Inflation, growth, and central banks : theory and evidence

The author reviews the theory and evidence on inflation and growth and provides additional empirical evidence for a large cross-section of countries. The evidence, he reports, suggests a robust negative relationship between inflation and growth. He argues that inflation limits growth mainly by reducing the efficiency of investment rather than its level. But this finding is difficult to explain using traditional theories that rely on the effects of inflation on employment, which are not supported by the data. Explanations focusing on the effects of inflation on the allocation of talents and the functioning of financial markets may help in understanding better the long-run relationship between inflation and growth. The author also reviews the theoretical and empirical literature on how central banks affect inflation and output growth. An independent central bank can be effective in reducing inflation if the public perceives that it is tough on inflation. But inflation persists because the cost of reducing it is high - the most evident cost being the loss of output from disinflation. The author concludes that although serious progress has been made in recent years in assessing empirically how central banks affect macroeconomic performance, the results are still inconclusive. The empirical evidence shows a negative correlation between inflation and central bank independence, especially in OECD countries, but the effects on growth are less conclusive. It is fair to say that the bulk of the evidence suggests that central bank independence produces lower inflation at no real costs.