Growth Versus Inflation
Definition
Demand-pull inflation: a rise in the general price level caused by aggregate demand growing faster than the economy's ability to supply.
Spare capacity: unused resources, such as idle labour and capital, that let output rise without pushing up prices.
- Rapid demand-led growth can cause demand-pull inflation as the economy nears full capacity.
- Slower growth eases inflation but tends to raise unemployment.
- Supply-side growth in productive capacity can raise output without adding to inflation.
Key Idea
- Fast demand-led growth tends to raise inflation as the economy nears full capacity.
- Slowing growth to control inflation tends to raise unemployment.
Why Growth and Inflation Are Linked
- Near full capacity
- With resources scarce, extra aggregate demand from, say, a fiscal stimulus pushes up prices rather than real output because aggregate supply is steep.
- With spare capacity
- Idle labour and capital let firms raise output to meet demand with little upward pressure on prices, since aggregate supply is elastic.
- The resulting trade-off
- Cooling inflation by cutting aggregate demand usually means slower growth and higher unemployment, the Phillips-curve trade-off.
Note
- This is why central banks aim for steady, sustainable growth close to the trend rate.
- Supply-side growth in productive capacity shifts long-run aggregate supply right, raising output without adding to inflation.
Example
- Suppose nominal GDP grows 7% in a year while the price level rises 5%.
- Only 2% is genuine extra output, so most of the fast money growth near capacity has leaked into higher prices rather than real goods.
The Policy Tension
- Boosting demand-led growth risks inflation when capacity is tight, so a central bank may raise rates to restrain it.
- Fighting inflation with tighter policy risks slower growth and higher unemployment.
- The tension eases when spare capacity exists or supply-side policy expands capacity, so the outcome depends on the economy's position in the cycle.
Must faster growth always mean higher inflation?
- When capacity is tight, largely yes: with resources scarce, extra aggregate demand pushes up prices rather than real output because aggregate supply is steep, so demand-led booms tend to be inflationary.
- But with spare capacity, or when growth comes from the supply side as rising productivity and investment shift LRAS right, output can expand with little price pressure, so growth and low inflation can coexist.
- On balance, whether growth is inflationary depends on its source and the economy's position in the cycle: demand-led growth near full employment risks inflation, while capacity-building supply-side growth can be non-inflationary, which is why steady growth close to the trend rate is the safer target.
Exam technique
- Explain that demand-led growth raises inflation near full capacity.
- Note that spare capacity or supply-side growth allows growth without inflation.
- Judge the trade-off against the current state of the economy.
Common Mistake
- Do not say growth always causes inflation, because with spare capacity demand can rise with little inflation.
- Do not ignore the unemployment cost of slowing growth to cool prices.
Self review
- Why can rapid demand-led growth cause inflation?
- What role does spare capacity play?
- What is the cost of slowing growth to control inflation?
- How can supply-side growth avoid the trade-off?
- What kind of inflation does demand-led growth cause?
