Is inflation caused by economic growth?

Readers Question: Is rise in prices a reflection of economic growth?

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.

Inflation caused by economic growth

Typically, higher inflation is caused by strong economic growth. If Aggregate Demand (AD) in an economy expands faster than aggregate supply, we would expect to see a higher inflation rate. If demand is rising faster than supply this suggests that economic growth is higher than the long run sustainable rate of growth.

For example, in the UK, the long-run trend rate of economic growth is around 2.5%.

If the UK economy expands very rapidly, e.g. economic growth of 5%, then you expect to get inflationary pressures:

  • With high growth, demand rises faster than firms can keep pace with supply; faced with supply constraints, firms push up prices.
  • High growth leads to more employment. Unemployment falls, but this may cause labour shortages. This fall in unemployment puts upward pressure on wages which leads to higher inflation.

Graph showing rise in AD causing inflation

keynesian-increase-ad-lras

Rising AD, when economy is close to full capacity leads to higher inflation.

Examples of inflation caused by growth

economic-growth-inflation-80-15

Inflation often increases when economies experience booms in the economy. The UK long had a history of boom and bust economic cycles. High growth leading to inflation (e.g. the late 1980s / early 90s when inflation increased to 8% as a result of high growth)

Note, it is possible to have economic growth without rising inflation. If economic growth is close to the long run trend rate if demand increases at a similar rate to supply. (Monetarists would put emphasis on money supply increasing at same rate as productive capacity)

e.g. in the great moderation (1994-2007), we had long period of economic growth and fairly stable inflation rate.

Inflation but low Economic Growth

It is possible to have rising prices and a higher inflation rate, despite low growth. This occurred in

  • Early 2008
  • 2010/11

In these cases, rising prices were caused by rising costs of production, e.g. rising oil prices were the main factor behind inflation in early 2008. This type of inflation is often just temporary.

inflation-monthly-target
After reaching 5%, RPI inflation soon fell when oil prices stopped rising.

In 2010/11, rising prices in the UK have been caused by a variety of factors

  • Rising oil and commodity prices
  • Rising taxes (e.g. increase in VAT rate)
  • Effects of devaluation causing price of imports to rise

These factors explain why prices have been rising, despite very low rates of economic growth.

it is important to understand why prices are rising. If the Bank of England though inflation of 4.4% was caused by the economy growing too quickly, then they would definitely have increased interest rates substantially.

However, that clearly isn’t happening. We have low wage growth, high unemployment and very low growth. Clearly, the rise in prices is caused by these cost-push factors.

Diagram showing cost push inflation

SRAS-shift-left

A rise in the price of oil could cause SRAS to shift to the left; this leads to higher inflation.

Inflation (rising prices) could also be caused by a decision to just print money. See: Printing Money

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3 thoughts on “Is inflation caused by economic growth?

  1. This essay really helps me a lot. But I got a question.
    Is economic growth means that must be increase in aggregate demand?
    Can I interpret the question ‘ is inflation caused by EG’ as ‘ is inflation caused by AD?’

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