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Money Supply, Inflation and Economic Growth: An Empirical Study - Essay Example

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There has been a lot of research in recent years with the intention to examine the relationship between inflation and economic growth. Many models have also been formulated to examine the relationship between money supply and inflation. However, there is still no evidence of a clearly defined empirical relationship that can be derived between inflation and growth…
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Money Supply, Inflation and Economic Growth: An Empirical Study

Download file to see previous pages... In some cases, there is a lack of any evidence of any relationship between the three factors. Many empirical analyses have been conducted to come to a definite conclusion. But it is still elusive. Some of the conclusions arrived at regarding this relationship through empirical studies are discussed in this paper.
The argument that inflation promotes economic growth has been mainly put forward by Felix (1961), Seers (1962), Baer (1967), Georgescu-Rogen (1970), and Taylor (1979, 1983).(Paul et al 1997 pp.1388) These analysts base their argument on two streams of thought. The first is derived from the Keynesian theory, which propounds that in economies with sluggish real wage adjustment, inflation can increase the rate of return on costs, and redistribute income away from workers, who have a lower propensity to save, to entrepreneurs who exhibit high propensities to save and invest. This redistribution in favor of entrepreneurs results in an increase in rate of economic growth. The other theory, which exhibits such a relation between inflation and growth, is the quantity theory of money. In an economy with flexible prices, inflation tends to redistribute wealth from the holders of cash balances to monetary authorities through the instrument of tax. The proceeds of this tax are then used by the authorities to expand their investment programs, hence promoting growth. The above empirical studies by economists' supports the causal relationship defined by these theories.

3. "Inflation Retards Growth"

The alternative view is that inflation leads to a distortion in growth. Campos (1961), Baer (1967), Mundell (1971), Logue and Willett (1978), Bhagwati (1978) and Feldstein (1982) have arrived at this view in their studies (Paul et al 1997, pp.1388) There are four channels through which inflation can retard growth. The first is the 'accumulation or investment' effect of inflation on growth. " High and variable inflation rates have the potential to raise the cost and riskiness of productive investment." (Paul, Kearney and Chowdhury 2002) Aside from this, inflation has the tendency to undermine the confidence of domestic and foreign investors about the future course of monetary policy. Inflation also affects the accumulation of other determinants of growth such as human capital or investment in R&D.

Another channel through which inflation retards growth is the "efficiency channel." Inflation worsens the long-run macroeconomic performance of market economies by reducing the total factor productivity. A high level of inflation has the effect of inducing a frequent change in prices which is costly for firms and it reduces the optimal cash-holding by consumers. A high inflation also causes forecast errors that are an effect of a distortion in the information content of prices. This leads to more effort and resources being placed for information gathering and mitigating the risk from damages caused by price fluctuations. This may endanger the efficient allocation of resources.

Another channel through which inflation can cause damage to economic growth is the "allocation channel." The allocation of resources, both by government and private holders, is an important decision of the production process with concurrent effects on growth. High inflation can lead to ...Download file to see next pagesRead More
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