Q. It has been generally viewed that when an economy grows beyond its potential growth rate, it causes inflation. How does growing faster than the potential rate cause inflation?
Answer: Fast growth causes quick resource utilization to fulfill the higher demand
Notes: There are two major determinants of the potential rate at which an economy can grow in the long run. One is the rate of increase in key inputs such as labour and capital, while the other is the rise in productivity. Within the two key inputs, labour has a bigger say in determining the potential growth rate. The increase in labour supply – through an increase in number of workers or the numbers of hours put by a given number of workers – and an increase in labour productivity will result in an increase in the long-term potential growth rate. Anything that aids productivity increases can help boost potential growth rate. Infrastructure investments and skilling of labour can raise India’s potential growth rate because the country has ample labour supply. The overall demand in the economy picks up due to fast growth and more resources are used to meet higher demand. After a point, the economy may not find enough inputs to meet the demand, leading to an increase in prices. If there is surplus capacity in the economy then it can grow above the potential rate for a while. But for an economy already working at full capacity, excessive demand results in increase in the price level.
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