Inflation and Growth Nexus: An Estimate of the Threshold Level of Inflation in Sierra Leone

Abstract

This study investigates the relationship between inflation and economic growth, and determines the threshold level of inflation in Sierra Leone, using a non-linear model (quadratic function) with time-series data from 1980 to 2020. The study employs the Ordinary Least Squares estimation technique within the framework of Hendry’s General-to-Specific approach to obtain a parsimonious result. The results of the unit root test confirm that all the variables are stationary in the first difference, i.e. they are integrated of order one or I(1), with an optimal lag length of two (2). The findings confirm the presence of a non-linear relationship in the inflation-growth nexus. The results reveal that the threshold level of inflation (optimal level of inflation) favourable for economic growth is 10.3 per cent. Thus, inflation is growth-enhancing in Sierra Leone when it is below 10.3 per cent, (i.e. ≤ 10.3 per cent). However, inflation above the threshold is detrimental to economic growth. The results also indicate that economic growth is largely influenced by investment, openness and dummy variable for war, with statistically significant coefficients. Specifically, the results confirm that both openness and investment have a positive impact on economic growth, whilst war dummy has a negative effect on economic growth. The results suggest that the regressors explain 86% of the variation in economic growth and the F-stat reveals that the regressors are jointly significant. The policy implication of this study is that the central bank should implement a prudent monetary policy aimed at maintaining inflation below the threshold level of 10.3 per cent. In this regard, the authorities should follow a rule-based approach to monetary policy implementation rather than discretion in order to contain inflation at the threshold level.