NCPA - National Center for Policy Analysis


July 20, 2007

The idea that an increase in economic growth leads to an increase in inflation -- and that decreased growth reduces inflation -- has been reflected endlessly in the media.  But it is an idea that makes no sense, says David R. Henderson, a research fellow with the Hoover Institution.

Take the equation of exchange, MV = Py, where M is the money supply; V is the velocity of money -- that is, the speed at which money circulates; P is the price level; and y is the real output of the economy (real gross domestic product):

  • If the growth rate of real GDP increases and the growth rates of M and V are held constant, the growth rate of the price level must fall.
  • But the growth rate of the price level is just another term for the inflation rate; therefore, inflation must fall.
  • An increase in the rate of economic growth means more goods for money to "chase," which puts downward pressure on the inflation rate.

For example:

  • If the money supply grows at 7 percent a year and velocity is constant and if annual economic growth is 3 percent, inflation must be 4 percent (more exactly, 3.9 percent).
  • If, however, economic growth rises to 4 percent, inflation falls to 3 percent (actually, 2.9 percent).

That being said, if the Federal Reserve Bank increases the growth rate of the money supply and if this increase is unanticipated, then sellers of products and sellers of labor will, for a while, mistakenly think that the higher dollar prices of goods and higher wages they are seeing are higher real prices and higher real wages, says Henderson.  Some will mistakenly conclude that the higher growth led to higher inflation.  It didn't.  Higher growth of the money supply led, temporarily, to both higher inflation and higher real growth.

Source: David R. Henderson, "A Rise-able Fallacy," Wall Street Journal, July 20, 2007.

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