The impact of inflation on economic growth evidence from a panel of selected asia countries

For this reason, it is necessary to make clear the relationship between economic growth and inflation in the selected developing Asia countries including China, India, Indonesia, Malaysi

IVERSITY OF ECONOMICS

HO CHI MINH CITY

VIETNAM

THE HAGUE THE NETHERLANDS

VIETNAM -NETHERLANDS PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

HE IMPACT OF INFLATION ON ECONOMIC GROWTH: EVIDENCE FROM A PANEL OF

A thesis submitted in partial fulfilment of the requirements for the degree of

MASTER OF ARTS IN DEVELOPMENT ECONOMICS

;

ACKNOWLEDGEMENTS

The first person I would like to send special thanks to is my supervisor- Dr Le Cong Tru I'm grateful not solely his help throughout the thesis process, but also enthusiasm and many lessons in an attempt to improve my knowledge and skills as well He is usually ready to assist me anytime, although he is bustling The professor often keeps track of my work and motivates me to finish the duty To gain the result today, I cannot miss out his contributions Thanks so much, Dr.Tru!

Next, I'm happy to thank to Dr Hoai, Dr Ngai, and Dr Nam They tried their best to help me select an appropriate topic for my thesis When I confront to issues, they supported to find the solution and give advice in hope that I might overcome the problems Besides, I also thank to the other professors ofVNP for lectures and precious materials

At the same time, I also send thanks to VNP officials, especially Ms Hong They are very nice in helping me when having troubles They inform exactly and quickly to students I enjoy their enthusiasm Additionally, I also send thanks to Mr Quy - a librarian He is nice to his duty I'm always welcomed by him

Last but not least, I cannot forget sending thanks to my family and friends I'm very grateful them to take care of and encourage me while performing the thesis Not only do they support for finance, but also for mental I always keep in mind devotion and sacrifice of all

Thanks so much for everything!!!

TABLE OF CONTENTS

TABLE OF CONTENTS IV

LIST OF FIGURES VII

LIST 0 F TABLES VIII

ABSTRA CT 2

CHAPTER 1 3

INTRODUCTION 3

1.1 PROBLEM STATEMENT 3

1.2 RESEARCH OBJECTIVES AND RESEARCH QUESTIONS 5

1.3 STRUCTURE OF THE PAPER 6

CHAPTER 2 8

LITERATURE REVIEW • 8

2.1 THEORIES RELATED TO INFLATION AND GROWTH 8

2.1.1 Classical Theory 9

2.1.2 Neo-Classical Theory 9

2.1.3 Endogenous Theory 1 0 2.1.4 Keynesian Theory 10

2.1.5 Nee-Keynesian Theory 11

2.1.6 Monetarist Theory 11

2.2 GROWTH MODELS 12

2.2.1 The Basic Growth Model 13

2.2.2 Solow Model 13

2.2.3 Augmented Solow Model 14

2.3 VARIABLE DEFINITION 15

2.3.1 Growth Rate 15

2.3.2 Inflation l6 2.3.3 Cost of Inflation • 17

2.3.4 Control Variables IS 2.3.5 Threshold Concept 21

iv

2.4 EMPIRICAL STUDIES 21

2.4.1 The Studies of 1960s-1980s 22

2.4.2 The Studies of 1990s 23

2.4.3 Recent Studies : 26

CHAPTER 3 31

ECONOMIC OUTLOOKS OF STUDIED COUNTRIES 31

3.1 Economic Outlook of Vietnam 32

3.2 Economic Outlook of Philippines 34

3.3 Economic Outlook of Malaysia 36

3.4 Economic Outlook oflndonesia 39

3.5 Economic Outlook ofThailand 42

3.6 Economic Outlook ofChina 44

3.7 Economic Outlook of India 46

CHAPTER 4 49

MODEL SPECIFICATION & RESEARCH METHODOLOGY 49

4.1 EMPIRICAL MODEL 49

4.2 MODEL SPECIFICATION 50

4.2.1 Non-Linear Inflation-Growth Relationship 50

4.2.2 Testing Thresholds in the Inflation-Growth Relationship 51

4.3 DATA 52

4.4 RESEARCH METHODS 53

CHAPTER 5 57

EMPIRICAL RESULTS ~ 57

5.1 DESCRIPTIVE ANALYSIS 57

5.1.1 China 57

5.1.2 India 60

5 1.3 Indonesia 62

5.1.4 Malaysia 64

5 1 5 Philippines 66

5.1.6 Thailand 68

5.1.7 Vietnam 70

5.2 REGRESSION ANALYSIS 72

5.2.1 China 75

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5.2.2 India 75

5.2.3 Indonesia 76

5.2.4 Malaysia 76

5.2.5 Philippines , 77

5.2.6 Thailand 78

5.2 7 Vietnam 78

5.3 INFLATION THRESHOLD ANALYSIS 79

5.3.1 Threshold Results ofChina 79

5.3.2 Threshold results oflndia 80

5.3 3 Threshold results of Indonesia 81

5.3.4 Threshold Results ofMalaysia 82

5.3.5 Threshold Results of Philippines 84

5.3.6 Threshold Results of Thailand 85

5.3 7 Threshold Results ofVietnam 87

CHAPTER 6 89

CONCLUSIONS, POLICY RECOMMENDATION, LIMITATIONS AND FUTHER STUDY 89

6.1 CONCLUSIONS 89

6.2 POLICY RECOMMENDATIONS 90

6.3 LIMITATIONS 92

6.4 FURTHER STUDY 92

REFERENCES 93

APPEND IX A···!'··· 99

APPENDIX B 101

APPEND IX C 107

APPENDIX » 113

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LIST OF FIGURES

Figure 2-1: Analysis framework for the impact of inflation on growth and thresholds remained

in the relationship 30 Figure 3-1 A comparison between inflation and growth rate ofVietnam from 1990-2010 33 Figure 3-2: A comparison of inflation-growth relationship of Philippines from 1990 to 2010

: 35 Figure 3-3 A comparison between inflation and growth rate of Malaysia in the period of years

1990-2010 38 Figure 3-4: A comparison between inflation and economic growth of Indonesia from

1990-2010 41 Figure 3-5: A benchmark between inflation and gro\\>1h of Thailand in the years of 1990-2010

43 Figure 3-6: A comparison between inflation and growth rate of China from 1990-2010 45 Figure 3-7: A comparison between inflation and economic growth rates of India in the period

1990-2010 47

LIST OF TABLES

Table 2-1 Summary of the papers with thresholds found in the inflation-growth correlation 27

Table 4-1 Summary variables used in the models 52

Table 5-l Correlation matrix between variables (China) 58

Table 5-2: Summary Descriptive Statistics (China) 59

Table 5-3: Correlation matrix between variables (India) 60

Table 5-4: Summary Descriptive Statistics (India) 61

Table 5-7: Correlation matrix between variables (Malaysia) 64

Table 5-9: Correlation matrix between variables (Philippines) 66

Table 5-10: Summary Descriptive Statistics (Philippines) 67

Table 5-11: Correlation matrix between variables (Thailand 68

Table 5-13: Correlation matrix between variables (Vietnam) 70

Table 5-15 Regression Results with Fixed Effects Method 73

Table 5-16: Estimation Thresholds ofChina 80

Table 5-17: Estimation Thresholds of India 81

Table 5-18: Estimation Thresholds oflndonesia 82

Table 5-19: Estimation Thresholds ofMalaysia - 83

Table 5-20: Estimation Thresholds ofPhilippines , 85

Table 5-21: Estimation Thresholds of Thailand 86

Table 5-22: Estimation Thresholds ofVietnam 87

Vlll

The Impact of Inflation on

Economic Growth: Evidence from

a Panel of Selected Asia Countries

ABSTRACT

The objective of this paper is to ascertain whether inflation significantly impacts on economic growth for the selected Asia countries The study relied on macroeconomic theories, the augmented Solow model, and empirical studies for seeking the key variables impacting growth Simultaneously the quadratic model is employed to find out the impacts of inflation

on growth, using a panel data of seven Asian countries in the period of 1990-2010 The fixed-effect method was used for capturing the differences among the selected countries The results show that only China, India, Thailand, and Vietnam have a negative effect of inflation

on growth, and among the countries, Thailand and Vietnam have statistically significant meaning at 1% and 5% Meanwhile the rest of countries comprising Indonesia, Malaysia and Philippines contain the positive effect of inflation on growth Except for Malaysia, Indonesia and Philippines have statistically significant meaning at 5%

For estimating thresholds for the countries, the paper adopted several methods including scatter diagrams, observing average inflation rates and the method of Khan and Senhadji The outputs indicate that only India has the threshold at 7% and statistically significant meaning at 5% The rest of countries including China, Indonesia, Malaysia, Philippines, Thailand and Vietnam also find out the levels of threshold in the relationship between inflation and economic growth are 6%, 12-13%, 4%, 10-13%, 4.2-4.5% and 8%; however, all are not statistically significant meaning

2

Chapter 1 INTRODUCTION

Theoretically speaking, rapid output growth and low inflation are the most common objectives of macroeconomic policy Along with monetary policy related to interest rate or money supply, and the fiscal policy associated to taxes policy or gr)Vernment expenditures are often applied in the macroeconomic stabilization In

o her words, they assist to reduce inflation pressures and support the sustainable g:·owth Since inflation is known as a harmful factor for both firms and families Jvlany countries put the price stability into the first priority While as some researchers agree that the economy may get some beneficial effects at moderate inflation rates For instance, thanks to inflation, investors will reallocate their p< 1rtfolios away from money and into capital, helping to decrease the real rate of interest, encourage investment and rise labour productivity (Tobin, 1965) Also, in 1~172, Tobin claimed that "a little inflation helps oil the wheels of the economy" through assisting labour market adjustment Furthermore, Jarret and Selody (1982) argued that a steady growth in demand contributed to moderate rates of inflation; as a consequence, it would promote productivity growth instead of reducing it Hence, the efforts to get zero inflation amount to a policy for "paying now for more pain later"

i

Nonetheless, in recent years, inflation has been a noticeable phenomenon in almost countries; especially in developing countries There are consequences that the world has been suffering from the global economic crisis and dramatically affected all countries over the world The developing countries in Asia sector are not exceptional These countries must be struggling to increase in all commodity prices, resulting in a difficulty in the people life The energy and food prices raising many folds during the crisis contributed to the soaring of the prices Besides, a strong domestic demand and rising wages are other drivers of inflation pressures Immediately it pushes the prices

of all commodities to grow up This causes the harness in all households and companies in the economy; they must endure escalating of living and production costs Although, the governments have tried their best to show many strategies associated to fiscal or monetary policies ·so as to decrease the inflation rate and help to stabilize the macroeconomic, but we realize that the prices still continue to increase without the end point It is the disasters that the 'families and individuals in the poor countries have

to face

Scientifically speaking, there are many studies involved in the relationship between inflation and growth Obviously many findings surrounding the correlation are not similar Some studies state that inflation has a positive effect on growth, in contrast to this; other research find that inflation has a negative impact on the growth While as the recent studies mention that there is a nonlinear relationship between inflation and growth, the authors point out the thresholds in the inflation-growth nexus However, the evidence is not clear for the developing countries and there is much less agreement about the precise relationship between inflation and economic performance

At the same time, base on many findings, the inflation has the effects on the economic growth that are not similar from the developing countries to the developed countries Most of the developed economies are usually stable in growth and inflation rates They have low inflation rates while the developing countries have higher and unstable inflation rates This influences remarkably to the economy and the households' life as

a whole

4

For this reason, it is necessary to make clear the relationship between economic growth and inflation in the selected developing Asia countries including China, India, Indonesia, Malaysia, Philippines, Thailand and Vietnam ofthe period 1990-2010 The paper selects the countries since these are prominent in the speed of economic development of Asia in recent years Nevertheless, they have been bearing from the consequences of the global economy depression, and particularly the inflation rates are surging so high in these countries In addition, the selected developing countries virtually belong to A SEAN group, and my country-Vietnam is a member of this group; therefore they are in common in many aspects of the economy such as structure, natural conditions and the speed of growth, etc

The core objective of the paper is examining the effects of inflation on economic growth in the selected Asian countries At the same time, the paper tries to understand how inflation will affect economic growth differently between developing countries in the sample Furthermore, the study also tests whether thresholds remain in the relationship between inflation and economic growth or not and how the thresholds obtained in the relationship are different between the countries Last but not least, based on the results, the paper will recommend the relevant policies for economic development in Vietnam

There are four questions raised for the study, comprising the following questions: (1) Does inflation impact the economic growth in the selected Asia countries? (2) How are inflation effects on growth different from the countries?

(3) Are there thresholds in the nexus between inflation and growth of the countries? And,

(4) How different are threshold levels captured by the countries?

1.3 STRUCTURE OF THE PAPER

The rest of this paper is divided into 5 chapters:

• The second chapter reviews theories associated to the correlation between inflation and growth In addition, this chapter provides definitions of the variables used in the model The thesis also presents empirical studies for reinforcing the evidences of existence the inflation-growth relationship

• The third chapter discusses economic outlooks of the selected Asia countries including various parts of economy contributing to GDP growth rate and inflation rate through the period of 1990-2010 The statement of each country will be summarized and captured through the figures in an attempt to expose partly the edge of economy for each country

• The fourth chapter presents specific theoretical and empirical research models on purpose of employing the appropriate models for the research Besides, the selected research methodology and data source using for estimating the models will be indicated in a detail way so as to catch the idea of the thesis

• The fifth chapter presents the empirical results of the study Firstly, descriptive statistics of each country will be pointed out as an overview about prediction of regression results Next, the results achieved from regression the models by using Eviews 4.0 software will be showed and discussed for each country consisting of influences of inflation on growth and thresholds obtained in the inflation-growth relationship

• Finally, the last chapter will provide conclusions related to the results achieved in the previous chapter Accordingly, the thesis will suggest some policy recommendations in the hope to aid the countries solve their issues At the same time, the paper will indicate research limitations and further study

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•

The thesis also consists of four appendices:

• Appendix A provides the regression result of the quc;tdratic model by using the fixed-effect method of panel-data and treated by SUR in an attempt to reduce the problems involved in regression

• Appendix B contains the scatter diagrams between two variables comprising squared-inflation and growth of each country The diagrams are showed for supporting to find out thresholds

• The results of testing Heteroscedastiscity via White-test approach for each country will be contained in Appendix C

• Appendix D consists ofthe scatter diagrams describing the correlation between the variables in the model of each country

• Chapter 2

LITERATURE REVIEW

This chapter will review the literature related to the relationship between inflation and growth, which are key issue in the research Firstly, the theories of the inflation-growth correlation will be addressed to give a foundation of the growth research Secondly, growth models are also indicated for the purpose of understanding the association between the growth and other primary factors apart from inflation, particularly one of the growth models will be employed for the study Thirdly, the variables included in the model will be clearly defined and described in details Finally, the empirical studies linked to the growth-inflation nexus will be mentioned as a prominent reference source

Base on the quantity theory of money cited in Azar's paper (2009), a negative relationship between output and the price level arises when there is a movement along the aggregate demand (AD) curve The derivation of the AD curve is from the equation of exchange:

MV=PY

The equation indicates that if money supply (M) does not vary and velocity (V) is kept constant, then an increase in real output (Y) would result in a decrease in the price level (P) so as the equality held Nonetheless, a movement in AD curve will only occur when aggregate supply (AS) curve shifts (Azar, 2009)

According to Mishkin (200 1 ), four core factors decide to movement of aggregate supply (AS) curve to the left, causing the price level grows up and conversely a fall in

8

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the output Firstly, when output is beyond the natural output rate, a pressure is boosted

in the labour market which increases in wages and obviously production costs As the result, the AS curve shifts to the left And the second determinant is that when expected inflation is not neutral and negative correlation with output And the last factor which is known as a negative supply shock such as an increase in oil price or volatility in the commodity markets will give a rise a movement of the AS curve to the left

The below section presents the additional theories linked to both variables: inflation and growth They comprise the Classical, Neo-classical, Endogenous, Keynesian, Neo-Keynesian and Monetarist theories Not only do the theories support to gain more understanding about the inflation-growth correlation, but also mention the impacts of other factors on the growth in general

It is widely knovm that Adam Smith and David Ricardo are the prominent economists for the classical theory Their perspectives to the theory are that the economy is self-regulating and always at full-employment The technological changes are highly assessed for impacts on the economic growth (Me Taggart et al., 1996)

Furthermore, the theory determines three factors having the effects on the economic growth are capital, labour and technology Among these factors, capital is embodied

by investment and saving, the target to mention the variable is its role to the inflation-growth relationship When inflation rate goes up, the real interest rate surely goes down; and it means that saving rate will reduce, this does harm to investment as saving is one of core sources facilitating to investment Although the real interest rate decreases, it is a chance for investors to increases in borrowing, the lack of capital is restricted borrowings (Me Taggart et al., 1996)

Solow (1956) and Swan (1956) are pioneers in indicating the neo-classical models

Nonetheless, the person who discovered a new mechanism involving the inflation-growth relationship is Mundell Base on the model of Mundell (1963), the affluent of people would decrease if the inflation or inflation expectations increase (Gokal and Hanif, 2004) Cass (1965) and Koopmans (1965) developed neoclassical growth model by comprising variables like investment and population growth in the growth regression The model estimates that a stimulus in economic growth is thanks

to an increase in investment rate and a combination to a reduction in population growth rate

For a New Classical theory, inflation puts a tax on money balances when the spending purpose of the government is for promoting growth Besides, high inflation often combines with a rise in variability of inflation, which give way to increasing costs and risks of capital and inversely influences resource allocation (Paul et al., 1997)

The Endogenous theory is commonly so-called the new growth theory The theory comprises the main motivations in explaining differences of growth rate across countries and a higher rate of the growth observed The economic growth determined

in the Endogenous growth theory is generated by factors within the production process (Todaro, 2000)

The theory identifies that inflation brings about the impacts on growth v1a two channels are investment and capital accumulation At the same time, with the help of the Endogenous models, growth is explained further with human capital And the growth rate is expanded through depending on the return rates of both human capital and physical capital (Gokal and Hanif, 2004)

In contrast to the Classical theory, the Keynesian theory states that the economy cannot be left alone and achieve full-employment without interventions of fiscal and monetary policies The Keynesian theory is one of the Aggregate Demand Theories,

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thus the factors influence the growth in terms of the aggregate demand such as consumption, investment, government expenditures and so on Besides, the theory assumes that fluctuations of aggregate demand depend on expectations which named

as "animal spirits"1

According to the conventional Keynesian viewpoint, inflation is viewed as a stimulus

to economic growth This is the view that is dominantly expressed via a short-run Phillips curve arises in light of sticky prices and wages (Dornbusch et al., (1996) and Mallik and Chowdhury* (2001)) Therefore, inflation is able to give rise to a faster real growth in the short-run (Motley, 1998) Nonetheless, when economic agents are likely to join in price changes, the Phillips curve trade-off maybe disappear The schools of thought were especially famous in the 1960's and still develop into the 1980's (Bruno et al., 1996) Also, Paul et al.( 1997) claimed that in a Keynesian theory, inflation stimulates growth through redistributing income from labours to firms with higher level of propensities to save and invest

The original ofNeo-Keynes~an theory is from the perspectives of the Keynesian theory The theory mentions that the level of real growth (GDP) and the natural rate of employment are the main factors influencing inflation (Me Taggart et al., 1996)

According to New Keynesians, there is non-neutral in the relationship between inflation expectations and money supply changes In particularly, if inflation is higher expected, money supply level would be expanded As a consequence, AD curve will shift to the right and promote to production a higher output

When it comes to the Monetarist theory, we cannot forget two representative

1 The expectations determined here are news or rumours about interest rate, tax rate, technological advances or world

economic events; whereas aggregate supply is in response to changes in money wage rate (Me Taggart et al., 1996)

i

economists for the theory, they are Milton Friedman and Brunner The theory agrees with the Classical theory that the economy is self-regulating and at full-employment And the fluctuations in the aggregate demand rely on the quantity of money In opposite to this, the factor which affects the aggregate supply is the money wage rate

as mentioned at the Keynesian theory

The Monetarist theory focuses on fiscal policy like reducing taxes, this resembles to the policy used by the Classical theory Moreover, the Monetarism convinced that the economic growth will be stable if the money supply increases steadily To be updated

by the Quantity theory, the Monetarism reconfirms the important role of monetary growth in affecting inflation (Me Taggart et al., 1996)

Base on many studies, the negative effects of inflation on economic growth have been estimated in the context of the economic growth models The models show that the outcome of capital accumulation along with technological progress results in the continuous increase of per capita income And the uncertainty of rate of return of capital and investment is caused by a high and volatile unanticipated inflation Nonetheless, even inflation is totally anticipated, also it may reduce the rate of return

of capital (Bruno and Easterly (1998), Pindyck and Solimaoo(1993))

Besides, inflation causes the negative effects on human capital or investment in research and development, and indirectly affects economic growth But the most significant impact of inflation leads the long-run macroeconomic performance of market economies to worsen via depreciating the total factor productivity (TFP) That

is known as the efficiency channel and difficult to set up in a theoretical model Nevertheless, the channel plays a core role in the transmission mechanism from inflation towards a lower economic growth, thus it cannot be rejected in the estimation the effects of inflation on growth

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•

This part will review the main growth models like the basic growth model, the Solow and augmepted Solow growth models The models are coherently described the effects of determinants to growth According to the growth theory, growth bases on three core processes: the first one is the accumulation of assets like capital, labour and land; the second one is making the assets more productive, especially saving and investment; and the last one is technological progress The premise of showing the models is to determine other main factors affecting on the GDP growth apart from inflation At the same time, one of the models will be applied as a basic model for the paper

The most fundamental models of economic growth are based on a small number of equations that relate saving, investment, and population growth to the size of the workforce and capital stock and, in tum, to aggregate production of an individual good These models initially focus on the levels of investment, labour, productivity, and output (Todaro, 2000)

As we have stressed, the aggregate production function is at the heart of every model

of economic growth This function can take many different forms, depending on what

we believe is the true relationship between the factors of production (capital and labour) and aggregate output Standard growth models are known to have had one or many production functions And at the national level, the production functions present the association of both the size of total labour force and the value of capital stock of a country with the scale of total output of that country (Todaro, 2000)

By virtue of the limitations in the Harrod-Domar model, Solow replied by eliminating the fixed-coefficients production function and superseding it with a neoclassical production function that helps to induce more flexibility and substitution between the factors of production The capital-output and capital-labour ratios in the Solow model

are not be fixed, instead they will change, and the variation will depend on the comparative endowments of capital and labour in the economy and the production process The model of Solow states that a production function with the same assets of diminishing returns to capital And the Solow model is known as the key of most theories of economic growth and having considerable influences in developing countries (Todaro, 2000)

For Solow model, decreasing marginal returns to capital is a core assumption which contributes an economy in the growth process to achieve the steady state where all factors output per capita, capital stock and consumption increase at a same rate equalling to the exogenously indicated rate of technological development

Base on Solow's suggestion, the economic growth is studied through decreasing returns to capital of a standard neoclassical production function He points out that the rates of saving and population gro\\-1h resemble exogenous, and they are responsible to show the steady state level of income per capita An advantage of Solow model is giving simple testable predictions in terms of how the saving rates and population growth affect the steady state level of income In details, the country is to be the richer

if having a higher saving rate While the country will become the poorer if the rate of population growth is higher (Mankiw et al., 1992)

Nevertheless, the Solow model's assumptions are not completely right; the model has

no accurate prediction about the magnitudes of the saving rates and population growth

As a consequence, the augmented Solow model is suggested in order to help us understand clearly the relationship between saving, population growth and income The model comprises accumulation of human and physical capital It is realized that eliminating human capital from the Solow model is main reason to explain why saving and population growth have a large effect on income Besides, the augmented Solow model confirms that accumulation of human capital is associated with the rates of saving and population growth, thus the estimated coefficients on saving and

14

population growth will be biased if we omit building up of the human capital (Mankiw

of value added in the economy during a given period Lastly, GDP is the sum of incomes in the economy during a given period

In macroeconomic theory, the economic growth is visualized as an outward shift in the production possibilities frontier (PPF) According to Me Taggart et al (1996), the real gross domestic product or GDP will be employed for measuring the economic growth There are two approaches used to determine GDP: the first one is the total expenditure

on goods and services It is explained that for the real GDP demanded (Y), it is the sum of consumption expenditures (C) by households, real investment (I) by firms, government expenditures (G) and net exports (X-M) (Me Taggart et al., 1996)

Y=C+I+G+X-M

And the second one is the total income earned through producing goods and services

or the real GDP supplied It is the total amount of the factors including wages, interest, rent and profit which are paid for production (Me Taggart et al., 1996) While the real GDP supplied is measured by the aggregate production function as follows:

Y= F (L, K, T) Where: L is labour, K denotes for capital, and T stands for technology

Inflation rate is determined as the per cent change per year in a price index, especially the consumer price index It is also known as the increase in the average level of prices Inflation is a process of rising prices and measures as the percentage change in the average level of prices and the price level Thirlwall (1974) defines that inflation as a

"rise in the general price level whatever its cause" According to the view of Mishkin

(200 1) inflation is "a continual increase in the price level" In the paper of Dornbusch

et al.( 1999), inflation is defined as ''the rate of change in prices" There are many various definitions about inflation, but it has a common point related to changes in price

The Consumer Price Index (CPI) is a common measure of the price level It is a signal

of how the average prices of goods and services bought by the specific household change from one period to the next (Gerber, 1999) Economically speaking, two key purposes of CPI consist of measuring variations in the cost of living and changes in the value of money And computing the inflation rate will meet these changes The following formula is used for calculating the inflation rate:

I n awn rae= fl t t (CPlt:hisy~rar-CPllasey~rar) X lOO

CPI lcut year

It is commonly known that besides CPI, there are two alternatives employed to measure the inflation rate The first one is the producer price index or PPI, obtained to compute changes in the input prices purchased by producers And the GDP deflator is a second one; it is calculated by multiplying the nominal GDP rate to real GDP of a given year for

16

100 Nonetheless, CPI has many advantages and common in use rather than PPI and GDP deflator According to many studies, CPI is used to reduce the negative impacts of inflation on growth, but is not caused by inflation Besides, CPI is a better choice in comparison to GDP deflators since the growth rates are negatively associated with the changes in GDP deflators (Gerber, 1999)

Although theoretical models clearly indicating the long-run impacts of inflation are shortage, this has not deprived many researchers from attempting to assess the costs of inflation There are many ideas surrounding that inflation is harmful to economic growth Indeed, inflation causes difficulties for economic agents to make accurate decisions because fluctuations in relative prices become difficult to anticipate (Harberger, 1998) Furthermore, Feldstein (1982) found that inflation is detrimental to economic growth through imposing many substantial costs, resulting in distorting relative prices and so investment decisions and resource allocation

Additionally, inflation leads to erode tax reduction for depreciation and to push up the rental price of capital, as a result of a deduction in capital accumulation and hence in production growth (Clark, 1982) Friedman (1977) indicates that at a higher inflation rate leads to a higher volatility of inflation, then affects seriously to growth The expectations-augmented Phillips curw shows that expected inflation is equal to actual inflation in the long-run, and the unemployment rate is at its natural level Hence, in the long-run, a nominal variable like inflation does not have an effect on real variables like unemployment rate or growth; in contrast, there are other nominal variables having

a negative impact on the real variables

When it comes to the impacts of inflation, we are familiar with the views of menu costs2 and shoe-leather costs3 Especially, inflation attributes many forecast errors by biasing the information contents of market prices, and compelling economic agents to

cost more time and resources for collecting or gathering information In addition, the economic agents ought to look for measures to detect them against the deteriorations or the dama,ges generated by price instability, therefore, causing dangerous for allocation

of resources It is known that if there is hyperinflation, variability of inflation increases

as well, causing complex the duty in forecasting inflation Moreover, if inflation is unable to anticipate precisely, savers and investors may make wrong decisions, which hurt economic growth Inflation might restrain the confidence of domestic and foreign investors about the future of monetary policy

At the same time, high inflation results in many negative effects First of all, inflation leads to welfare costs on society What's more, inflation also constrains financial development in light of generating intermediation more expensive More seriously, it accelerates the poor dramatically inasmuch as these do not have financial assets that help to fight with inflation For international trade, inflation restricts competition in a country owing to making its exports comparatively more costly; consequently, it negatively affects the balance of payment and most considerably, decreases long-run economic growth (Feldstein (1982) and Khan and Senhadji (2001)) According to Feldstein (1982), inflation can link to tax system through making inaccurate lending and borrowing decisions This grows up the cost of capital, thus limitation in investments and consequences in growth

It is universally agreed that almost all of the empirical studies based on endogenous, neoclassical and neo-Keynesian growth theories cannot indicate or determine a correct list of explanatory variables This is viewed as a common issue in seeking explanatory variables for the model Thus, how we must do to find out the main independent variables for the model so as to avoid omitting key variables For this reason, three suggestions are raised Firstly, we can base on macroeconomic theoretical framework Secondly, the paper takes the explanatory variables from the augmented Solow model chosen for the research model The last one is relied on the empirical growth literature

18

The total output of a country depends on the amount of available capital and labour and productivity of the assets In addition, the neoclassical growth theory attributes the output growth to more than three factors comprising the increases in both labour quantity and quality via population growth and education, rises in capital through saving and investment, and lastly advances in technology (Todaro, 2000) Many studies point out that aside from growth in the labour force, the key determinants for economic growth are investments in both physical and human capital, open trade policies, and low inflation rates Besides, another important factor contributing to output growth is ability to adopt the technological progresses Since it is widely known, developing countries rely mainly on agriculture, so the supply shocks in the sector give rise to a negative impact on growth as well

At the same time, there is some evidence about the core components of the economic growth: the first is capital accumulation with all investments, physical equipment, and human capital with progresses in health, education and so on The population growth contributes to the growth in labour force which is a good determinant in inducing the economic growth, and the improvements in technology will become good methods to get the objectives (Todaro, 2000)

• Human capital: One of the important factors influencing the gro·wth is human capital taken in the forms of education and health Assume that at a given values

of potential and actual GDP, a country will grow faster and get a long-run position more quickly, if the human capital level is greater at the curre11t time The causes are that to match a high human capital, physical capital must be expanded Additionally, a high level of human capital aids a country to acquire and adapt quickly to the high technologies developed in the top countries (Barro, 1996)

According to Ghosh and Phillips (1998a), a faster output growth is associated to

a higher human capital And the growth theories also recognize the crucial role

of human capital in an economy There are lots of different measures of human capital including school emollment rates, the average completion years of

'

elementary and high school, etc Some studies argue that in the case human capital is not mentioned in the model, the quantitative implications of both various saving and population growth rates will fall into biased upward status (Knight et al., 1993) Base on the estimation results, savings and population growth positively associate to human capital development

• Physical capital consists of investment and saving Investment adds to the stock

of capital and is one of the determinants of the rate at which production grows Investment is financed from three sources: private saving, government budget surplus and borrowing from the rest ofthe world (Me Taggart et al., 1996) The neoclassical theory theorizes that capital accumulation is a motivation of the economic growth

• Labour force is the participation rate of labours in the economy According to Nelson and Phelps (1966), an enormous size oflabour force makes it easier for

a country to catch up with new products or ideas from other countries The quality development of labours assists new products or inventions that contribute to technological progress Furthermore, both a large and well grown labour force give way to a more quick rate of production of new products and hence tend to develop faster Nonetheless, a faster population growth will result in a lower output growth owing to an increase in shares of government consumption, incomes and an overvalued exchange rate

• Net export defined is the value oftotal exports of a country minus the value of

its total imports Net export is employed to compute aggregate expenditures, or GDP of a country in an open economy Or another definition is addressed in a more clearer way is that net export equals exports of goods and services produced in a country minus imports of goods and services of the country produced other countries It is referred to as a trade surplus when exports are over imports or net exports are positive; adversely a trade deficit will occur when exports lower than imports or net exports are negative

20

i

Base on the research, there are two main reasons which growth is led by export The first one is that export can generate profit and support a country to balance its finances, simultaneously allow the country to surpass its debts if th€ goods and services for the exports exist Secondly, an increase in exports is able to bring about a greater productivity

Net export= Export- Import

• Total factor productivity (TFP)

Total factor productivity or TFP is a measurement of the quantity of output per unit of input Increases in TFP mean that overall productivity has improved and that a given level of inputs will create more output; hence, technology or enterprise organization must have improved (Gerber, 1999)

Inflation threshold is defined as the turning point in which impacts of inflation on growth will switch the direction Specifically, it can be positive or even insignificant effects at inflation rates which are lower than the threshold level And the effects of inflation on growth will be negative if the inflation rate is at inflation rates higher threshold Sarel (1995) and Ghosh and Phillips (1998a) showed that threshold levels in the inflation-growth relationship are likely to exist, it is expressed that if the inflation rate is above the threshold, it will have a negative impact on growth, conversely it is able to have a positive effect or no clear, if the inflation rate is below the threshold

According to Sarel(l995), if threshold or structural break is neglected, the impact of inflation on growth is biased by a factor of three The threshold is a central part in the inflation-growth correlation The structural break is far more powerful in the impacts

of inflation on growth than the results of the past papers (Slok, 1999)

The paper of Drukker et al (2005) proposes four main predictions in the literature

related to the effects of inflation on economic growth The first one is that inflation does not have any impact on growth because base on the view of Sidrauski(l967), money is super-neutral Nevertheless, the second prediction points out the view of Tobin (1965) that there is a positive effect of inflation on long-term growth now that money is a substitution for capital Theoretically speaking, Tobin and Stockman indicated the effect of inflation on growth is more than on the balanced-growth rate of output

In contrast to the second prediction, according to Stockman(l981 ), money is complementary to capital in cash-in-advance model; hence inflation will have a negative effect on long-run economic growth Applying the endogenous growth framework of Lucas (1996) and Gomme (1993) connected to a cash-in-advance exchange technology to measure a remarkable negative effect of inflation on growth (Gillman and Nakov, 2001 ) Conversely, a latest prediction or a new class of models suggests that inflation will only impact negatively long-run growth if the level of inflation surpasses a threshold level (Huybens and Bruce, 1998)

A perspective of the new growth models is that inflation has a positive effect on growth at short-run; in contrast, in the long-run the impact will be negative on growth Meanwhile, Fischer*(1993) shows that the long-run growth is positively related to good fiscal policy and an ~distorted foreign exchange rate, but negatively connected to inflation Nonetheless, in the long run, it will not be robust in inflation-growth relationship if there is a cross-section data (Levine and Renelt, 1992) In the new growth literature, the relationship between inflation and growth will be a statistically significant negative impact if we use panel data with many options such as decade averages, five year averages or annual data (Bruno and Easterly, 1998)

In 1960s, the economy all over the world is in high-growth and low-inflation, the conventional idea that it is no longer so tough for destroying caused by inflation And

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- - - -

-the Phillips curve has become a prominent -theory in this period because it states a positive relationship between inflation and growth in the short-run Especially, Tobin (196_5) and Sidrauski (1967) found a positive impact of inflation on growth in the long-run, even with a high inflation rate An explanation is that when inflation is in a high level, richness will allocate into physical capital instead of money This is similar

to the development theories in which inflation is viewed as a good approach to move resources for accumulation of capital (Bruno and Easterly, 1998)

The examinations into remains of the relationship between inflation and growth have experienced a long period Though nowadays almost economists commonly agree that inflation has a negative impact on economic growth, some researchers ofthe 1950s and the 1960s found out the opposite evidence There are the studies conducted by the IMF staffs around 1960s indicated no evidence of negative effects from inflation to growth (Li, nd) Also, implemented in 1970s, the researches state that the effect of inflation on grov.rth is insignificant and even positive Mubarik (2005) supports that moderate inflation rates are one of the determinants stimulus economic growth Deeply, in the short-term, inflation is possible to promote growth by broadening macroeconomic policies, however in the long-term, the impact is not sustainable

Nevertheless, the inflation-growth association had not been ensured until countries have suffered from some crises of high inflation in the 1980s It is apparently ambiguous in the relationship between inflation and growth whether the relationship is short-run or long-run since the empirical relationships was weak in the long-run but strong in the short-run (Bruno and Easterly, 1998) Also, it is known that high and persistent inflation took place in many countries in the 1970s and the 1980s which lead to changing in the viewpoints of the previous studies In addition, lacking of data and ignorance of thresholds in the relationship between two variables are the reasons

of why inflation has a positive impact on growth

2.4.2 The Studies of 1990s

Some papers around 1990s found the damages of inflation to growth in a research of Fischer*(1993) and Barro (1995) , an increase in the average inflation rate by 10 percentages would decrease the real growth rate by 0.2 to 0.3 percentages per year Plus, the increase of inflation rate results in diminishing the marginal value of consumption, hence causing people to work less This gives rise to consistently reducing of the marginal product of capital, and a slower rate of accumulation of capital is an outcome (Gomme, 1993) Another studies are implemented to look for whether inflation is likely to straightforward influence physical capital accumulation and so the growth The evidence is that a rise of inflation rate leads to the return of deposits to go down, and the deposits are built up at slower level Meanwhile capital

is a part of deposits, in this way the capital accumulation and the growth will slow as well (Marquis et al.( 1995) and Haslag ( 1997) ) Furthermore, it is stated that inflation affects growth via the investment channel (Barro, 1996)

There is a wide consensus that in the long-run, it is not sceptical about negative relationship between inflation and economic growth (Barro (1995), Fischer* (1993), and Bruno and Easterly(1998)) Though Barro (1996) and Sala-i-Martin (1997) did not obtain inflation variable in any their papers, the new growth theorists were often attracted notice to the variable The theorists suggested mechanisms in which inflation is able to negatively affect growth Inflation is like taxes on capital in models with asking for cash-in-advance for investment Bruno and Easterly (1998) Moreover, it is widely known that a negative impact of inflation

on growth is now found in the new growth literature A study in 1985 had indicated that inflation had a negative impact on growth At the same time, it was also reported that growth was linked reversely to inflation (Fischer*, 1993)

Although inflation is a bad impact, it is not significant if there is not any evidence from previous studies The studies have found a nonlinear relationship between inflation and economic growth Sarel (1995), (Ghosh and Phillips, 1998a, Ghosh and Phillips, 1998b), (1998) In other words, the relationship between inflation and growth captures thresholds Sarel (1995) and Ghosh and Phillips (1998a) showed that

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threshold levels in the inflation-growth relationship are likely to exist, it is indicated that if the inflation rate is above the threshold, it will have a negative impact on growth, conversely it is able to have a positive effect or no clear, if the inflation rate is below the threshold Moreover, if the structural break is neglected, the impact of inflation on growth is biased by a factor of three (Sarel, 1995) The threshold is a central part in the inflation-growth correlation The structural break is far more powerful in the impacts of inflation on growth than the results of the past papers (Slok, 1999)

There are many detailed findings in the studies so as to the impact of inflation on growth Sarel (1995) examined the inflation-growth relationship of 87 countries including developing and developed countries during 1970-1990 by using OLS with fixed effects And the results showed that there is a nonlinear correlation between two variables In particularly, he found a threshold of 8 percentages for the relationship Furthermore, a paper of Ghosh and Phillips (1998a) checked again the findings of Sarel (1995), they stated that a lower structural break point at 2.5 percentages in annual inflation rate remained in the association Another research of Christoffersen and Doyle(1998) gave a different result of the turning point which inflation would have the effects on growth is at 13 percentages for transition countries Expanding the study, Christoffersen and Doyle(l998) added the four Asian transition economies to panel data set, resulting the inflation threshold reduces from 13 percent to

·approximately 8 percent This proves that although a negative impact of inflation on growth obtained in Asian transition countries, it does not mean that the negative effect will increase if inflation rate go beyond a certain point

However, it is invisible that at intermediate rates of inflation is how growth will be influenced Since if considering to one threshold level in the inflation-growth relationship, we will merely know the impacts of inflation at below or above threshold level on growth It is impossible for us to get an answer for how to deal with middle rates of inflation; consequently we will forget or omit a central part affecting the results To make up the shortage, the economists found two thresholds in the relationship between inflation and growth The paper of Ghosh and Phillips(1998a)

- - - r - - -

pinpoint that two thresholds recorded in the relationship, at inflation rates of less than 2-3%, inflation affects positively growth However, it will be much more negative impact of inflation on growth if inflation grows up from 1 0% to 20% rather than from 40% to 50%

To contribute to the evidence in terms of two thresholds in the inflation-growth correlation, Khan and Senhadji (2001) carried out the study specializing in testing the thresholds with a large sample for both developing and industrial countries And they found that there are two pairs of thresholds in the inflation-growth relationship, a pair threshold of 1-3 percentages for developed countries and the rest pair is 11-12 percentage for developing countries Additionally, they also indicated a general threshold for a whole sample is 8 percentages Some contributions of other authors to the inflation-growth association, Li (nd) estimated that the relationship between two variables is nonlinear In details, he pointed two outcomes obtained in two different groups comprising developing and developed countries For the developing countries, two thresholds found in the relationship are 14% and 38%; meanwhile for the developed countries, the only threshold proved in the correlation is at 24% Another study of Sepehri and Moshiri(2004) used Sarel's model for estimating thresholds across four groups of countries, but they only found three thresholds including 15% for the lower-middie-income countries, 11% for the low-income countries and 5% for the upper-middle-income countries

As indicated above, two threshold levels will fulfil a precise result in comparison to one threshold Nevertheless, Le (20 11) used the method of Khan and Senhadji (200 1)

to seek the threshold in the inflation-growth relationship for Vietnam She found at the threshold level of 9.2 percent will be an ideal level which inflation can help the economy to grow up Moreover, she indicates that the relationship between inflation and growth is negative; nevertheless, the growth is higher in response to changes of inflation than the response of inflation to the growth elasticity Although this paper also uses the method of Khan and Senhadji (2001) for search for thresholds, it has

26

The study will follow the Augmented Solow model and run regressions with panel data; in addition, this paper will add some core variables in the model in an attempt to sidestep biases

Table 2-1: Summary of the papers with thresholds found in the inflation-growth correlation

1998b 87 countries lower than 2-3%; and a negative

40-50%

Transition

1998a countries Doyle, 1998)

Added four Christoffersen and Asia transition

previous study

Khan and Senhadji 2001 140 countries 1-3% for developed countries, and

11-12 % for developing countries 19.16% for full sample

(Drukker et al., 2005) 2005 13 8 countries 2.57% and 12.61% for industrialized

countries (Munir et al., 2009) 2009 Malaysia 3.89%

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120 countries Pakistan CIS countries SADC region Lesotho Nigeria

28

countries 3.89%

15% for the lower-middle-income countries; 11% for the low-income countries; and 5% for the

8%

18.9%

10%

7%

Wachtel, 2002)

2005 80 countries

(Jha and Dang, 2011) 2011 213 countries 1 0% for developing countries

(Morar, 2011) 2011 South Africa 9.5% and the range of 5.5%-6.5% also

stimulates growth rate

in the inflation-growth relationship or not Simultaneously, the meaning of effects of inflation

on growth when there are the structural breaks remained will be described shortly Lastly, the approaches employed to look for the thresholds also are indicated in Figure 2-1

•

Chapter 3

ECONOMIC OUTLOOKS OF THE STUDIED

COUNTRIES

The developing Asia countries tackled well with the global economic crisis, it is due

to decisive and efficient fiscal and monetary approaches applied by governments that helped these countries overcome the turmoil It is realized that economies have been recovering step by step, especially for the richer economies Base on statistics, the gross domestic product growth of some of Asian countries noticeably gained double-digit in the middle of 2010 Asia's rapid gro"'1h path can be explained by an extended version of the neoclassical growth model that incorporates the role of human capital and technology catch-up (Barro (1996), Sala-i-Martin (1997) and Lee and Hwang (2001))

Developing Asian countries are known as grown impressively over the period of roughly three decades Real GDP in terms of purchasing power parity of the Asian area accelerated from around $3.3 trillion in 1980 to $24.5 trillion in 2009, an eight-fold increase It is double to the economic growth rate of the world economy in the same period With robust and strong growth in the long-run obviously helped to lift up incomes, reduce poverty and expand the global economic impact of the Asia area Lucas(1996) indicates that the economic growth of Asia is a miracle in the 1990s, and there are determinants having an effect on growth including investment, human resources, fertility, and institutional and policy variables Lee and Hwang (200 1) state that East Asia grow rapidly owing to immense potential for catching up alongside favourable geography and structural characteristics, demographic dividend,

•

3.1

economic policies and strategy that encourage to growth The economic policies associating to openness are showed to play a prominent role in sustained growth of the region The growth rates across developing Asia countries have changed in the past 30 years The foiJowing sections wiiJ review the economic development of the selected Asian countries in study

Economic Outlook of Vietnam

The GDP growth rate and the inflation rate of Vietnamese economy in the period of 1990-2010 are presented in Figure 3-1 Vietnam has a background of a high inflation rate and low growth rate Inflation rate of Vietnam often reaches at 2 digits, but growth rate is only at 1 digit In 2008, Vietnam suffered from the global economic crisis, as a consequence it pushed inflation rate up to more than 20 per cent Although it decreased in 2009, continuing to increase significantly in 2010 Whileas growth rate also recovered but at a modest portion

The Vietnamese economy grew quickly in 201 0; it is thanks to recovery in exports and an efficient monetary policy However, inflation reached to double-digit by lately

2010 and the currency increased With the macroeconomic stability as a priority, the governments introduced some measures comprising of a combination of tightened monetary and fiscal policies Consequently, GDP growth is anticipated to moderate

in 2010 and will rise up in 2011 Moreover, inflation is expected to reduce in 2011 The prompt challenge is to perform well the tightened policies, the longer-term one

is to give a new energy structural reforms (Mellor et al., 2011)

Vietnam growth achieved roughly 5.66% in 2010, partly thanks to recovery in the global economy plus the appropriate domestic fiscal stimulus in 2009, and monetary policy as well Besides, a significant increase in consumption of9.7% stimulated the investment in private sector, industry increased by 7 7% which contributed to GDP around 3.2% The external demand grew strongly and added 8.4% to growth in manufacturing, moreover the investment in public infrastructure encouraged construction growth at 10 1% Services estimated to grow by 7 5% and complement

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