Economics Letters 53 (1996) 61-65
Growth, inflation and the exchange rate regime
Javier Andr6s a'b'*, Ignacio Hernando b, Malte Kriiger c
"Dpto. Andlisis Econ6mico, University of Valencia, Avda. Blasco Ibd~iez, 32, 46010 Valencia, Spain ~'Estudios Econ6micos, Bank of Spain, Alcald, 50, 28014 Madrid, Spain "University of Cologne, Cologne, Germany
Received 6April 1996; accepted 11 July 1990
Abstract According to the Balassa-Samuelson effect, growth and inflation are positively correlated in economies with pegged currencies. This paper shows that the costs of inflation on long-term growth are underestimated in samples that include countries and periods with fixed exchange rate regimes.
Keywords: Inflation; Growth; Exchange rate
JEL classification:F43; 049
1. Introduction In spite of the existence of several theoretical models that predict negative effects of inflation on long-term growth, ~ the econometric evidence is far from conclusive) Even among those who find significant negative coefficients of inflation in growth equations, the estimated effects are fairly small. As an example, in a recent study, Barro (1995) concludes that " .. . an increase in average inflation of 10 percentage points per year reduces the growth rate of real per capita GDP by 0.2-0.3 percentage points per year". 3 In this paper we argue that many of these empirical studies are likely to underestimate the costs of inflation if they do not control for the influence of different exchange rate regimes opei'ating during the sample period. The argument forthis downward bias runs as follows. Suppose that there is a genuine negative effect of inflation on growth and that we try to estimate it with a panel of countries
* Corresponding author: J. Andr6s, Dpto. Anfilisis Econ6mico, University of Valencia, Avda. Blasco Ibdfiez, 32, 46010 Valencia, Spain. E-mail: email@example.com. See, inter alia, De Gregorio (1993) and Roubini andSala-i-Martin (1995). 2 See Levine and Renelt (1992) and Fischer (1993). 3 Furthermore, this effect is only significant for the group of countries whose average inflation rate lies above 15% per year. 0165-t765/96/$1200 © 1996 Elsevier Science S.A. All rights reserved Pli S0! 65- ! 765(96)00895-6
J. Andrds et al. / Economics Letters 53 (1996) 6 1 - 6 5
over time periods that are dominated byfixed or pegged exchange rate regimes. According to the well-known Balassa-Samuelson effect (see Balassa, 1964, and Samuelson, 1964), a country with high productivity growth will experience a real appreciation in its currency which, under a fixed exchange rate regime, will be achieved through higher inflation. This will induce a positive correlation between both variables which, in turn, will biasdownwards the estimated effect of inflation on growth in all those empirical studies that do not control for the exchange rate regime in operation. In this paper we try to assess this possible bias by exploiting the variability of exchange rate regimes both across a sample of OECD countries and across time.
2. The Balassa-Samuelson effect
The theoretical underpinning of the Balassa-Samuelsoneffect can be summarized as follows. Let us assume a simple Ricardian model with two countries which use labour to produce two types of goods: a traded good (t) and a non-traded good (n). Under perfect competition and a constant returns to scale (CRS) technology, the foilowin[ equilibrium
ltP , = w = 1.P.
• l t*P * = w * = I , P . • .t
The symbols P, e, w and I denote the price level, the nominal exchange rate, the wage rate and the marginal product of labour, respectively. In turn, variables without superscript denote domestic variables, and variables with an asterisk denote fore;gn variables. Eq. (1) describes the law of one price for traded goods. Eqs. 2(a) and 2(b) st:~e that the wage rate (w) is the same in both the...