Simple and probably naive question: how is it that inflation is said to take away from economic growth? For instance, recently quartley economic reporting shows the economy has been growing amazingly at around 2 or 3 percent. However, “adjusted for inflation” which is around 5 percent, growth would be at a negative 3 or 2 percent. In other words, the economy is contracting. But how is this possible? If total output grows, where is the contraction? My understanding is, in order to have a contracting economy, that would mean companies go out of business, and economic activity is less than where it used to be. So what if there is inflation? That only means there is more money per good in the economy (as well as causing market distortions but let’s keep it simple for now). Is it that GDP doesn’t really measure economic growth, that it really measures pricing?
The reason the GDP is deflated is to account for the fact that the currency, once its supply relative to demand for it, has been inflated and thus lost purchasing power. It is misleading to say the GDP in year X is the same in terms of dollars as the GDP in year X - 1, when the dollar has fallen in value. The dollar-denominated value of economic activity will be lower in real terms than in nominal (i.e. before inflation is taken account of) terms. As for why inflation is bad, it discourages savings. If your money is simply going to lose value in the future, there is no point to put it in the bank. As savings dwindle away, the natural rate of interest will rise, making investment more costly (from the POV of a capitalist.) Meanwhile, there is every incentive to borrow, and spend as much as possible now as opposed to later, since one’s income will often not keep pace with inflation (official measures of inflation are nonsense and understate inflation.) The Austrian Business Cycle Theory shows why the process of credit expansion does more damage than this even, by meddling with the interest rate.
-Jon
The “output” you’re speaking of is not real growth, it’s simply nominal. If for instance inflation is at 10%, thus there is that much more money and credit in the economy and now just about everybody can have more monetary units. However, each of these units, because there is more of them, they are easier to obtain, each one has a lesser value, each unit (dollar, euro, etc.) purchases less than it previously had. As we previously stated, we’ll assume inflation is at 10%. You have a savings account, which had a 3% interest rate. This means that your real rate is at -7%, even though the nominal rate is still at 3%. Your money, even though it gained some interest, still on a whole lost 7% of its purchasing power. As the poster above me correctly stated, it’s essentially worhtless to keep the currency which keeps inflating, you’d be better off spending it on assets before their prices rise due to an increase in the supply of money and credit. GDP has some flaws with it, one substantial one being that it accounts for government expenditure. Thus if the government borrows, taxes, or inflates a lot and spends this money, this gets counted as growth. As we’ve just discussed in the example, let’s say they inflate the currency to increase expenditures, the wealth of everybody is diminished, however, GDP increases significantly - is this real growth? Of course not. I hope I gave a clear explanation.
Ah, I see. I knew this for a long time but I confused myself trying to think too much about it recently. It’s not that the economy/output actually grew as much, if at all, but inflation could make it seem like it did.
Professor Shostak explains this in simple terms in his article posted on this web site this morning. He explains that the wealth in the economy remains the same but the medium of exchange changes.