Alan C. Stockman

English

Research Papers in Economics

FE D E R A L RE S E RV E BA N K O F ST. LO U I S
62
MAY/ JU N E 1 9 9 6
Commentary
Alan C. Stockman
I
n nearly any endogenous growth model,
a tax on investment reduces the steady-
state rate of economic growth. V.V.
Chari, Larry E. Jones, and Rodolfo E.
Manuelli attempt to explain the apparent
empirical relation between inﬂation and
economic growth by postulating that coun-
tries which raise their inﬂation rates also
raise their taxes on investment. However,
the authors focus on an implicit tax rather
than an explicit tax on investment. That
implicit tax operates through ﬁrms’ trans-
actions costs. Chari, Jones, and Manuelli
assume that ﬁrms ﬁnance marginal invest-
ment at least partly through banks and that
banks are required to hold non–interest-
bearing reserves on their deposits. As a
result, an increase in the reserve require-
ment taxes investment implicitly by taxing
the ﬁnancial intermediation that is an
input into that investment activity.
How plausible is this explanation for
the apparent relation between inﬂation
and economic growth in the data? Chari,
Jones, and Manuelli argue that alterna-
tive models of inﬂation and economic
growth predict a relation between the two
that is quantitatively too small to match
the data. Second, Chari, Jones, and
Manuelli argue that their model—in
which higher reserve requirements accom-
pany higher inﬂation—can quantitatively
match a number of features of the data.
I remain unconvinced by both argu-
ments. I believe Chari, Jones, and
Manuelli have understated the ability of
alternative models to match the data quan-
titatively, partly by overstating the magni-
tude of the growth effects of inﬂation
found in empirical work and partly by cal-
ibrating their model to U.S. parameters
that are nonrepresentative of the sample of
countries in empirical work on this topic.
Second, I believe that Chari, Jones, and
Manuelli have overstated the ability of
their model to match the data, because
that model ignores the well-documented
(negative) empirical relation between ex-
pected inﬂation and the currency-deposit
ratio.
AN UNDERSTATEMENT
The authors cite estimates of the rela-
tion between inﬂation and economic
growth in the data. They argue that con-
ventional models of inﬂation and growth
predict relations that are considerably
smaller than the estimates found in the
data. However, these estimates they cite
involve a mixture of the level effects on
real gross domestic product (GDP) of an
increase in the rate of inﬂation and the
growth effects on real GDP of an increase
in the rate of inﬂation. Suppose an in-
crease in the rate of inﬂation reduces the
level—but not the growth rate—of real
GDP and this effect takes time to manifest
itself. (Perhaps an increase in inﬂation re-
duces the steady-state level of the capital
stock, but not its growth rate. The transi-
tion to the new steady-state growth path
would occur over time as the capital stock
grows more slowly than it would have
grown had inﬂation not increased.) With
the sample sizes and simple linear regres-
sion techniques common to empirical
studies on inﬂation and growth, these
studies would be unable to distinguish
these level effects on GDP from growth
effects. In fact, most empirical studies of
inﬂation and growth have simply assumed
that inﬂation affects growth rates rather
than levels (at least in the interpretations
given to results in those studies).
This would not present a problem if
Chari, Jones, and Manuelli were to include
calculations of inﬂation’s effects on the
level of GDP, as well as on its growth rate,
when evaluating alternative models of in-
ﬂation and growth. But they don’t. Instead
Alan C. Stockman is Marie Curran Wilson and Joseph Chamberlain Wilson professor of economics at the University of Rochester.MAY/ JU N E 1 9 9 6
FE D E R A L RE S E RV E BA N K O F ST. LO U I S
63
they contrast the implications of those al-
ternative models for the steady-state
growth rate of GDP with estimates from
the data that include both the growth ef-
fect and the level effect. Consequently, it
should come as no surprise that the esti-
mates exceed the (steady-state) predictions
of the models.
For example, Robert J. Barro, in his ar-
ticle in this issue, estimates that a 10 per-
centage point increase in inﬂation sus-
tained over 30 years creates a level of
output that is 4 percent to 7 percent lower
at the end of that period than it would
otherwise be. For the moment, take this
estimate at face value and suppose that in-
ﬂation has no effects on steady-state
growth. An empirical study that covers a
30-year time horizon may falsely create
the impression that a 10 percentage point
increase in inﬂation reduces the average
growth rate of output by about 0.2 percent
per year. The exercise conducted by Chari,
Jones, and Manuelli would contrast this
0.2 percent ﬁgure with a model that im-
plies no growth effects of inﬂation and
would falsely conclude that the model fails
for this reason.
AN OVERSTATEMENT
Of course, there are many other rea-
sons as well to believe that empirical esti-
mates of the growth effects of inﬂation
overstate the true relation. High rates of
inﬂation often reﬂect packages of bad gov-
ernment economic policies. Because most
of these policies are not measured, or ac-
counted for in the empirical studies of
growth, inﬂation appears (partly, at least)
as a proxy for an entire array of bad eco-
nomic policies.
It may also be important—in the con-
text of the question that Chari, Jones, and
Manuelli ask—to treat the growth rate of
the money supply as endogenous and to
ask what determines its differences across
countries. If the answer includes real eco-
nomic performance, then empirical esti-
mates of the connection between inﬂation
and real growth mix effects running in two
directions. If temporarily bad conditions
create pressures for monetary expansion
(whether to ﬁnance government spending
when a fall in the growth of output creates
a fall in the growth rate of tax revenue, or
to try to exploit short-run non-neutralities
of money), then monetary expansion will
tend to be associated with a subsequent
increase in the growth rate of real output,
partly masking any negative growth effects
of inﬂation. Economists need a better
model of the political economy of mone-
tary actions (than we currently have
available) to begin to answer such
questions.
The effects of inﬂation on the level or
growth rate of real GDP may depend criti-
cally on certain features of an economy,
such as the degree to which ﬁnancial mar-
kets are developed. Well-developed ﬁnan-
cial markets may reduce the real effects of
inﬂation by reducing the importance of
currency (and the inﬂation tax on it) in
transactions, and by reducing the sizes of
wealth redistributions from inﬂation. The
“typical” country in the Summers and
Heston (1991) International Comparison
Project differs from the United States in
ways that may affect the connection be-
tween inﬂation and growth. One impor-
tant difference is that investment is con-
siderably more money-intense in many
less-developed countries than in the
United States, making these countries
more like the Chari, Jones, and Manuelli
“CIA-everything” model. Not only is cash
a more important method of formal ﬁ-
nance in much of the world than it is in
the United States, but cash also plays an
important role in the common practice of
bribery (for licenses, protection of prop-
erty rights, and other important forms of
capital broadly conceived). Consequently,
the effects of inﬂation on real GDP are
likely to be larger in countries with less-
developed ﬁnancial markets. Because
Chari, Jones, and Manuelli calibrate their
model to U.S. data (which are nonrepre-
sentative of the sample of countries in em-
pirical work on inﬂation and growth),
their calibration may lead the model to
understate the predicted relation between
inﬂation and GDP.MAY/ JU N E 1 9 9 6
FE D E R A L RE S E RV E BA N K O F ST. LO U I S
64
In addition, their article overstates the
ability of their new model to match those
data. Previous studies have documented a
strong relationship between expected inﬂa-
tion and the ratio of currency to bank de-
posits. Higher expected inﬂation induces
people to substitute out of currency and
into deposits, reducing the currency-
deposit ratio. Because banks hold reserves
on deposits, this raises the fraction of the
monetary base held by banks as reserves.
The model proposed by Chari, Jones, and
Manuelli ignores this effect and assumes
that the entire increase in the fraction of
the monetary base held by banks as re-
serves results from an increase in required
reserves. As a result, the authors overstate
the extent to which an increase in inﬂation
is accompanied by an increase in reserve
requirements. Therefore, they overstate the
increase in the implicit tax on investment,
through this source, that accompanies an
increase in inﬂation. This leads them to
overstate the extent to which their model
conforms to the data.
Although Chari, Jones, and Manuelli
view an increase in the reserve require-
ment ratio from .04 to .35 as “moderate,”
this increase is quite large. Their model of
the money growth rate and changes in re-
quired reserves implies much too large an
effect of actual changes in required re-
serves on the growth rate of output. For
example, the effect of the Fed’s increase in
required bank reserves in 1937 appears to
have produced a much smaller change in
real GDP than implied by the Chari, Jones,
and Manuelli model, as did the 1980
changes associated with the Monetary
Control Act and banking deregulation.
Moreover, a study of cross-country differ-
ences in required reserves would probably
show vastly smaller effects on real GDP
than their model implies.
A NEED FOR
STRONGER EVIDENCE
To make their argument more persua-
sive, the authors would have to provide
stronger evidence on two claims: (1) that
increases in inﬂation are typically accom-
panied by large increases in required bank
reserve ratios and (2) that increases in re-
quired bank reserve ratios have large ef-
fects on the growth rate of real GDP. More
generally, are increases in inﬂation more
strongly associated with increases in re-
quired reserves or with decreases in the
transactions demand for money (the focus
of the cash-in-advance models that Chari,
Jones, and Manuelli criticize)? The au-
thors have made a valuable contribution in
this article by calculating the quantitative
sizes of the growth effects of inﬂation in a
variety of monetary models with endoge-
nous growth. For the reasons outlined
above, I am less convinced by their use of
those calculations to suggest that the mod-
els underpredict the true effects of inﬂa-
tion in growth and by their proposed alter-
native model.
REFERENCE
Summers, Robert, and Alan Heston. “The Penn World Table (Mark 5): An
Expanded Set of International Comparisons 1950–88,” Quarterly
Journal of Economics (May 1991), pp. 327–68.

The Penn World Table (Mark 5): An Expanded Set

Inflation, growth, and financial intermediation - commentary

http://research.stlouisfed.org/publications/review/96/05/9605as.pdf

Inflation, growth, and financial intermediation - commentary

Abstract

Similar works

Full text

Available Versions

Research Papers in Economics