Analyzing relationship between inflation rate and per capita GDP growth

There have been different theories for explaining crucial relationship between inflation and per capita GDP growth. In this paper we will consider the neoclassical model and wage equation. This approach is very useful in terms of flexibility to understand underlying assumptions behind the theory. Along with this, this model does include the adjustments in real wages, which is very important while determining relationship between unemployment, inflation and growth. To prove that this theory holds in practice we will examine a country based example. For this purpose we will analyze some macroeconomic data of Azerbaijan and try to link them to see how the theory works in reality.

In the first part we will have a look at some theoretical issues and describe the relationship between inflation and unemployment, and then inflation and per capita GDP growth. The second part deals with economic processes that have been happening in Azerbaijan during last few years. Obviously, to understand the essence of macroeconomic statistics and some correlations and deviations from theory it is very important to know some key facts about economy. And finally, in the third part, we will look through some statistics and figures and try to observe theoretical issues in practice.

NEOCLASSICAL WAGE EQUATION, PHILIPS CURVE AND OKUN’S LAW

The following equation is called neoclassical wage equation:

(1)

Where, left hand indicates wage inflation, and right hand holds two variables: expected price inflation and difference between natural and actual unemployment rates. If we consider expected price inflation constant (because, it is usually hard to measure), from this equation, we can see that wage inflation is negatively related to unemployment _(Farmer, 2002)._ We will come back to this issue when we start analyzing data from Azerbaijan. This idea is the basic assumption behind Philips curve, which implies negative relationship between inflation and unemployment.

Now, let’s have a look at other law, called Okun’s law. According to this law, deviations between potential and actual GDP are proportional to difference between natural and actual unemployment (Gartner, 2003):

Y*-Y= A (U*-U) (2)

So, Philips curve shows negative relationship between inflation and unemployment and Okun’s law describes relationship between unemployment and GDP. Thus, if we consider equations (1) and (2) together, we can see a correlation between GDP growth and inflation rate, i.e., both inflation and GDP growth is negatively correlated to unemployment. So, there is a positive relationship between inflation and GDP growth.

For now, it is enough with theoretical part. Now, let’s see what is going on in practice.

AZERBAIJAN: KEY FACTS ABOUT GROWING ECONOMY

Due to huge oil revenues, country’s GDP growth rate was enormous in last few years. Azerbaijan held 1st place in the world economy for its GDP growth rate from 2006 to 2009. In 2007 GDP growth rate was 34.50%. Baku-Tbilisi-Ceyhan pipeline that started operational phase in 2006 is expected to bring the country $160 billion during next 30 years.

Huge revenues brought about implementation of huge projects in Azerbaijan. This in turn resulted in more governmental spending and thus more aggregate demand. The latest factor pushed pressure on inflation rate. Therefore, inflation was upward in Azerbaijan parallel to increasing oil revenues. Along with this, governmental program aimed to development of non-oil sector is being implemented successfully. New plants and factories have been built during last decade to decrease economy’s dependence on oil. As a result, unemployment rate is downward slopping.

Country’s currency was re-denominated in 2006. This was very crucial factor for the financial sector. Increased confidence in New Azerbaijan manat (AZN) resulted in appreciation of this currency against USD. National Bank of Azerbaijan is still trying to limit this appreciation to stimulate exports.

THEORY IN PRACTICE

Now we have a general idea what we are talking about. We can put together the theory and check it on macroeconomic data of Azerbaijan. We will start deriving Philips curve for this country. And then see whether Okun’s law holds in Azerbaijan. Finally we will find relationship between these two theories and derive relationship between inflation and per capita GDP growth.

_Figure 1. Unemployment rate in Azerbaijan_

_Source: State Statistical Committee of Azerbaijan Republic (www.azstat._org_)_

_Figure 2. Inflation rate measured by CPI._

_Source: National Bank of Azerbaijan (www.nba.az)_

Figure 1 shows downward sloping unemployment line. As it was emphasized, this is due to creation of new work places, especially in non-oil sectors. Figure 2 represents the level of inflation in Azerbaijan, measured by CPI. Only in 2006 the slope is negative, but then it is positive again. We will come back to the reason of decreasing inflation in 2006 later. Now, if we put these figures together we can derive Philips curve for Azerbaijan.

_Figure 3. Philips curve_

On the y axis we have inflation rate and on the x axis we have the level of unemployment. From this graph we can see that there is a negative relationship between these two indicators. If we recall neoclassical wage equation, it implies the negative relationship as well (if expected price inflation is considered constant).

As we emphasized above, the only deviation in this graph happens in 2006. What is the main reason for this? Actually, huge oil revenues flowed into the country in 2006 and GDP growth rate was enormous (34%). So, inflation rate should even increase more. The issue is that, to fight rising inflation in the shape of growing oil prices and huge revenues government of Azerbaijan decided to re-denominate its currency by 5000 times. So, AZN exchange rate was really close to leading World currencies (1 AZN≈1.25 USD). The National Bank of Azerbaijan and private banks set higher interest rates for refinancing and deposits in AZN rather than USD. This resulted in increase of deposits in general. The growth rate of deposits and savings was 58% in 2006, while it was 22% in 2005 (_National Bank of Azerbaijan, Deposits and Savings for currencies in 2006_). Increase of deposits in AZN was 37% in 2006, while it was 20 % in 2005. These factors show that Government could achieve its goal to lower inflation for 2006. That is the main reason why there is such a deviation when we analyze Philips curve.

Let’s now try to find relationship between GDP growth and unemployment rate.

Figure 4. Per Capita GDP in Azerbaijan, USD.

_Source: State Statistical Committee of Azerbaijan Republic_

If we consider this graph together with unemployment graph we can see the negative relationship between per capita GDP and inflation rate in Azerbaijan. Let’s put these two indicators together in one graph.

_Figure 5. Okun’s saw_

On the x axis we have the rate of unemployment and on the y axis we have the per capita GDP from 2003 till 2008. From this graph we can see that this law holds in realties of Azerbaijan. Now, we have seen that per capita GDP growth is negatively related to unemployment, and on the other hand, inflation is also negatively related to unemployment. This means that, inflation and GDP growth (i.e. per capita GDP growth) is correlated, they have positive relationship. This positive relationship can be observed if we put these two indicators together.

_Figure 6. Positive relationship between per capita GDP and inflation rate_

To conclude our analysis about how neoclassical model of inflation, growth and unemployment works in practice let’s analyze following chart. If we recall neoclassical wage equation (1) we can see that left hand holds difference between wage growth and productivity growth (wage inflation). In the chart below, we see that average monthly salary growth rate exceeds both non-oil labor productivity growth rate and non-oil sector GDP growth rate. So, it means that

> 0. Then the right hand of the equation should be also positive, in other words, price inflation must be positive. From here we come to conclusion that neoclassical theory is appropriate while discussing these relationships.

_Figure 7._

We have observed that, both Philips curve and Okun’s law hold in real figures of Azerbaijan. After analyzing these relationships we came into conclusion that indeed, there is a correlation between inflation and per capita GDP. For this purpose we have used neoclassical wage equation. Of course, each theory has its implications, advantages and disadvantages. Obviously, this relationship could be proved using other approaches and other models. In any case, there is a positive relationship between per capita GDP growth and inflation.

BIBLIOGRAPHY:

Roger E.A., Farmer (2002), _Macroeconomics,_ 2nd edition, South-Western.

Gartner M. (2003), _Macroeconomics,_ Harlow: Financial Times Prentice Hall.

Nellis G., Parker D. (2004), _Principles of macroeconomics,_ Harlow: Financial Times Prentice Hall, 2004.

Montiel P. (2009), _International Macroeconomics_, Fabulous Printers Pre.

State Statistical Committee of Azerbaijan Republic, www.azstat.org

National Bank of Azerbaijan Republic, www.nba.az

Mosley L.(2005), Currency Redenomination in Developing Countries. www.unc.edu/~lmosley/APSA%202005.pdf

Annual Reports of National Bank of Azerbaijan for 2005, 2006, 2007 and 2008. Downloadable from NBA website.