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INFLATION AND ECONOMIC GROWTH IN CANADA

by

Graduate Student

A paper submitted for INDM 5240 Engineering Economy School of TechnologyUniversity of Central Missouri

February, 2014

ABSTRACT

by

Graduate Student

The question posed by this analysis is whether economic growth in Canada altered by inflation. Inflation may increase or reduce economic growth depending on if it is larger or smaller. There may be a delay between inflation and economic growth, or it may occur simultaneously. Using quarterly data from 2000 to 2007, the findings of the study are that there is a positive correlation between moderate inflation (positive 0.149% to positive 0.984% per quarter) and economic growth when economic growth is measured 3 months after the inflation.

INFLATION AND ECONOMIC GROWTH IN CANADA by

Graduate Student

A paper submitted for INDM 5240 Engineering Economy School of TechnologyUniversity of Central Missouri

February, 2014

2014

Graduate Student

ALL RIGHTS RESERVED

TABLE OF CONTENTS

CHAPTER1. INTRODUCTION.12. DISCUSSION ...........................................................33. RESEARCH PLAN .....................................................................5Questions .....5 Software used.....54. METHOD OF ANALYSIS...............6Variables .....6Charts.................................................................... 7Statistical Analysis...................................................9Relationships found....................................................115. FINDINGS, CONCLUSIONS, AND RECOMMENDATIONS ...12Findings ..............................................12Conclusions ................................12Recommendations ........................12REFERENCES .....................13Indm 5240 Research Paper2/17/2014

CHAPTER 1

INTRODUCTION

This topic has been chosen for two reasons. First, data from Canada is available in English. The government of Canada has kept data on their economy for decades, and possesses a good infrastructure allowing public access to this data. Second, interest is higher on the topic of relationships between inflation and economic growth since the recession of 2007 is now under recovery. There is some concern that deficit spending may increase inflation, and this inflation may result in reduced economic growth. The subject of Canadian economic information is less referenced by individuals and organizations in the United States, but the close proximity and the relatively large size of trade between the United States and Canada provides further interest.Canadian Government datasets are available containing data from 2000 to 2007 for most indicators. While some data was found extending into 2013, leaving out these added few years were not a significant deterrent to the research. This allowed pertinent variables to be sourced from the same time period. Keeping all data from the same time period avoids the complication of seeking multiple data sources and reconciling potentially different data collection methodologies.There are many possible data variables in the datasets available from Statistics Canada, the online Canadian Government data repository. These variables have different dates, different incremental time periods, different geographic distributions, and cover different portions of the economy. To help choose between options, the researcher applied the following guidelines. First, the sources needed to be shown in constant dollars to reduce any bias effects of inflation, other than a direct effect on economic growth. Secondly, the data needed to be available from an identical overall time period. Third, the data needed to be in the same time categories or buckets. It turned out this was not possible, but accommodations were made to adjust the datas time periods without compromising data integrity. Fourth, the data needed to cover the Canadian economy. Extensive trade between provinces and shifts of development from one province to another could obscure possible relationships between inflation and economic growth unless the whole nation was included in the dataset. In addition to the geographic breadth of the desired data, the sectors of the economy needed to be as broad as possible. Avoiding a focus on limited areas of the economy such as petrochemicals or natural resources will provide the broadest possible base to see data relationships.The data sources were readily available. The Statistics Canada website was quickly found and allowed sufficient bandwidth for ready access to data. Additionally, the website contained features to allow customized data extracts, reducing the need to perform extensive data culling and processing after the data was identified and downloaded.Prior to data analysis, three possible relationships between inflation and economic growth were identified. First, it is possible that a higher inflation rate would either depress or enhance economic growth. Second, it is possible that a lower inflation rate would either depress or enhance economic growth. Third, it is possible that a narrow range of inflation values would provide the best possible economic growth.

CHAPTER 2

DISCUSSION

The two variables chosen were the consumer price index as a measure of inflation and the gross domestic product as a measure of economic growth. The consumer price index chosen was from Statistics Canada Table 326-0001 and used a 2001 basket content. This time period most closely matched the time period for the gross domestic product data. The 2001 basket has been retired, but its contents were chosen to closely match a typical consumers purchasing choices. The underlying reason for using a fixed basket of commodities is that the resulting index will reflect only pure price movements (Government of Canada, 2013). The official time base for this index was 1992 = 100. The use of any particular base does not affect the difference between two time periods as long as the same base is used. This is the methodology used in the analysis, so the choice of base year is immaterial.In this data extract, the consumer price index is shown for 27 different sets of basket items. Following the plan of using the broadest possible set of data, the consumer price index for all items was chosen.The gross domestic product chosen is from Statistics Canada Table 380-0064 and is expenditure-based. An income-based table is available, but deemed to be more distant from the consumer price index data than an expenditure-based source. This choice was more likely to reduce bias in the data relationships, since income may not reflect consumer spending changes as closely as expenditures.In this data extract, gross domestic product is shown for 31 economic sectors. Following the plan of using data sources as closely aligned as possible, the Final consumption expenditure is used. All gross domestic product values shown are in Canadian dollars x 1,000,000 (Government of Canada, 2014).

CHAPTER 3

RESEARCH PLAN

Questions

Three questions were identified prior to analysis, and a sensitivity question on lagging time periods was applied to all three questions. 1. A higher inflation rate will either depress or enhance economic growth. 2. A lower inflation rate will either depress or enhance economic growth. 3. A narrow range of inflation values provides the best possible economic growthThe sensitivity question is: what (if any) is the lagging relationship between inflation and economic growth. There were three scenarios to this sensitivity question:a. Keeping the gross domestic product changes in the same time period as consumer price index changes (no lag.)b. Delaying the gross domestic product changes by one time period compared to consumer price index changes (a three month lag in gross domestic product.)c. Delaying the gross domestic product changes by two time periods compared to consumer price index changes (a six month lag in gross domestic product.).Software usedMicrosoft Excel 2007 was used for data storage and preparation, Minitab 16.2.4 was used for charting and analysis.

CHAPTER 4

METHODS OF ANALYSIS

VariablesTo prepare the two variables, several steps are needed. First, the data needs to be in the same size time categories. Consumer price index (CPI) is stored as monthly values and gross domestic product (GDP) is stored in quarterly values. To fix this, the researcher will average the monthly CPI values into quarterly time periods. An assumption is made that each month was equally weighted in effect on CPI. For example:CPI January 2000 = 111.4, CPI February 2000 = 112.0, CPI March 2000 = 112.8CPI Q1 2000 = (111.4 + 112.0 + 112.8) /3 = 112.07The second step in the preparation is to convert the two variables into change measures. For example, the as-provided values of the CPI relative to 1992 are not important; the changes in CPI from one quarter to another are crucial. Subtracting each value from the prior value and dividing by the current time period value provides a percent change form one time period to the next. For example with the CPI,CPI Q1 2000 = 112.06, CPI Q2 2000 = 113.03CPI change Q2 2000 = 113.03 112.06 = 0.97CPI % change Q2 2000 = 0.97 / 113.03 = 0.855% For the GDP:GDP Q1 2000 = 925,562 GDP Q2 2000 = 915,751GDP change Q2 2000 = 925,562 915,751 = 9,817GDP % change Q2 2000 = 9,817 / 925,568 = 1.072%By using a % change instead of a value change, the scale of alterations from quarter to quarter is equalized for the two variables. This reduces bias based on differing values of the two indexes.

ChartsCharts created are of two types. Charts 1 and 2 establish the frequency distributions of the two prepared valuables, and charts 3 and 4 show relationships between the two prepared valuables.

Chart 1: Consumer price index % change (CPI % change)The changes of CPI from quarter to quarter between 2000 and 2007 are more or less normally distributed. There are 28 data points, with a mean quarterly CPI % change of positive 0.562% primarily ranging from positive 0.149% to positive 0.984%.

Chart 2: Gross Domestic Product % change (GDP % change)The changes of GDP from quarter to quarter between 2000 and 2007 are less normally distributed than the CPI. There are 28 data points, with a mean GDP % change of positive 0.775% primarily ranging from positive 0.549 to positive 1.017. Statistical AnalysisWhat is the relationship between CPI changes and GDP changes? In chart 3, we can see that without any lag time relationship, there is little to no relationship between CPI and GDP. These may be a slight reduction of economic growth at higher inflation levels, but the slope of the plotted regression line is nearly flat. The Pearson correlation factor for these two variables is -0.125 (on a scale from -1 to +1, with 0 showing no correlation) which agrees with the visual in chart 3 that there is little to no correlation.

Chart 3: Plot of CPI % change against GDP % changeLooking at the effect of a one quarter lag, Where the CPI changes in Q1 are compared to GDP changes in Q2 alters the Pearson correlation factor for these two variables from -0.125 to +0.621 (on a scale from -1 to +1, with 0 showing no correlation). A two quarter lag shows a Pearson correlation factor of -0.183, so there is virtually no correlation here. We cannot conclude that high or low inflation causes faster or slower growth, but we can see that high or low inflation has no effect on growth for the current quarter or 6 months later. With a correlation of +0.621, there exists a possibility that higher inflation precedes higher growth in the following quarter. Chart 4 shows this one quarter lag relationship more clearly.

Chart 4: Plot of CPI % change against GDP % change with a one quarter lag of GDP

Relationships foundAnswers to our initial questions can be stated as follows:1. A higher inflation rate will either depress or enhance economic growth. (enhance)2. A lower inflation rate will either depress or enhance economic growth. (depress)3. A narrow range of inflation values provides the best possible economic growth (not evident for this range of data)The sensitivity analysis when lagging the GDP after the inflation shows that a three month lag provides the largest correlation, so if there is a relationship, if is not immediate and not six months but about three months.

CHAPTER 5

FINDINGS, CONCLUSIONS, AND RECOMMENDATIONSFindings No time- immediate relationship was found between inflation and economic growth. There is a positive correlation between moderate inflation (positive 0.149% to positive 0.984% per quarter) and economic growth when economic growth is measured 3 months after the inflation. No relationship was found between inflation and economic growth when economic growth is measured 6 months after the inflation.ConclusionsModerate inflation is good for economic growth three months later.Recommendations for further study. Portions of the Canadian economy may react more vigorously to inflation and economic growth Some provinces may show a different relationship Industrial sectors of the Canadian economy may show a different relationship to inflation More extreme values of inflation beyond +0.149% to +0.984 may demonstrate different relationships with economic growth, either in magnitude or in time lag and duration.

REFERENCES

Government of Canada (2013, November 29) Statistics Canada: Table 326-0001 Consumer Price Index (CPI), 2001 basket content, monthly (1992=100) retrieved 2/16/2014 from http://www5.statcan.gc.ca/cansim

Government of Canada (2014, February 16) Statistics Canada: Table 380-0064 Gross domestic product, expenditure-based, quarterly, retrieved 2/16/2014 from http://www.statcan.gc.ca/tables-tableaux/sum-som/l01/cst01/gdps03a-eng.htm1