Inflation and Productive Capacity - An Empirical Risk Reduction Model

Abstract

An economy’s ability to provide food, energy, and manufactured goods for its population to consume reduces the chance that it experiences high consumer price inflation. However, no research has been done on exactly how much of these critical goods a country needs to be able to produce to keep inflation low and manageable. In this paper, I use an empirical risk reduction model to analyze over seven hundred and fifty data points from twenty-five countries over a thirty-eight-year period to show that a country can significantly reduce it chance of experiencing medium inflation and virtually eliminate the risk of hyperinflation by improving productive capacity such that its output of critical goods is approximately 174% of what the average person would consume in a country with a high standard of living. This effect remains even after adjusting for the growth in government expenditures. Unfortunately, fewer than one third of countries have the capacity to produce enough of these critical items to reliably keep inflation low. The policy recommendation that flows from these findings is that countries should engage in industrial policy to support the stable production of food, energy, and high-value manufactured goods until they reach the production threshold of 174% of desired consumption.