Introduction

The economic reform in Vietnam began in 1979 as efforts were made to overcome a striking economic crisis in which standard of living declined drastically. In the early 1980s, the economy was a hybrid of a central planning system and a market system at the bottom, both in the agricultural sector and industrial sector. Facing the threat of a deviation from a central planning system, the Communist Party tried to re-regulate the deregulated economy. However, re-regulation showed apparent failures.

Consequently, the Sixth Congress of the Vietnamese Communist Party launched a critical move from a central planning system to a market one in December 1986. The economic reform has brought about considerable improvements in living standards. After a period of price instability, even hyperinflation, in 1986-1991, which was associated with moderate growth rates, the Vietnamese economy entered a period of moderate inflation with rapid growth over 1992-1997. More specifically the annual average growth rates over 1986-1991, 1992-1997, and 1998-2000 are 4.7 percent, 8.8 percent and 5.8 respectively. The corresponding inflation rates are 180 percent, 9.5 percent, and 2.8 percent.

Especially, a new phase of economic performance that clearly emerged in 1999 shows low inflation, even deflation. This phenomenon is associated with a slowdown in growth. With a perception of stagnancy in demand growth, the government has carried out a stimulus package, which involves expansion in both monetary and fiscal policies. So far, this stimulus package has seemed to fail to prevent deflationary pressures, which are assumed as signals of a downturn. Facing this fact, a debate over further expansion has appeared. Some economists and policy makers argue for further stimuli while some others argue for cautious responses. This debate cannot be settled without the knowledge of possible effects of monetary growth and inflation on economic growth.

The thesis is concerned with the research question: ‘What is the pattern of effects of inflation on growth’. Via the literature review and the stylized facts of the Vietnamese economy, we formulate a hypothesis about a possible inverted U-shaped relationship between inflation and growth. That is under a threshold inflation may be harmless or even conducive to growth; and beyond that threshold, inflation may retard growth.

To test the hypothesis about a possible inverted U-shaped relationship between inflation and growth, we use econometric methods. Two different approaches are adopted to test the hypothesis. One approach involves a growth accounting exercise and a test on the effects of inflation on productive efficiency. As only dealing with efficiency, which is one of the various channels running from inflation to growth, this approach is a test of partial effects of inflation on growth. The other approach involves VAR models to identify the total or full effects of various channels running from inflation to growth.

In testing the hypothesis in two different approaches, we rely on two sets of data. One is an annual data set from 1986 to 2000 that is used to test the partial effects. The other is a quarterly data set over 1991-2000 used to test the full effects. The General Statistical Office, MOLISA and World Bank report all the data used.

The Thesis’s body has three chapters. Chapter one presents a literature review of theories and empirical studies on the relationship between inflation and growth. Chapter two serves to review Vietnam’s economic performance, especially inflation and growth, in the renovation process. Chapter three presents and tests the hypothesis about an inverted U-shaped relationship between inflation and growth. Finally, we summarize the main findings of the thesis in Conclusion.

What Theories and Empirical Studies Say?

Theories

While the classical school holds neutrality of inflation, the “Prior saving” approach and the “Forced saving” approach argued for negative and positive impacts of inflation on growth, respectively.

The classical school maintains neutrality and super-neutrality of money. Neutrality of money means money is neutral to real variables like relative prices, employment and output. Though neutrality of money is highly likely to hold in the long run, it may not hold in the short run. However, there are different explanations for non-neutrality of money in the short run. While the hypothesis of neutrality of money is restricted to static conditions of various real variables, the concept of super-neutrality of money is examined in comparative-static conditions and dynamics. Super neutrality of money means that changes in the nominal money stock and inflation does not affect (1) the growth path of other real variables in their steady-state levels, except for real cash balances; (2) the process in which real variables approach their steady states or equilibrium levels.

The “prior savings” approach maintains that inflation retards economic growth. In the “prior savings” approach, classical economists maintain that prior savings are the determinant of investment and all savings find their investment outlets. In addition, it is assumed that investments not financed from prior savings will generate inflation but no real income. And to grow, there is no need for inflation. Moreover, inflation retards economic growth. This approach rests on some propositions. First, inflation lowers real returns to savings and hence discourages savings. Second, high and variable inflation rates may raise the cost and risk of productive investment. The high variability of inflation may induce the private sector to invest in quick-yielding financial assets rather than longer-term projects. Third, high inflation can lead to ‘rent seeking’ and directly unproductive activities when the government has to impose various price controls. Fourth, high inflation may encourage investment in unproductive real assets like gold or real estate. Fifth, if resources or seigniorage transferred to the government are not invested, the net increase in total investment will be lower. Finally, in an open economy, if domestic inflation exceeds world inflation in the case of an inflexible exchange rate, inflation will worsen the balance of trade. This may aggravate the exchange gap. In addition, hyperinflation can give rise to speculation on devaluation and hence can induce capital flights. The implication of this approach is that monetary policy is to mobilize and channel funds for investment. To this end, real interest rate must be positive. Positive real interest rate can be achieved by financial liberalization and low inflation.

The “forced savings” approach, which is dominated by the Keynesian school, holds that inflation can facilitate growth. In the “forced savings” approach prior savings are not the requirement for growth. The government via money expansion can increase investment. In the case of underemployment, money expansion will raise aggregate demand and hence output and saving.  In the case of full employment or supply rigidities, money growth will raise the inflation rate, reducing real interest rate, shifting funds to physical capital, strengthening capital intensity and hence stimulating output and saving. In addition, inflation, in which prices rise faster than wages, arising from money expansion will lead to redistribution effects in favor of profit earners. This helps to increase the marginal propensity to save or MPS for short. Moreover, inflation will drive resources from the private sector to the government budget for real investment. The implication of this approach is that to increase investment, there is need for low or negative real interest rates. So inflation and financial repression by ceilings are necessary for growth.

Empirics

Besides the theoretical debate, empirical evidence also provides inconclusive results.

In empirical studies, economists follow two main approaches. First, they investigate a sample of many countries over a certain period of time. Second, they study cases of individual countries. The results of the first approach, though empirical, are too general and are theoretical in some sense. Clearly, this kind of research is significant for further theoretical and empirical studies. However, policy makers should be careful in the applications of those results. In the second approach, economists often adopt, follow and are guided by the hypotheses, methods and results, which are theoretical in some sense, of cross-country studies. Empirical results of single-country studies are more reliable in the policy making process because they are more specific, accounting for peculiarities of a certain economic system.

On the empirical ground, via various single-country and cross-country studies, inflation does not have a consistent effect on growth. Some economists find that inflation does not have significant effects or stable effects on growth and productivity growth. Others identify positive relationship between inflation and growth. A greatly larger body of the literature finds harmful effects of inflation on growth. Recently, some economists arrive at an inverted U-shaped relationship between inflation and growth.

In the case of Vietnam, there are a few studies on inflation and growth. However, these studies do not identify empirical effects of inflation on growth. Hence, the thesis is aimed at filling the gap in the literature and may provide empirical suggestions for policy responses to the hot issue of deflation. Hence the study is empirically oriented and worthwhile.

Why inconclusive?

In fact, the inconsistence relationship between inflation and growth results from numerous channels between them, both direct and indirect. It is noted that our concern here is only the direction from inflation to growth, not the opposite direction. Inflation will affect growth directly if money is treated as a direct productive input in the aggregate production function. Except for this channel, inflation will affect growth via other variables like saving, investment, productivity and so on. This complication can be illustrated via Figure 1.

Figure 1. Complication in the inflation-growth nexus

Note: The arrows only denote direct effects, not indirect ones. The figure shows that inflation affects growth both directly and indirectly.

Growth may come from the growth in stocks of resources or improvement in the efficiency in combination of these resources. So the channels serve to link inflation and growth in two ways. First, they affect resource accumulation, especially capital accumulation. Second they influence the combination of resources.

Inflation affects resource accumulation by influencing government saving, private saving, foreign saving. In addition inflation affects investment via altering real interest rates and the degree of uncertainty.

Besides the accumulation of resources, inflation can play some role in changes of efficiency in the combination of resources, which affects potential output, actual output, and hence growth. More specifically, inflation may have impacts on transaction costs, portfolios, financial depth that is crucial to flexibility of the economy, pro-growth processes, incentives and competition.

Inflation and Growth: Policy Responses

The 1986-2000 period can be divided into 4 sub-periods. This division is based upon both the nature of reform and the distinctive developments of inflation and growth. In the first and the second sub-periods 1986-1988 and 1989-1991, economic conditions were unstable. These conditions are characterized by low growth rates and high and fluctuating inflation. In the third sub-period 1992-1997, the economy experienced moderate inflation and rapid growth. The average growth rate was 8.77 percent per annum while inflation was 9.5 percent on average. The fourth sub-period 1998-2000 shows signs of slow down with too low inflation and even deflation on the quarterly basis.

The overview of what Vietnam has achieved since 1986 is demonstrated via two macroeconomic indicators, namely inflation and output growth (Figure 2).

Figure 2. Inflation and growth in the period 1986-2000 (%)

Source: based on GSO (2000a, 2001).

Inflation

Developments of inflation can be observed via CPI, GDP deflator. In general, CPI-based inflation and GDP-deflator-based inflation have the same trend. The series of GDP-deflator-based inflation also shows high inflation in the sub-period 1986-1991 and a declining trend in inflation rate after 1994. In addition, there is a clearly positive correlation between inflation and its variability.

In 1985, a year before the Sixth Congress of Vietnamese Communist Party, the price-salary-money reform was conducted. In the subsequent years, 1986-1988, the government continued gradually the price reform. The economy had to suffer much from hyperinflation in the period 1986-1988.

In 1989, the government launched a powerful campaign to combat high inflation. At the center of this campaign was the positive-real-interest-rate rule, which helped to drive inflation rate down. However, large budget deficits, covered by money creation, gave rise to the return of high inflation in 1990-1991.

From 1992, Vietnamese government cautiously and austerely carried out monetary and fiscal policies. Budget deficit was declining and covered by internal and external borrowings and grants. Year 1992 marks the beginning of a period in which prices became more stable. Over the 1995-2000 period, price growth tended to slow down, except for suddenly rapid inflation in year 1998 due to an external price shock caused by the Asian financial crisis.

The declining trend in CPI started in 1999. This phenomenon signals a new phase of economic performance, 10 years after the launch of doi moi. Both price cycles in 1999 and 2000 have a negative development and the cycle in 2000 is below that of 1999. All these signs suggest an ongoing deflationary situation. In general this phenomenon is caused by excess aggregate supply. More specifically, in Vietnam, the fact that demand growth does not catch up with supply growth is what causes deflation. The causes of deflation are: (1) some industries in the industrial sector and the service sector show signs of unbalances between demand and supply; (2) the deflationary trend in the world agrarian markets helps keep domestic prices low. Moreover, the redistributional effects via changes in relative prices against farmers, a dominant body of the population, lead to slow demand growth; (3) signs of unemployment, piling up of inventories, and deflation bring about the deterioration in people’s confidence. This discourages both investment and consumption; (4) the decline in Total Factor Productivity (TFP) growth. All the mentioned effects are woven together to give rise to deflationary pressure.

In short the developments of inflation are closely linked with policy changes in the early stages of the reform process. For the past recent years, there have been signs of a declining trend in prices, which led to deflation in 2000.

Growth

We will consider the three pillars of total output, namely the agricultural sector, the industrial sector and the service sector. Second, we will look at the trend in the perceived backbone of growth, namely investment. Finally, we will study the developments of TFP growth.

Overall growth can be divided into growth in the agricultural sector, the industrial sector and the service sector. Throughout the period 1986-2000, the industrial sector always had the leading speed of growth. The average rates of growth of the agricultural sector, the industrial sector and the service sector over the period 1986-2000 are 3.7%, 9.1% and 6.7 % respectively. It is noted that developments in the industrial sector may play the most important role in the developments of total output growth over 1989-2000.

The three sectors also show the four typical sub-periods like those of total output growth. This fact also suggests that growth rates of the three sectors seem to be associated with inflation in an inverted-U-shaped pattern. That is low growth rates seem to be associated with too low and too high inflation and high growth rates seem to prevail in the condition of moderate inflation.

Like in many other countries, investment is agreed to be the most important factor of growth. Investment ratio and growth has drifted together, suggesting the prominent role of capital accumulation in the growth process. Over 1986-2000, the investment ratio increased considerably, from less than 15 percent to more than 30 percent. The efficiency of investment can be reflected by the ICOR coefficient. After 1996, there is an upward shift in ICOR. This fact may partially express the efficiency gains brought about by the economic reform.

Figure 3. Contribution of capital and TFP to economic growth

Source: own calculations.

In going further to understand the contribution of investment to growth, we examine the developments of both investment and Total Factor Productivity (TFP), which we have to calculate. Right after the launch of the economic renovation, when various reforms in price and agricultural production were conducted, TFP grew rapidly. After that, TFP growth slowed down before it regained momentum in the period 1992-1995, in which the economy grew rapidly. From the end of 1995, TFP growth slowed down. In addition, contributions of investment and TFP to economic growth are shown in Figure 3.

In the period 1986-1989, growth may come all from efficiency growth stimulated by a new incentive system. Two years after bold reforms in 1989, contribution of TFP to growth regained momentum in 1991 before having a declining trend over 1992-2000.

It is also noted that while contribution of TFP to growth has a declining trend over 1992-2000, the growth in capital stock plays a more and more important role in economic growth. This fact suggests a sustained decline in productivity of the capital stock after 1991. Hence, the underlying pattern or nature of growth in Vietnam may not give rise to sustainable rapid long run growth.

In conclusion, the developments of both inflation and growth suggest a distinctive pattern in the relationship between them in the renovation process. That is too high and too low inflation seem to be associated with slow growth. In addition, though, investment and capital accumulation play an important role in the economic growth process, their growth contribution may be increasingly quantitative and not qualitative.

Policy Responses

Since 1986, the government has combined various policies to promote economic development. One of the important policy groups is the macroeconomic policy mix, which is designed to stabilize the economy and to promote growth. This policy mix is a group of price policy, monetary policy that includes interest rate and exchange rate regimes, and fiscal policy. These macroeconomic policies have shown both successes and failures in addressing inflation and growth. With reference to the aims of macroeconomic policies, there are two periods, namely 1986-1995 and 1996-2000. Policies in the period 1986-1995 were planned to focus on stabilizing macroeconomic conditions. Later, the aim of the period 1996-2000 is macroeconomic stabilization for higher growth. More specifically, macroeconomic policy mix is reviewed in four sub-periods, namely 1986-1988, 1989-1991, 1992-1997, and 1998-2000.

In the sub-period 1986-1988, macroeconomic policies were subject to structural reforms. The structural reforms were price reforms, production reforms in both agriculture and industry, and the establishment of a two-tier banking system that has the State Bank and other commercial banks. The elimination of price controls and credit expansion to the state-own enterprises led to hyperinflation in 1986-1988. As macroeconomic policies for stabilization over 1986-1988 failed, the government adopted new approaches in 1989.

The sub-period 1989-1991 began with bold reforms in 1989. The reforms in 1989 include structural reforms and the adoption of orthodox stabilization policies, concerning interest rates, exchange rate and credit expansion. The stabilization package in early 1989 created a synthesized effect to bring inflation to a halt in the middle of the year. Moreover, the strong actions by the government brought back confidence of economic agents in dong. However, these policy actions imposed great hardship to the state own enterprises. After 1989 poor coordinated macroeconomic policies led to the return of high inflation in 1990-1991.

In sum, macroeconomic policies were not constantly well coordinated in 1986-1991. It is noted that, policy success in curbing inflation would not be achieved without two important facts. First, the dual nature of the economy, i.e. formal and informal economies, helped to smooth out the structural adjustment process. Second, the emphasis on openness helped spur growth and create many jobs in export industries, especially after the shrinkage of foreign outlets in the former Soviet bloc.

The Seventh Congress held in June 1991set out a plan to double total output by 2000 in comparison with that of 1990. In fulfilling the general guidelines, in 1992, the government clarified the scope of price control and stipulated the rights and responsibilities of government bodies and enterprises in price stabilization. In 1993, the government established the price stabilization fund. This facility was designed to stabilize prices and protect domestic production. Besides reforms in price policy, this is also the period of fundamental fiscal adjustments. Cuts back in expenditure came from further reforms in the state own enterprise sector, demobilization of half a million of soldiers, and various investment projects. The ease in the budget constraints in this sub-period facilitated the monetary policy in dealing with inflation, facilitating rapid growth. In addition, the State Bank adopted a more flexible management of interests to promote growth in various conditions of price changes. Under the new regime regulating the two-tier banking system, the State Bank was flexible to use various tools as money supply, interest rate ceilings, reserve requirements, credit limits and a managed float regime, which was set up in 1992, to coordinate with other macroeconomic policies to control inflation and encourage production.

In the period 1998-2000 there are two prominent sub-periods. The first is when the government had to deal with the adverse effects of the Asian financial crisis. The second is when the first signs of slow down appeared.

In July 1997, the Asian financial crisis broke out in Thailand, and then swiftly spread to other countries. The financial crisis imposed many adverse effects on Vietnam, especially in 1998. In dealing with the adverse effects, the Vietnamese government adopted a policy package involving prices, monetary growth, credit growth, interest rates, exchange rate, foreign exchange, revenues and expenditures in the budget, foreign trade regime, and operations of the banking system, and so on to stabilize the economy. The government succeeded in gradually adjusting the exchange rate, facilitating gradual adjustments in production, foreign trade and external financial transactions. Fortunately, in fact, the Asian financial crisis tolled a bell on the importance of the matching among various macroeconomic policies, and on the soundness of the financial system. Learning from these lessons, the Vietnamese government has carried out decisive reforms in monetary policy, exchange rate policy, the banking system, and the budget system.

However, while the effects of the financial crisis were dying down in the late 1998 and early 1999, a new trend became clear, which raised negative expectations. That is consumer prices decreased in 8 consecutive months in 1999. In 2000, the first time after the start of the economic renovation, the Vietnamese economy faced deflation. There were concerns about a down turn in the economy. Facing this fact, the government took a comprehensive demand stimulus package to prevent recession. The package involved credit expansion, especially to the farmers, and increases in expenditure, mostly on infrastructure. So far, the stimulus package has failed to prevent the declining trend in CPI. This failure may be the results of the failures to address two groups of problems in Vietnam. First are the objective difficulties of the agricultural sector, which are brought about by the market mechanism. Second may be the quantitative nature of the growth process in Vietnam.

To summarize, in 1998-2000, the coordination of macroeconomic policies succeeded in dealing with one of the greatest financial crises in the 1990s. However, the macroeconomic package designed to eliminate the signs of a down turn in late 1990s seemed not to achieve the desired outcomes.

In conclusion, the review of the developments in inflation and growth in Vietnam from 1986 to 2000 gives us four stylized facts. First, the developments in and effects of non-food CPI may greatly differ from those of CPI. Second, there seems to be an inverted U-shaped relationship between inflation and growth in Vietnam. Third, the developments of industrial output play an important role in GDP growth. Fourth, the nature of economic growth in Vietnam over 1992-2000 may be quantitative rather than qualitative. To put it differently, economic growth may rely more and more on resource accumulation and less and less on efficiency.

Empirical Inflation-Growth Nexus

The two previous chapters, chapter one and chapter two, provide us with two important suggestions. These suggestions are the hypothesis and the approach used to test the hypothesis. First, chapter one and chapter two give a suggestion on the possible pattern of the relationship between inflation and growth, both on the theoretical and empirical grounds. Second, chapter one offers a wide range of approaches, which can be used to test the hypothesis.

We first formulate the hypothesis and then discuss the appropriate approach used to test the hypothesis. Finally, based on the empirical evidence, we present some policy implications, which may be helpful in the short run, medium run and long run contexts.

Hypothesis: Inverted U-shaped Relationship

As the literature review in chapter one shows, there are many channels running from inflation to growth.

On the theoretical ground, inflation can have no effects, negative effects or positive effects on growth. Most of the arguments on the role of inflation are involved in capital accumulation and the flexibility of the economy. In fact, the absence of a unified theory on the effects of inflation on growth comes from the differences in the starting points of various arguments. The differences are composed of different assumptions about the contexts in which inflation works. Consequently, various theories on the effects of inflation on growth can capture only a certain set of effects, which are far from a complete set that tells the nature of the inflation-growth nexus.

On the empirical ground, the absence of a unified theory on the relationship between inflation and growth, clearly, leads to diverse methods and results of various studies. In addition, these empirical studies cover different samples and different measures of inflation and growth. It is noted that most of these studies specify the relationship between inflation and growth with no formal theories underlying the mathematical models. This fact, again, reflect the striking complication in the inflation-growth nexus.

Figure 4. The hypothesis on inflation-growth nexus in Vietnam

The stylized facts about an inverted U-shaped relationship between inflation and growth in Vietnam, which are discussed in chapter two and are in line with some theories and empirical studies, suggest us an asymmetric effect of inflation on growth. That is under a threshold inflation may be harmless or even conducive to growth; and beyond that threshold, inflation may retard growth. This notion is illustrated in Figure 4.

In the next section, we will discuss the analytical framework used to test the hypothesis about a possible inverted-U-shaped relationship between inflation and growth in Vietnam.

Analytical Framework and Data

The Study employs two approaches to test the u-shaped relationship between inflation and growth. In the first approach, by adopting the Granger causality test, we study the effects of inflation on total factor productivity, and hence on growth. As the concern of this approach is the TFP, it provides a test on partial effects of inflation on growth. Though facing a small number of observations, this test is meaningful in the sense that it may provide us empirical clues on an appropriate price environment that is crucial for macroeconomic performance in the short run and growth in potential GDP in the long run.

In the second approach, by adopting a bivariate VAR model, we can trace the total effects of all the channels running from inflation to growth. Hence a VAR model can provide a test on the full effects of inflation on growth. This test is preceded by the Granger Causality test. In testing the full effects of inflation on growth, we use two inflation variables, namely CPI and non-food CPI, and five growth variables. As noted earlier, we are concerned with both actual output growth and potential output growth. After the Granger causality test, we run the regression, which accounts for the threshold effects as:

where is called the threshold term,  is the threshold assuming values from 0.5% to 4.5% with increments of 0.5%. This range of inflation rates is chosen because most of the quarterly inflation rates lie in that range. The threshold  is chosen to minimize the sum of the squared residuals or ESS/RSS of the above regression.

In testing the partial effects and full effects, we rely on two data sets. Out of the two data sets, one is annual from 1986 to 2000, and the other quarterly from 1991Q1 to 2000Q4. Most of the data have official sources like the General Statistical Office, World Bank and MOLISA. It is noted that, we have to establish the data series of the capital stock and TFP growth over 1986-2000. In addition, the series on quarterly potential GDP is derived with the Hodrick-Prescott (HP) filter. As revised by GSO, the data samples are consistent.

Empirical Evidence

The test of partial effects shows that inflation may not have effects on the efficiency measured by TFP of the economy. As the number of observations is limited, these results only provide some suggestions. In the economic reform process, the technological progress should originate from institutional changes, incentives for competition, and opening up, rather than inflation.

In the test of full effects, there are only two cases in which inflation Granger causes growth. The two cases are: (1) CPI inflation affects potential output growth; (2) CPI inflation affects industrial output growth. In testing the u-shaped relationship between CPI inflation and growth, some stylized facts are:

In the case of Vietnam, inflation seems to be conducive to growth at moderate inflation rates, i.e. increases in inflation rates can promote economic growth. However, inflation exerts the first negative effects as it reaches 0.5% per quarter or 2% per annum where the positive marginal effects of inflation on potential output growth are reduced in magnitude. Beyond 0.5% per quarter, inflation is still conducive to both potential output growth and industrial output growth. In passing the critical point of 4.5% per quarter or 19% per year, inflation has large negative impacts on industrial output growth.  Figure 5 illustrates the empirical marginal effects of inflation on growth. It is assumed that both growth and inflation start from zero. The numerical values show the discrete marginal effects of inflation rate on growth rate.

Figure 5. Marginal effects of inflation on growth

In addition, we test an extra hypothesis. The hypothesis is: after the earliest stage of economic reform, as economic performance becomes more stable, the inflation threshold may decline. This hypothesis is also in line with the distinctive inflation profiles of developed and developing countries: the inflation threshold of developed countries is smaller than that of developing countries. The test shows that there has not been such threshold decline in Vietnam.

Policy Implications

The empirical evidence suggests two facts. First, the tolerance inflation rate is 19% per year, beyond which inflation may have large negative impacts on industrial output growth and hence on GDP growth. Second, the most appropriate inflation rate for long run sustainable growth may be around 2% per annum, too far above which inflation may be harmful. The existence of the threshold suggests that we should take into account the threshold effects of inflation to the policy making process. The general guide is the achievement of an inflation rate that is best for policy goals.

The incorporation of the threshold effects should be embedded in a more comprehensive and specific policy framework. This suggests that we should (1) revise the macro framework and (2) come up with some policy implications for Vietnam.

(b)

Figure 6. The Modified Phillips Curves in the Short Run and the Long Run

First, traditionally, the Phillips Curve shows the trade off between inflation and unemployment rate in the short run, and the vertical Phillips Curve illustrates the proposition that there is no such a trade off in the long run. However, with the threshold effects, those traditional propositions may no longer hold. More specifically, the economy may not tolerate high inflation rates. This effect leads to a forward bending Phillips Curve in the short run (Panel a) and a backward Phillips Curve in the long run (Panel b) in Figure 6.

The threshold effects give rise to a modified macroeconomic framework, which should be noted in the monetary policy. Each monetary regime may have a single intermediate target or several priorities. Economists have proposed various regimes. They are monetary targeting, interest rate targeting, nominal exchange rate targeting, nominal GDP targeting, and inflation targeting. The existence of the threshold effects of inflation on growth suggests that in a country that meets the necessary conditions, inflation targeting may help achieve sustainable growth, a combination of short run and long run desirable outcomes. It can be seen that there is a match between the inflation-targeting regime and the modified macroeconomic framework discussed above. The match is that inflation should be controlled and targeted at an appropriate level.

Second, for Vietnam, the empirical results presented above suggests some policy implications in the short run to medium run, and in the long run to address inflation so as to achieve sustainable rapid growth. The policy implications are:

The short run and the medium run

In the short run perspective, various tools of the macroeconomic policy framework should be well coordinated to achieve rapid growth at acceptable inflation rates discussed above. In other words, policy should incorporate the modified macroeconomic framework. This means all the tools are designed in a comprehensive framework so that they complement each other and do not have conflicts, or at least have minimized conflicts.

In the current situation of deflationary pressures, the monetary and fiscal policies should be more expansionary to spur growth. However, expansionary actions should be under control to ensure an appropriate inflation level, preventing the possible threat of accelerating inflation.

In the medium run and also long run, as suggested by the discussion on the possibility of the quantitative nature of growth in Vietnam and the partial test on the effects of inflation on growth, macroeconomic policy should be combined with structural reforms. These structural reforms should put emphasis on two sectors. The first is agriculture and the second is the system of state own enterprises. In general, the reforms should create more competition incentives, which encourage technological progress. In addition, structural reforms in the agricultural sector should minimize the crop effects, which often drive down prices of produce. These may be involved in the increase in share of agricultural processing and other industrial activities in the rural area.

In addition, various financial institutional reforms and development should be carried out to strengthen the macroeconomic tools. With more powerful macroeconomic tools, the government will be more active in controlling inflation rates for sustainable rapid growth. These reforms and development should comprise of:

§         Reforms in the fiscal policy, including both revenue and expenditure sides, especially the system of state own enterprises.

§         Reforms and development in the banking system.

§         Development of financial markets especially the securities markets.

§         Integration into the international financial markets.

§         Strengthening of the monitoring system, especially the accounting and auditing systems.

The long run

The existence of threshold effects of inflation on growth suggests that in the long run, if these effects still remain and all the necessary conditions converge, Vietnam should study and adopt inflation targeting. To adopt the inflation-targeting regime, Vietnam has to prepare carefully to reduce the possible negative outcomes. In the long run we have to satisfy two prerequisites to explicitly adopt this regime. The prerequisites are: (1) the ability to carry out an independent monetary policy, which involves in an independence of the State Bank to some extent; (2) a robust quantitative framework that links policy instruments to inflation.

Conclusion

The Sixth Congress of the Vietnamese Communist Party launched a critical move from a central planning system to a market one in December 1986. As a result, the Vietnamese economy experienced great institutional changes in the late 1980s. Through out the 1990s, further reforms have been fulfilled in the forms of newly established institutions and deregulations. Those reforms mean further movements towards a market mechanism.

The economic reform has brought about considerable improvements in living standards. After a period of price instability in 1986-1991, which was associated with moderate growth rates, the Vietnamese economy entered a period of moderate inflation with rapid growth. However, a new phase of economic performance, which clearly emerged in 1999, shows low inflation, even deflation. This phenomenon is associated with a slowdown in growth. With a perception of stagnancy in demand growth, the government has carried out a stimulus package, which involves expansion in both monetary and fiscal policies. So far, this stimulus package has seemed to fail to prevent deflationary pressures, which are assumed as signals of a downturn. Facing this fact, a debate over further expansion appeared. Some economists and policy makers argue for further stimuli while some others argue for cautious responses. This debate cannot be settled without the knowledge of possible effects of monetary growth and inflation on economic growth. Unfortunately, the literature on inflation-growth nexus does not provide a conclusive answer to the case of Vietnam.

On the theoretical ground, inflation may be and may not be conducive to growth.

On the empirical ground, via various single-country and cross-country studies, inflation does not have a consistent effect on growth. Besides international studies, In the case of Vietnam, there are a few studies on inflation and growth. However, these studies do not identify empirical effects of inflation on growth. Hence, the thesis is aimed at filling the hole in the literature and providing empirical suggestions for the policy responses. Hence the study is worthwhile and empirically oriented.

We formulate a hypothesis about a possible inverted U-shaped relationship between inflation and growth. That is under a threshold inflation may be harmless or even conducive to growth; and beyond that threshold, inflation may retard growth.

To test the hypothesis about a possible inverted U-shaped relationship between inflation and growth, we use the econometric method. We adopt two different approaches to test the hypothesis. One approach involves a growth accounting framework to compute growth in Total Factor Productivity, which is then related to inflation. As only dealing with efficiency, which is one of the various channels running from inflation to growth, this approach is a test of partial effects of inflation on growth. The other approach involves VAR models to identify the total or full effects of inflation on growth. This second approach allows for all the possible channels that connect growth to inflation.

In testing the hypothesis in two different approaches, we rely on two sets of data. One is an annual data set from 1986 to 2000 that is used to test the partial effects. The other is a quarterly data set used to test the full effects. The General Statistical Office reports all the data used.

From the approaches and data samples mentioned above, we arrive at some main findings as:

First, the consumption basket may change greatly over time, especially in the renovation process. This fact suggests that the weights used to calculate CPI should be adjusted every 10 years, in line with the national census. The adjustments in the calculation of CPI help reflect the true consumption basket.

Second, through out the economic reform process, economic growth may rely more and more on resource accumulation, and less and less on efficiency. In fact, while contribution of TFP to growth has a declining trend through out the renovation process, the growth in capital stock plays a more and more important role in economic growth.

Third, based upon annual data, we find that inflation may not affect TFP or efficiency. However, it should be borne in mind that this test relies on a small data sample. This fact suggests that, in the economic renovation, efficiency may come from institutional and fundamental structural reforms rather than inflation. This means macroeconomic policy should be combined with structural reforms. These structural reforms should put emphasis on two sectors, namely agriculture and state-own enterprises.

Fourth, based on the quarterly data, we find that inflation affects growth in a limited number of cases. That is CPI inflation only has effects on growth rates in quarterly potential GDP, which has a long run perspective, and growth rates in output of the industrial sector, which has a short run perspective. This fact also suggests that inflation has different effects on the agricultural sector, the industrial sector and the service sector. It is noted that non-food CPI inflation hardly has any effects on growth.

More specifically, the empirical evidence suggests two facts. Firstly, the tolerance inflation rate is 19% per year, beyond which inflation may have large negative impacts on industrial output growth and hence on GDP growth. Secondly, the most appropriate inflation rate for long run sustainable growth may be around 2% per annum, too far above which inflation may be harmful to growth. These findings suggest that, in the current situation of deflationary pressures, the monetary and fiscal policies should be more expansionary to spur growth. However, expansionary actions should be under control to ensure an appropriate inflation level and to prevent possible threats of accelerating inflation.

In addition, the existence of threshold effects of inflation on growth suggests that in the long run, if these effects still remain and all the necessary conditions converge, Vietnam should study and adopt inflation targeting. In the long run we have to satisfy two prerequisites to explicitly adopt this regime. The prerequisites are: (1) an ability to carry out an independent monetary policy; this involves in an independence of the State Bank to some extent; (2) a robust quantitative framework that links policy instruments to inflation.

The thesis has both objective and subjective weaknesses. The objective weaknesses are small data samples and lacks of reliable data in some cases. The subjective weaknesses come from the approaches adopted. Under the philosophy set out at the beginning, we investigate the effects of inflation on growth without testing the specific channels running from inflation to growth. In the future, studies on the relationship between inflation and growth can be based upon structural models, which can tell the nature of inflationary effects.