Q:

How does inflation affect GDP?

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Quick Answer

Inflation generally increases when the gross domestic product (GDP) growth rate is above 2.5 percent due to several factors, such as demand for goods overstretching supply and higher wages in an ultra-competitive job market, according to Investopedia. When inflation starts to rise, consumers tend to spend more money before prices go higher.

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Full Answer

When demand is larger than supply, prices increase because goods are harder to find and consumers are willing to spend more for the same products. Manufacturers attempt to meet demand by increasing supply and accelerating growth. Companies hire more people to increase supply in a competitive market, notes Investopedia. Firms spend more money to hire the best people. These extra hiring costs are passed on to consumers in the form of higher prices because companies don't want to decrease profits. Higher consumer prices lead to inflation, even though the GDP has increased due to higher output.

Inflation can lead to hyperinflation when consumers note the rise in prices and then spend more before prices go even higher. When consumers suddenly spend more money on goods, demand rises with less supply and prices go up even further when companies hire far more people, according to Investopedia.

GDP growth does not necessarily mean a rise in inflation. However, too much economic growth tightens the money supply, increases interest rates and causes the Federal Reserve to make policy changes to stem worse inflation, notes the Cato Institute.

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