Effects of Inflation on GDP

Effects of Inflation on GDP

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Introduction

Inflation has been one of the most commonly used terms both among scholars and the general public. The general public expresses panic in instances where it inflation goes beyond a certain level. Economists are usually concerned about inflation thanks to its effects on the Growth Domestic Product (GDP) or the economy of a country at large. The resultant effects of inflation are a product of its effects on other variables in the economy including consumption and investment. Macroeconomic policy makers have had their central objective as the sustenance of low levels of inflation coupled with high and sustained economic growth. The increased research on inflation usually emanates from the serious implications that it has for income distribution and growth in the economy. Debates, however, have also concentrated on factors that determine the rate of inflation as they have a bearing on its consequent effects. There is demand-pull inflation, which results from an increase in the aggregate demand in the economy. Cost-push inflation, on the other hand, results from supply shocks. This should have strong and positive correlation with the output gap in the economy. However, the relationship existing between inflation and growth depends on the economy. It is possible to have high growth devoid of inflation in cases where the economy’s potential output grows sufficiently to cover up for the increased demand (Samuelson & Nordhaus, 2005). This would also be possible in instances where the actual output of the country is lower than the potential output, and there exists enough spare capacity available to accommodate the demand pressures. In instances where the actual output equals the potential output, the economy would have no spare capacity as it would be operating on full level of employment. In essence, increased growth would eat at the rising inflation. In case the growth of demand persists and there is no commensurate expansion of the productive capacity, the general price level would be likely to experience rapid growth in the long run without additional output growth. This phase of increased inflation is likely to have severe effects on the economy.

The United States has, in the recent times experienced rising inflation rates. The most commonly used measurement of the increase in prices is the CPI (Consumer Price Index), a measure whose basis is the monthly survey carried out by the United States Bureau of Labor Statistics. The Consumer Price Index compares the past and current prices in a sample market basket of goods derived from varied categories such as apparel, transportation, food and housing. While the CPI has its shortcomings or limitations, it is widely recognized that inflation is an extremely consistent fact of the United States economy. The purchasing power of the U.S. dollar has been reducing every year since 1945 except in 1949 an 1950. The inflation rate per year since 1900 to 1970 rested at about 2.5%. This rate went up from 1970, spiking to approximately 6% and going to an all-time high of 13.3% as at 1979 (Mankiw, 2009). However, the inflation rates since then have been close to the range between 2% and 4%. In fact, the rate of inflation in 2010 rested at 1.5%. These variations in inflation have different effects on the GDP of the United States.

One of the effects of inflation on the United States’ GDP revolves around the investment decisions that individuals make. Economists have lays emphasis on the fact that inflation may result in economic damage through distorting consumption and investment decisions. These distortions result from uncertainty in business and households pertaining to the future course of inflation, as well as from the interaction between inflation and the United States’ tax code (Samuelson & Nordhaus, 2005). The interaction between inflation and personal income taxes may distort decisions pertaining to the amount of income that an individual would spend on housing. This can be seen especially in owner-occupied housing where the payments of mortgage interest are deductible. Inflation is built on nominal interest rates, in which case even a moderate increase in the price level results in an increase in the deductions. Housing services representing a proportion of the housing investment returns escape taxation (Masimo, 2001). In essence, moderate to high levels of inflation prompt individuals to invest more in housing than they would do in the case of low rates of inflation. This was the case in the 1970s when there was a real estate boom, which was triggered by distortions induced by inflation. High rates of inflation resulted in an increase in the purchase of homes through increased real, after-tax returns on investments pertaining to owner-occupied housing rather than other investments (Mankiw, 2009). Constant interest rates reinforced the demand uptick. The faster increase in the price level of houses relative to the general price level stimulated an increase in purchasing as individuals feared facing higher prices in the future. The distortions were projected in other markets such as forestry and lumbering (Wessels, 2006). Distortions pertaining to the economic activity could also emanate from uncertainty pertaining to the future course of inflation. However, economists have acknowledged that there is a correlation between high inflation and increased variability in price (Masimo, 2001). Such variations pertaining to the prices would result in uncertainty on how profitable investment projects would be in the future. This uncertainty, therefore, results in an increasingly conservative investment decisions compared to how they would be likely to be (Masimo, 2001). This, ultimately, results in reduced levels of investments, as well as economic growth. Considering that the United States’ Gross Domestic Product (GDP) is the total aggregate output of its entire economy, a reduction in investment would, therefore, result in a reduction in the Gross Domestic Product.

Still on investments, inflation increases the costs pertaining to information and transactions thereby limiting economic development. Inflation makes investment planning difficult due to the resultant uncertainty in the nominal values. Investors would be reluctant to get into contracts in instances where there is uncertainty pertaining to future inflation. Intermediaries such as financial institutions would be less eager to offer long-term financing (Masimo, 2001).

In addition, inflation has a bearing on the employment component of GDP. Scholars note that inflation being an increase in the prices of commodities where a dollar would purchase less products than it used to in the past means that commodities become more expensive. This would cause employees to demand higher wages and salaries in an effort to maintain their way of life or keep up with inflation (Lipsey et al, 2007). However, this results in a reduction in the employment rate as companies try to cut their labor costs to manageable levels. This, therefore, results in reduced household income and a reduction in the GDP or total aggregate output in the economy.

In addition, inflation has an impact on the balance of payment in the United States. When the cost of items increase relative to those of other countries, it becomes cheaper for consumers to obtain these commodities from outside the country than buy them domestically. On the same note, other countries would find the commodities in the United States too expensive (Lipsey et al, 2007). This means that the United States would be importing more than it would be exporting as its commodities would be considerably less competitive in the world market. In essence, trade deficits would occur thereby reducing the Gross Domestic Output and the economic growth at large (Wessels, 2006).

Needless to say, high rates of inflation would trigger negative effects on the Gross Domestic Product of the United States. However, this does not mean that the government should entirely eliminate inflation. However, too high inflation has a bearing on the investment decisions. Investors and lenders would be unable to invest as they cannot predict the future prices of their investment projects. On the same note, the overall costs of investment would be increased especially considering that investors would incur higher costs in gaining information pertaining to future trends, as well as transacting on any investment that they make. In addition, the government would be likely to put a price ceiling in order to limit the interest rates, which discourages investment (Lipsey et al, 2007). In addition, it increases unemployment, and the trade deficits as the United States would be importing more than it exports, thereby reducing the Gross domestic Product. All these factors hamper economic growth and reduce the Gross domestic Product of the country.

References

Lipsey, R. G., Chrystal, K. A., & Lipsey-Chrystal, . (2007). Economics. Oxford [u.a.: Oxford Univ. Press.

Massimo, Ca. (2001) “Investment and the Persistence of Price     Uncertainty,” Research in economics, Vol. 55,

Mankiw, N. G. (2009). Principles of economics. Mason, OH: South-Western Cengage Learning.

Samuelson, P. A., & Nordhaus, W. D. (2005). Economics. New Delhi: Tata mcGraw-Hill.

Wessels, W. J. (2006). Economics. Hauppauge, N.Y: Barron’s.