Conflict Between Economic Growth and Inflation

Readers Question: What is the relationship between inflation & economic growth?

If growth is caused by rising AD, then the growth is likely to cause inflation. This is because as the economy ,and therefore, firms approach full capacity they start to increase prices due to  supply constraints. Wages will also start to rise because of the decline in unemployment; rising wages will cause both demand pull and cost push inflation.  An example of high growth causing inflation was the Lawson boom of the 1980s. In this period economic growth reached 5% per year, this was much higher than the UK’s long run trend rate of growth and caused inflation to increase to 11%.

Diagram of Demand Pull Inflation

• Basically, If economic growth is above the long run trend rate (average sustainable rate of growth over a period of time) then inflation is likely to occur.

Growth and Low Inflation.

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. This enables economic growth without inflation. For example, since 1993, the UK has experienced low inflationary growth. This is partly due to economic growth being sustainable i.e. close to the 2.5% average; it is also due to productivity improvements such as privatisation and more flexible labour markets.

Diagram showing Low Inflationary Growth

Low Inflation Causes Growth

It is argued that low inflation can contribute to a higher rate of 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.

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Is unemployment a price worth paying for lower inflation?

Inflation and unemployment in UK