# Relationship between inflation and consumption

For many years the relationship between economic growth and inflation has power of money, which reduces consumption and therefore GDP decreases. world, the relationship between consumer inflation expectations and aggre the inflation expectations - consumption relationship is still scarce. expectations may succeed in stimulating consumption expenditure. In this paper, we study the cross-sectional relationship between inflation expectations.

Moreover, he states that some exceptional cases show that even though high growth is not necessarily associated with low inflation and small budget deficits, high rates of inflation are not consistent with permanent growth. Barro examined data for almost countries for the period between and and found that the impact of inflation on growth and investment is significantly negative, given that a number of countries characteristics are constant.

An average increase in inflation of ten per cent leads to a decrease of GDP and investment by 0. He also showed that even if inflation has a small impact on growth, this appears to be significant in the long run. Bruno and Easterly examined the relationship between inflation and economic growth and they found that this relationship exists only if there are high inflation rates.

To determine the high rates of inflation, they set a threshold of 40 per cent. Above this threshold, inflation has a temporally negative impact on growth, whereas below this threshold, they found no robust relationship. The decrease in growth is temporary because after a high inflation crisis, the economy quickly recovers to its previous level. Their results are robust after controlling for other factors such as external shocks.

Ghosh and Phillips studied the relationship between inflation and GDP for a large set of IMF countries for the period from to They found that, generally, the coefficient, with respect to inflation, was negative.

The findings were statistically significant. The relationship between these appeared to be negative for very low inflation rates around two to three per cent.

They also found a negative correlation for higher values but the relationship was convex, meaning that a decline in growth related to an increase of from ten to 20 per cent inflation was larger than that related to an increase in inflation of from 40 to 50 per cent. GDP, in real terms, is measured in levels and seasonally adjusted with being the base period.

Inflation is measured as the logarithm of the CPI rate[1], also being seasonally adjusted. Having the variables in logarithms reduces the variance and heteroskedasticity and makes their relationship linear. Figure 1 shows the trend of inflation and LGDP.

Inhowever, when another recession began, there was an enduring drop in LGDP, starting from Finally, the UK economy started improving in On the other hand, there is no apparent trend in inflation and thus we might infer that inflation is either stationary around the mean or, at most, a drift-less unit root process.

However, these will be checked later by doing the unit root test.

### The relationship between inflation and economic growth (GDP): an empirical analysis

Table 1 below illustrates the descriptive statistics of these variables. We see that inflation is more spread out than LGDP, because its standard deviation is higher 0.

Moreover, LGDP has a left-skewed distribution Both variables have a platykyrtic distribution, flatter than a normal with a wider peak LGDP: In this section we will estimate empirically the impact of inflation on GDP using the following ad-hoc relationship: An additional factor that motivates our paper is the process of economic integration in Latin America in recent years with the advent of regional customs union agreements such as Mercosur Brazil, Argentina, Paraguay, Uruguay, and now Bolivia and Chile as associate membersNafta Mexico, USA and Canadaand the Andean Pact.

Consolidating economic integration in the region calls for a better understanding of cross-country consumption behaviour such that the impact on consumption of income-related external shocks can be fully assessed.

A better understanding of consumption behaviour in the region is crucial to ensure effective policy co-ordination and harmonisation. The paper is organised as follows. The Model A unifying framework to study consumption behaviour is provided by the following conventional infinite-horizon representative agent set-up: It is assumed that the utility function is concave and additively time-separable, there is a finite number of tradeable assets, and there are no a priori short sales or borrowing constraints.

Equation 1 is an Euler equation-type consumption function. If negative consumption is to be avoided, the returns on assets holdings have to exceed the rate of time preference of the utility maximiser Hall,; Turnovski, Optimal consumption is then a fraction of permanent income or wealth, which grows at rate r. In all cases, consumption volatility is increased, since households may not be able to smooth consumption through time by changing the composition of their portfolios in line with changes in asset returns.

Data and Empirical Results 3. If n t is statistically significant and correctly signed, there is evidence of significant deviations from the benchmark case. In this respect, the error-correction term should not be interpreted as a disequilibrium term, but rather as an excess-volatility term or, alternatively, as a measure of the difference between observed and perceived income.

A statistically significant ECM term would suggest that the difference between perceived and observed income is an important determinant of private consumption behaviour. As for the portfolio of the representative consumer, we focus on: The rates of return of each of these assets are, respectively, the rate of interest paid on government bonds, the rate of inflation as a measure of the capital losses associated with holding non-interest-bearing assetsand the parallel exchange market premium.

In what follows, we focus on 17 countries in Latin America that experienced spells of high inflation in the 70's and 80's. The variables are defined in logarithms and in real per capita magnitudes. Visual inspection of the ratio of consumption to income and inflation patterns of some of the countries in the sample reveals some interesting features.

The consumption ratio does not seem to trail behind inflation in the case of Peru. Some consumption volatility is also observed in most countries, with the exception of Brazil and, to a lesser extent, Argentina and Mexico, since the early 80's. As a result, despite persistent inflation, the latter countries seem to have been able to smooth consumption fairly effectively. The estimating equation is: In the first two models, all coefficients are statistically significant and present reasonable absolute values.

In fact, financial innovation in most Latin American countries facing persistently high inflation has not necessarily been associated with the need to improve efficiency in the commercial banking sector.

The motivation has mainly been the need to upgrade existing indexation mechanisms in periods of accelerating inflation and circumvent legal restrictions on indexation contracting in periods of decelerating inflation. An additional factor related to the possibility of liquidity constraints and credit rationing has been Latin America's limited access to foreign capital markets in the 80's, which prevented the usual financing of domestic fiscal and current account imbalances via external borrowing, given the region's traditionally low savings rates.

The overall pattern is therefore consistent with our previous findings. The results suggest that consumers tend to save less in an environment of persistent or accelerating inflation. This means that consumers incorporate their predictions on future changes in inflation in their current consumption decisions which is consistent with RE-PIH arguments.

### Consumption behaviour and persistently high inflation: evidence from Latin America

Income surprise DDWt is defined by current values of the second derivative of real per capita income, which intends to capture the effect of growing income on consumers' spending behaviour. IV estimates are preferred due to the likely simultaneity of these two variables Pagan,and the upward bias in the coefficient of the lagged dependent variable in panel data models Hsiao, Model 3 fails to accept the inclusion of country dummy variables, which might be viewed as an indication that the countries in the panel present rather similar behavioural patterns.

Price and income surprises attracted the negative and positive theoretically consistent signs, respectively, but inflation surprise is not statistically significant.

This figure is much higher in the time series estimates presented below. Government spending does not appear significant in any of the specifications. Under the RE-PIH, consumption is not reduced in the presence of inflation or if the premium is increasing. The conclusion is reinforced by the large coefficient of the income surprise variable.

In this context, the black market premium might be capturing a wealth effect, rather than representing an excess demand for foreign currency. In the three models, consumption was found to be insensitive to a variety of interest rates. This is not surprising, given that interest rates are scarcely market-determined in most countries in the region. The fact that government spending was found to be statistically insignificant, and was, therefore, eliminated from the three models above, is not suggestive of Ricardian equivalence in the region in the period under examination.

Hence, financing budget deficits via seignorage requires high inflation rates to finance even very small deficits Taylor, Time Series Analysis Time series analysis is carried out for the period for six countries of the panel Argentina, Peru, Brazil, Uruguay, Paraguay, and Venezuela.

**Inflation Expectations and Consumption Expenditure**

Preliminary time series analysis was conducted on the data using unit root tests. The results not reported show that the growth rates of consumption, prices, income, government spending, and foreign exchange premia for the six countries under examination are stationary around a linear deterministic trend.

If income changes are to have a similar impact on consumption in high-inflation economies, then we would expect the underlying responses of income to consumer spending to be broadly similar across the countries under examination Carruth et alii, Ideally, we would like to compare the results of an underlying structural model for the whole region with individual estimates.

But whilst our aggregate results obtained with panel data analysis might be suggesting some general applicability of our theoretical framework across the countries in the region, it does not seem that individual country consumption functions are identical. The analysis which follows illustrates this point. For the time series analysis, we selected six countries that experienced persistently high inflation in the sample period Argentina, Peru, Venezuela, Brazil, Uruguay, and Paraguayand investigated two alternative consumption patterns.

Actually, the equations were initially specified with the same set of regressors, but the variables that were found to be insignificant were dropped and only our preferred specifications are reported.

The Schwarz and the Hanna-Quin criteria defined the number of lags for each variable. As argued by Charemza and Deadmanif our interest is in the parameters of a short-run equation with an error-correction mechanism, it is essential that the marginal processes for the variables modeled in this short-run equation do not contain the same error-correction mechanism.

In this case, weak exogeneity is guaranteed, as well as the robustness of the model. We have performed tests of weak exogeneity for changes in government spending and inflation, due to their possible endogeneity.

## Melanie Smith

The tests consisted of including the error-correction term of the conditional models in the marginal models for these two variables and testing for the significance of the error-correction terms. In both cases, weak exogeneity of government spending and inflation was confirmed.

In all cases, the ECM term attracts the theoretically consistent negative sign and the test statistics are fairly favourable, suggesting excessive sensitivity in the cases of Peru and Argentina. In line with Hendry and von Urgern-Sternbergthe significance of the ECM term measures deviations between perceived and observed income and explains the perverse consumption behaviour in the presence of persistently high inflation.

In Argentina and Peru, changes in the foreign exchange premium are negatively associated with changes in consumption per capita, unlike the panel data estimates. The positive coefficient in the panel suggests that the foreign exchange premium reflects less the excess demand for foreign currency, given the international liquidity constraints of most Latin American countries in the 80's and the extent of domestic financial repression, than the wealth effect due to dollarisation in particular countries of the region Mello Jr.

Also, Peru and Argentina are notably the two most dollarised economies in the sample, and this might be representing evidence of excess demand for foreign currency. For the case of Venezuela, the ECM term is not significant and remains within a closer range when compared with the panel data results. Also differently signed are the coefficients of lagged changes in consumption in Venezuela and Peru, indicating some hysteresis in consumption in these two countries.

In the case of Peru, current changes in inflation affect positively current changes in consumption, but this effect would have been mitigated if inflation had been rising in the previous year. Current changes in income affect positively consumption in both Venezuela and Peru, but are not found significant for Argentina. In the case of Paraguay, current changes in consumption are negatively related to lagged changes in consumption, while lagged changes in inflation and income are positively associated with current consumption.

In this country, lagged changes in the foreign exchange premium present a negative and significant coefficient, suggesting that any excess demand for foreign currency depresses domestic consumption. The opposite situation is found for the case of Uruguay, where the coefficient of the foreign exchange premium is positive and statistically insignificant, suggesting significant wealth effects.

Also, consumption tends to increase with increasing inflation and income, but, again, this would have been mitigated if income had been growing in the past as suggested by the negative coefficient of lagged changes in income.

Parameter stability was confirmed for most of the countries by a one-step-ahead Chow test results of which available from the authors. Conclusion Usual RE-PIH consumption models posit that private consumption depends on permanent income financial wealth and that liquidity constraints and capital market friction, such as high transaction costs, labour income risk and short sale or borrowing constraints, may increase the sensitivity of consumption to transitory income changes.

It is also known that persistently high inflation leads to perverse consumption behaviour since perceived income may be significantly different from observed disposable income. As far as the empirical findings are concerned, if external shocks are to have a similar impact on high-inflation countries in Latin America, we would then require that the underlying consumer spending responses to shocks should be broadly similar. Ideally, we would like to compare the results of an underlying structural model for the whole region with individual country estimates.

Against this background, the results of our panel data analysis suggests some general applicability of our theoretical framework across the several countries of the region. However, it does not seem to be the case that individual country consumption functions are identical.