What Is the Relationship between Inflation and Economic Growth?

Inflation and economic growth are linked terms with an often contradictory relationship. While the resulting interaction of inflation and economic growth is not always easily predicted, many economists believe that low, stable levels of inflation are preferable to high, unpredictable ones. After more than a century of modern economics, many studies have shown that most economies tend to grow at a faster rate when accompanied by low or moderate inflation levels. High levels of inflation, by contrast, are generally linked to a variety of problems, including slowed or halted economic growth.

Inflation usually occurs when money supply increases relative to the production or price of goods. For example, if a hamburger costs $5 US Dollars (USD), and a person has $50 USD to spend on lunch per week, he or she would be spending 10% of that money on the hamburger. However, if the person gets an extra $50 USD per week, and the hamburger seller raises his prices to reflect this wage increase, the same exact hamburger would cost $10 USD, yet still be the same percentage of buyer's income. In other words, the purchasing power of the dollar decreases, since the increase of money has affected both the buyer's income and the seller's prices.

Low levels of inflation and economic growth are often linked for several reasons. First, the existence of inflation allows central banks to maintain tighter control over interest rates. If a recession or depression has caused a central bank to reduce the interest rate to zero, they are unable to further adjust if the situation worsens. A low level of inflation guarantees that interest rates will remain above zero, giving the central bank the option to reduce interest as a means of counteracting an economic slowdown.

Another way that low inflation and economic growth are linked is through the maintenance of price stability. When inflation levels are low, they also tend to be more stable, meaning that fast, destabilizing shifts in either purchasing power or prices are less likely. Price stability generally encourages investments, since investors feel more confident about the future of the market.

High levels of inflation, by contrast, can sometimes wreak havoc on economic growth. When inflation levels are high, people may hoard goods for fear of shortages, causing market transactions to slow down and spurring the real possibility of shortages on essential goods. High inflation levels can also reduce the buying power of the dollar faster than labor markets can respond with wage increases, causing many workers with previously sufficient income to suddenly be unable to make ends meet.

Another potential danger of high inflation and economic growth is an increasing risk of market instability. Rapid or high inflation can destabilize price levels, making it far more difficult to accurately predict future market behavior. Price destabilization can be extremely dangerous, as investors may become discouraged, thus slowing the growth of new business investments and stock trading. Furthermore, the unpredictability of high inflation can make it difficult for economists, central banks, and governments to come up with viable plans to control or reduce inflation rates.