Question

What 3 economic theories affect GDP in relation to inflation?

Answer 1

There are different economic theories that affect the GDP w.r.t. inflation. The first theory is classical theory that involves flexible wages and prices. As per this theory, the GDP level always moves towards the full employment GDP level. When the demand increases and goes beyond the level of potential output. Then, demand pull inflation is created. Due to this reason, the wages of the workers increase and supply shifts to the left direction. It causes the GDP to come back on potential output level, but at the higher prices. The similar mechanism works, when the demand decreases and supply shifts to the rightward direction due to the decrease in wages. This theory does not involve government intervention.
The second theory is Keynesian theory that says that government intervention is necessary to bring change in GDP and inflation. If the economy faces a recessionary gap, then expansionary policies are implemented to stimulate the aggregate demand and GDP increases to the full employment level as well as the inflation. When, the economy faces an inflationary gap, then contractionary policy is used to bring back the GDP to the potential output level and inflation is also controlled. It operates on the basis of sticky wage theory and people’s marginal propensity to consume and save.
The third theory is monetarist theory that says that increase in money supply, causes the increase in the GDP, but it also increases the inflationary pressure. Hence, the control in money supply, effectively control the GDP growth and inflationary pressure in the economy.