Posted by: Dirk | April 24, 2010

How bad is inflation for growth?

Recently, talk at the IMF by Olivier Blanchard has tried to intellectually pave the way for distributing the losses from the financial crisis to the people by inflating. Blanchard states:

As a matter of logic, higher average inflation and thus higher average nominal interest rates before the crisis would have given more room for monetary policy to be eased during the crisis and would have resulted in less deterioration of fiscal positions. What we need to think about now if whether this could justify setting a higher inflation target in the future.

This is a technical argument that I find completely unconvincing, since inflation rates dropped to close to zero almost everywhere in the world, independent from the level they had before. So there is no difference for monetary policy whether before you hit the zero nominal bound your inflation was low, moderate or high, above your inflation-target or below.

By inflating you take away purchasing power from those that hold money, and by money I mean liquid funds. The prices of stocks, real estate and other investments like art, classic cars and so on will rise during an inflation. Wages normally will not, and this is why the regular John Doe is most likely to be harmed by inflation. If you spend most of your income on consumption, you cannot invest in inflation-safe assets, while when you are rich you can save a higher share.

The problem with inflation is that it can harm growth. This is especially so if higher prices lead to higher wages, igniting a spiral of cumulative inflation. So, until which points are inflation rates “safe” for growth? Of course, this question can only be answered looking back.  One paper that deals with this question is Bruno and Easterly (1996). Here’s their last paragraph:

In our own recent work on high inflations and growth, we have reexamined the long-standing conventional wisdom that growth and inflation are positively related in the short run and negatively related in the long run. We find the conventional wisdom to be consistent—consistently wrong, that is. We find no evidence of any relationship between inflation and growth at annual inflation rates less than 40 percent— our definition of high inflation. We do find a short- to medium-run relationship between high inflations and growth, but it is a negative relationship. And we find there is no lasting damage to growth from discrete high inflation crises, as countries tend to recover back toward their precrisis growth rate.

There is a more recent paper by Khan and Senhadji from the IMF, concluding:

The empirical results strongly suggest the existence of a threshold beyond which inflation exerts a negative effect on growth. The threshold is lower for industrial than for developing countries (the estimates are 1–3 percent and 11–12 percent for industrial and developing countries, respectively, depending on the estimation method). The thresholds are statistically significant at 1 percent or less. The confidence intervals are very tight, which implies that the threshold estimates are very precise.

However, I would be careful about backward-looking predictions on what inflation rate is safe. In the real world, the question to ponder is whether people will resist higher inflation by demanding higher wages. If they believe that the burden should not be on their shoulders, it is likely that they will fight for and finally get higher wages, leading to subsequent price rises by companies, which will create a vicious circle. This has happened before and should not come as a surprise to any economist.

So, from which rates onwards will you go to hyperinflation? That question, I believe, cannot have a sensible answer. Even if you find one, it is backward-looking and since we are in an extraordinary position it might not be enough, or, worse, lead to wrong policies that make things even worse by underestimating the possibility of hyperinflation.


  1. If the stated value, of “Federal” Reserve notes, declines enough with respect to copper and nickel, the 1946-2009 U.S. Mint nickels, composed of cupronickel alloy, could become somewhat rare in mass circulation.

    The April 23rd metal value of these nickels is “$0.0625836” or 125.16% of face value, according to the “United States Circulating Coinage Intrinsic Value Table” available at

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