Inflation and Mexican economic growth: long-run relation and threshold effects

Purpose - The purpose of this paper is to estimate the long-run relationships and threshold effects between inflation and economic growth in Mexico. Design/methodology/approach - The paper shows the existence of such relationship in a cointegrated vector on economic growth (log of real gross domestic product (GDP)) and inflation rate finding a corresponding elasticity significantly negative. Moreover, the causal relationship between these two series is studied using a more robust Granger causality test, without finding any directional causality between them. Findings - The estimated threshold model suggests 9 percent as the threshold level (i.e. structural break point) of inflation above which inflation significantly slows the Mexican economic growth. Research limitations/implications - This paper uses the cointegration technique, and finds a significant and negative long-run relationship between inflation and economic growth for the Mexican economy. In addition, it is found that inflation is weakly exogenous. In the period 1970-2007 real GDP was elastic with respect to inflation, and therefore, considering the estimated coefficient, an increase of 1 percent on inflation produces a decrease of 1.5 percent on real GDP. Since, for most of the period under consideration Mexico experienced inflation rates higher than 10 percent, this result is consistent with most of the research suggesting that high levels of inflation produce a negative effect on economic growth. Practical implications - The analysis could be useful for policymakers in providing some clue in setting an optimal inflation target. For instance, the Mexican Central Bank could apply an expansionary monetary policy for supporting economic growth until the inflation rate does not exceed the threshold level. In fact, the threshold analysis suggests that if the inflation rate exceeds 9 percent, then Mexico's current favorable economic performance might be jeopardized. Originality/value - Specifically, this paper focuses on two questions: is there any long-run relationship between economic growth and inflation in Mexico? Is there a statistically significant threshold level of inflation above which inflation affects growth differently than at lower inflation rates in Mexico? Motivated by these questions, this present paper first examines cointegration techniques and then, threshold estimations.