Previous Year Question

Economic Growth means an increase in an economy’s Real Output or Real GDP. During an expansion, production, income, employment, investment and aggregate demand generally increase.

Economic growth is commonly accompanied by moderate or controlled Inflation. Therefore, option (b) is correct.

Why can economic growth be accompanied by inflation?

When an economy expands:

• Household incomes and employment may rise.

• Consumption Demand increases.

• Business Investment Expenditure may rise.

• Bank Credit and Money Supply may expand.

• Demand for labour, land, machinery and raw materials increases.

• Higher Capacity Utilisation may create pressure on costs and prices.

If Aggregate Demand increases faster than Aggregate Supply, Demand-pull Inflation may arise.

Aggregate Demand can be expressed as:

Where:

C = Consumption

I = Investment

G = Government Expenditure

X-M = Net Exports

During an expansion, an increase in C, Ior Gcan raise Aggregate Demand. If production capacity cannot expand proportionately in the short run, prices may increase.

Option (a): Deflation

Deflation is a sustained decline in the general price level. It is commonly associated with:

Weak demand;

Declining investment;

Unemployment;

A rising real burden of debt; and

Economic contraction.

Consumers may postpone purchases in anticipation of still lower prices, further weakening demand and production. Deflation is therefore not ordinarily associated with economic growth.

Option (c): Stagflation

Stagflation combines:

High Inflation;

Slow or stagnant Economic Growth; and

High Unemployment.

It is therefore the opposite of the normal growth-inflation combination. The oil shocks of the 1970s are a prominent example.

Option (d): Hyperinflation

Hyperinflation is an extremely rapid and uncontrolled increase in prices. It can:

Destroy confidence in the currency.

Erode the real value of savings.

Disrupt long-term contracts.

Make investment and production decisions difficult.

Generate widespread economic instability.

It is not a normal feature of healthy Economic Growth.

Important qualification

Inflation is not a necessary condition for Economic Growth. An economy can grow with price stability. The expression “usually coupled” indicates that an expansion commonly generates some inflationary pressure through rising incomes and demand.

Under India’s Flexible Inflation Targeting framework, the CPI inflation target is 4%, with a tolerance band of ±2 percentage points. The framework seeks to maintain price stability while keeping growth in mind.