Up to the 1970s it was mostly observed that inflation does not have a significant effect on growth, or that the effect was even slightly positive (Sarel 1996). However, due to the following decades of high and persistent inflation in many countries1, the available data showed changes in the inflation-growth nexus. It was univocally confirmed that inflation has a negative impact on growth, and macroeconomic policies are aiming to spur growth by keeping inflation at low levels. This having said, intuitively the question arises, how low should the target inflation be? Or, which is the threshold level of inflation between a positive and negative impact on growth? Many authors in the 1990s attempted to solve this question, with fairly divers results. Sarel (1996) analysed a panel of 87 countries over the period 1970 to 1990 using OLS estimation. He finds a structural break at an average annual rate of inflation of 8%. Below this level, inflation has no significant effect on growth, but for inflation levels above 8%, growth is significantly and strongly negatively affected. Gosh and Phillips (1998) find a much lower threshold at 2.5%, and Christoffersen and Doyle (1998), applying Sarel’s methodology on transient countries between 1990-1996, obtain a threshold of 13%. Bruno and Easterly’s (1998) results are somewhat striking. Their analysis is based on a sample of 31 countries that experienced high-inflation episodes over the period 1961-1994, and results in the fact that inflation does not have a significant effect on growth for normal levels, however the relationship becomes negative with high-frequency data and highinflation observations of 40% or higher.Motivated by this variety of results, Khan and Senhadji re-examined this issue in their 2001 paper “Threshold Effects in the Relationship Between Inflation and Growth”. They contribute to existing work by extending and modifying their analysis compared to previous literature by, first, looking separately on developing and industrialized countries, and second, by applying new econometric methods, which include the non-linear least squares (NLLS) estimation combined with a hybrid function of inflation, where the threshold level is found with conditional least squares. Furthermore, Khan and Senhadji (2001) use the bootstrap method, proposed by Hansen (1999), in order to test for statistical significance of the threshold effect. Accordingly, their results differ in so far from previous work as the threshold...
Table of Contents
1. Motivation
2. Model and Discussion
3. Conclusion
Objectives and Research Themes
The primary objective of this literature review is to critically examine the research paper "Threshold Effects in the Relationship Between Inflation and Growth" by Khan and Senhadji (2001). The review aims to evaluate the methodological contributions—specifically the use of non-linear least squares and hybrid inflation functions—in determining the threshold levels at which inflation significantly impacts economic growth in both industrialized and developing nations.
- The evolution of the inflation-growth nexus in economic literature.
- Econometric challenges in identifying non-linear threshold effects.
- Application of hybrid inflation functions to handle negative and low inflation rates.
- Robustness of threshold estimates across different economic development levels.
- Methodological critiques regarding endogeneity and continuous model assumptions.
Excerpt from the Review
Model and Discussion
First major point Khan and Senhadji (2001) make is that growth rates should be regressed on the logarithm, instead of the level, of inflation. As already shown in Sarel (1996), using the levels of inflation highly skews the distribution across the sample and time as such a regression puts a lot of weight on high-inflation observation, although the majority of countries has medium or low rates of inflation. Moreover, the implication of log models is that multiplicative inflation shocks will have the same effects on growth in economies with high and low inflation, or in other words, if inflation is doubled in both countries, then growth will be affected in the same magnitude.
However, the problem of log transformation of inflation rates arises when the rate is less than 1 or even negative, then taking logs is not possible. Unlike Sarel (1996), and later also Burdekin et al. (2004), who convert negative inflation rates into small positive in order to allow log transformation, Khan and Senhadji (2001) adopt the hybrid inflation function of the form:
f(πit) = (πit − 1)I(πit ≤ 1) + log(πit)I(πit > 1) (1)
The first term is a linear function for values of inflation rates less or equal to one, so that f(πit) = (πit − 1) for inflation rates πit ≤ 1. The second term expresses log of inflation for values above one, such that f(πit) = log(πit) for inflation rates πit > 1. By subtracting 1 from the first term, f(πit) is kept continuous at unity in order to keep it at the turning point from being linear to log linear in πit. Hence f(πit) takes into account all inflation rates, positive and negative. In fact, deleting all zero and negative observations, substantially decreases the threshold level, for the reason that not only high inflation is bad for growth but also deflation (Burdekin et al. (2004)).
Summary of Chapters
1. Motivation: This chapter contextualizes the inflation-growth relationship by reviewing preceding studies and identifying the research gap that Khan and Senhadji (2001) address using refined econometric techniques.
2. Model and Discussion: This section details the hybrid inflation function and the non-linear estimation methods employed to identify threshold effects, while also critiquing the continuity assumptions of the model.
3. Conclusion: The final section synthesizes the findings, acknowledging the paper's influential status while noting the limitations regarding endogeneity and the complexity of the applied bootstrap methods.
Keywords
Inflation, Economic Growth, Threshold Effects, Non-linear Least Squares, Hybrid Inflation Function, Industrialized Countries, Developing Countries, Bootstrap Method, Econometric Modeling, Conditional Least Squares, Macroeconomic Policy, Structural Break, Log Transformation, Endogeneity, Literature Review.
Frequently Asked Questions
What is the fundamental topic of this paper?
The paper examines the non-linear relationship between inflation and economic growth, specifically seeking to identify the "threshold level" of inflation beyond which it significantly harms growth.
What are the central research themes?
The review focuses on the methodology of determining inflation thresholds, the distinction between industrialized and developing economies, and the econometric modeling of growth regressions.
What is the primary goal of the original research?
Khan and Senhadji (2001) aim to provide a more precise estimation of inflation thresholds by applying non-linear least squares and a continuous hybrid inflation function, overcoming the limitations of earlier linear or OLS-based studies.
Which scientific methods are analyzed in the review?
The review covers the use of Non-linear Least Squares (NLLS), Conditional Least Squares, the bootstrap method for statistical significance testing (Hansen, 1999), and the use of hybrid inflation functions.
What topics are covered in the main section?
The main part of the review discusses the shift from level-based to log-based inflation regressions, the mathematical formulation of the threshold model, and robustness testing against data frequency changes.
What are the characteristic keywords of this research?
Key terms include inflation, economic growth, threshold effects, non-linear least squares, and hybrid inflation functions.
Why did the authors choose to use a hybrid inflation function?
The hybrid function allows for the inclusion of low and negative inflation rates (deflation) in the analysis, which would otherwise be impossible to process using standard logarithmic transformations.
How does the model handle the distinction between developing and industrialized nations?
The authors analyze these groups separately, finding that developing nations exhibit a much higher inflation threshold (11-12%) compared to industrialized nations (1-3%).
What is the significance of the "continuity" assumption mentioned in the review?
The authors ensure the inflation function remains continuous at the unity turning point, though recent literature argues this assumption may fail to capture actual economic "jolts" or discontinuous growth drops.
What is the main limitation of the Khan and Senhadji (2001) approach according to the reviewer?
The reviewer notes that the paper fails to address potential endogeneity bias and utilizes a continuous model that may conflict with the assumptions of the bootstrap test method proposed by Hansen.
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- Anna Miller (Autor:in), 2013, Threshold Effects in the Relationship Between Inflation and Growth, München, GRIN Verlag, https://www.grin.com/document/263451
