Abstract

A structural theory of inflation and growth potential is developed based on a two-sector model of the economy, the traded goods sector and the non-traded. Since the traded goods sector is directly exposed to international competition unlike the non-traded, the latter is more prone to inflation. As the non-traded products have inelastic demand, their consumption propensity rises with the sector’s price level with the consequence that consumption propensity for traded products falls with inflation. As derived from the model, the threshold inflation rate is the upper bound for non-negative impact of non-traded goods sector on the growth of the traded goods sector, indicating the inflation tolerance level of the traded-goods sector of the economy. The model shows that the threshold inflation varies with the level of output, consumption propensity, investment expenditure ratio, and inflation rate in the non-traded sector. A growth potential indicator based on the inflation threshold rate is constructed for predicting an economy’s growth potential or prospects.

As applied to Nigeria, the model confirms the expected negative impact of non-traded sector inflation rate on the output of traded goods. The empirical result shows wide yearly variation in the threshold inflation rates; but generally a 1% inflation rate above the threshold causes 0.32% fall in the output of the traded-sector and 0.27% fall in GDP.

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