Economic Growth=inflation (so says my economics professor)

Economics Economics Questions
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1

My economics professor keeps saying economic growth causes price inflation. Something about this does not make sense to me. If the economy is more productive, then the supply of goods is greater, so would not prices (assuming the money supply is stable) actually drop?

He would argue that it is aggregate demand, because more production means people have more disposable income, which=more consumer spending. As a result, prices rise in response, and in conclusion because agreggate demand grows faster than long-term aggregate supply, economic growth will be coupled with inflation.

That still seems off, or at least missing something, but I can’t put my finger on it. If the federal reserve is inflating as the economy is growing, then of course inflation of prices and economic growth will both occur. But my professor insists that data shows that there is a very close connection between economic growth rate and price levels. If inflation is 3% and economic growth also 3%, the net rise in prices should be zero, correct (at least if I simplify the situation and assume other factors are held constant)? So if inflation was 6% and growth still only 3%, it would appear that there is inflation that corresponds exactly with growth. Could that be the problem? I am not sure where to go with this. Thanks.

2

I think that with a central bank economic growth will come with inflation, but I’m not really sure about that. It seems bogus to me as well that prices will ALWAYS rise as an economy grows. I would think that some prices will rise and some will fall according to supply and demand. I think government intervention and central banks really screw with all of it.

3

GDP is used to measure “economic growth”. GDP is a limited measure of money supply. The real question: is GDP economic?

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There it is! The lightbulb that should have turned on right away in my mind but only flickered, letting me know something was wrong with the explanation but preventing me from seeing it clearly.

If the overall price level rises even if production has increased, (not just one price in relation to another) there must be inflation of the money supply. Certain prices may rise for demand reasons, but others would necessarily have to fall, so the net effect would be lower prices with economic growth and a stable money supply. The higher demand is brought about by the lower prices, rather than being a cause for higher ones. Is all the above correct?

Now that I think about it, the computer industry is an excellened example of this. Clearly, computer production has been increasing. Yet prices are only getting lower. How would my econ professor explain this I wonder…

Thanks for the help. Also, I have read the article about GDP, but I still need to do more research in that area. Thanks!

6

He is talking about the AD-AS model, meaning Aggregate Demand and Aggregate Supply. Here is how it looks like:

By the economy being more productive, you mean an outward shift in the Aggregate Supply (AS) curve to the right, which means, providing the Aggregate Demand (AD) remains the same, the price level will decrease, while output (Y) increases.

By the Aggregate Demand, your professor is saying the government, through monetary and fiscal policy, can stimulate increase investment (I) by either lower interest rates or increase government expenditures, which will increase AD and shift AD outward toward the right.

This increased investment will improve productivity, thus increase output, and shift the AS right. Because AD increases first, then AS, provided this is primarily driven by monetary policy, then increasing prices must accompany increasing output.

But of course, the Austrians will say, that increased output, must come from increased investment, which must be done through savings, not increased aggregate demand. In other words, AS will shift outward, without a necessary shift in AD.

Furthermore, Say’s Law says that supply must create its own demand, so increased supply must come first, through increased productivity, which should result in sufficient demand via wages, rent, profits, and capital

Let’s be very clear hear. By “inflation is 3%”, you mean an increase of the money supply by 3%. Then the rise in the price level should be 0%.

Remember, in the mainstream, the word “inflation” means increase in the price level, not increase in the money supply, so in your above example highlighted, the inflation rate (per mainstream definition) is 0%.

7

yep

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Thanks Think Blue, all that info further clarified everything.

I don’t follow what you mean exactly. How does the order in which they occur change the effect on prices? And my econ professor is currently teaching us about the AD-AS, so I am familiar with it.

Yes. That is what I was trying to say, sorry. I should have been clearer. I later used inflation to mean rise in prices, which was confusing.

9

Because the government, through fiscal or monetary policy, must stimulate investment to shift the AD curve outward to the right.

But it takes time for investments to increase output, so in the short term, AS stays in place, while AD shifts right, thus increasing the price level.

This is assuming the economy is starting at full employment Y*.

Then once the AS shift outward to the right, then the government repeats the process again, and pushes AD outward through stimulus, and so on.

For the price to continually increase, while output continually increase, AD must increase more than AS, else any price increase by AD will be negated by a price decrease by AS, and the price level effectively remains the same.

This is because the central bank, often times, will set an inflation target, which it will increase AD as much as it can, until it hits the inflation target, then it backs off, through slowing down money supply growth.

But keep in mind, sometimes it works, sometimes it doesn’t, and sometimes the model completely breaks down.

In the Austrian understanding, AS will shift outward to the right on its own, without a necessary shift in AD. Because the AD stays in place, while the AS shifts outward, the price level must naturally decrease.

Because increased output, from increased productivity, will lower the price for each good, the quantity demanded for each good will increase, but the total demand expressed as AD will remain the same, and the AD curve should not shift at all.

Even though nominal income remains the same, real income has increased, because prices have dropped, with the same amount of total demand.

From a Keynesian point of view, private investment is never enough, because there are excess savings (known as the paradox of thrift). Thus the government has to step in and increase investment through fiscal and monetary means.

From a Austrian point of view, private investment will always equal private savings, thus excess savings will never be a problem, and the economy will increase output on its own accord.

In summary, Keynesian says AD shifts outward, then shifts AS outward. The Austrian says AS shifts outward, while AD remains in place.

10

Some numbers diproving profs assertion:

For example, during the 20-year period from 1971 to 1991 – often referred to now as an economic miracle – the Japanese yen tripled in value against the dollar, an average appreciation rate of about 10% per year. This increasing purchasing power enabled the Japanese to enjoy steady economic growth and rising living standards. Over that time, Japan’s GDP grew at an average rate of 4.5% and net exports increased fivefold. Government debt as a percentage of GDP fell slightly to about 20%.

Over the following 20 years, from 1991 – 2011, the Japanese economy has been dead in the water. Yen appreciation slowed considerably, with the currency rising by approximately 50% against the dollar, or about 2.5% per year. However, over that time, the Japanese economy and net export growth essentially stagnated, with GDP growing by less than 1% per annum and government debt exploding to over 120% of GDP.

This is from http://www.europac.net/commentaries/quake_response_puts_yen_line

The whole article is worth reading.