Non-productive consumption loans and threshold effects in the inflation-growth relationship

Abstract

Recent empirical evidence indicates that two inflation thresholds exist in the inflation-growth relationship. Pre-existing theoretical models, however, fail to generate such a pattern. By adding consumption loans (which are non-productive) into a standard model of imperfect information, this paper finds that an increase in the inflation rate may increase, decrease, or have no significant effect on economic growth for inflation rates below a threshold level; however, for inflation rates higher than this threshold level, an increase in the inflation rate significantly reduces economic growth. Moreover, the marginal impact of an increase in the inflation rate in terms of reducing economic growth increases with the rise in the inflation rate, until the inflation rates reach the second threshold level, from which such a marginal effect significantly decreases. These results accord well with recent empirical evidence.