Does inflation cause growth in the reform-era China? Theory and evidence

- The seigniorage revenue retained by the government hires away more workers (the government crowding-out effect).
- There is also a seigniorage effect when part of the revenue goes to entrepreneurs, acting as a subsidy to R&D.
- When entrepreneurs get the larger share of the revenue, the seigniorage effect dominates, and inflation increases growth.
- When government retains the larger share, the government crowding-out effect dominates, and inflation retards growth.
- Regressions using time-series data in China show that inflation has a significantly positive effect on growth.

The government reaps seigniorage revenue from higher rates of money growth, hiring away more workers from entrepreneurs (the government crowding-out effect). There is also a positive seigniorage effect when part of the revenue goes to entrepreneurs, acting as a subsidy to R&D. When the government retains a larger share of the revenue, the government crowding-out effect dominates, and inflation retards growth. When entrepreneurs get the larger share, the seigniorage effect dominates, and inflation increases growth. Both OLS (ordinary least squares) and IV (instrumental variable) regressions using time-series data during 1979-2014 in China show that differenced inflation (to ensure stationarity) has a significantly positive effect on growth. When we use the level of inflation, we find that a 1 percentage point increase in annual inflation would bring a 0.53 percentage point increase in annual growth of per worker real GDP. The robust, causal effect of inflation on growth in China provides support for our theory.