Some inflation basics

Back in first or second quarter of 2015, China posted year-on-year GDP growth of 5.8 percent in nominal currency terms. However, because inflation was at -1.2 percent (negative inflation, i.e. actual deflation), the rate of real GDP growth was 5.8 minus -1.2 percent, or 7.0 percent.

The basic formula, then, is this:

Real GDP growth rate = Nominal GDP growth rate - Inflation rate
OR
Real GDP growth rate + Inflation rate = Nominal GDP growth rate

To illustrate with a bare-bones example, let's say our economy produces only widgets, and our GDP is generated by purchasing them. In the first year, Y1, we produce 100 widgets and purchase them for $1.00 apiece, generating a GDP of $100, which also represents our economy's money supply. In the next year, Y2, real output grows to 107 widgets, and to purchase all of them at the same price of $1.00 each - that is, to maintain zero price inflation - we increase the money supply by $7 to $107, which is also our Y2 GDP. At this zero inflation, both nominal GDP growth and real GDP growth are the same, 7 percent.

If we want to generate some inflation, we simply increase the money supply by more than the $7 needed to absorb the growth in widgets to purchase. Let's say we increase the money supply by $10 instead of $7. Then our Y2 GDP is $110, or a 10 percent nominal GDP growth over Y1's $100. But since only $7 of that $10 is necessary to purchase all Y2 widget production at the constant price of $1.00 each, the other $3 is an inflated addition. So this is 3 percent inflation: $3 have been added to the original money supply of $100 that's over and above what's needed for price stability; the other $7 was legitimately added for price stability, and hence represents the real GDP growth of 7 percent over the base GDP/money supply of $100. So our real GDP growth of 7 percent ($7/$100) plus the 3 percent ($3/$100) inflation gives us the 10 percent nominal GDP growth ($10/$100).

On the flip side, deflation happens if we don't add enough to the money supply to maintain the unit price for widgets in Y2. Let's say we only add $5 to the money supply, meaning a nominal GDP growth of 5 percent: this leaves us $2 short of the $7 increase needed to purchase all 107 widgets in Y2 at a constant $1.00 price. So instead of an inflated addition to the money supply over and above the price equilibrium, we get a constriction of the money supply below that level: a relative contraction of $2, or 2 percent ($2/$100) deflation. Then our nominal GDP growth of 5 percent minus our inflation rate of -2 percent yields us our real GDP growth (same as before) of 7 percent.

This last calculation is much like the first I made above for China's quarterly GDP earlier this year: low nominal growth minus negative inflation (deflation) for a higher real growth. Needless to say, this only happens in tight monetary environments often characterized by considerable overcapacity, which China suffered from in 2014 and 2015.