Some of the most prominent economists believe that inflation is a solution to the economic woes of US and Euro Area, and I particularly mean Krugman and DeLong. But is it so?
DeLong writes here that we simply need more inflation to solve US problems. Krugman, on the other hand, is more elaborate. In this 2012 blog post, a simple AD-AS “model” is put forward as a basis for understanding why higher inflation will lead to economic growth. In this more recent post, he derides the ECB president Mario Draghi for not seeing low inflation as a problem.
To start with, it is a bit worrying when models are put forward just for the sake of the argument. We were supposed to think that model should explain the data, and that is why we should always look first at the data.
And what does the literature on the relationship between economic growth and inflation say? Let’s take the thorough study by Javier Andres and Ignacio Hernando (published later as a NBER book edited by Martin Feldstein). There are here some key findings of interest to anybody:
– In most the cases, there is a negative correlation between inflation and economic growth;
– There appears to be causality from inflation to economic growth (not that clear, though), always negativ.
Wait, maybe the model based evidence might be different (in the spirit of the AS-AD model proposed by Krugman, see above) and inflation might actually cause growth. Let’s turn to the working paper by Amano, Carter and Moran at the Bank of Canada. They integrated key New Keynesian features (like nominal price and wage rigidity) into an endogenous growth model. The results: when inflation is varied from -5 to 5, the steady state growth rate might vary over a 0.5% span.
But this was expected after all. We know very well that economic growth is actually determined by productivity and innovations and in no way by inflation. There are some nice points that Cochrane makes here, though the focus is on the debt problem.