Appropriate Threshold Level of Inflation for Economic Growth: Evidence from the Three Founding EAC Countries

Abstract

This paper empirically estimated threshold level of inflation, which is conducive for economic growth in the three founding EAC countries, Kenya, Tanzania and Uganda using panel data set for the period 1970 to 2013. The non-linear quadratic model was used to estimate the threshold level or the turning point beyond which inflation exerts a negative impact on economic growth. To examine the inflation-growth relationship other moderating variables were included in the model. It was found that credit to GDP ratio, degree of openness of the economy and foreign direct investment flows to EAC member states have significant and positive impact on growth.

In determining threshold level of inflation for the three EAC member states, regression results of the random effect model establish that the average rate of inflation beyond 8.46 percent has negative and significant impact on economic growth. For individual countries, findings from the Seemingly Unrelated Regression (SUR), which treats each country separately, indicate that the optimal levels of inflation for Kenya, Tanzania and Uganda are 6.77 percent, 8.80 percent and 8.41 percent, respectively, beyond which inflation starts exerting cost on economic growth. The implication for monetary policy is that policy makers in the EAC member countries need to continue putting effort in achieving and maintaining single-digit level of inflation to support economic growth.