EDEN IAS

Economic growth and inflation| GS ARTICLES

<p>A sustained rise in prices is known as inflation. A large rise in prices / higher inflation rate is often caused by economic growth. However, there are also occasions, when we can get inflation despite weak or negative economic growth.</p>

<p>&bull; If economic growth is caused by aggregate demand (AD) increasing faster than productive capacity (LRAS) &ndash; if economic growth is above the &lsquo;long-run trend rate&lsquo; then economic growth is likely to cause inflation.<br />
&bull; If economic growth is caused by increased productivity (LRAS), then the growth can be sustainable and not cause inflation.<br />
&bull; With cost-push inflation, it is possible to get both negative economic growth and inflation at the same time (Stagflation).</p>

<p><span><img alt=”” src=”https://i.filecdn.in/476edenias/image-1612419902345.png” /></span></p>

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<p><span><strong>Why can economic growth lead to inflation?</strong></span><br />
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<p><span>&bull; If demand rises faster than firms can increase supply, firms will respond to the excess demand and supply constraints by putting up prices.<br />
&bull; In a period of rapid growth, firms will employ more workers and unemployment will fall. As unemployment falls, firms may find it harder to fill job vacancies; this shortage of labour will cause wages to rise.<br />
&bull; If wages rise, firms costs increase and therefore firms pass these cost increases on to consumers.<br />
&bull; Also, with rising wages, workers have more disposable income to spend &ndash; causing a further rise in aggregate demand (AD)<br />
&bull; With higher economic growth, people may start to expect inflation &ndash; and this expectation of rising prices can become self-fulfilling.<br />
&bull; Therefore, rapid economic growth tends to cause upward pressure on prices and wages &ndash; leading to a higher inflation rate.</span></p>

<p><span><strong>Economic growth and low inflation</strong><br />
It is possible that we can have economic growth without causing inflation. If growth is caused by increased productivity and investment, then the productive capacity of the economy can increase at the same rate as aggregate demand (AD). This enables economic growth without inflation.</span></p>

<p><span><strong>Low inflation causes long-term economic growth</strong><br />
It is also argued that low inflation can contribute to a higher rate of economic growth in the long term. This is because low inflation helps promote stability, confidence, security and therefore encourages investment. This investment helps promote long-term economic growth. If an economy has periods of high and volatile inflation rates, then rates of economic growth tend to be lower.</span></p>

<p><span><strong>High Inf lation and Low Growth</strong><br />
It is possible that an economy can experience low growth and high inflation This can occur if there is cost-push inflation. Cost-push inflation could be caused by rising oil prices. It increases costs for firms and reduces disposable income. Therefore, there is lower growth, whilst high inflation. This is sometimes known as stagflation.<br />
The inflation was caused by<br />
&bull; Rising food prices/oil prices<br />
&bull; Devaluation of the pound &ndash; causing rising import prices.<br />
&bull; Rising taxes<br />
Therefore, despite low growth, inflation was high.</span><br />
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