Inflation
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.
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.
GDP Trend
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.
Unemployment
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.
Ah the memories of Economics classes. Nice outline of these key concepts. A basic understanding of economic drivers and how everything fits together is very helpful in life and understanding the news.
Thanks pal!
It is true that we can apply economics to everyday life.
Nice article david, during inflation our purchasing power is greatly affected negatively. We need more education concerning the economy.
Definitely a great idea! Balancing what is important vs what is not is going to be a huge and important step in the world of education.
Well written. I definitely love reading about economics now, since I avoided anything involving math in college like the plague. Wish I could do that over. Knowledge is power, and is more and more valuable in everyday life.
Thanks for the comment Ryan!
Words of wisdom coming from a poet who didn’t even know it.
Hmm interesting. I wonder how increasing the minimum wage will play into this equation.
That is something I definitely have to consider.
Maybe that will be the next article.
Thanks for stopping by Stefanie.
[…] @ Financial Nerd writes The Three Pillars of the Economy: Inflation, GDP and Unemployment – The three pillars of the economy, inflation, unemployment, and GDP are connected to each […]
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Well written. I would like to know how this can be applied and studied for Indian economy in the current context of September 2017, wherein GDP is low in last three years, high unemployment and low inflation
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Thanks but i still don’t understand how decrease in unemployment causes increase in inflation in the long run
People will spend more because they have more as employers will have to increase wages when employment is high. As they spend more companies will raise prices of goods and services to maximize profit which will in turn lead to inflation which is the continual rise in prices of goods in a country.
Thanks but i still dont understand how decrease in unemployment leads to increase in inflation in the short run