Inflation and economic growth nexus in the Southern African Development Community : a panel data investigation

Abstract

The aim of the thesis is to examine the relationship between inflation and economic growth using the Southern African Development Community (SADC) as a case study. The motivation emanates not only because of the lack of studies analysing this relationship in the SADC region, but also due to the fact that this relationship may differ from the one that exists in developed countries due to the level of economic development and prudent macroeconomic policies being practised in the latter (Sarel, 1996). The relationship may differ because the vast majority of developed countries have established independent central banks with a clear mandate to keep inflation levels within a specific range (adopted an inflation targeting framework). However, in most developing countries, central banks do not have a clear inflation targeting monetary policy framework, for instance, in the SADC region, only South Africa has adopted an inflation targeting monetary policy framework. High inflation episodes are known to contribute to macroeconomic instability, therefore policy makers find it important to understand the kind of the relationship that exists between inflation and economic growth in order to develop and implement sound macroeconomic policies. Therefore, inflation is viewed to be one of the basic indicators of macroeconomic stability; hence it is an indicator of the ability of the government to manage the economy. High levels of inflation may be indicative of a lack of sound governance by the monetary authority of a country. In addition, it is a sign of government that has lost control of its finances (Fischer,1993). The thesis addresses issues of nonlinearities in the inflation-growth nexus by endogenously estimating the threshold level of inflation below which inflation may have no, or positive, impact on economic growth, or above which inflation may be detrimental to economic growth. It also assesses the effects of a shock to inflation in South Africa, being the largest economy in the region, on inflation and economic growth of the rest of the region. First, different panel data methodologies; Fixed Effects (FE), Difference Generalised Method of Moments (DIF-GMM), System Generalised Method of Moments (SYSGMM), and Seemingly Unrelated Regression (SUR) estimators are used in order to examine the relationship between inflation and economic growth in the region. Second, Panel Smooth Transition Regression (PSTR) methodology is utilised to examine the nonlinearities in the inflation-growth nexus. In particular, the threshold level of inflation is endogenously estimated and the smoothness of the transition from a low to a high inflation regime in the region is also estimated1. Thirdly, the effects of South African inflation on the inflation and economic growth in the rest of the region are assessed using impulse-response functions derived from estimating a Panel Vector Autoregression (PVAR) model. Overall, the study deals with problems which are normally encountered when using cross-country data such as endogeneity, heterogeneity and cross-sectional dependence. The main findings of the study are that inflation and economic growth in the region are negatively related, as is also the case in other regions of the world as depicted by the empirical literature (Fischer, 1993 and De Gregorio, 1993). Therefore, in terms of the inflation-growth link, the SADC region is not different from all the other regions around the globe. Secondly, the threshold level of inflation in the region is estimated at 18.9 per cent, which is in line with the findings of authors like Drukker et al. (2005), Mignon and Villavicencio (2011), and Ibarra and Trupkin (2011), who found a threshold level of 19.2 per cent, 19.6 per cent, and 19.1 per cent for developing countries. However, this threshold level marginally exceeds that of Khan and Senhadji (2001), Schiavo and Vaona (2007), Moshiri and Sepehri (2009) and Espinoza et al. (2010), which studies report threshold values between 10 and 12 per cent for developing countries. The empirical results also reveal that shocks to South African inflation have significant economic impact on inflation, openness, investment and economic growth in the rest of the SADC region. In particular, more interestingly, South African inflation is found to have a negative and statistically significant impact on economic growth in the region for up to about 12 years after the shock, after which, it becomes insignificant. The contribution of the thesis to the literature is that, firstly, this looks into the inflation-growth relationship in the context of Africa, in particular the SADC region; as such an investigation or research has not been conducted before. Secondly, the research takes advantage of panel data methodologies so as to provide more robust estimates and confront the potential bias emanating from problems such as endogeneity, heterogeneity and cross-country dependence that may have affected previous empirical work on inflation-growth nexus. This is believed to provide more informative estimates on the inflation-growth link, and therefore deepens our knowledge of the region.