Inflation not only reduces the level of business investment, but also the efficiency with which productive factors are put to use.
Since 1984, inflation control has become the unquestioned mantra of economic policymakers worldwide. Even a whisper of "the I-word" by Alan Greenspan in the financial press creates havoc in global stock markets. Based in part on the 1973 to 1984 period of macroeconomic distress experienced by OECD countries, when inflation reached an average rate of 13 percent, monetary policymakers have assumed that faster sustainable growth can only occur in a climate where the inflation monster is tamed.
Unfortunately, there has been a shortage of research conducted to support this intuitive belief. In an attempt to correct this, an NBER Working Paper by Javier Andrés and Ignacio Hernando analyzes the correlation between growth and inflation in OECD countries during the 1960-92 period. In Does Inflation Harm Economic Growth? Evidence for the OECD (NBER Working Paper No. 6062), Andrés and Hernando find that even low or moderate inflation rates (as we have witnessed within the OECD) have a temporary negative impact on growth rates, leading to significant and permanent reductions in per capita income. A reduction in inflation of even a single percentage point leads to an increase in per capita income of 0.5 percent to 2 percent.
As the authors point out, their analysis leaves little room for interpretation. Inflation is not neutral, and in no case does it favor rapid economic growth. Higher inflation never leads to higher levels of income in the medium and long run, which is the time period they analyze. This negative correlation persists even when other factors are added to the analysis, including the investment rate, population growth, schooling rates, and the constant advances in technology. Even when the authors factor in the effects of supply shocks characteristic of a part of the analyzed period, there is still a significant negative correlation between inflation and growth.
Inflation not only reduces the level of business investment, but also the efficiency with which productive factors are put to use. The benefits of lowering inflation are great, according to the authors, but also dependent on the rate of inflation. The lower the inflation rate, the greater are the productive effects of a reduction. For example, reducing inflation by one percentage point when the rate is 20 percent may increase growth by 0.5 percent. But, at a 5 percent inflation rate, output increases may be 1 percent or higher. It is therefore more costly for a low inflation country to concede an additional point of inflation than it is for a country with a higher starting rate. Given their detailed analysis, the authors conclude that "efforts to keep inflation under control will sooner or later pay off in terms of better long-run performance and higher per capita income."