15 percent and 140 percent of one year’s income. Even the lower of these projections would be larger than most estimates of the costs of bringing inflation down. Since the beginning of the 1980s, the Federal Reserve has stressed its long-run commitment to achieving and maintaining low inflation. A number of other central banks have espoused a similar objective, and many have adopted (or had imposed on them by their governments) numerical targets for inflation and have followed monetary policies designed to achieve them.1 There have been a number of proposals that the Federal Reserve also should focus its attention on keeping inflation low and refrain from policies that are primarily intended to affect output or employment.2 The argument that the Federal Reserve should emphasize holding down inflation comes from the twin beliefs that inflation imposes costs that reduce economic welfare and that monetary policy can lower inflation but cannot have a permanent effect on real aggregate demand. This paper focuses on the first of these points and examines the argument that persistent inflation leads in the long run to a reduced growth rate of real GDP. Since a policy to reduce inflation is likely to slow economic activity in the short run, it is useful to estimate its benefits through higher long-run output growth. In the short run, faster real growth may be associated with more rapid inflation. Often, this is because strong growth is the result of a rise in aggregate demand that causes real output to increase at the same time as it bids up prices.3 To reduce inflation, the central bank must curb aggregate demand, and this may lower output and employment temporarily. This is why resisting inflation often is unpopular. However, this paper is concerned with the long-run relation between inflation and real growth rather than with the