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We question the empirical foundation of keeping inflation at 5% or below in developing economies. Using System Generalized Method of Moments we investigate the issue in the context of 14 Asian developing countries for the period 1961–2010. We find no robust empirical justification for targeting inflation at such a low level. The inflation threshold for these countries is found around 13% and it may range between 7% and 14% depending on the level of development. The findings suggest that developing countries can gain from moderate levels of inflation and should not be alarmed when inflation crosses the 5% benchmark.
Acknowledgements
We thank Anis Chowdhury, Ron Ratti, Gerald Epstein, Malcolm Treadgold, Geoffrey Harcourt, and participants at the 11th Annual Society of Heterodox Economists Conference held at the University of New South Wales, Australia for very helpful comments on an earlier draft. An earlier version of the article was written as a background paper for the United Nations Economic and Social Survey of Asia and the Pacific 2013. Usual caveats apply.
Notes
1. The 1970s was a period of high inflation and stagnation, caused mainly by commodity price shocks and the breakdown of the Bretton Woods system as a result of high US inflation. The Great Moderation was characterized by an unusually high degree of macroeconomic stability, with steady growth and low and stable inflation in most of the advanced economies since 1993 until the Great Recession hit in 2008.
2. Source: IMF-Supported Programs – Frequently Asked Questions, available at http://www.imf.org/external/np/exr/faq/progfaqs.htm#q4.
3. Paul Krugman, “The Low Inflation Trap (Slightly Wonkish),” The New York Times (23 September 2011), available at http://krugman.blogs.nytimes.com/2011/09/23/the-low-inflation-trap-slightly-wonkish/.
4. It cannot go below zero.
5. The Japanese economy is a classic example in this regard. This idea is also captured in the Keynesian Liquidity Trap. There is however an opposing view which considers higher inflation rate to cause higher cost of borrowing. Rising inflation leads to higher inflation expectations. Fisher's equation explains that this would lower the real return for lending and hurt lenders. As a result lenders tend to charge higher nominal interest rates.
6. The Economist (15 February 2010), “Monetary policy: a healthy dose of inflation.” Available at http://www.economist.com/blogs/freeexchange/2010/02/monetary_policy_1 (this is because of the problem of the zero bound to nominal interest rate).
7. The Global Financial Crisis of 2007–2008 and the Great Recession of 2009–2010.
8. See the opening remarks by Dominique Strauss-Kahn, at the IMF conference on ‘Macro and Growth Policies in the Wake of the Crisis’, Washington D.C., March 7, 2011, available via the internet at http://www.imf.org/external.
9. Developing countries are defined according to their Gross National Income (GNI) per capita. Countries with a GNI per capita of US$ 11,905 and less are defined as developing. In 2012, Argentina's GNI per capita was around US$ 11,572. The World Bank classifies Argentina as an upper middle income country.
10. The article by Khan and Senhadji (2001) also suffers from the same problem.
11. They also find two but lower threshold levels, 2.57% and 12.61%, for industrial countries.
12. One may question this aspect of the dataset as it is difficult to create a balanced dataset for developing countries due to poor availability of data.