SPECIAL ARTICLE

Non-linear Relationship between Inflation and

Growth in Developing Countries
Anupam Das, John Loxley

While the orthodox consensus is that there is no

trade-off between inflation and output in the long run,
there is no unanimity on the short-run effect of inflation
on economic growth. We attempt to estimate the
non-linear relationship between inflation and economic
growth for 54 developing countries over the 19712010
period. Our results suggest a positive association
between inflation and gross domestic product growth
up to a rough inflation threshold; we did this separately
for Asia, Latin America and the Caribbean, and
Sub-Saharan Africa. The threshold rate of inflation is
found to be 23.5% for Latin America and the Caribbean,
approximately 11% for Asia, and 23.6% for Sub-Saharan
Africa. These results have important policy implications
for developing countries, which often struggle to find
the right balance between low inflation and high
economic growth.

Authors are thankful to an anonymous reviewer of this journal for the

valuable comments.
Anupam Das (adas@mtroyal.ca) is at the Department of Economics,
Justice and Policy Studies, Mount Royal University, Calgary, Canada;
and John Loxley (john.loxley@umanitoba.ca) is at the Department of
Economics, University of Manitoba, Winnipeg, Canada.
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vol l no 37

1 Introduction

hile there is a consensus among mainstream theorists that there is no trade-off between inflation and
output in the long run, there is no unanimity on the
short-run effect of inflation on economic growth. Positive effects of inflation on economic growth may be due to the fact
that higher inflation makes capital more attractive to hold relative to money. It reduces the value of debt and makes labour
markets more efficient by making real wages more variable
than otherwise. Hence, an increase in the expected rate of inflation can cause a rise in capital accumulation and overall
growth in the economy. On the other hand, the negative
effects of inflation on economic growth can be manifold.
High rates of inflation can discourage savings and productive
investment, encouraging consumption and speculative asset
buying. They can undermine a countrys export competitiveness, reducing exports and increasing imports, and perhaps
also encouraging capital flight. This will put pressure on both
the exchange rate and on interest rates. Inflation may also
have adverse effects on income distribution which may also
cause political instability. Typically, volatility of inflation is
high during periods of high inflation.
Researchers have found unanticipated inflation to be one of
the most important determinants of investment and economic
growth (Bruno 1993; Pindyck and Solimano 1993; Andrs and
Hernando 1999; Freedman and Laxton 2009). If an investor
undertakes a long-term project with long-term debt during a
period of high inflation, the risk of losses rises significantly in
the case of an unexpected disinflation (Freedman and Laxton
2009). The rate of return on capital and investment would fall,
which could lead to a fall in output. If the relationship between
inflation and economic growth is positive at a low rate of inflation, but negative at a high rate, it means that there exists a
non-linear relationship between these two variables. In other
words, it should be possible, at least in principle, to find an
inflexion point at which the sign of this relationship switches
from positive to negative (Khan and Senhadji 2001).
Inconclusive findings on the growth-effects of inflation raise
an important question: What is the rate of inflation at which the
negative effects on growth prevail over its positive effects? Recent
empirical studies recognise the importance of these questions
and therefore, attempt to examine the threshold level of inflation
at which the relationship between inflation and economic growth
becomes negative. While the seminal paper by Fischer (1993)
first identified the possibility of a positive inflationgrowth
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SPECIAL ARTICLE

relationship at a low rate, but a negative relationship at a high

rate, Sarel (1996) empirically examined the non-linear effects of
inflation on growth. Using a panel of 80 countries from 1970 to
1990, Sarel (1996) found evidence of the existence of an inflexion
point when the rate of inflation is 8%. Ghosh and Phillips (1998)
used a larger dataset of 145 countries over the period of 1960
to 1996, and found that the threshold level of inflation is only
2.5%. Below that rate, inflation has a positive effect. The effect
becomes negative for inflation rates greater than 2.5%.
One of the most influential papers on the non-linear relationship between inflation and growth was by Bruno and Easterly
(1998), who examined this relationship for 127 countries over the
period 1960 to 1992. They found a negative inflationgrowth
nexus in high frequency data and when the hyperinflation periods
(that is, rates of inflation of at least 40%) are included in the data
set. If these periods are discarded, Bruno and Easterly found
that the growth-cost of inflation was insignificant up to 20%
inflation. Khan and Senhadji (2001) also examined the inflation
growth relationship in a non-linear framework. Their data set
covered 140 developing and industrialised countries for the
period 1960 to 1998. Using the non-linear least square (NLLS)
technique, they found the threshold level of inflation above which
inflation exhibited a negative relationship with economic growth
to be 1% to 3% for industrialised countries, and approximately
11% for developing countries. In a more recent paper, Ibarra
and Trupkin (2011) used a large data set of 120 countries for the
period after World War II. Applying the panel smooth transition
regression (PSTR) model with fixed effects, they found that the
threshold rate of inflation was 4.1% for industrialised countries
and 19.7% for non-industrialised countries. Similar results for
advanced economies were also found by Espinoza, Leon and
Prasad (2010). Burdekin et al (2004) however, found just the
opposite. Their data set included 21 industrial countries from
1965 to 1992 and 51 developing countries from 1967 to 1992. Their
results suggested that the threshold rates of inflation in industrial and developing countries were 8% and 3% respectively.
Sepehri and Moshiri (2004) also argued that the inflation
growth relation for developing countries would be more likely
to differ from that of developed countries. This is because, as
they explained, the adverse effect of inflation on investment
and growth owing to the partial indexation of taxes on investment income would likely be larger in the rich countries than
in the poor countries where the income tax system in general
and taxes on investment income in particular are rudimentary,
and where revenues from consumption and foreign trade taxes
generally account for the bulk of revenue from taxes (Sepehri
and Moshiri 2004: 193). Their empirical results confirm their
theoretical argument. The estimated turning points in their
work were found to be 15% for the lower-middle-income countries, 11% for the low-income countries, and 5% for the uppermiddle-income countries. On the other hand, no significant
long-run relationship between inflation and growth was found
for high-income Organisation for Economic Co-operation and
Development (OECD) countries.
While criticising the orthodox inflation-targeting policy of
maintaining lower inflation rates, Pollin and Zhu (2006) argued
60

that government policy should focus on promoting economic

growth and employment instead of maintaining a low inflation rate being an end in itself. Their argument is based on the
empirical results that the threshold levels of inflation are
approximately 19.3% to 23.3% for low-income countries and
14% to 16% for middle-income countries. While the coefficients for low-income countries were significant by at least one
econometric technique, the coefficients for the middle-income
group were never found to be significant.
While there has been a spurt of research on the relationship
between inflation and growth in developing countries, most of
these papers have implicitly assumed all developing countries
to be a single entity, that is, there is a single structural break in
the relationship between inflation and economic growth for
all developing countries in the sample. Only in a few cases
(such as Sepehri and Moshiri 2004; Pollin and Zhu 2006) were
countries grouped according to their level of income. However,
since there are regional variations across developing countries,
the factors that determine inflation vary across economies and
depend on institutional arrangements and structural realities
(Heintz and Ndikumana 2010). Hence, it is imperative to group
countries according to different developing regions. For example,
many Latin American countries are well known for periods of
high rates of inflation and erratic rates of economic growth, particularly in the 1980s and 1990s (Bittencourt 2012). Hence, any
regression equation that includes Latin American countries
with other developing countries from different regions may
produce spurious results. This could be a likely reason for
Pollin and Zhu (2006) obtaining inflation coefficients which
were either insignificant or slightly significant at the 10% level.
How the threshold rates of inflation vary across different
developing regions in the world remains an empirical question
since research on this area is conspicuous by its absence. To
our knowledge, no paper has attempted to examine the threshold level of inflation for different regions of the developing
world, which have their own socio-economic characteristics.
To that end, the purpose of this paper is to present empirical
evidence on the relationship between inflation and economic
growth for 54 developing countries from Asia, Latin America
and the Caribbean, and Sub-Saharan Africa with an up-todate data set. Using a non-linear framework, we estimate the
threshold rates of inflation at which the sign of the inflation
growth relationship switches. Our results have important
policy implications for developing countries, which often face
the dilemma of striking a balance between low inflation and
high economic growth.
The remainder of the paper is organised as follows. Section 2
describes the data used and presents the methodology. Econometric results are presented and discussed in Section 3. The
final section provides some concluding remarks.
2 Data and Methodology

The data set used in this paper runs from 1971 to 2010 and
includes 54 developing countries. Eleven of these are from
Asia, 19 are from Latin America and the Caribbean, and 24
countries are from the Sub-Saharan Africa (Table 1, p 61).
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Table 1: List of Countries
Asia

Latin America and the Caribbean

Sub-Saharan Africa

Bangladesh
China
India
Indonesia
Malaysia
Nepal
Pakistan
Philippines
Sri Lanka
Thailand
Vietnam

Belize
Bolivia
Chile
Colombia
Costa Rica
Dominican Republic
Ecuador
El Salvador
Guatemala
Guyana
Honduras
Jamaica
Mexico
Nicaragua
Panama
Paraguay
Peru
Uruguay
Venezuela

Benin
Botswana
Burundi
Cameroon
Central African Republic
Congo, Republic
Congo, Democratic
Cote dIvoire
Gabon
Gambia
Ghana
Kenya
Lesotho
Malawi
Mali
Mauritania
Mauritius
Niger
Sierra Leone
Swaziland
Tanzania
Togo
Uganda
Zambia

The growth equation estimated in this paper relies heavily

on the equation used by Pollin and Zhu (2006) where the dependent variable is growth of gross domestic product (GDP)
and the independent variables are government consumption
as a percentage of GDP (gcy), life expectancy (life), level of education (edu), natural disaster (disas), and the rate of inflation
(in). To capture the non-linear relationship between inflation
and growth, we introduce the squared term of inflation (in2)
as an explanatory variable in the growth equation, which
makes the equation a second-degree polynomial. This technique of using a squared term of the main interest variable has
been widely used in the empirical literature on growth (see for
example, Burnside and Dollar 2000; Pollin and Zhu 2006;
Rajan and Subramanian 2008). Introducing this explanatory
variable would allow the slope of the estimating equation to
vary with changes in the inflation rate. This equation can be
written in the following form:
gY = + 1 (in)+ 2 (in2) + 3(gcy)+4(edu)+ 5 (life)+6 (disas)
...(1)
Economic growth and the rate of inflation are defined as the
growth rates of GDP and the growth rates of the consumer
price index (CPI), respectively. Life expectancy represents life
expectancy at birth, and the level of education is represented
by the average years of secondary schooling in the total population of age 25 years and above. Government consumption is
the total consumption of the government as a percentage of
GDP. Natural disaster is defined as the share of population affected by natural disasters that happened in the year weighted
by the share of agricultural output in GDP. Following Pollin
and Zhu (2006), any unreported natural disasters are treated
as zero. Yearly data on economic growth, life expectancy, and
inflation are collected from the World Development Indicators
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(WDI) published by the World Bank (2012). Annual data on

government consumption comes from the United Nations (UN)
database (United Nations 2012). Five-year average data on
education is collected from the BarroLee (2010). Natural
disasters data has been obtained from the Emergency Events
Database (EM-DAT): the Office of United States Foreign Disaster
Assistance (OFDA)/Center for Research on the Epidemiology of
Disasters (CRED 2012).
With the exception of education, yearly data of all other
variables (defined previously) are collected over a span
of 40 years from 1971 to 2010. The data on the level of
education is in five-year intervals from 1971. We generate a
series of averages for all variables but education (which is
already in five-year intervals) in our annual panel data set.
This is done to reduce business-cycle effects and measurement error when analysing a panel data set with a longer
time period.
As discussed, we introduce the inflation squared variable as
an explanatory variable to capture the non-linear relationship
between inflation and economic growth through allowing for
changes in slopes as a function of changes in the inflation rate.
Pollin and Zhu (2006) argued that this technique would enable
us to calculate the threshold inflation rate (TIR) by using the
following formula:
in
...(2)
TIR =
(2* (in2))
where in is the coefficient of inflation, and in2 is the coefficient
of inflation squared. In this investigation, we also
estimate the inflationgrowth relationship and the TIR for
different regions of the developing world. The growth equation is estimated for Asia, Latin America and the Caribbean
and Sub-Saharan Africa.
The robustness of the relationship between inflation and
economic growth has been widely discussed in the literature
(Levine and Zervos 1993; Ghosh and Phillips 1998; Sepehri
and Moshiri 2004; Pollin and Zhu 2006). Previous literature
including Bruno and Easterly (1996), and Pollin and Zhu
(2006) defined hyperinflation as being yearly inflation rates in
excess of 40% per year. Ghosh and Phillips (1998) conducted a
battery of robustness checks, including stability across various
alternative samples and the role of high inflation outliers.
They found that the slope of the relationship between inflation
and growth became steeper in the 10%40% range as compared to the slope above the 40% range. Pollin and Zhu (2006)
excluded the inflation rates of more than 40%. We therefore
separate out the periods of hyperinflation. Since hyperinflation is a specific case that represents a breakdown of economic
functioning, following earlier literature, we exclude all observations with more than 40% inflation. Sepehri and Moshiri
(2004) first estimated the model for the 1960 to 1996 period, and
then excluded the high-inflation period, 1973 to 1982, from the
full sample. The detrimental effect of high inflation mostly
persisted even when the period of high inflation was excluded
from the data set. In our case, due to the small number of
observations, we were unable to remove any specific period of
high inflation from our data set. However, since the periods of

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hyperinflation were already excluded from the data set, we could

avoid any spurious results that might have occurred from outliers.
Pollin and Zhu (2006) undertook the robustness tests by
utilising different panel data techniques. While the fixed effects
estimates are calculated from differences within each country
across time, the random effects estimates include information
from both individual countries and time periods. Hence,
random effects are more efficient than fi xed effects. Despite
the efficiency of this technique, one important caveat of the
random-effect estimate is that it is consistent only if the countryspecific effects are uncorrelated with other control variables
(Forbes 2000). The pooled ordinary least squares (OLS) do
not assume the omitted-problem bias. An important shortcoming of the between-effects is that this model provides
variation on a country-by-country basis, as opposed to considering variation between time periods as well as countries
(Pollin and Zhu 2006: 602). Hence, to check for robustness, we
use the pooled OLS, fixed-effect and random-effect techniques
to estimate the growth equations.
3 Results

Key findings from our estimations are presented in Tables 2

through 5. The coefficients and standard errors for the inflation
and inflation-squared variables are reported for each of the
regressions. Additionally, estimated TIRs are presented in the
tables. The results for all developing countries are presented in
Table 2. Inflation is found to be positively significant (at least at
the 5% level) in all models. The magnitudes of this variable
are 0.09%, 0.14%, and 0.12% in pooled OLS, fixed effect and
random effect respectively. These results suggest that a 1%
increase in the rate of inflation tends to increase the GDP growth
rate by approximately 0.09% to 0.14% in developing countries.
As expected, the inflation squared variable is negative and
significant in all three equations. Coefficients of this variable
are 0.003 and 0.002 respectively.
Table 2: InflationGrowth Nexus in Developing Countries: 19712010
Dependent Variable: GDP Growth
Variable

Pooled OLS

Fixed Effect

Inflation

0.087**
(0.04)
-0.003***
(0.10)
14.50
54

0.142***
(0.04)
-0.003***
(0.09)
23.67
54

Inflation squared
Threshold inflation rate (TIR)
Number of groups

Random Effect

0.117***
(0.04)
-0.003**
(0.09)
19.50
54

(1) Standard errors are in the parentheses. (2) *** and ** represent 1% and 5% levels of
significance respectively. (3) TIRs are calculated using equation 2.

With the coefficients of the inflation and inflation squared,

we are able to calculate the TIR. The estimated TIRs are found
to be 14.5 (pooled OLS), 23.7 (fixed effect) and 19.5 (random
effect). Therefore, it can be argued that the rate of economic
growth in developing countries rises by between 0.09% and
0.14% for every percentage point increase in the inflation rate
up to a threshold ranging from 14.5% to 23.7% where the inflationGDP growth nexus becomes negative. These findings are
strongly reminiscent of Sepehri and Moshiri (2004), and Pollin
and Zhu (2006), who found similar threshold rates for lowincome countries. Some broad, but key points flow from these
62

results. First, while we do not contend that inflation is a positive engine of growth, with the increase in aggregate demand
and growth, economies in the developing countries may experience some inflationary pressure. However, as Pollin and Zhu
(2006: 595) argued, some inflationary pressures are likely
to emerge in this scenario as a relatively benign by-product.
Second, our results support any policy that allows governments and policymakers in developing countries to promote
economic growth and employment even while maintaining
double-digit inflation rates.
Table 3: InflationGrowth Nexus in Asia: 19712010
Dependent Variable: GDP Growth
Variable

Pooled OLS

Fixed Effect

Inflation

0.417***
(0.10)
-0.020***
(0.59)
10.43
11

0.461**
(0.20)
-0.022***
(0.82)
10.48
11

Inflation squared
TIR
Number of groups

Random Effect

0.453***
(0.11)
-0.021***
(0.61)
10.79
11

Note: Same as Table 2.

In the next set of experiments, we examine if there is a wide

range of inflation rates that are likely to be positively associated with GDP growth in different developing regions of the
world. Table 3 presents the results from Asia. Inflation coefficients from all three techniques suggest a positive relationship
between inflation and economic growth in Asia from 1971 to
2010. Similar magnitudes (0.42, 0.46 and 0.45) show the robustness of the equation. As expected, the inflation squared
variable is found to be significant at the 1% level in all three
cases. Estimated threshold rates of inflation are found to be
very similar and vary between 10.4% and 11.8%. Hence, GDP
growth becomes negative in Asia when the rate of inflation
reaches around 10% to 11%.
Table 4 presents the results on the inflationgrowth nexus
for the Latin America and the Caribbean region. Inflation and
inflation squared variables are significant in one (fixed effect)
out of two equations. Results for this region are sensitive
to changes in technique used and hence, not robust. The
estimated TIR (from the fixed-effect model) is found to
be 23.5%.
Table 4: InflationGrowth Nexus in Latin America and the Caribbean:
19712010
Dependent Variable: GDP Growth
Variable

Inflation
Inflation squared
TIR
Number of groups

Pooled OLS

Fixed Effect

Random Effect

-0.008 (0.05)
-0.001 (0.12)

19

0.141** (0.07)
-0.003** (0.13)
23.5
19

0.022 (0.05)
-0.001 (0.12)

19

Note: Same as Table 2.

Table 5 (p 63), provides the results for Sub-Saharan Africa.

Inflation is always positive and significant at the 1% level,
while inflation squared is negative and significant at the 1%
level. The size of the inflation variable varies from 0.18 in the
pooled OLS and fixed-effect models to 0.23 in the random-effect model. This suggests that a 1% increase in inflation leads
to an increase in the rate of GDP growth by 0.18% to 0.23%.
The magnitude of the inflation squared variable lies between
-0.005 to -0.004. The estimated turning points are very
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similar, irrespective of the type of the techniques used. Calculated threshold rates are 23.6%, 22%, and 23.6%, respectively.
In other words, economic growth rises by around 0.18%
0.24% for every percentage point increase in the inflation rate
up to a 24% threshold for the Sub-Saharan Africa region.
Table 5: InflationGrowth Nexus in Sub-Saharan Africa: 19712010
Dependent Variable: GDP Growth
Variable

Pooled OLS

Inflation

0.181***
(0.05)
-0.004***
(0.12)
23.63
24

Inflation squared
TIR
Number of groups

Fixed Effect

0.176**
(0.06)
-0.004**
(0.14)
22
24

Random Effect

0.236***
(0.05)
-0.005***
(0.13)
23.6
24

Note: Same as Table 2.

Overall, inflation has a positive and significant impact on

economic growth when the full panel of 54 countries is taken
into consideration for the 40-year period from 1971 to 2010.
Regional investigation suggests that inflation and GDP growth
are positively associated in all three regionsAsia, Latin
America and the Caribbean, and Sub-Saharan Africa. Although
it should be cautiously noted that the results for Latin America
and the Caribbean are not as robust as the results from two
other regions. Additionally, growth becomes negative when
inflation rises to approximately 15% to 24% for the full panel.
TIRs are approximately 11% for the Asian region, 23.5% for the
Latin America and the Caribbean region, and around 22% to
23% for Sub-Saharan Africa. These results echo the findings
of Sepheri and Moshiri (2004) and Pollin and Zhu (2006).

Therefore, our results support the hypothesis that developing

countries can maintain increasing growth rates of GDP with
low or medium rates of inflation. How much inflation can be
tolerated varies widely across regions. For countries from Asia
and the Pacific, policymakers can allow inflation to go up to
11% without compromising the growth of the region. This
number is even higher for the Sub-Saharan African region,
where inflation can be maintained in the range of 22% or
somewhat higher, without any negative growth effect. Finally, at
least one of the models suggests that Latin America and the
Caribbean can tolerate inflation up to 23.5% without any detrimental effect on economic growth. In line with Epstein (2003),
we would argue that given the positive association between
moderate inflation and economic growth, developing countries should attempt to achieve real targets such as growth
generation, employment creation and investment acceleration
without worrying about the cost of inflation.
4 Concluding Remarks

The debate on the relationship between inflation and growth

is yet to be resolved. Although researchers have long found
that there is no trade-off between inflation and economic
growth in the long run, recent evidence suggests that this
relationship may be non-linear. It has also been argued that
the threshold rate of inflation varies across countries. This
paper has examined the relationship between inflation and
economic growth for a panel of 54 developing countries from
1971 to 2010. Results suggest that inflation is generally

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63

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positively related with economic growth when the full panel is

taken into account. The magnitude of the inflation coefficient
lies between 0.09 and 0.14. The estimated threshold rates of
inflation are found to vary from 15% to 24%. One important
goal of this paper is to identify regional variations of the
inflationgrowth nexus. Hence, we divide the set of developing countries into three groups based on their geographical
locations. These groups are Asia, Latin America and the
Caribbean, and Sub-Saharan Africa. Indeed, the threshold rate
of inflation varies significantly across different regions of the
developing world. Estimation results suggest that the inflexion

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64

points at which the inflationgrowth relationship switches

from positive to negative are approximately 11% for Asia and
around 22% for Sub-Saharan Africa. For Latin America and
the Caribbean, the threshold rate of inflation was found to be
23.5%. This result is, however, less robust than that of Asia
and Sub-Saharan Africa. These results have important policy
implications for developing countries, which often struggle to
find the right balance between low inflation and high economic
growth. We argue that developing countries should focus on
formulating policies to curb inflation at relatively higher levels
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for Formal Inflation Targeting in Sub-Saharan
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afdb.org/fileadmin/uploads/afdb/Documents/
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september 12, 2015

vol l no 37

EPW

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