The high inflationary environment has opened up a debate among researchers and policy making institutions on threshold inflation and economic growth. It is generally believed that a low inflation rate is conducive while the high inflation rate is harmful for economic growth. Recently, many economists have conducted several studies on the topic and explored a threshold level of inflation for developed and developing countries.
Khan and Senhadji (2001) estimated 1-3 per cent and 7-11 per cent threshold levels for industrial and developing economies respectively. Later on Mubarik (2005) estimated nine per cent threshold inflation level for Pakistan. Most recent study was conducted by Hussain (2005), who estimated five per cent conducive inflation level for Pakistan.
The recent research work done on inflation for formulating better national economic policies needs to be appreciated. Personally, confused after a thorough study of all these papers, I collected the data for the period of 1973-2005 on inflation and growth and then computed simple averages of inflation and growth for three and half decades (1970, 1980s, 1990s, 2000-05).
Here two extreme values of 1974 and 1975 were excluded (inflation and growth). The computed data show that the economic growth was on average 5.1 percent in 1970s, 6.2 per cent in 1980s, 4.4 percent in 1990s and 4.7 percent in last five years (2000-05) while the inflation remains 8.8 percent, 7.4 percent, 9.5 per cent and 4.7 per cent respectively.
Such analysis of three and half decades indicates that inflation in the range of 6-8 per cent supported economic growth (5.1-6.2 per cent) of the country. However, 9.5 per cent average inflation adversely impacted the GDP growth (4.4 per cent). This is a very simple analysis for a general comprehension about the relationship of both variables.
Mubarik (2005) estimated nine per cent threshold inflation point for Pakistan and established a significant negative relationship between inflation and GDP growth. However, this study does not estimate that level of inflation that is too low for economic growth.
In this regards, Hussain (2005) also conducted a study and estimated five per cent inflation having a weak significant positive impact on economic growth while above as well as below five per cent inflation level, there is an insignificant relationship between inflation and economic growth. This shows a very surprising result that the five per cent inflation is the only best choice and any increase or decrease in inflation from that level would yield insignificant relationship between inflation and economic growth.
This study also suggests a favourable range of inflation (4-6 percent) for the economy but does not give any proof of estimation of this favourable range. Because at both (4 and 6 per cent) levels, there is an insignificant relationship between inflation and economic growth. Moreover five per cent favourable inflation level itself shows a weak relationship.
Economists in the area of inflation and growth have general agreement that unlike the developed countries, the economic resources in developing countries are underutilized. The economic growth in developing countries is stimulated through enhanced capacity utilization and therefore higher inflation (in single digit) at that time is openly accepted by policy makers.
As in case of Pakistan, the State Bank started tightening its monetary policy when inflation was close to double digits in order to contain inflationary pressure in the economy, because higher inflation (in double digits) brings uncertainty in future investment decisions and thereby hurts economic growth. However, earlier tightening of monetary policy when inflation was above seven per cent could be detrimental for tremendous economic growth of 8.4 per cent achieved in FY05.
In my view, single digit inflation is conducive for economic growth in developing countries like Pakistan.
