Inflation, Finance and Growth: A Trilateral Analysis

Peter L. Rousseau, Vanderbilt University
HAKAN YILMAZKUDAY, VANDERBILT UNIVERSITY

Abstract

A large body of evidence links financial development to economic growth, yet the channels through which inflation affects this relationship and its stability have been less thoroughly explored. We take an econometric and graphical approach to analyzing these channels, and find that higher levels of financial development, combined with low inflation, are related to higher rates of economic growth, especially in developing countries, but that financial development loses much of its explanatory power in the presence of high inflation. In particular, to maintain steady growth, relatively large increases in financial development must compensate for small increases in the price level when the annual rate of inflation lies between 5 and 14 percent, whereas less compensation in terms of finance is required when inflation rates exceed 14 percent. Growth is generally much lower, however, in such high inflation, low financial development settings.