GDP & inflation: what’s the link?

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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 about what that relationship is or how it works. As a result, when governments make decisions based on this information, the outcome often cannot be guaranteed.

Exploring the relationship between GDP and inflation is best started by developing an understanding of each term individually. GDP stands for Gross Domestic Product, which is the value of a nation’s goods and services during a specified period. This figure is generally considered a leading indicator of the health of an economy. One can think of much the same way that lab results indicate an individual’s health.

Inflation refers to a situation where average price levels rise or when the quantity of currency increases. Consequently, money has less purchasing power. As a simplistic example, pretend that a country’s monetary unit is called the yen and that each yen buys a cup of rice and a slice of meat. When people go to the market one day, they find that it will cost two yen to get a cup of rice and a slice of meat. In this case, inflation has occurred.

Understanding how these two terms are connected will not be so simple. The main reason 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 raised when people compete for a limited supply of items. This means that an increase in GDP, or a growth in the quantity of goods and services, should equate to a decrease in the price level for those items, or deflation, for those who wish to use economic jargon, should occur. Everyone does not agree that this relationship is absolute.

GDP and inflation are often associated with each other because governments and central banks often make decisions based on these figures and attempt to manipulate them. If an economy isn’t growing or growing fast enough, a central bank can lower interest rates to make lending more attractive. The rationale behind this is that it will encourage spending, which will lead to an increase in GDP. The downside of this move is that, according to many popular beliefs, it will also spur inflation.

If an economy is growing too fast, which could lead to shortages because people demand products and services faster than they can be supplied, the movements could slow down GDP. This can be done by raising interest rates, which is seen as a means of making money harder to get because borrowing is more expensive. According to many, this should help control inflation because the effect should be lower demand for goods and services. Problems tend to arise however, as actions focused on manipulating GDP and inflation may not produce the expected effects, which tends to fuel debate about their relationship.

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