It is now widely accepted that inflation has a negative effect on economic growth. This negative effect, however, was not detected in data from the 1950s and the 1960s. Until the 1970s, many studies found this effect to be nonsignificant, or even positive. The change in view came only after many countries experienced severe episodes of high and persistent inflation in the 1970s and the 1980s. As more data became available on these episodes, studies confirmed repeatedly that inflation has a significant negative effect on economic growth.
The abrupt change in the view regarding the effects of inflation on growth raises three important questions: (i) Why did it take so long and so many studies to uncover such an obvious link between two of the most important and most closely watched macroeconomic variables? (ii) As the estimated effect of inflation on growth is relatively small, should the results of these studies affect policy priorities and institutional arrangements? and (iii) If a specific range for inflation is adopted as a policy target, what should this range be?
Motivated by these questions, this paper explores the possibility of nonlinear effects of inflation on economic growth. It finds evidence of the existence of a structural break in the function that relates growth rates to inflation. When inflation is low, it has no significant negative effect on economic growth; the effect may even be slightly positive. But when inflation is high, it has a powerful negative effect on growth. The structural break is estimated to occur where the average annual rate of inflation is 8 percent.
The existence of such a structural break can explain why the negative effect of inflation on economic growth was not detected for such a long time: before the 1970s, there were not many episodes of high inflation. It also suggests a specific numerical target for policy: keep inflation always below the structural break. Most important, the existence of a structural break implies that previous studies seriously underestimated the negative effects on economic growth of higher rates of inflation. This study demonstrates that when the existence of the structural break is ignored, the estimated effect of inflation on economic growth for the higher rates of inflation decreases by a factor of three. Taking the structural break into account, the paper finds evidence that the effects of inflation on growth are much more powerful than previous studies had estimated.