Inflation, Growth, and Financial Intermediation

T he key role of government policies in the process of development has long been recognized. The recent availability of quality data has led to quantitative analyses of the effect such policies have on development. Most of the renewed research effort on this front, both theoretical and empirical, has emphasized the relationship between fiscal policy and the paths of development of countries. 1 Although there have been several empirical studies on the relationship between monetary policy and growth, 2 there has been very little theoretical work in this area. 3 We have two goals in this article. One is to summarize the recent empirical work on the growth effects of monetary policy instruments. The other is to compare the empirical findings with the implications of quantitative models in which monetary policy can affect growth rates. We ask, in particular, What is the relationship in the data between monetary policy instruments and the rate of growth of output? Are the predicted quantitative relationships from theoretical models consistent with the data? Monetary policy plays a key role in determining inflation rates. In the next section, we summarize the empirical evidence on the relationship between inflation and growth in a cross-section of countries. This evidence suggests a systematic , quantitatively significant negative association between inflation and growth. Although the precise estimates vary from one study to another, evidence suggests that a 10 percentage point increase in the average inflation rate is associated with a decrease in the average growth rate of somewhere between 0.2 percentage points and 0.7 percentage points. Some researchers are tempted to view this link as implying that if a country conducts monetary policy so as to lower its inflation rate by 10 percentage points, its growth rate will rise by anywhere from 0.2 percentage points to 0.7 percentage points. Obviously, the data alone cannot give us an answer to the policy question we care about. Therefore we explore the ability of various models with transactions demand for money to account for this association. We use the growth rate of the money supply as our measure of the differences in monetary policies across countries. Although many models predict qualitatively that an increase in the long-run growth rate of the money supply decreases the long-run growth rate of output in the economy , we find that in these models, a change in the growth rate of the money supply has a …