Does Economic Growth Cause Inflation? Sometimes -- And That Sometime Is Now

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How does the growth of the economy divide between real economic growth and inflation? In my first year in graduate school, the macroeconomics professor said that was the great unsolved question in the field.

The simplest model of inflation assumes that there is some level of output that our economy is capable of producing. If we are below that level and give the economy a little nudge, all stimulus goes to more output, with no change in inflation. But if we try to grow the economy beyond our capacity, then all of the stimulus would be inflationary. In essence, we’d be trying to spend more dollars in an economy that cannot produce more goods, so prices would rise.

(We usually think of this stimulus as coming from monetary or fiscal policy, but it could also come from the private sector, for example, if expectations for future income rose very high.)

Two challenges limit the value of this simple theory. First, we don’t have a good handle on how much the economy can produce. Second, there is a substantial gray area around the potential output.

How much can our economy produce? When I develop an economic forecast and we might be near full capacity, I run a simple supply model of the economy focused on how many people will be working, and how productive each worker will be. This is quite difficult. We certainly know with high accuracy how many people are of working age in our country, but we are not sure how many of them actually want to work. The unemployment rate measures those who say they are actively looking for a job. But some other people may want jobs but be too discouraged to look for work. Other people, such as stay-at-home mothers, may not want to work at all. We call such folks “not in the labor force,” and they also include the disabled, early retirees, slackers living off their girlfriends and so forth. How many of them would come out if jobs were easy to get, and if jobs paid higher wages? That’s hard to determine. In my current forecast, I believe that more of these people will come out of the woodwork as wages rise and word-of-mouth information about available jobs increases, but the result is subject to a pretty wide range of possibility.

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