The inverted-U effect of inflation on growth: Cross-country evidence

What is the effect of inflation on growth? There is no consensus in existing empirical literature. This study argues that the effect may be inverted-U shaped. Using panel data for 154 countries during 1970–2014, both non-parametric cubic spline and parametric regressions show that growth is an inverted-U function of the inflation rate in samples with an annual inflation rate below 30%. The cutoff point for inflation to have a zero marginal effect on growth is around 5% in ordinary least squares estimation and 3% in instrumental variables (IV) estimation. We also find that the share of labor employed in R&D—rather than the physical capital investment rate—is an inverted-U function of inflation in IV estimation. Our inverted-U results are consistent with recent R&D-based theories. Our results on the channels help differentiate R&D-based theories from capital accumulation models, but we need future studies to differentiate between the R&D-based theories.