Intro: When more people are working there are more of goods and services being produced, which in the absence of increased money supply tends to lead to falling prices. Rapid growth can occur alongside high inflation but this tends to be the result of increased economic confidence leading to faster bank lending and borrowing, increasing the money supply.
While rising demand for one particular good tends to lead to an increase in the price of that good, for the economy as a whole rising demand does not cause inflation. The reason is that demand is effectively infinite and is only constrained by how much an economy can produce. In the absence of any additional increase in the supply of money, an increase in the demand (or spending on) one good or service must result in an offsetting reduction in the demand for another good or service.
Strong Real GDP Growth is a Deflationary Force, All Else Equal
However, inflation isn’t only about money supply growth. For any given amount of money supply growth (all else equal), the lower the rate of growth in real goods and services production (i.e real GDP growth), the higher the rate of inflation. This may contradict popular economic thinking, but it is perfectly in line with simple supply and demand dynamics and is borne out clearly by the data as seen below. The following chart shows the inverse correlation between real GDP growth and core CPI in the US over the past 50 years or so. Only since the Global Financial Crisis has there been no inverse correlation between the two:
This makes perfect sense: the greater the availability of goods and services in an economy, the cheaper they will become. We can easily see this by looking at the price of electrical goods decline over time as their availability increased due to greater production. It is no different for the economy overall.
The Output Gap
There is a tendency for central bankers to look at the output gap as a driver of inflation. When real GDP growth is below potential, they argue, this is disinflationary as there is ‘idle capacity’. However, there is no evidence that an economy operating below its so-called potential is inflationary, and neither should there be. When growth is weak relative to potential this tends to be inflationary. Indeed, the countries with the highest rates of inflation are always the ones with the weakest growth rates. Zimbabwe and Venezuela are clear examples of this.
Higher Unemployment Does Not Usually Cause Lower Inflation
Central banks often work under the assumption that low unemployment causes high inflation. Based on the output gap idea, they argue that the tighter the labour market (less idle resources), the higher wage pressures will be, and as wages are the main cost to business, inflation will rise. This is a case of focusing on what is easily ‘seen’ but less easily ‘unseen’. What is unseen is that in the absence of an increase in the money supply, any increase in wages must come at the expense of corporate profits, in which case there is no overall increase in spending. As the chart below shows, there is no indication whatsoever that a lower unemployment rate causes higher inflation. In fact, the data runs slightly in the opposite direction, as indeed simple supply and demand analysis would predict.
Strong Growth Can Cause Rapid Money Supply Growth, Which May Be Inflationary
The key point to remember regarding stronger real GDP growth being disinflationary is ‘all else equal’. The disinflationary force of stronger growth can often be offset by the inflationary force of an increase in money supply growth.
When economic growth is strong, consumers are confident, and business are profitable, banks tend to be willing to lend and business and consumers tend to be willing to borrow at a rapid base. As a result, money supply tends to grow rapidly. Conversely, when the economy is slowing down or in recession, consumers and businesses tend to prefer to pay back their loans rather than take on new ones and money supply growth slows.
This explains why occasionally (although rarely), particularly in developed markets, low growth and low inflation can go hand in hand. However, this does not mean that the low inflation is actually caused by weaker growth. In fact, the causality goes in the opposite direction. Lower GDP growth (inflationary) leads to lower money supply growth (deflationary), with the latter often dominating to result in lower inflation.
In developed markets, low real GDP growth is more likely to be disinflationary when compared to emerging markets. During developed market recessions, for instance, the disinflationary force of falling money supply growth resulting from people paying back loans can dominate the inflationary force of a reduction in real GDP growth. In emerging markets on the other hand, recessions are more likely to be inflationary as the latter effect dominates. The impact of money demand also plays a crucial role, as explained in Velocity: The Impact of Money Demand on Inflation.
