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Economic growth does not cause inflation (Read 1411 times)
John
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Economic growth does not cause inflation
Jun 15th, 2008 at 6:41pm
 
It seems common for economists to say that rapid growth puts pressure on inflation.

I don't know where this myth started, or why people, including the Reserve Bank, continue to propagate it.

By definition, economic growth means a reduction in real prices of things in an economy. As an economy develops, production methods and technology develop and the price of such goods and services falls. In other words, you can buy more of them with the same amount. An example of this is the technology industry, which has arguably grown faster than any other industry in the last two decades - so much so that products are not only cheaper in real terms, but also in nominal terms, despite enormous monetary expansion.

Economic growth also helps to put downward pressure on interest rates. By saving more money, people have more to invest to contribute to even more economic growth. Higher savings means interest rates will be lower, as there is more money available to be lent.
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freediver
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Re: Economic growth does not cause inflation
Reply #1 - Jun 15th, 2008 at 7:00pm
 
Welcome to OzPolitic John. I suspect you have opened up a proverbial can of worms here.

It seems common for economists to say that rapid growth puts pressure on inflation.

I think this is a bit of an oversimplification. It is unsustainable growth that puts pressure on inflation. The goal of the reserve bank is not to prevent growth, but to limit it to what is sustainable. This is usually regarded as being when inflation is between 2% and 3% per year. I think that inflation is a good indicator of how the short term economic growth differs from the long term sustainable rate of growth.

Anyway, what the reserve bank is actually trying to do is stop economic growth becoming cyclical. Up until about fifty years ago, economic growth was marked by strong boom-bust cycles. The great depression was one of the 'bust' times. It was not a one off event, but part of a series of such cycles.

I think part of the reason for this is that there is so much psychology involved in the market place. This leads it to irrational highs and lows, when the public is way too confident (ie borrows too much to invest) or way to skeptical (refusing to invest or take any risk).

So what the reserve bank does is hike up interest rates to slow down borrowing when the market is too 'hot', then drop interest rates to encourage borrowing when it gets too cold. Like a shepherd guiding a flock of sheep. We still get economic cycles, but they are no where near as bad as they used to be. They are just small fluctuations around the long term trend in growth.

Obviously economists were not keen to support this sort of government control over the economy, but the need arose through some very hard lessons from past centuries.

Economic growth also helps to put downward pressure on interest rates. By saving more money, people have more to invest to contribute to even more economic growth. Higher savings means interest rates will be lower, as there is more money available to be lent.

This is only half the story. If the economy is growing rapidly, more people will be borrowing to invest. This will push up the price of money (ie, interest rates).

Rapid growth does put pressure on inflation. Very high and very low inflation rates cause problems by transferring wealth among groups within society. However the biggest problem with high inflation is the fact that it is always associated with highly variable inflation, which puts a damper on investment.
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« Last Edit: Jun 15th, 2008 at 7:07pm by freediver »  

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John
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Re: Economic growth does not cause inflation
Reply #2 - Jun 16th, 2008 at 11:51am
 
freediver wrote on Jun 15th, 2008 at 7:00pm:
Welcome to OzPolitic John.


Thank you.

freediver wrote on Jun 15th, 2008 at 7:00pm:
I think this is a bit of an oversimplification. It is unsustainable growth that puts pressure on inflation. The goal of the reserve bank is not to prevent growth, but to limit it to what is sustainable. This is usually regarded as being when inflation is between 2% and 3% per year. I think that inflation is a good indicator of how the short term economic growth differs from the long term sustainable rate of growth.


There is no valid explanation as to why economic growth of any kind would cause price inflation.  By definition this is a contradiction. Rather, unsustainable economic growth and price inflation are symptoms of the same thing: monetary expansion.

When newly created money enters the economy, investors and consumers are given false signals: that there is more money than exists and that there are more investors with more savings they are willing to lend. This isn't the case - there isn't that much money, there aren't that much savings, and the money is being created from thin air. Initially, production speeds up and unemployment drops as the new money is thrown around, but this is unsustainable when shortages of capital and labour emerge. Eventually, prices will rise to reflect this, and the Reserve Bank will be forced to react to increasingly apparent CPI increases resulting from this phenomenon. The businesses that relied on loosely available money at low interest rates will become inviable, and the economy may go into recession. Resources were wasted and goods and services were provided when they didn't need to be. Perfect example: property speculation, which, unfortunately, many people still blame negative gearing for.

freediver wrote on Jun 15th, 2008 at 7:00pm:
Anyway, what the reserve bank is actually trying to do is stop economic growth becoming cyclical. Up until about fifty years ago, economic growth was marked by strong boom-bust cycles. The great depression was one of the 'bust' times. It was not a one off event, but part of a series of such cycles.


Yet, ironically, it is central banks that predominantly cause the business cycle. There was no need to establish a central bank in the first place.

The great depression occurred due to rapid monetary contraction.

freediver wrote on Jun 15th, 2008 at 7:00pm:
I think part of the reason for this is that there is so much psychology involved in the market place. This leads it to irrational highs and lows, when the public is way too confident (ie borrows too much to invest) or way to skeptical (refusing to invest or take any risk).


Share markets may be psychological day to day, but the economy isn't. People still need to consume, trade, and produce.

Without a central bank's intervention, nobody can "borrow too much" for the same reason they can't "buy too much" of anything else - because it is scarce. Thanks to central banks, money isn't scarce when it can be created from thin air, and hence, people can "borrow too much", fuelling speculative bubbles.

freediver wrote on Jun 15th, 2008 at 7:00pm:
So what the reserve bank does is hike up interest rates to slow down borrowing when the market is too 'hot', then drop interest rates to encourage borrowing when it gets too cold. Like a shepherd guiding a flock of sheep. We still get economic cycles, but they are no where near as bad as they used to be. They are just small fluctuations around the long term trend in growth.


They follow the wrong figures and manipulate the wrong things. Instead of responding to the money supply, they actually set the money supply to target interest rates to target the CPI, which is a poor indicator of real inflation.

It's not interest rates that allow for increases in spending, but the very thing they use to set interest rates - money creation.

If the money supply was fixed and didn't expand, interest rates would set themselves.

Simply put, it all comes down to the money supply. Significant increases in the money supply spark unsustainable growth patterns, bubbles, malinvestments, and eventually price inflation.

Expansion of the money supply is not necessary for economic growth.

freediver wrote on Jun 15th, 2008 at 7:00pm:
This is only half the story. If the economy is growing rapidly, more people will be borrowing to invest. This will push up the price of money (ie, interest rates).


It won't push it up as high, because in order for a greater quantity of money to clear (be borrowed), it needs to come down in price. Unless there was a shortage in the first place (ie. if interest rates were too low for the quantity of money available), extra money can't clear for the same price because it is simply not as valuable as the first lot was or there aren't as many people who can afford it at that rate.

freediver wrote on Jun 15th, 2008 at 7:00pm:
Rapid growth does put pressure on inflation.


I still haven't heard an explanation for this.

As far as I'm concerned, the more rapid an economy's growth, the faster prices fall.
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Re: Economic growth does not cause inflation
Reply #3 - Jun 16th, 2008 at 12:17pm
 
Yet, ironically, it is central banks that predominantly cause the business cycle. There was no need to establish a central bank in the first place.

They do not create it. They respond to it and reduce it. To a certain extent they may shorten the period, which is a good thing. Economic cycles existed before reserve banks. Reserve banks pretty much eliminated the drastic cycles we used to have. There was a genuine need to do this.

Share markets may be psychological day to day, but the economy isn't. People still need to consume, trade, and produce.

Only a small part of the modern economy is based on necessity.

Without a central bank's intervention, nobody can "borrow too much" for the same reason they can't "buy too much" of anything else

Yes they can. Regular banks can act as creators of money. The typical example given is: suppose you dig up $100 from your back yard. You put it in the bank. The bank takes it, then lends $95 to someone else, who invests it in a company that puts it in the bank, the bank takes that $95, then lends $90 from it. And so on.

I think one of the roles of central banks (or some government body) is to limit this activity - say by forcing the bank to keep that 5% to prevent 'bank runs'.

It's not interest rates that allow for increases in spending, but the very thing they use to set interest rates - money creation.

If interest rates go up, people spend less. The reserve bank does not just create money, it effectively removes it when it wants tor educe the money supply.

Simply put, it all comes down to the money supply. Significant increases in the money supply spark unsustainable growth patterns, bubbles, malinvestments, and eventually price inflation.

No, it is not all caused by money supply. You get economic cycles independent of changes to the money supply. For example, we are in a boom now with high itnerest rates, even though the reserve bank has reduced money supply. Yes money supply could have an effect on this, but even if it was held constant, we would still get cyclical behaviour. Even if the money supply moves in the opposite direction under the control of the reserve bank, we still get cycles, just not as bad. The reserve bank is not creating the cycles, it is cutting them back.

Expansion of the money supply is not necessary for economic growth.

Agreed.

It won't push it up as high, because in order for a greater quantity of money to clear (be borrowed), it needs to come down in price.

Not necessarily. The supply side does not control it all. The demand side is just as important. If demand goes up, price goes up, even if the supply is fixed.

I still haven't heard an explanation for this.

Part of the reason is that the money cycles through the economy faster. It is not just the amount of money that controls inflation, but how quickly it cycles through the economy.
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Re: Economic growth does not cause inflation
Reply #4 - Jun 17th, 2008 at 11:53am
 
I've come up with a better explanation of what the reserve bank does, that does not rely on interest rates:

Macroeconomic cycles are caused by people being too eager to invest when times are good and making irrational investments, and being too timid to invest when times are bad and squirreling their money away. The reserve bank smooths out the cycles by doing the opposite. It squirrels the money away when times are good and splurges when times are bad.

The effectiveness of the reserve bank is partly dependent on whether people give it credibility and react to it. The perfect solution would be if people stopped investing irrationally merely because the reserve bank said the bubble is about to burst, and started investing when the reserve bank said it's a good time. Obviously that will never happen. Adjusting interest rates is the next best thing. In fact, adjusting interest rates and squirreling money away or splurging is effectively the same thing. This is why the reserve bank says it is going to push interest rates up or down by 0.25%. It doesn't actually demand the rates go up or down, it just hides money or pushes it out until it happens.

The benefit of this is that interest rates become fairly predicatable, because the actions of the reserve bank are fairly predictable. It takes fewer people by surprise when interest rates go up. People can plan for this, and start holding back on irrational investments before the bank actually puts the rates up, or start borrowing more before the rates are pushed down. This means that interest rates do not have to go up or down as far in order to smooth out the cycles, which is good for long term investments.
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« Last Edit: Jun 17th, 2008 at 12:01pm by freediver »  

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