Threshold Effects of Inflation on Economic Growth in Indonesia: A Nonlinear Analysis

Abstract

Aims: This empirical study aims to examine the non-linear dynamics between inflation and economic growth in the context of Indonesia by estimating the relevant threshold effects, while simultaneously controlling the role of capital formation and working aging population growth. Place and Duration of Study: This study employs annual data spanning the period 1991–2024, resulting in a total of 34 observations. All variables investigated, i.e, Gross Domestick Product (GDP) growth, inflation as measured by the GDP deflator, and gross fixed capital formation growth, were obtained from the World Bank. Methodology: This study utilizes two principal econometric approaches, specifically the unit root test and a robust threshold regression technique, to investigate the inflation threshold in relation to economic growth. Furthermore, the Fully Modified Ordinary Least Squares (FMOLS) estimator is applied as a robustness check to substantiate the reliability and consistency of the results. Results: The empirical findings reveal that the estimated inflation threshold is 3.82 percent, effectively separating the observations into low-inflation and high-inflation regimes. When inflation remains below this threshold, its effect on GDP growth is negative but statistically insignificant, thereby supporting the neutrality hypothesis. Conversely, once the inflation rate exceeds the threshold, it exerts a significant negative impact on economic growth. In addition, growth in gross fixed capital formation and the working-age population are validated as key drivers of economic growth across both regimes. Conclusion: The non-linear inflation–growth relationship is confirmed, with an estimated threshold of 3.82 percent. Beyond this threshold, inflation becomes detrimental to economic growth, while capital formation and population growth continue to serve as drivers of long-run economic growth. Policymakers should maintain inflation below the estimated threshold while simultaneously promoting capital formation and enhancing the productivity of the working-age population to sustain long-term economic growth.