Inflation and Economic Growth: Evidence From Liberia

Abstract

This study set out to estimate the optimal level of inflation which is conducive for economic growth in Liberia and to determine and establish the direction of causality between economic growth and inflation. Using time series data for Liberia for the period 1960-2007, the study employs an optimization model to analyze the threshold level of inflation for Liberia. The study also utilizes the Johanson cointegration technique to determine the existence of a long-run cointegration between growth rate of gross domestic product, foreign direct investment, investment rate, inflation rate, exports and exchange rate. The Granger-Causality test identifies a feedback or bilateral causality between inflation and economic growth and the results from the optimization model recommend a 19% optimal level of inflation, which is conducive for economic growth. The implication is that any inflation rate above this optimal level would affect economic growth negatively in the Liberian economy. The long-run and short-run results indicate that growth rate of gross domestic product is positively affected by foreign direct investment, inflation rate, exports, exchange rate, investment rate and the dummy variable. On the other hand, the dummy variable for war is found to negatively influence growth rate of gross domestic product in Liberia. Moreover, a stability test suggests that the estimated parameters do not suffer from structural instability. Given the ambiguous relationship between inflation and economic growth and the primary objective of the Liberian government as envisaged in its Poverty Reduction Strategy, the findings of the study provides policy makers, especially the monetary authority, in Liberia with the necessary information to formulate monetary policies that would target the reported- optimal level of inflation in the Liberian economy thereby stimulating economic growth. Besides, the findings suggest a bilateral causality between economic growth and inflation. Policy makers can rely on this finding to institute policies that would enhance price stability thereby attractive economic growth.