CENTRAL BANK OF SRI LANKA

In ation - Growth Nexus in Sri Lanka: Is there a Threshold Level of In ation for Sri Lanka?

- B.G. Nilupulee De Silva

1

A Measurement of Financial Inclusion Index Development and its Relationships

- Vathsalya Weligama

27

Real E ective Exchange Rate and Export Performance: The Case of Sri Lanka

- S.D. Nilanka Chamindani

71

ISSN 1391 - 3743

Volume 47 No. 02 - 2017

STAFF STUDIES STAFF STUDIES

CENTRAL BANK OF SRI LANKA CENTVRoAluLmBeA4N7KNOo.F2S?R2I0L17ANKA

Volume 47 No. 2 ? 2017

The views presented in the papers are those of the authors and do not necessarily indicate the views of the Central Bank of Sri Lanka.

ISSN 1391 ? 3743

Printed at the Central Bank Printing Press, 58, Sri Jayewardenepura Mawatha, Rajagiriya, Sri Lanka. Published by the Central Bank of Sri Lanka, Colombo 01, Sri Lanka.

ii

Director of Economic Research, Central Bank of Sri Lanka

Dr. Y.M.Indraratne

Research Advisory Panel of the Economic Research Department

Dr. C Amarasekara (Chair) Dr. R Yatigammana Dr. D S T Wanaguru Dr. R A A Perera Dr. E W K J B Ehelepola Dr. S Jegajeevan

List of External Reviewers

Prof. K Amirthalingam (University of Colombo) Dr. Rahul Anand (International Monetary Fund) Prof. Prema-chandra Athukorale (Australian National University) Prof. Sirimewan Colombage Dr. P Dunusinghe (University of Colombo) Dr. Manuk Ghazanchyan (International Monetary Fund) Dr. Shirantha Heenkenda (University of Sri Jayewardenepura) Dr. Ananda Jayawickrama (University of Peradeniya) Dr. A G Karunasena Dr. Vincent Lim (The SEACEN Centre-Malaysia) Dr. Koshy Mathai (International Monetary Fund) Mr. Adam Remo (OG Research) Prof. Sirimal Abeyratne (University of Colombo) Dr. T Vinayagathasan (University of Peradeniya)

Editorial Committee

Dr. C Amarasekara (Editor) Ms. S M S M Kumari (Assistant Editor) Mr. K A D A Ekanayake (Assistant Editor) Ms. N S Hemachandra (Assistant Editor)

For all correspondence about the Staff Studies Journal, please contact:

Director of Economic Research Central Bank of Sri Lanka 30, Janadhipathi Mawatha Colombo 01 Sri Lanka Email: directorerd@cbsl.lk

iii

iv

Inflation - Growth Nexus in Sri Lanka: Is there a Threshold Level of Inflation for Sri Lanka?

Inflation - Growth Nexus in Sri Lanka: Is there a Threshold Level of Inflation for Sri Lanka?

B.G. Nilupulee De Silva 1 2

Abstract

It is of significant economic importance to investigate the relationship of the inflation-growth nexus in Sri Lanka, to identify whether there is a linear or non-linear relationship between the two macro variables. This can lead to the discovery of the threshold level of inflation for Sri Lanka. Accordingly, this research explores the inflation-growth relationship in Sri Lanka, using annual data from 1965 to 2014. The results reveal an inflation rate of 9 per cent, which maximises the per capita GDP growth rate in Sri Lanka. However, the results do not confirm any significant structural break in per capita GDP growth rate when the inflation rate exceeds 9 per cent. Therefore, based on the findings, there is no statistically significant evidence to suggest the existence of a non-linear relationship between per capita GDP growth and inflation in Sri Lanka. Some conjectures, such as errors in data and not including savings and investment data can be made regarding the non-existence of a significant inflation threshold. Furthermore, the findings highlight that there is no negative effect of inflation towards the GDP per capita growth at any rate of inflation in Sri Lanka. This is an indication that any adverse effects of contemporaneous inflation are neutralized due to the significant positive effects from the inflation lag of two years. Furthermore, the results are not in favour of the view of maintaining inflation at low levels and thus, this study is important for policymakers in Sri Lanka, when implementing inflation targeting in Sri Lanka in the future.

Keywords: Per-capita income growth, Inflation threshold, Structural break, Sri Lanka

JEL Classification: C22, E00, O11

1 Senior Assistant Director of International Operations Department of the Central Bank of Sri Lanka. 2 I wish to thank Professor Kaliappa Kalirajan, Professor Renee Mckibbin and Anne Patching of the Australian National University, Australia for their valuable comments in writing this paper. Any errors and omissions are, however, mine.

1

1

Central Bank of Sri Lanka ? Staff Studies ? Volume 47 Number 2

1. Introduction

Most of the development policy objectives of an emerging economy revolve around achieving rapid and sustainable economic growth. Yet, when rapid growth is achieved, as a result of increasing pressure on inputs utilized by excess demand, prices can increase. Hence, sustaining high growth requires that inflation be kept under control, if a rise in inflation causes negative effects on economic growth. The study of the inflation- growth nexus in developing countries is vital to understand the true nature of the relationship between inflation and growth, as maintaining excessively low inflation can lead to high unemployment and reduced output (Philips curve3). This can create inadvertent consequences to economic growth in developing countries. In view of this, Pollin and Zhu identify a positive nexus between Gross Domestic Product (GDP) growth and high inflation up to 15-18 per cent for 80 middle and low income countries, where they argue that targeting inflation at low levels of around 3-4 per cent may not be optional for emerging economies and doing so could harm economic growth (593).

A number of empirical studies, which are discussed in detail under Section Two, have shown that high inflation can be costly and can affect the macroeconomic stability of the country. A study based on data from Latin American countries reveals that there is a negative relationship between inflation and GDP per capita growth (Gregorio 59). Barro shows that when inflation exceeds 10 per cent, the per capita GDP growth rate reduces by 0.2 - 0.3 percentage points (19). A similar inflation threshold is evident in a study by Espinoza et al., where they conclude that for developing countries, a significant structural break in per capita GDP growth is caused by an inflation rate above 10 per cent (100).

A study that was carried out using data from 86 countries including Sri Lanka, found a structural break in per capita GDP growth at 8 per cent of inflation rate for emerging and developed nations and suggests that if such a significant structural break for per capita GDP growth exists for a country, and the failure on the part of policymakers to take into consideration the same will impose a greater bias on the inflation effect towards GDP growth (Sarel 203). Sarel further emphasises that the existence of a structural break provides a numerical policy target for Central Banks to maintain inflation below the structural break (213). He is the first to identify the detrimental effects of high inflation by taking into account the structural break in growth in GDP. He points out that when the inflation rate doubles (for example, an increase in inflation from 20 percent to 40 percent), the growth rate declines by 1.7 percentage points (214).

One of the core objectives of the Central Bank of Sri Lanka is to maintain economic stability by controlling inflation, which may be harmful to the economy. The lack of well-researched

3 Philips Curve is a historical inverse relationship between rates of unemployment and corresponding rates of inflation that result in an economy.

2

2

Inflation - Growth Nexus in Sri Lanka: Is there a Threshold Level of Inflation for Sri Lanka?

and published papers regarding the threshold level of inflation for Sri Lanka, which quantifies any significant structural break of GDP per capita growth in Sri Lanka, creates a research gap in this field of studies. Motivated by the identified research gap and also by the findings of Sarel (213), this study attempts to explore whether such a structural break for per capita GDP growth exists in the Sri Lankan context. Accordingly, this research explores the inflationgrowth nexus in Sri Lanka, using annual data from 1965 to 2014. Principally, this paper addresses whether there is any inflation threshold that maximises per capita GDP growth for Sri Lanka. If any, is the effect of inflation on growth in per capita GDP significantly different above the threshold level from what it is below the inflation threshold.

This study mainly follows the methodology used by Sarel, (207) and Hayat and Kalirajan (8). The results of this study reject the argument that the inflation rate and per capita GDP growth rate in Sri Lanka has a non-linear relationship. Accordingly, there is no statistically significant evidence to suggest the existence of a non-linear relationship between per capita GDP growth and inflation in Sri Lanka. Nevertheless, the study reveals an inflation rate of 9 per cent, which maximises the per capita GDP growth rate. However, the results do not confirm any statistically significant structural break in per capita GDP growth rate at the 9 per cent of inflation.

The structure of the remainder of the paper is as follows. Section Two reviews the empirical literature on the inflation-growth nexus. Section Three includes data and the methodology used in the study, followed by a summary of the results and an analysis in Section Four. Finally, Section Five discusses the limitations and policy implications, and concludes, suggesting future extensions of this study.

2. Literature review

A survey of the available theoretical and empirical literature is carried out with a view to enlighten policy makers on the on-going debate of the inflation- growth nexus and also to discover the threshold level of inflation, if any, for Sri Lanka. Many previous empirical studies have analysed the inflation growth nexus in developing countries as well as developed countries and there is evidence for both a positive and negative relationship between inflation and growth. More interestingly, the non-linearity of the inflation and growth relationship has been identified in many country specific studies as well as cross country analyses which include both developing and developed countries. Previous studies have been categorized according to the nature of the inflation-growth nexus and salient features are briefly explained.

2.1. Positive relationship

Latin American countries experienced high double-digit inflation along with moderate growth during the 1950s and 1960s, and Bruno and Easterly researched the behaviour of growth in pre, during and post high inflation periods (3). They found that there is no permanent harm

3

3

 ................
................

In order to avoid copyright disputes, this page is only a partial summary.

Google Online Preview   Download