Inflation, Financial Development, 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 examining these channels, and find that higher levels of financial development, combined with low inflation, are related to higher rates of economic growth, especially in lower-income countries, but that financial development loses much of its explanatory power in the presence of high inflation. In particular, small increases in the price level seem able to wipe out relatively large growth effects of financial deepening when the annual rate of inflation lies between 4 and 19 percent, whereas the operation of the finance-growth link is less affected by inflation rates above this range. Growth is generally much lower, however, in such high inflation settings where financial development is typically repressed.