People often suggest that a fast growing economy is inflationary.   I would argue that exactly the opposite is true.  Consider this data for Venezuela and Singapore from an old Robert Barro textbook:

Venezuela (1950-90):  Average RGDP growth = 4.4%    Average inflation = 8.0%

Singapore (1963-89):  Average RGDP growth = 8.1%    Average inflation = 3.6%

Singapore grew much faster and had much lower inflation.

On the other hand, you might argue that I’m not holding “other things equal”.  Actually, I did:

Venezuela (1950-90):  Average money (base) growth rate = 10.7%

Singapore (1963-89):  Average money (base) growth rate = 10.8%

Inflation is too much money chasing too few goods.  Because Singapore produced lots more goods, the double-digit money growth created less inflation than a similar money growth rate in Venezuela.  You might think of the faster RGDP growth as “absorbing” some of the extra money, leading to less inflation.  BTW, the numbers don’t precisely add up because velocity also changes gradually over time.  (Recall MV=PY, or m + v = p + y using rates of change.)  But that doesn’t change the basic point.  For any given money growth rate, faster RGDP growth leads to lower inflation in the long run.

Some might argue that long run increases in RGDP are not inflationary, but at cyclical frequencies an economic boom is still inflationary.  

But even at cyclical frequencies the correlation between growth and inflation is unstable.  Fast growth driven by an increase in aggregate demand is inflationary, while fast growth driven by an increase in aggregate supply is deflationary.  That’s the basic AS/AD model.  It’s why I keep saying “never reason from a price change” and “never reason from a quantity change”.  (Compare inflation in the hot economy of 2000 and recessionary 1974.)

Paul Krugman has a piece in the NYT discussing various approaches to the Phillips Curve—the relationship between inflation and unemployment. The piece begins as follows:

It is a truth universally acknowledged — well, anyway, a truth acknowledged by everyone I know who thinks about the subject — that a hot economy leads to higher wages and prices. When demand for labor is strong, workers can and do demand wage hikes; when demand for goods and services is strong, businesses have “pricing power,” or the ability to raise prices without losing customers.

But does a hot economy lead to a higher level of prices? Or does it lead to a higher rate of change in prices, i.e., ongoing inflation? Or maybe even to accelerating inflation, a higher rate of change in the rate of change?

If a hot economy meant fast RGDP growth, then I would disagree.  But in the second sentence Krugman defines “hot” as strong demand.  So he’s not making the mistake I see so many others make.

But in that case, maybe we shouldn’t even be using inflation as our nominal aggregate when analyzing Philips Curve models.  The relationship between inflation and unemployment depends on the cause of the inflation.  Is the higher inflation due to more aggregate demand or less supply?  A more useful nominal aggregate would be something like NGDP growth, which much more accurately tracks shifts in aggregate demand, and thus clarifies the real issue in the Philips Curve debate.  It really is a truth universally acknowledged that a nominally hot economy leads to more inflation.  And it also leads to more jobs (in the short run.)  The profession made a serious mistake when it spent decades on macro models where inflation was the key nominal aggregate, instead of NGDP growth.  (Both monetarists and New Keynesians are to blame.)  The Phillips curve ought to look at the relationship between NGDP growth and unemployment.  Do reason from a price times quantity (PY) change.

Even if we switch to NGDP, we still face the same sort of unresolved issues that Krugman wrestles with in his column.  Is it the level of NGDP that matters?  Or the growth rate?  Or the change in the growth rate?

The answer is that all three matter.  On average, the job market will be stronger with 6% NGDP growth than with 2% NGDP growth.  But it’s also true that the job market will be stronger with 4% NGDP growth and the level of NGDP 2% above trend, than with 4% NGDP growth and the level of NGDP 2% below trend.  In a sense, it is all about where NGDP is relative to expectations.  But expectations formed when?  That depends on the extent of wage stickiness.  The longer that wages are sticky (i.e., the longer the duration of wage contracts), the longer the period over which NGDP expectations matter.

If one defines economic “hotness” as strong nominal demand, then the question of whether hotness leads to a one-time rise in inflation or a permanent rise in inflation is actually pretty simple.  If you have a one-time increase in demand (NGDP growth) then you get a one time increase in inflation.  If you have a permanent increase in NGDP growth then you have a permanent increase in inflation.  It depends on monetary policy (broadly defined to include velocity.)

Some Keynesians wish to define aggregate “demand” as a real concept.  I’ve seen graphs that conflate “demand” and real GDP, which makes no sense at all.  Consider the AS/AD model.  If the AD curve is stable and AS shifts to the right, then RGDP rises and prices fall.  Do you want to call that an increase in “demand” just because consumers are buying more stuff?  I’ve seen prominent economists do just that.

Here’s Krugman’s conclusion, which makes some good points:

Pessimists who insist that we’re doomed to years of high unemployment are basically asserting that we’re back to the inflation environment of the 1970s and early 1980s, that expectations have gotten unanchored and that to reduce inflation we’ll need to go through an extended period of unemployment well above the NAIRU.

I don’t agree; when I look at various measures of medium-term inflation expectations, they still look pretty anchored to me. But I could, of course, be wrong — the brief history of inflation theorizing I’ve just recounted doesn’t inspire much confidence that any of us has a really solid grip on the relationship between economic hotness (or coldness) and prices.

The point I want to make, however, is that you do need a theory. The evidence is fairly overwhelming that the U.S. economy is currently running too hot and needs to cool off. But how much cooling it needs isn’t a question that can be settled without deciding what kind of inflation process you think is currently operating.

HT:  Ken Duda