The Effect of Inflation Threshold on Financial Development and Economic Growth: A Case Study of D-8 Countries

Although financial development facilitates economic growth, inflationary conditions can negatively affect the relationship between financial development and economic growth. This paper studies the threshold inflation rate for the effect of financial development on economic growth by using the panel smooth transition regression (PSTR) model and the data from eight Islamic developing countries of the D-8 Group over the period 1990–2017. Results show an asymmetric relationship at different levels of inflation between financial development and economic growth. The inflation rate will be transferred at the smooth transition speed of 0.93 bypassing the threshold of 11.88 from the first regime to the second regime, which is a nonlinear relationship in the model. Higher inflation levels reduce the motivation of the investor and consequently reduce the investment. On the other hand, the reduction in the productivity of production factors brings about the negative effect of financial development on economic growth. Thus, countries with a higher inflation rate threshold must have access to an efficient financial system to achieve low inflation rates.