Reexamining the relationship between inflation and growth: Do institutions matter?

This paper revisits the empirical relationship between inflation and growth, focusing on the differences that arise across countries' levels of development. In particular, we estimate the inflation thresholds above which its effect on economic growth is negative, allowing for a smooth transition between the low and high inflation regimes. We use a panel data of over 130 countries, during the period after the Second World War. We provide evidence that the relationship between inflation and growth is non-linear. We find, in line with previous literature, that the estimated threshold is substantially higher for developing countries (19.1%) compared to that of developed countries (4.5%). However, we also show that the latter group's inflation threshold falls well below the two-digit figures, provided we consider reduced groups of developing economies that are above minimum levels of institutional quality. This reveals, on the one hand, the importance of taking account of institutions. On the other hand, it allows to find threshold levels closer to the inflation targets that have been adopted in practice. The results also indicate that the speed of transition is relatively smooth for the group of industrialized countries, while, for the group of non-industrialized countries, inflation quickly affects growth when it exceeds the threshold. Once again, the speed of transition falls considerably for those developing countries that appear to have better institutions. We also estimate the effect on growth from the control variables that are standard in growth models: initial per capita income, population growth, the investment-output ratio, openness to trade, and the standard deviations of terms of trade.