Inflation And Economic Growth: A Time Series Analysis

ABSTRACT

The essence of this study is to empirically explore the impact of inflation and economic growth in the context of the Nigerian economy. The study contends that while high rates of inflation is detrimental to economic growth, moderate and stable inflation rates supplements return to savers, enhances investment and therefore economic growth of a country. Using annual data set on real GDP and inflation rates for the period of 1970 to 2008, an assessment of empirical evidence has been acquired through the ordinary least squares (OLS) estimation technique. The empirical evidence demonstrates that there exists a statistically insignificant impact of inflation on economic growth. This result indicates the existence of structural constraints and a non – performing productive sector in the Nigerian economy. However, base on the strength of our findings, we recommend that macroeconomic policies aim at achieving sustain able economic growth should not over concentrate at fighting inflation but should also focus on factor input productivity, human capital development and good governance.

CHAPTER ONE

1.1     BACKGROUND OF THE STUDY

Over the past few decades, the nexus between inflation and economic growth has continued to dominate the center of stage of economics discuss amongst macroeconomists, policy makers and the central bankers of both developed and developing countries. Specifically, the central issue which has generated a plethora of debate both theoretically and empirically is the question of whether inflation is necessary or harmful for economic growth. The issue originally evolved from the controversial notion between the structuralist and monetarists. In this connection, and in line with the submission of the structuralists, Mundel (1965) and Tobin (1965) cited in Mortaza and Ahmed (2005) suggest positive relationship between inflation and economic growth through the new growth theory. Their argument is validated on the premise that inflation leads to increased capital accumulation, which promotes economic growth. Conversely, Fischer and Modigliani (1978) cited in Mortaze et al (2005) suggest a negative and non linear relationship between the rate of inflation and economic growth.

          More interestingly, there are two fundamental aspects in the inflation economic growth relationship. The first is to determine the existence and nature of the relationship (correlation) assuming that both macroeconomic variables exists, while the other has to do with establishing the direction of causality (regression), in this regard.

          Therefore, Friedman (1973) in Chowdhury and Mallik (2001) explicitly summarizes the inconclusive nature of the relationship between inflation and economic growth as follows: “historically all possible combinations have occurred: inflation with or without growth: no inflation with and without growth.

          Not surprisingly therefore, several economic theories and evidences from empirical studies have either supported or refute the claim that high rates of inflation may have many adverse economic and social consequences on economic growth. As noted by Obadan (1996:210) Anyanwu (1995), and Barnugi et al (1997). Inflation not only dampens macroeconomic viability by destroying domestic savings and investments, but it also creates an unstable economic climate, causing distortions in relative prices, resource allocation and distribution of income and wealth. High rates of inflation can also lead to the non-productive expansion of the financial system as has happened in Nigeria where the financial sectors share of the GDP increased from 6.2 percent in 1989 to 9.02 percent in 1994 (CBN, 2004) while inflation is often times caused by such factors as market imperfection, budget constraint, exchange rate instability as well as supply and demand shocks. The main economic consequences of inflation on economic growth can be distinguished in two broad Categories; the internal and external consequences. Internally, inflation can lead to a situation of conservative investment strategies and the crowing out of the private sector especially when high inflation is also associated with increased price variability alternately leading to lower levels economic growth.

          On the external sector inflation reduces an economy’s international competitiveness by making its exports relatively expensive thereby impacting negatively on the balance of payments and economic growth. However, inflation can equally have some positive effects on the economy through its impact on capital accumulation and capacity to reduce the severity of economic recession by enabling the labour market to adjust more quickly in a down turn and also reduces the risks that a liquidity trap prevents monetary policy from stabilizing the economy (Anyanwu, 1995).

          Historically, the Nigerian economy has suffered years of economic setbacks and considerable levels of economic instability as a result of the persistent growth of inflation. During the early political independence era of the 1960s, inflation rates were relatively modest. However, the oil boom era of the 1970s,kick started the double digit inflation rates reported at 15.6%, 33.9% and 21.2% for 1971, 1975 and 1976 respectively (CBN 2005).

          To date, although the relationship between inflation and economic growth remains controversial and somewhat in conducive, several empirical studies have confirmed either a positive or negative relationship between the macroeconomic variable of inflation and growth. Moreover, with time a general consensus evolved that moderate and stable inflation rates promotes economic growth and vice versa (Mubarik, 2005). This further raises the question of how low inflation should be.

          The answer evidently depends on the nature and structure of the economy and varies across countries. In this regard recently, macroeconomists, have adopted a econometric technique simply by looking at a non-linear or structural break effects, which states that the impact of inflation on economic growth could be positive to a certain threshold level and beyond this level the effects turns negative (Sweidan, 2004).

          Against this background, therefore, this study seeks to carryout an empirical research of the present relationship between inflation and economic growth in Nigeria. This study is largely motivated by the seminal work of Mallik  and Chowdhury (2000) in which they performed an econometric (i.e Engle – Granger two – step cointegration procedure) analysis of the relationship between inflation and economic growth for four South African countries Bangladesh, India Pakistan and Sir Lanka. Following the works of Khan and Senhadji (2001), Sweidan (2004) and Mubarik (2005), this work attempt to carry out an empirical investigation of the relationship between inflation and economic growth.

1.2     STATEMENT OF THE PROBLEM  

          Nigeria’s economic history can hardly be completed without a full acknowledgement of the impact that inflation has on the health of her economy. Following Nigeria’s political independence in 1960, the economy experienced minimal levels of inflation and robust economic growth characterized by internal and external balances.

          However, the 1970’s, which is noted as the era of the oil boom Singled the commencement of double digit inflation episode. As Ekpo (1991) notes, “the inflationary spiral of the 1970s lead to a situation of declining domestic savings and investments, falling agriculture production, high levels of the employment, growing government expenditure as a result of the narrowing of tax base of government over indebtedness and poor levels of social services.”

          Given the seemingly negative consequences that inflation might have on economic growth. The central problem that has always agitated the mind of scholars is to know the true impact of inflation on economic growth.

1.3   OBJECTIVE OF THE STUDY

          Generally, the primary objective of this work is to investigate the impact of inflation on economic growth of Nigeria for the period under study (1970 – 2008). It specifically seeks to achieve the below objective.

1.       To determine the impact of inflation on economic growth in the      Nigerian economy.   

1.4     STATEMENT OF HYPOTHESIS

          The following hypothesis is tested in the study.

HO  - There is no significant impact of inflation on economic growth.

H1 - There is a significant impact of inflation on economic growth.

1.5     SIGNIFICANCE OF THE STUDY

          This study is significant in that, it is expected to highlight the impact of inflation on economic growth in Nigeria and also identifying the channels through which its transcends into the real sector. 

          Based on the empirical findings, recommendation shall be made on how inflation can be curb. The findings is also expected to add to the body of knowledge in this area as well as spur up interest for further research in allied fields.

1.6     SCOPE AND LIMITATION OF THE STUDY

          This study is an investigation of the impact of inflation on economic growth in Nigeria.Specifically, the study will concentrate on inflation and other economic variables as they affect Nigeria economic growth. Also, data analysis will be done through regression and the data will be gotten from published materials of central bank of Nigeria.

          The coverage of this study is between 1970-2008. the study of is nationally based and it is limited to Nigeria internal variables, data and information.