Question

Specifically explain the problems with inflation. Is the inflation consumers have in their real life really greater or less than the government's recorded inflation rate? What does this mean about the real GDP growth rate for the economy based on real life inflation if the nominal GDP growth rate stays the same?

Answer 1

Inflation

As prices for goods and services that we consume increase, inflation is the result. The inflation rate is used to measure the rate of change in the overall price level of goods and services that we typically consume.

The Effects of Unanticipated Inflation

In many ways the problem with inflation is not the higher prices, but the way it can creep up, suddenly creating a big stir and causing us to lose our balance and spill our cup of tea. Or put another way, as long as we properly anticipate inflation, we can prepare and absorb much of its shock. Problems occur when inflation is greater than we predicted, when it is unanticipated. When the actual inflation rate is greater than the anticipated (planned for) rate, several problems may arise.

The three things we can conclude:

• bank profits fall during periods of rising interest rates (caused by increased
• in general, unanticipated jumps in inflation hurt lenders while helping borrowers who pay off their debts with money, the value of which has been eroded by inflation; and
• if inflation is properly anticipated lenders can raise the interest rates that they charge borrowers in order to maintain a positive rate of return.

Another problem caused by unanticipated inflation is for workers on fixed contracts. If a labor union makes a long-term agreement for salary increases based on the projected inflation rate, then the real wage may actually decline if the inflation rate shifts up.

real wage = nominal wage - inflation rate

Other Consequences of Inflation

1. Inflation distorts the price mechanism by making it difficult to distinguish changes in relative prices from changes in the general price level.
   Changes in relative prices may be offset by the substitution of lower price inputs used in production. If almost all prices are rising rapidly, there is little incentive to search for cheaper substitutes that could help keep production costs low.
2. Inflation creates uncertainty.
   If businessmen are unsure about the future level of prices, and thus of real interest rates, they will be less willing to take risks and invest, especially in long-term projects. As investment is reduced, so is the long-run growth potential of the economy.
3. Inflationary uncertainty pushes up real interest rates, as lenders demand a bigger risk premium on their money.
   
   Longer-term interest rates are especially punished as a high inflation premium is added to account for inflationary uncertainty. As a result, the cost of borrowing by businesses and consumers increases substantially, reducing the rate of real economic growth.
4. Overall redistribution of productive and financial resources may lead to a loss in efficiency.

Real Economic Growth Rate

The real economic growth rate measures economic growth, in relation to gross domestic product (GDP), from one period to another, adjusted for inflation - in other words, expressed in real as opposed to nominal terms. The real economic growth rate is expressed as a percentage that shows the rate of change for a country's GDP from one period to another, typically from one year to the next. Another alternate economic growth measure is gross national product (GNP), which is sometimes preferred [if a nation's economy is substantially dependent on foreign earnings.

The Real GDP Growth Rate

GDP is calculated as the sum of consumer spending, business spending, government spending and the total of exports minus imports. In order to factor in inflation and arrive at the real GDP figure, the calculation is as follows:

Real GDP = GDP / (1 + Inflation since base year)

The base year is a designated year, updated periodically by the government, that is used as a comparison point for economic data such as the GDP.

Once real GDP is calculated, then the real GDP growth rate is calculated as follows:

Real GDP growth rate = (most recent year's real GDP - the previous year's real GDP) / the previous year's real GDP

Knowing a country's real economic growth rate is helpful to government policymakers in making decisions about fiscal policy and other steps a government may take in order to accomplish goals such as spurring economic growth or controlling inflation. The first primary use of the real economic growth rate is in comparing the current rate of economic growth to the growth rate during previous time periods, in order to ascertain the general trend of the rate of economic growth over time.

Secondarily, real economic growth rate are helpful in comparing the growth rates of similar economies that have substantially different rates of inflation. Comparison of the nominal GDP growth rate for a country with only 1% inflation to the nominal GDP growth rate for a country with 10% inflation would be substantially misleading.