Tuesday, May 19, 2009

Ideal Inflation Rates

Readers Question: I have always wondered why economic growth and inflation are seen together, one seems to be good, the other not... I understand it theoretically... But still the question stays in my mind... You know we are keen on economic growth... But then there comes inflation, I just don't get it. Which one is the cause of the other, and is there a certain inflation rate that helps the economy to grow?

Economic growth can cause inflation. If the economy expands faster than the underlying trend rate of growth it generally means demand is rising faster than supply. Firms are facing supply constraints so they tend to put up prices. Also as labour shortages occur because of fast growth, wages tend to rise causing inflationary pressure.

Economic growth doesn't have to cause inflation. If aggregate demand increases at the same rate as aggregate supply, it means the economic growth will be sustainable and non-inflationary. For example, between 1993-2007, economic growth in the UK was averaging around 2.5%, this caused inflation to remain low.

Does Inflation Affect Growth?

It is assumed that a low but postive inflation rate helps economic growth.
Firstly, if inflation is negative (deflation) then this fall in prices is likely to lead to lower growth or negative growth. Falling prices reduce growth because:
  • Falling prices means consumers delay purchasing items, leading to lower consumer spending
  • Falling prices increases the real burden of debt reducing disposable income and reducing consumer confidence
  • Falling prices mean real interest rates will be too high.
If inflation is 'too high' then it is argued it may create uncertainty and lack of confidence causing lower growth rates.

Boom and Bust Cycles.

The main problem of inflation is that if growth is too fast we get high inflation. And this boom in the economy tends to be unsustainable. After the boom and high inflation we get an economic downturn. A good example is the Lawson boom and 1991 recession.

When Low Inflation is Insufficient

It was hoped that maintaining a low inflation rate of around government's target of 2% would avoid future booms and busts. But, the problem is that despite low inflation we had a credit and asset price bubble. When the credit and housing bubble burst in 2007-08 this caused a severe recession. This shows that targeting inflation can be insufficient.

1 comment:

دخترک ژولیده said...

Thank you very much for answering my question! I am very proud to have found your weblog, and am keen to introduce it to my friends who study econimcs as well.