Demystifying the economy | What is the relationship between GDP and the inflation rate?

2023-05-13 05:32:28

Every Saturday, one of our journalists answers, in the company of experts, one of your questions on the economy, finances, markets, etc.




I would like to understand how a country can have an economy with a GDP growth of less than 3%, while its inflation rate is more than 6%.

Chantal B.

To answer this question, The Press called on the economist Alexandra Ducharme, of the National Bank. Mme Ducharme regularly produces analyzes on the evolution of GDP (gross domestic product) and inflation figures in the Canadian economy.

From the outset, M.me Ducharme points out that this apparent gap between the GDP growth rate and the inflation rate is not considered to be a really relevant indicator in the analysis of the economic situation. As well as in the analysis of the management of monetary policy and interest rates by the Bank of Canada.

As an alternative, Alexandra Ducharme suggests explaining this decoupling between the GDP growth rate and the inflation rate by turning to a more important indicator in the analysis of the economic situation, that is to say the gap between the level of “real GDP” and the “potential GDP” of the Canadian economy.

Why these two notions of GDP?

“Essentially, real GDP refers to the measure of economic activity in Canada that is updated quarterly, and already widely covered in economic news,” summarizes Ms.me Ducharme.

“As for potential GDP, it is an estimate maintained by economists, including those of the Bank of Canada, in order to determine the economy’s capacity in relation to certain socioeconomic factors, in particular the growth of the population in job. »

What is the relationship between these two notions of GDP?

Generally, when the level of real GDP exceeds that of potential GDP, it is considered an indicator that the demand for goods and services in the economy exceeds the available supply. It can therefore be a potential cause of inflationary pressures.

Alexandra Ducharme, National Bank economist

“On the other hand, when real GDP is lower than the estimate of potential GDP, it is usually an indicator that the demand for goods and services is lower than the available supply. Such a situation may augur a drop in inflationary pressures in the economy. »

That said, adds M.me Ducharme, one of the main objectives of the management of monetary policy (interest rates) by the Bank of Canada is “to maintain a certain balance between the level of real GDP and the level of potential GDP in the Canadian economy”. .

Thus, in a period of negative difference between these two GDP figures, the Bank of Canada will be motivated to keep interest rates low in order to stimulate the economy without risking stoking inflation.

On the other hand, in the event of a positive deviation of real GDP from potential GDP, the Bank of Canada will then be encouraged to raise interest rates in order to curb demand for goods and services, and thus reduce inflationary pressures. in the economy.

This is also the situation that has persisted in the Canadian economy since the end of the pandemic crisis. This largely explains the rapid sequence of interest rate hikes led by the Bank of Canada since the beginning of last year, the effects of which are increasingly being felt in the economy.

In this regard, Alexandra Ducharme notes that the Bank of Canada’s most recent forecast of real GDP growth in the first quarter of 2023 – at 2.3% – is now equal to its estimate of the growth rate of potential GDP.

However, given the delayed impact of interest rate hikes already achieved, real GDP growth in the second quarter of 2023 could be lower than potential GDP growth.

In the opinion of M.me Ducharme, this observation augurs for an imminent return of real GDP to the level of potential GDP, and therefore an easing of inflationary pressures in the Canadian economy.

This is also what would have motivated the Bank of Canada to recently announce its intention to pause its policy of interest rate hikes over the next few months.

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