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Chapter 1 Inflation and Growth: Is There a Trade-Off?

Manuel Guitián, and Robert Mundell
Published Date:
June 1996
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Manuel Guitián

The existence and the nature of the linkage between inflation and economic growth have been the subject of perennial interest and debate. And, like most truly controversial issues, they will continue to stimulate debate for some time. Indeed, our having gathered in the People’s Republic of China to examine precisely those topics is but another indication of the longevity of the interest in this general question.

The subject of my paper—is there a trade-off between inflation and growth?—addresses the issue squarely. In examining this question, I shall try to avoid straying from it and shall therefore not dwell on other related matters of undeniable importance, such as the causes of inflation, which have been exhaustively studied in the literature and therefore require little, if any, further elaboration. Nor will I explore the sources and process of economic growth, this being another subject that has been thoroughly examined elsewhere.

My aim in this paper is more modest: to analyze and discuss whether, how, and to what extent inflation and growth are related. There are at least three perspectives from which this complex issue can be viewed: from the standpoint of theory, from the vantage point of practice, and from the policy angle. In the following sections, I intend to review briefly each of these perspectives.

Before moving to these specific issues, though, I should stress a critical aspect of the trade-off between price performance and output developments. For a proper assessment of the characteristics of the relationship between them, it will be necessary to specify the time horizon over which its existence is predicated. After all, a key question is whether there is a trade-off between inflation and growth in the short run.1 Another, altogether different question is to examine whether this trade-off exists also over the medium to long run. The importance of this distinction must be underscored, because it brings to the surface that intertemporal choices are at stake, choices that must be taken into consideration in the pursuit of price and output objectives. It is often said that to bring inflation down by a given amount it will be necessary to sacrifice economic expansion and accept a slower than otherwise growth rate. At best, such statements hold only in the short run, as will be argued below. The relevant question should focus on the medium- to long-run evolution of growth depending on whether inflation is or is not curtailed (Bruno, 1995).

Conceptual Perspective

Numerous sources in the economic literature have posited a positive relationship between inflation and growth. Well known among them are the views, typically grouped under the label of structuralism, that were particularly prevalent in the Latin American context more than three decades ago (Harberger, 1964; and Johnson, 1967). Writers in this tradition analyzed inflation as a phenomenon caused by, and emerging from, developments on the real side of the economy, such as supply inelasticities and related rigidities in the structure of the productive sector. In their view, inflationary pressures originated in supply factors, and those pressures had to be financed in order to sustain—indeed, to promote—economic growth and development. In the structuralist analysis, growth and development were unlikely to occur and be sustained in the absence of a measure of inflation. Price-level increases and output expansions were thus bound by an uneasy but inevitable partnership. The prevalence of this type of analysis has since waned, with progressive evidence that its postulates overstated the severity and seriousness of supply inelasticities and sectoral rigidities. Possibly more to the point, the evidence indicated that structuralism also understated the extent to which the distortions and structural rigidities on which its conclusions depended were generally induced by policies and were not basic features of the productive sector of the economy.

Another set of sources focused on the relationship between inflationary financing and growth. There are several variants of this linkage that focus on different variables and causal relationships. One centers on expenditure flows, particularly outlays for investment—and, more specifically, government investment—and their impact on the growth rate of the economy. The essence of the argument is that inflationary financing, by making feasible an increasing level of investment, is an efficient vehicle for economic expansion. The argument, of course, overlooked the adverse effects of inflation on the saving-investment balance and on economic efficiency. These, as is now generally acknowledged, outweigh any apparent favorable short-run effect of inflationary financing on growth.2

Another variant of the inflationary financing and growth argument that also prevailed three decades ago was based on growth and inflation models that underscored portfolio substitution effects. These effects were based on the postulate that, with rising inflation, resources moved from money holdings toward investments in physical capital, thus raising the economy’s capital intensity and, with it, its rate of growth. This argument, however, neglects the fact that reductions in real cash balance holdings lower the efficiency of resource allocation and use and, thus, run counter to growth objectives.3

Yet another strand of the same argument is represented by early analysis based on the Phillips curve relationship, which postulated a negative link between inflation and unemployment and, therefore, by implication, a positive association of inflation with output. The analytical framework of the Phillips curve gave renewed currency to Keynesian policies because it provided another rationale for exploiting the postulated trade-off between inflation and growth. The analysis in question did not, however, provide for a role for expectations. When these are taken into account, as was the case in subsequent arguments, it became evident that the Phillips curve relationship vanished in the long run. At the level of the natural rate of unemployment (or at the more modern—though less elegant—concept of the nonaccelerating inflation rate of unemployment), the Phillips curve becomes vertical; that is, it makes unemployment independent of inflation.4

In general, the underlying proposition of all these theoretical arguments was that governments have (and should play) a pre-eminent role in the economy. In fact, governments and their policies, with their consequent financing, were viewed as the agents and instruments that were required to overcome structural supply inelasticities or sectoral rigidities; or to ensure high levels of public sector investment; or to strike the appropriate balance between inflation and unemployment.

But the pendulum has recently swung toward the market as the dominant force behind the allocation of resources. And inflation has been progressively acknowledged as an impediment to efficient resource allocation because it obscures the signaling role of relative price changes, the essential guide for efficient economic decision making. Not only does inflation undermine the effectiveness of the price mechanism, it also impairs factor productivity and diverts resources away from productive activities. This line of reasoning denies the existence of an exploitable trade-off between inflation and growth in any but a very short-run context. On the contrary, it postulates a negative relationship between them in the medium to long run.

True enough, indexation mechanisms have been devised to reduce (though not eliminate) the costs of inflation. But the continued prevalence of those mechanisms tends to be undermined by their very effectiveness. To the extent that they shield economic agents from inflation, indexation regimes reduce the base of the inflation tax and, with it, incentives to resort to inflationary policies. And to the extent that it insulates economic agents, indexation also tends to increase the costs of reducing inflation. It should not be surprising, then, that indexation schemes, where they have become widespread, have tended to be abandoned in the effort to combat inflation.5

Empirical Evidence

Another relevant perspective from which to examine the inflation-growth relationship centers on the evidence available from country experiences. And although ambiguous conclusions can rarely be derived from empirical episodes, a strong case can be made on the basis of available statistics that, by and large, country experiences support the view that inflation and sustained growth are negatively associated.

Aggregate regional data covering relatively long periods speak for themselves (see Table 1).6 Cross-sectional data, such as those presented in Table 1, mask, of course, individual country experiences and differences; therefore, they must be viewed with caution; indeed, they must be interpreted, at most, as representative only in the broadest of senses. Econometric investigations, though, tend to support the data and lead to similar conclusions. A large number of cross-sectional growth studies published during the 1980s broadly support the proposition that countries with relatively low inflation rates are also those that have experienced high growth (Levine and Renalt, 1991 and 1992). This observation, which was also made on the basis of empirical research conducted in earlier periods, becomes particularly applicable in those instances where inflation is already proceeding at significant rates.

Table 1.Inflation and GDP Growth—Regional Data(In percent a year)
Per capita growth1.10.4−1.0
Per capita growth3.23.74.9
Latin America
Per capita growth3.32.5−0.9

The shortcomings of cross-sectional examinations can be reduced, if not eliminated, by supplementing them with case studies, based on time-series analyses of country- or region-specific experiences, many of which have also been undertaken. A large share of this research points to the importance for growth performance of price stability and adequate macroeconomic management. The experience of the Asian economies in this context is often heralded (World Bank, 1993). Broadly speaking, countries in the Asian region have exhibited high standards of economic policy, and their performance record, in terms of low inflation and high growth, has been matched by few economies in other regions. In Africa, however, a recent IMF study provides mixed evidence, as a combination of low inflation and low growth has characterized the experience of a substantial number of countries (Hadjimichael and others, 1995). It is possible that the most robust evidence of a negative relationship between growth and inflation can be found in Latin America, although in this region there have also been cases where growth was maintained for some time in an inflationary environment (de Gregorio, 1992a and 1992b).

So much for regions. Let me now turn briefly to country-specific cases. Here again, there is significant evidence of a negative relationship between inflation and sustained growth (see Table 2). The evidence, though, is not conclusive because there are instances of high (low) growth accompanied by high (low) inflation, which would seem to indicate that price stability is neither a necessary nor a sufficient condition for a satisfactory growth performance, at least in the short run. But the existence of these cases must be viewed in the context of the substantial number of cases in which the posited negative link between the two variables prevails. Here again, the experience of the Asian countries would support the proposition that low inflation is critical for the maintenance of growth over the longer term.

Table 2.Inflation and GDP Growth: Selected Country Data, 1980–92(In percent a year)
High GrowthLow Growth
Inflation(above 3 percent)(below 3 percent)
High inflation (above 20 percent)ChileArgentina
Costa RicaMexico
Low inflation (below 20 percent)ChinaCameroon
IndiaCôte d’Ivoire
Sri Lanka

Empirical studies have also been conducted in the IMF to assess the effectiveness of the adjustment programs that have been supported by the institution’s financial resources. A question that has been addressed in this context has, of course, been the effect of the programs on the countries’ inflation and growth performance. The results of the various investigations have inevitably been mixed. Still, they do provide some support for the judgment that the steady implementation of adjustment efforts improves an economy’s growth and price performance. But there are also cases for which the evidence is inconclusive. Further investigation conducted to eliminate sample selection bias supports the proposition that sustained adjustment efforts have positive effects on inflation and growth (see, for example, Khan, 1990; Schadler and others, 1993; and Donovan, 1982).

Policy Consensus

I now turn to the third perspective from which the inflation-growth link can be examined. This is the perspective of the policy trend that has emerged in recent years in most countries’ economic management. This trend reflects, I believe, a widespread consensus on three fronts: the role of the government in the economy, the limits of economic policy, and the proper aim of monetary management.

First, the role of government. The consensus on this role in the context of development economics has been described as a new paradigm. Its essence is that, rather than restrain and compete with private initiatives, government action should be exercised mainly to allow and support them. Government responsibilities to foster growth and development fall into three basic categories: the maintenance of a stable macroeconomic framework; the support of the economic infrastructure, broadly interpreted to include investment in human and physical capital; and the development of the institutional infrastructure, encompassing appropriate legal, regulatory, and social frameworks, support of economic incentives, and, more generally, the setting of a competitive, open, and liberal economic regime.7 This is a major departure from the activist role (in the sense of competing or interfering with market forces) contemplated for the government in the theories that postulated a positive relationship between inflation and growth.

Second, the limits of macroeconomic policy. The related consensus that has developed on this subject is based on both conceptual analysis and empirical observations. On the conceptual front, the propositions associated with the theory of public choice, with the rational expectations hypothesis, and with the related literature on credibility have been critical in the formation of the consensus. All of them stress the constraints that economic policy faces and the consequent need for viewing its basic relevance as an instrument to provide a predictable framework in which market forces can operate. On the empirical front, most countries, industrial and developing alike, as well as those in transition to market-based economic regimes, have moved in the direction of viewing economic policy as a key means for encouraging and supporting market forces and initiatives, rather than as an instrument to mold and compete with them.8

And, third, the appropriate aim for monetary management. This more specific dimension of the policy consensus relates to the role and implementation of monetary policy and the consequent institutional setting for the monetary authority or central bank. The essential proposition behind the consensus in this area is twofold. One aspect is the general belief that the primary objective of monetary policy is price stability. And the other aspect is that the best way to ensure its sustained pursuit is to give independence to the monetary authority. These two dimensions of the consensus on monetary management have manifested themselves in a variety of forms: the growing fraternity of independent central banks; the use of nominal exchange rate anchors; and the renewed interest in currency boards and currency convertibility (see Guitián, 1994b, 1995a, 1995b).


Several inferences can be drawn from the analysis presented in this paper. The most general of them is that persistent and variable inflation will endanger long-term growth prospects.9 In this regard, therefore, stable macroeconomic management cannot but be conducive to growth. This said, though, it must also be acknowledged that such management is not sufficient to guarantee good growth performance. Another inference worth underscoring is that, in the presence of economic disturbances, prompt adjustment efforts represent the best route for safeguarding growth. There is ample evidence that in economies in which inflation has long prevailed, not only has growth tended to falter, but conflicts have arisen regarding the distribution of the burden of reducing inflation. This outcome only strengthens the argument in favor of efforts to control inflation from the outset, to nip it in the bud, so to speak. Delays lead to adaptation of behavior and adoption of indexation schemes that combine to entrench the inflationary process, thereby making its eradication difficult and progressively costly.

From a policy standpoint, the analysis in this paper has stressed the supportive role of the government in providing a stable and predictable setting for the operation of market forces as the essential contribution that public policymakers can provide to control inflation and enhance growth. It has also emphasized the severe constraints economic policy would face if it were to seek, instead, an unduly active role in the pursuit of growth (Guitián, 1988). Last, this paper has viewed the consensus on the important role of monetary policy in securing price stability as a representation of a widespread recognition of the absence of a trade-off, or the presence of a negative trade-off, between inflation and growth.


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Note: The views expressed in this paper are mine and they should not be attributed to the International Monetary Fund. I am grateful to my colleagues Tomas J.T. Balino, Hassanali Mehran, and Lorena Zamalloa for their help in the preparation of the paper.


For recent examinations of this subject, see Fischer (1994) and Debelle and Fischer (1994).


For a classical analysis of this subject, see Mundell (1965).


A detailed analysis of these points will be found in Fischer (1983).


For the classical statement on this subject, see Friedman (1968).


On indexation issues, see Dornbusch and Simonsen (1983).


For a study of the empirical evidence on these matters, see Fischer (1993).


For elaboration, see Guitián (1994a).


For further discussion of these subjects, see Guitián (forthcoming).


See, on this subject, a recent exchange of views between Robert Barro and Samuel Brittan in the Financial Times (Barro, 1995; and Brittan, 1995).

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