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HomeFeaturedInflation and GDP – A Complicated Relationship (Part I)

Inflation and GDP – A Complicated Relationship (Part I)

By Chaahat Khattar

This article is the first part of a series of two articles by Chaahat Khattar. Find the second part here.

Urjit Patel takes over as the Central Bank Governor of the world’s seventh largest economy on 04 September 2016. One of the immediate tasks on his plate would be to control inflation. Expected to increase uncontrollably with the impending 7th Pay Commission recommendations, their effect shall pressurize prices and wages in sectors beyond the public sector.

Even though inflation is out of the dangerous upper levels, the expected sudden surge in demand will pose as the first test for the newly announced Governor of Reserve Bank of India (RBI).

It will be a daunting task for Mr. Patel to control inflation without hurting growth and without being seen as the interest rate hawk, a title the outgoing celebrated RBI Governor Raghuram Rajan had to carry unwillingly.

Understanding The Theory

While inflation is defined as an increase in prices and fall in the purchasing value of money, growth of an economy is measured as the monetary value of all the finished goods and services produced within a country’s borders in a specific time period commonly known as Gross Domestic Product (GDP). Inflation and GDP do salsa together on the beat of economy supporting each other and presenting a show the world looks out for. In theory, an increase in inflation means a hike in price levels or money supply by the government. Consequently, it leads to an expansion of demand while pushing production levels to improve the overall throughput and GDP. Excited with the increased profitability of the companies and GDP, investors’ from all over will inject stock markets with boosts of confidence.

Now, the other side of the show is a situation of excess GDP growth. We have always been made aware by our forefathers that excess of anything is dangerous. Similarly, as inflation increases beyond a point, the GDP will correspondingly increase excessively making money in the market (and future corporate profits) less valuable.

We have always been made aware by our forefathers that excess of anything is dangerous. Similarly, as inflation increases beyond a point, the GDP will correspondingly increase excessively making money in the market (and future corporate profits) less valuable.

This is where economic cycle comes into the picture. As the demand in an economy increases, it creates pressure on the industries to supply more. To increase supply, industries will incur more on procuring inputs especially labour, leading to a tight labour market. The increase in the cost of procuring inputs will eventually be borne by the consumers in the form of higher prices as the industries would continue to look to maximize profits.

It will not take much time for the increased inflation to quickly spiral out of control. People, by virtue of sentiments, will spend more assuming that it will be less valuable in the future. They fail to realize that if the entire country does so it will rapidly erode the consumer buying power, slowing down the economy, rapidly pull down GDP and shut down of industries leading to unemployment.

The Unfortunate Case of Tulips and Netherlands

What really happened in ‘Tulipmania’ is a classic practical explanation of how inflation and GDP dance together. Tulipmania happened much before the Great Depression of 1929 and it was the beginning of legalization of greed. Dutch people brought Tulips from Turkey because of their intense petal color which to Dutch became a status symbol. As tulips were limited back then, there was a spiked inflation in the price of tulip bulbs.


The phenomenon of “Tulipmania”provides a perfect example of the relationship. | Source: Unsplash

Off course, the trade of tulip in Netherlands for the very short term increased economic growth there and so much so, one bulb of tulip became so precious in Netherlands that people exchanged their complete estates and acres of land for it. However, very soon to pay off the ballooning debts and daily expenditures (which exponentially increased as a result of a fancier lifestyle of Dutchmen), people started selling tulips. This created a domino effect of selling of tulip and the price of tulip crashed leading to an economic meltdown like never seen before. At the peak of the market, a person could trade a single tulip for an entire estate, and, at the bottom, one tulip was the price of a common onion.

The Precarious See-Saw 

Any government and its central bank have to work in tandem to ensure a sustainable growth for the economy. GDP and inflation are the basic parameters for both the government and the central bank to make economic decisions. A central bank will focus on making borrowing more attractive by lowering the interest rates and this is what the government would want to happen. This will encourage spending and will lead to a rise in GDP.

However, there is a major climax to this sweet equation; it will also prompt inflation and create pressures on the supply side. Ultimately, the Central Bank would have to make borrowing expensive to control the demand and ensure stability in the economy which would dampen any government’s aspirations of having an ever-growing economy.

Chaahat Khattar is an ardent economist and is working with an international consultancy firm. He is an MBA and pursuing Masters in Business Laws. He is also a Harvard University alumnus and a certified financial modeller.

Featured Image Courtesy : Unsplash

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