Modelling the Impact of Inflation on Economic Growth for Countries with Different Levels of Economic Freedom

Abstract

The article examines the impact of inflation on economic growth for countries with different levels of economic freedom basing on the data collected in 182 countries during the period from 1981 to 2015. The countries are divided into groups through clustering. The estimates obtained in the framework of threshold regression with fixed effects indicate that if a country has high levels of the rule of law, regulatory efficiency, and open markets, the level of government intervention in the economy determines the impact of inflation on economic growth: in the countries with high levels of government intervention the threshold level of inflation is higher (approximately 10%), and its impact is more negative if the threshold is exceeded; in the countries with low levels of government intervention the threshold level is lower (approximately 2%), and the negative impact of inflation is softer if the threshold is exceeded. In the countries with low economic freedom (and with high levels of government intervention) the threshold level is low (approximately 3%), but inflation rates higher than the threshold lead to serious negative consequences.The article also provides a modification of the Solow model of economic growth. Total savings are divided into private and public. Private investors are assumed to be risk-averse, therefore their saving rate and level of investment depends negatively on the level of risk in the economy described by inflation. Public investors are assumed to be risk-neutral. Thus, inflation leads to a sharp decrease in private and a gradual decline in public investment, which leads to lower rates of economic growth depending on the ratio of private and public investors in the economy.