Wednesday, April 20, 2011

Does Economic Growth Cause Inflation?

A good example of this conventional fallacy is manifest in a recent report from Bloomberg News documenting that officials at the European Central Bank are mulling over further interest rate increases because it fears that an economic boom is countries like Germany will fuel increased overall prices. As is reported, "The ECB is balancing the need for tighter policy in countries like Germany, whose economy is booming, against the risk that it could exacerbate the sovereign debt crisis afflicting Greece, Ireland and Portugal."

This sort of analysis is fundamentally Keynesian in that it sees the economy driven by spending. Recessions, it is argued, are due to insufficient aggregate demand. The central bank can help by increasing the money supply, encouraging more spending. Nominal GDP increases, which is equated with economic growth. The concern, however, is that nominal GDP could increase too fast due to too much spending which would result in price inflation. Too much economic growth, therefore, causes inflation.

This line of thinking is in error because economic expansion is the result of production, not spending. True economic expansion is the result of producing more goods with which we can satisfy more ends. Economic growth, then, occurs as we become more productive through a more extensive development of the division of labor and capital accumulation. As we produce more goods, however, prices on those goods will fall, rather than rise. Economic expansion, therefore, contributes to falling prices, not rising prices.

Any apparent economic growth that causes higher prices is no growth at all. It is merely the result of an increase in the money supply. 

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