Inflation threshold and economic growth: Does central bank independence matter?

This article examines the impact of Central Bank Independence (CBI) on economic growth with the inflation threshold considered. There is a growing literature on the impact of CBI on economic growth. An independent central bank can control inflation (a central bank perceives high inflation to inhibit growth). Therefore, the link between CBI, inflation, and economic growth is examined in this article. It is argued that Central Bank Independence is linked to lower inflation, and lower inflation is linked to higher growth. Consequently an independent central bank would boost economic growth. But the main question is to what extent CBI can stimulate growth when dealing with inflation. In other words, what is the optimal threshold for inflation that justifies the benefits of having an independent central bank? To answer this question, a sample of 31 developed and developing countries were analysed using the threshold regression analysis. This approach has been used frequently to identify threshold level in various contexts.

There are studies that show the impact of CBI on growth and have identified thresholds for the per capita GDP in which CBI has a negative impact on growth in rich countries and a positive impact on growth in developing and poor countries. The result of an earlier paper by Gharleghi (2019) revealed a threshold of $23,000 USD for GDP per capita, when a set of developed and developing countries were considered.

With regards to the inflation and its impact on growth, various threshold levels have been identified by scholars in different contexts, ranging from 1% for developed countries and 11% for developing countries (Khan and Senhadji, 2000; Sepehri and Moshiri, 2004). Below these rates the impact of inflation on growth is positive and any threshold above these rates would deter growth. Kremer, Bick, and Nautz (2013) identified the threshold inflation of 2% for industrialised countries (above this rate there will be a negative association with economic growth) and 17% for non-industrialised economies in which any inflation below this threshold significantly reduces economic growth. So generally speaking, developed countries have a lower inflation rate (below ~5%) and developing countries have a higher inflation rate (more than ~15%). But which rate is optimum? What is the reaction of growth to the optimum threshold level?

In order to identify the role of CBI on economic growth by identifying a threshold level for inflation, some control variables are considered to make the results robust. The following equation is estimated:

Where, GDPgrowth is the PPP GDP per capita growth rate, CBI is Central Bank Independence index, POP is population growth rate, SHDW is shadow economy in percentage of GDP, CPI is corruption Perceptions Index, GOVeff is government effectiveness, INF is inflation rate, u_i is individual effect, e_it = disturbance term, β, θ, and ɤ are parameters.

Several regressions with different combinations of above control variables have been estimated to yield the most reliable results. The below table shows the estimation result of inflation threshold regression. The level of threshold is found to be 3.22% when the full sample is utilised.

Table 1 shows the impact of CBI on economic growth in the presence of threshold inflation. The threshold level is found to be 3.2% and is significant at 5%.

Table 1. Full sample countries

Note:

• *,**, *** denotes significant at 1%, 5% and 10% respectively
• Dependent variable is GDP growth. Number of countries: 31, no of observations: 124, R-square= .203

The above table specifically signals that when inflation is below 3.2%, the CBI impact on growth is negative. Generally, industrial economies experience low inflation (less than 3.2%), therefore having an independent central bank would negatively affect growth (in line with the previous findings of Gharleghi, 2019). This negative impact could be due to the excessively restrictive monetary policy under the conditions of rigid prices that leads to losses in growth as compared to potential. When inflation is more than 3.2%, CBI would positively affect growth. Central bank independence may be good for growth in poor countries due to its benevolent effect on preventing excessively expansionary monetary policy – and thus avoiding ruinous high inflation and hyperinflation – even though it can prevent the kind of moderate inflation that helps to grease the wheels of rigid markets.

In order to be more specific on the threshold inflation level, the sample is split into two group of countries – developed countries and developing countries with a similar analysis performed. Table 2 shows the threshold level for inflation in developed countries to be 2.5% and able 3 shows the threshold level for inflation in developing countries to be 15.9%. Both findings are consistent with the literature (Kremer, Bick, and Nautz, 2013; Sepehri and Moshiri, 2004).

Table 2. Sample of developed countries (Threshold inflation, developed countries, Threshold level reached at 2.5% and significant at 1%).

Note:

• denotes significant at 1%
• Dependent variable is GDP growth. Number of countries: 13, no of observations: 52, R-square= .874

Table 3. Sample of developing countries (Threshold inflation, developed countries, Threshold level reached at 15.90% and significant at 10%).

Note:

• ** denotes significant at 5%
• Dependent variable is GDP growth. Number of countries: 18, no of observations: 72, R-square= .180

The result of table 2 suggest that the impact of central bank independence on growth is negative for developed economies (inflation threshold ~2.5%). CBI profoundly reduces growth if inflation is below 2.5% in developed economies. Table 3 suggests that when inflation threshold is below 15.9% for developing countries, CBI would positively affect growth. If inflation is above 15.9% then CBI would negatively affect growth. However, it should be noted that the coefficients of CBI are not significant. This study once again confirms that there is a significant difference between the level of development and level of inflation threshold impact. One should be careful not to generalise these results as the sample group covers only 31 countries.

References

Gharleghi, B., 2019, Central Bank Independence, inflation, and Economic Growth, Chapter in Book title Macroeconomic Policies in the Countries of Global South, NOVA publications, pp. 211 – 231.

Kremer, S., Bick, A. and Nautz, D. (2013). Inflation and growth: new evidence from a dynamic panel threshold analysis. Empirical Economics, 44(2), pp. 861-878.

Sepehri, A. and Moshiri, S. (2004). Inflation‐growth profiles across countries: evidence from developing and developed countries. International Review of Applied Economics, 18(2), pp. 191-207.