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What Is the Relationship Between GDP and Inflation?

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  • Written By: Felicia Dye
  • Edited By: Melissa Wiley
  • Last Modified Date: 27 June 2014
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GDP and inflation are both considered important economic indicators. It is widely believed that there is a relationship between the two. The problem is that there are disagreements as to what that relationship is or how it operates. As a result, when governments make decisions based on these pieces of information, the outcome often cannot be guaranteed.

Exploration of the relationship between GDP and inflation is best begun by developing an understanding of each term individually. GDP is an acronym for gross domestic product, which is the value of a nation's goods and services during a specified period. This figure is generally regarded as an important indicator of of an economy's health. It can be thought of much in the same way that lab results indicate an individual's health.

Inflation refers to a situation where average price levels increase or when the amount of currency increases. As a result, money has less purchasing power. As a simplistic example, pretend that a country's monetary unit is called a yen and each yen purchases a cup of rice and a slice of meat. When individuals go to the market one day, they find that getting a cup of rice and slice of meat will cost two yen. In this instance, inflation has occurred.

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Understanding how these two terms are related will not be as simple. The main reason why is because the relationship is the subject of much debate. To begin with, there is no consensus on the exact causes of inflation. Many people believe that it occurs when there is too much money and not enough goods and services available.

According to this belief system, prices are pushed up when people are competing for a limited supply of items. This means that an increase of GDP, or growth in the amount of goods and services, should equate to a reduction in the level of prices for those items, or that deflation should occur, for those looking to use economic lingo. Everyone does not agree that this relationship is absolute.

GDP and inflation are often associated with one another because governments and central banks often make decisions based on these figures and they attempt to manipulate them. If an economy is not growing or is not growing fast enough, a central bank may lower interest rates to make borrowing more attractive. The logic behind this is that it will encourage spending, which will lead to a rise in GDP. The drawback of this move is that, according to many popular beliefs, it will also prompt inflation.

If an economy is growing too fast, which could lead to shortages because people are demanding products and services faster than they can be supplied, moves may be made slow GDP. This may be done by increasing interest rates, which is considered a means of making money harder to come by because borrowing is more expensive. According to many, this should help to control inflation because the effect should be less demand for good and services. Problems tend to arise, however, because actions focusing on manipulating GDP and inflation may not produce the intended effects, which tends to fuel the debate regarding their relationship.

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sandrews
Post 1

I’m curious to know how wage growth factors into inflation. How does inflation affect real earnings, and what shows the true state of the economy: wage growth or inflation? Can either one of these potentially predict the state of our economy in the next five years?

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