Economic Development and Inflation in the United States
However, all this would not have been possible but for a very sound political and legal support system that has always been on its toes to regulate the key economic indicators and to keep them at an optimal level. Economic development is not an easy task as it comes with its own sets of woes and complexities to handle. For instance, a direct fall out of an economic growth is inflation, which if not managed properly can do more harm than good for its citizens.
And the United States is no exception to this rule. For instance, the months from June to August 2008, which were characterised by positive growth rates in GDP also witnessed an average inflation of 5.323 (Bureau of Labour Statistics, 2008). All this found the regulators witnessing tough times handling inflation amidst the booming economy.
This research proposes to study the relationship between the economic growth and inflation rates in the United States during the span of 1986-2009 using the panel data regression analysis. The project begins with theoretical discussions on the relationship between the economic growth and inflation. This is followed by a statistical analysis of the historical data of economic growth (measured in terms of GDP growth) and inflation (measured in terms of changes in the consumer price index with 1982 bases of 100) by using E-Views software to calculate the coefficient of correlation using regression analysis to arrive at our conclusion based on the statistical relationship between these two variables.
LITRATURE REVIEW
The relationship between the economic development and inflation is a subject matter of considerable debate among economist. While a certain number of economists emphasize the need for inducement to save and invest if an economy needs to grow, another section lays more importance on consumption. As a direct fallout of this difference, some economists feel that the monetary growth critically determines the inflation while others feel that inflation, which acts as an incentive for the producers to produce more primarily defines the extent of economic growth.
While several empirical studies have been conducted to study the issue using econometric analysis, economists have not been able to arrive at any concurrent conclusion. The reason for the differences in opinions stems from the fact that both inflation and growth rate are interdependent.
Based on these observations, two sets of economic models have evolved, namely, the growth led inflation and the inflation led growth.
Growth led inflation
The growth led inflation is held to be a healthy signal for an economy. It is a common observation that any economic growth is characterised by the increase in the demand which is immediately followed by inflation.
While inflation generally boosts the production, it also brings along negative externalities like the reduction in the export competitiveness (as international prices may not have risen by the same degree as the domestic prices), the tendency to hoard (to sell at higher prices later) and the lowering of investments (if inflation is combined with severe price volatilities causing uncertain investment environment) on the economy.
The US economy with one of the worlds highest level of consumer spending is, perhaps, the best examples to demonstrate these negative externalities. Consumer spending as a percentage of the economic activity stood at 29 in 1929, grew to 83, dropped to 50 during world war periods but since then has remained in the 70-85 levels. Even during the recession hit 2008 when the consumers were supposedly saving than spending, the consumer spending stood at 72 percent in the U.S. (Mehra, Yash P., and Elliot W. Martin 2009).
Inflation led growth
Given the negative aspects of inflation, most of the economist while agreeing that inflation affects the growth rates of a country, agree that it is not a wise idea to artificially increase inflation to boost economic growth. In the past some developing or underdeveloped countries have experimented with inflation to boost a declining economy. There is enough empirical evidence in this world to show that such attempts have spelled disaster for an economy in the long run.
Nevertheless to analyse the affect of inflation on economic growth in the context of the United States, a regression analysis with inflation as the independent variable (Y) and growth as the dependent variable (X) has been conducted elsewhere in the paper.
III. RESERCH OBJECTIVES
Considering that the growth and inflation are interdependent variables with considerable amount of differences in their relationship interplay and wide differences observed in data collected for different countries, this project aims to study the two hypotheses only in the context of the U.S. economy.
Hypothesis 1 - There is a strong positive correlation between the growth rate (independent variable) and the inflation (dependent variable) in the context of the U.S. economy.
Hypothesis 2 - There is also a direct positive correlation when inflation is taken as the independent variable and the growth is taken as the dependent variable for the U.S. economy.
These hypotheses will be tested using the historical data pertaining to the GDP growth per year and the indicative inflation rate for the US economy from 1986 to 2009. (48 years)
Methodology
For the purpose of this study, the inflation has been measured using the consumer price index (CPI) which is defined as the change in the prices paid by urban consumers for a representative basket of goods and services. The producer price index (PPI) has not been used as CPI is traditionally assumed to give a greater representation of the prevalent prices in the economy as compared to PPI.
Similarly to measure the economic growth we have decided to use the annual GDP growth from amongst large number of economic indicators.
The researchers are aware that the results of such a study may vary widely from country to country. While some country may have a strong positive correlation others may show a negative correlation as well.
These two hypotheses are therefore being tested only to study their interplay in the American context and are not intended to arrive at any judgments about the general relationship between the economic growth and inflation.
Theory Discussions
The aggregate supply-aggregate demand (AS-AD) economic theory suggests a positive correlation between inflation and growth, when viewed from the growth led inflation framework. However since 1970s several countries experienced stagflation which is characterized by very slow economic growth, but accompanied by inflation. The most recent situation of stagflation was witnessed nowhere else, but in the United States in 2008, when it grew at a meagre 0.43 where as inflation rose to as high as 5.2 in the months of June to August in the country. (The average inflation for the year was 3.85). All these events, thus, negate the AS-AD postulation of a positive correlation between the inflation and the economic growth.
The classical theory which postulates a supply driven economic growth suggest that economic growth of a country is primarily led by savings which are then used for further production than being used in the current consumption. However, even this theory is not able to explain, how the United States with the highest proportion of consumption and almost negligible savings rate was witnessing 10-11 growth in several years during the period of 1970-1985. The personal savings rate in the United States has averaged around 1 since 2000, as compared to the average 13 personal savings rate in Japan, 12 in Germany and 15 in France. (Federal Reserve Bank of San Francisco). If an economy is growing even at 3 with a negligible savings of 1, the classical theory also does not seem to hold good in the situation.
The Keynesian model which studies the interplay between the aggregate demand and the aggregate supply in the short run and a long run time-frames explains the relationship between the economic growth and the inflation including an explanation for the stagflation which is not offered by other economic models. According to this model, the AS curve is upward sloping in the short run inflation and output exhibit a positive relationship, because in the short run, producers feel that the price rises are happening only for their product. However, as the general price rises, and the manufacturer continues producing more, a time comes in the long run when the production decreases and the inflation rises. This theory, thus, postulates that any level of inflation is sustainable however, for the inflation to fall there must be an intermittent period when the economic growth is below the natural rate. Keynesian model is, therefore, somewhat able to explain the situations of stagflation witnessed in the U.S. economy in the second half of 1998.
The monetarism theory (Friedman, 1960) links inflation to an increase in the supply or the velocity of money. It states that inflation occurs when the velocity of money is greater than the rate of growth in the economy. This theory, however, does not explain the effect of inflation on the economic growth. In short, the monetarism proposes that in the long-run, prices are mainly affected by the growth rate in money, while having no real effect on growth.
EMPIRICAL RESULTS
This part of our research paper is divided into two sections
Regression analysis with GDP growth as the independent variable and inflation as the dependent variable (Growth led inflation model).
Regression analysis with inflation as the independent variable and GDP growth as the dependent variable (Inflation led growth model).
The data used for the regression analysis were taken from two websites providing statistical facts about the U.S. The hypothesis was then tested against the results of regression analysis.
Regression analysis results with GDP growth as the independent variable and inflation as the dependent variable (Growth led inflation model).
According to the regression results for the growth led inflation model, the results are symmetric to the proposed hypothesis. The coefficient calculated with inflation as the dependent variable is positive. R2 which is the measure of fit between the regression and the data, appears to be 0.305659 which indicates a reasonable the fit of the values between the dependent and independent variables.
Regression analysis with inflation as the independent variable and GDP growth as the dependent variable (Inflation led growth model)
According to the regression results for the inflation led growth model, the results are again symmetric to the proposed hypothesis. The coefficient calculated with GDP as the dependent variable is also positive.
Conclusion
This simple panel regression exercise reconfirms a significant degree of correlation between the inflation and the growth rates in general and a positive correlation between these two variables in the United States.
While no hard and fast conclusions can be drawn out from this analysis, we can always look at the results derived from this and similar exercises to help economists and decision makers identify the best ways of using inflation to drive economic growth and to understand what aspects of such an analysis inhibits the economic growth.
Concerning how much inflation is the best for the economic growth of the United States - some economists
suggest that with such a high level of consumer spending, a 2.5-3.5 GDP growth per year is the most that the U.S. economy can safelymaintain without causing negative side effects. (Ryan Barnes 1).
Possible implications for policy and practice
VI. Comparison with other empirical research
Several other researches, conducted on the same topic, but concerning different countries and situations, have pointed to and confirmed the results obtained in our regression test.
The results of this study have been compared to the working paper on the same topic for the Island of Fiji and both these results seem to point to a high degree of positive correlation between inflation and economic growth.
A NBER working paper titled Inflation and Growth, 1986 also points to a high degree of positive correlation between inflation and growth rates in various econmies.
While in some cases of the stagflation trend in the economy, negative correlation has been observed, in general all the papers that we came across on the subject confirmed of positive correlation between these two variables when the study covered more than 10 years of historical data.
Appendix
YEARInflationReal GDP growth rate in 2009 -0.34-3.23 2008 3.850.43 2007 2.852.13 2006 3.242.65 2005 3.393.08 2004 2.683.58 2003 2.272.48 2002 1.591.83 2001 2.831.08 2000 3.384.15 1999 2.196.4 1998 1.555.51997 2.346.3 1996 2.935.7 1995 2.814.7 1994 2.616.3 1993 2.965.1 1992 3.035.8 1991 4.253.3 1990 5.395.8 1989 4.837.5 1988 4.087.7 1987 3.666.2 1986 1.915.81985 3.557.3 1984 4.3011.2 1983 3.228.6 1982 6.164 1981 10.3512.1 1980 13.588.8 1979 11.2211.7 1978 7.6213 1977 6.5011.3 1976 5.7511.4 1975 9.209.2 1974 11.038.51973 6.1611.7 1972 3.279.9 1971 4.308.5 1970 5.845.5 1969 5.468.2 1968 4.279.3 1967 2.785.7 1966 3.019.5 1965 1.598.4 1964 1.287.4 1963 1.245.5 1962 1.207.5