Timed essay- Trade of between inflation and economic growth (33 minutes)

 

Assess the view that economic growth always comes with inflation [25 marks]:


Economic growth refers to the level of real GDP increasing over a period of time. It is important that this is real GDP and not nominal GDP, as inflation needs to be accounted for to see whether this growth is sustainable or merely limited to the short run. Inflation refers to the tendency of average price levels to increase. It is common for average price levels to increase in periods of economic growth, as consumers have a greater marginal propensity to consume, which tends to lead to demand-pull inflation.

Inflation is inevitable as the rate of economic growth increases, especially if demand-side policies such as fiscal and monetary policies are used. If the Monetary Policy Committee decides to lower the UK's base rate, consumers will be incentivised to spend a greater proportion of their income. This means that consumption, which is a component of aggregate demand (C + I + G + (X – M)) and accounts for about 60% of the UK's aggregate demand, will increase. Economic growth will increase as a result. However, whether this growth due to expansionary monetary policy is inflationary depends on the position of aggregate demand in the economy. Here is a diagram to illustrate this.


The diagram illustrates that there is a greater change in price level, which might be inflationary, when the economy is overheating and near its full long-run potential. However, economic growth is sustainable if the economy is in demand-deficient unemployment and there is slack in the economy. This means that economic growth levels may increase the price level if an economy is near full long-term potential but may also not if the economy is in a recessionary period.

Economic growth may also not lead to inflationary pressures if supply-side policies are implemented. The extract suggests that unemployment remained low in 2018, about 4%, which is near the government's 3% target. The inflation rate was 1.8%, which is below the 2% target. This was in part due to commodity prices, such as oil and fuel, being low. This means that if economic agents see stability, economic growth and a stable inflation rate may coexist. Furthermore, supply-side policies help improve the long-run potential of the economy, which reduces inflationary pressures. For example, the diagram below illustrates how deflationary effects are possible if the productive potential of an economy is shifted outwards. For instance, if market-based supply-side policies such as the reduction of income or corporation tax are implemented, then consumers have a greater amount of disposable income, which leads to greater consumption and hence pressures aggregate demand. But also, firms have a greater amount of revenue, which they can invest and spend on capital and innovation. This shifts the PPF of the UK economy outwards, and as a result, like in 2018, deflationary effects are possible. However, as the extract also suggests, inflation and unemployment may come as a trade-off.

This can be illustrated with the Phillips Curve, which shows how during periods of economic growth, employment increases, which means that the demand for workers is quite high. Therefore, the wage of workers increases. As labour is an example of derived demand, this leads to inflationary effects, especially cost-push inflation, as the cost of production for firms increases. Hence, the average price level increases, which illustrates how, as the rate of economic growth increases, there might indeed be rising inflation.

Overall, economic growth tends to lead to demand-pull and cost-push inflation but also depends on the position of aggregate demand. One might also argue that during periods of high economic growth, automatic fiscal stabilisers such as a greater proportional income tax may help cool an overheating economy. However, it is also important to consider the evidence which showed how, in 2018, economic growth did not lead to inflationary pressures, which was in part due to supply-side stability.

Points to include for next time: 
  • Compare short-run vs long-run growth more explicitly. 
  • Discuss elasticity of AS in more depth or add a relevant LRAS diagram
  • Consider external shocks (e.g., oil price rises or currency depreciation) that might override domestic supply-side stability.
Overall thoughts- A really fun essay to write. Was a bit tight for time, but yeah, I can't mention everything. I need to add more depth in my chains of reasoning as well.


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