Financial Threshold relationships among inflation , financial market development , and growth 1

This paper tests for and estimates relationships among inflation, financial market development (FMD), and growth. This trivariate relationship changes across a statistically robust inflation threshold of about 14%. Below 14%, the relationship between growth and FMD is positive; above 14%, the relationship between growth and inflation is negative. The interaction between FMD and inflation has a significant impact, however: below 14% there is a positive correlation between growth and inflation, but marginal increases in inflation impair the relationship between growth and FMD; above 14% marginal increases in inflation have little or no impact on this relationship. This suggests that the role of financial markets as a channel of economic growth is important and changes with the level of inflation. 141 1 This is adapted from a 2000 University of Adelaide Working Paper # 00-4 of the same title. 2 The authors thank Bruce Hansen for providing his threshold panel testing and estimation code on his website, Thorsten Beck and Ross Levine for allowing the use of their data, and Colin Cameron, Ananda Chanda, Mark Gersovitz, Tony Hughes, Oscar Jorda, Richard Pomfret, Ramkishen Rajan, and Christie Smith for their helpful comments. Views herein do not necessarily represent those of the Federal Reserve System or the Federal Reserve Bank of Boston. 3 Temple (2000) provides an excellent survey of the theoretical and empirical literature on the relationship between inflation and growth. 4 In the linear context, many studies (e.g. Logue and Sweeney (1981), and Thornton (1987) among others) argue that moderate inflation rates can boost growth. Aghevli (1977) also shows that seniorage revenue can engender positive growth effects from inflation. 5 Frischtak (1992) offers a potential counterpoint by arguing that at high rates of inflation there are incentives to increase branch expansion in order to obtain the large returns associated with low-interest bank deposits. Threshold relationships among inflation, financial market development, and growth