Introduction to Unit 6 - Inflation and Economic Growth

Among the tremendous amount of economic data that is released by the government and other organizations, there are three statistics that are considered to be the most important indicators of the overall condition of an economy. In section 5 we looked at the unemployment rate, in this section we discuss the other two; the inflation rate and the rate of change in the Gross Domestic Product (GDP).

The Consumer Price Index (CPI) is the accepted statistic for measuring inflation in the economy. Inflation simply represents an increase in prices of goods and services that are purchased by consumers. Inflation is generally caused by an increase in demand (demand-pull), where the demand curve for a good shifts outward, driving up prices, or by increases in production costs that cause the supply curve to shift inward (cost-push) also raising prices.

We will also take a look at an area of important political controversy. The majority of economists agree that the reported CPI overstates actual inflation rates. Politicians see the solution to this discrepancy as a way to raise taxes without really raising taxes. The reason for this is that large parts of government spending are tied to cost of living increases that in turn are adjusted to match changes in the CPI. Income tax brackets, Social Security adjustments and government entitlement programs are all adjusted annually to the CPI.

For example, if the CPI is estimated to be 3% for the past year the standard deduction on income tax forms is also raised by 3%. As a result, if a taxpayer receives a 5% raise during the same taxable year, 3% of the raise is compensated for by the inflationary adjustment in the tax bracket. The remaining 2% of the raise is treated as a gain in real(1) income and the wage earner will pay additional taxes on his or her real gain in income.

 (1) Real variable = nominal variable - inflation rate % change in real income = % change in nominal income - inflation rate

A lower CPI, means less government benefits are paid out and income taxes paid will increase, even though overall income tax rates stay constant. In our example, while marginal tax brackets are not changed, the adjustment to the standard deduction is lower (e.g. only 2%), leading to higher real gains in taxable income. Congress and the President see this as a lucrative way to help balance the federal budget, without telling taxpayers they have to raise their taxes(2) and cut their benefits to do so, even though taxes will be raised and benefits will be cut. Confused, then read section 6 carefully.

 (2) Technically, marginal tax brackets would have to be adjusted to be considered a change in tax rates.

GDP is the most widely accepted indicator of economic growth. GDP measures the annual or quarterly change in the production of goods and services in the economy. It is comprised of four sectors:

• (C) consumption by individuals,
• (G) government spending by federal, state and local governments, and
• (NX) net exports, or the difference in the value of goods and services exported abroad and good and services imported from another country.

Our basic equation for GDP is:

GDP = C + I + G + NX

In previous sections we took a look at the product market for a good or service and the labor market. Now we expand our understanding of demand and supply into the capital market. The price of capital is the interest rate and capital markets are used to determine the equilibrium interest rate. The demand for loanable funds represents those businesses and individuals seeking to borrow money. The supply of loanable funds represents savings by individuals, businesses, and governments (a government budget deficit lowers domestic savings). Increases in the demand for loanable funds will increase the price of money - raise the interest rate, and increases in savings will lower interest rates.

Supply of loanable funds = private savings + public savings + net foreign savings

where:

• Private savings = sum of savings by individuals and businesses.
• Public savings = federal, state and local government. If the federal government runs a budget deficit, then public savings will be negative (if state and local governments in total have a surplus, it is relatively insignificant).
• Net foreign savings = foreign savings entering the domestic economy - domestic savings leaving the country.

In this section we expand our discussion of GDP with some interesting applications. One area that we will look at is a broader definition of GDP. One of the major criticisms of the use of GDP of a measure of economic growth is that it does not account for the depletion of resources. GDP only measures the value of the additional goods and services produced in a given time period. Using these general criteria, higher levels of GDP are desirable since they are leading to the largest gains in wealth and improvements in living standards. But what if economic growth is accompanied by unhealthy levels of pollution and the destruction of a country's resource base? The World Bank is trying to broaden the definition of GDP to include the latter. Producing a good increases a nation's GDP, but the natural resources depleted in order to produce that good take away from that same country's GDP. The World Bank goes on to define genuine investment as a way to develop resources in a desirable method to make sure the gains to society exceed the losses in the form of resource degradation.

Another issue we will address is the paradox that has been found between the presence of natural resources and economic growth. Contrary to what you might expect, countries that are abundant in natural resources actually lag in economic growth rates behind countries that are natural resource scarce in relation to their capital. In this study, the definition of capital includes what is known as human capital; knowledge and skills that we gain during our lifetime. The primary reason is that resource-scarce countries seek to develop diversified industries while resource-abundant countries tend to rely too heavily on the development of resources to generate industry and wealth.