An Empirical Analysis of Inflation-Growth Nexus in Developing Countries: The Case of Sri Lanka
Nawalage S. Cooray
The maintenance of price stability is regarded as a key economic policy goal, as inflation is costly and hinders economic growth. There is a vast literature on the relationship between inflation and growth across time, regions, and inflation ranges. The conventional neoclassical view postulates a linear negative relationship between inflation and economic growth. The Keynesian and Neo‐Keynesian frameworks, however, have established a linear positive relationship between inflation and growth in the short‐run. Some researchers maintain that neither positive nor negative associations exist between inflation and growth.
Although there seems to be an obvious positive relationship between inflation and growth in Sri Lanka in the long‐run, it is difficult to establish a clear link between the two without a thorough investigation. Moreover, the high and volatile inflation rates have sparked a confusing debate within policy circles over the nexus of growth and inflation in the country. Given this background, this paper develops an econometric model to identify the real nature of the growth‐inflation link in Sri Lanka and to determine the optimum or threshold rate of inflation that would minimise the economic cost of inflation in terms of economic growth. To the best of the author’s knowledge, there has been no attempt previously to find such a threshold level of inflation for Sri Lanka. The proposed model uses long time series data to establish the plausible link between growth and inflation and also to estimate the inflation threshold.
The current study finds a non‐linear relationship between inflation and growth in Sri Lanka, contradicting the general belief about the linear relationship between inflation and growth. Growth increases with inflation, showing a positive relationship between the two variables up to 11 per cent of inflation, and then, growth becomes negative if inflation increases beyond that level. This finding implies that in Sri Lanka, there is a significant structural break of inflation at the 12 per cent level. The paper also finds that GDP growth and per capita GDP maximising inflation rate for the country falls between 7.4‐9.6 per cent.