Inflation can mean either an increase in the money supply (i.e. the government printing more money) or an increase in price levels. Increase in money supply will increase prices of products and services because an ample supply of “easy money” will encourage people to spend it fast and increase the demand for all kinds of “goodies”, causing their prices to increase.
On the surface, inflation is good, since high demand will encourage companies to increase production and this will improve the overall throughput and GDP. Improved GDP will strengthen the stock market, because investors are always excited about companies’ profitability which has a strong link to higher production throughput and enhanced GDP.
However, too much GDP growth is also dangerous, as it will most likely come with an increase in inflation, which erodes stock market gains by making our money (and future corporate profits) less valuable. Most economists today agree that 2.5-3.5% GDP growth per year is the most that our economy can safely maintain without causing negative side effects. Why so?
In order to answer that question, we need to better understand the relationship between inflation, GDP and unemployment rate.
Historical data suggests that annual GDP growth in excess of 2.5% will caused a 0.5% drop in unemployment rate for every percentage point of GDP over 2.5%. It sounds like the perfect way to kill two birds with one stone – increase overall GDP while lowering the unemployment rate. Unfortunately this positive relationship starts to break down when employment rate gets below 4%. (The current US unemployment rate is ~ 7% so GDP can increase further without putting a strain on inflation rate). Extremely low unemployment rates have proved to be more costly than valuable, because an economy operating near full employment will increase the inflation rate for two important reasons:
- Demand for goods and services will increase faster than supply, causing prices to increase.
- Companies will have to raise employee’s salaries as a result of the tight labor market. This increase will be passed on to consumers in the form of higher prices as the company looks to maximize profits.
Over time, the growth in GDP coupled with a tight labor market will increase the inflation rate. Increased inflation can quickly spiral out of control. People will spend more money because they know that it will be less valuable in the future. This will further increases the GDP in the short term, bringing about further price increases. Higher inflation rate will have an exponential effect on prices, rapidly eroding the consumer buying power. This in turn will slow the economy down, will reduce GDP, and will increase unemployment rate.
A delicate balance must be maintained between the three pillars of the economy: inflation rate, GDP and unemployment rate, in order to keep the economy churning.