Threshold Effects in the Relationship between Inflation and Economic Growth: Evidence from Rwanda

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Rutayisire, Musoni J.
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African Economic Research consortium
It is now widely agreed among economists, policy makers and central bankers that the main objective of macroeconomic policy is to achieve a high and sustained economic growth rate while maintaining a low inflation rate. It is also believed that high inflation has an adverse effect on economic growth. But how low should the inflation rate be not to impact negatively on economic growth? Monetary authorities in Rwanda have been targeting an inflation level of around 5% for economic policy purposes. Was this inflation target the most appropriate for economic growth? Recent studies have demonstrated that, depending on the structure and level of development of the economy, inflation becomes detrimental to economic growth when it exceeds a certain threshold. Below this threshold the impact of inflation on growth is non-significant or even positive. Against this backdrop, this paper assumes a non-linear relationship between inflation and economic growth and attempts to identify the existence of threshold effects between these variables in the case of Rwanda using a data set spanning the sample period 1968–2010. The existence of a threshold level above which inflation has an adverse effect on economic growth in Rwanda has been investigated by means of a quadratic regression model and the ordinary least squares technique. The results showed that at low levels inflation does not hurt economic growth, while at higher levels inflation reduces economic growth. The estimated inflation threshold level is 12.7%. As the findings of this study have unveiled the estimated threshold inflation rate consistent with economic growth in Rwanda, they would provide some useful guidance to economic decision makers in designing a more appropriate macroeconomic policy