Economic Growth vs Inflation: Which is more Important?

Readers Question: Low inflation but slow economic growth, if any, or GDP growth , with the risk of 2 digits inflation?  Which one is a better option,or the least harmful?

The choice is not enticing. These are some point to consider:

At the moment the UK economy is experiencing inflation of 5% (above the target of 2%) but economic growth has slowed down and we face the prospect of a recession. In this situation, the MPC has cut interest rates (so we have negative interest rates) This suggests two things:

  1. They think the threat of recession and unemployment is more serious than a moderate rise in inflation
  2. Inflation will fall next year as the economy moves into recession.

Cause of Inflation?

If inflation is caused by cost push factors (rising oil and energy prices) the Monetary authorities are more likely to agree to higher inflation. This is because with cost push inflation, we are faced with a worse trade off (aggregate supply shifts to the left). Also cost push inflation is more likely to be temporary.

However, if the inflation is caused by demand pull factors, if economic growth is too fast, then the MPC may be more willing to raise rates and prevent the economy overheating. For example, in the Lawson boom, the economy grew rapidly allowing inflation to reach double figures. This boom then caused a bust. However, the alternative to the Lawson boom was a slower rate of growth (3% rather than 5%).

This choice between 0% growth or 2% growth and high inflation, suggests the economy is facing a pretty difficult situation, with a combination of supply and demand side shocks.

Reasons to Target Inflation

There would be some who argue that it is better to keep inflation low, even if it means 0% growth. This is because low inflation is important for the long term success of the economy. It encourages investment and stable growth in the long term. If the authorities allow inflation to get out of control, it will only require a more painful readjustment in the future. Keeping inflation low may lead to 0% growth in short term, but, the economy should recover. (costs of Inflation)

Further Reading

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