Given the analysis below... What reaction is expected of the central bank? Can there be a threshold rate for the central bank?

IMF Working Paper

Middle East and Central Asia Department

Estimating The Inflation–Growth Nexus—A Smooth Transition Model

Prepared by Raphael Espinoza, Hyginus Leon and Ananthakrishnan Prasad

Authorized for distribution by Abdelhak Senhadji

March 2010

Abstract

This Working Paper should not be reported as representing the views of the IMF.

The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate.

Motivated by the global inflation episode of 2007–08 and concern that high levels of inflation

could undermine growth, this paper uses a panel of 165 countries and data for 1960–2007 to

revisit the nexus between inflation and growth. We use a smooth transition model to

investigate the speed at which inflation beyond a threshold becomes harmful to growth, an

important consideration in the policy response to rising inflation as the world economy

recovers. We estimate that for all country groups (except for advanced countries) inflation

above a threshold of about 10 percent quickly becomes harmful to growth, suggesting the need

for a prompt policy response to inflation at or above the relevant threshold. For the advanced

economies, the threshold is much lower. For oil exporting countries, the estimates are less

robust, possibly reflecting heterogeneity among oil producers, but the effect of higher inflation

for oil producers is found to be stronger.