There has been a lot of debate over whether or not deflation is good for an economy.

The two most important

periods of deflation in modern history are the Great Depression and Japan's Lost Decade. These have already been studied
in great detail, so I am not going to discuss them here.

Many people, such as the folks at Mises.org have pointed out that price deflation was much more common in the
1800's, and did not always result in lower GDP growth. In this blog I will try to examine the relationship between yearly
changes in the consumer price index (CPI), and yearly changes in real GDP. This data was downloaded from Measuring
Worth. I will attempt to compare and contrast the years from 1790-1913, with years of the post-Federal Reserve era:
1914-2009.

First I want to mention that the relationship between CPI and GDP can be seen very cleary, if nominal GDP is
used instead of real GDP. But I am not going to discuss these graphs because I believe that would be misleading. If
nominal GDP increases by 3%, but the CPI also increases by 3%, then we haven't really gained anything in terms of
purchasing power. So I will stick to real GDP for my analysis.

First, here is the modern period shown in Figure 1: A timeline of the yearly percentage changes in both CPI and real
GDP, from 1914-2009.
CPI % Change Real GDP % Change
25.00%
20.00%
15.00%
10.00%
5.00%
0.00%
-5.00%
-10.00%
-15.00%
1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 2020

Now, we can contrast this with Figure 2, which shows the same data, for 1791-1913:
CPI % Change Real GDP % Change
25.00%
20.00%
15.00%
10.00%
5.00%
0.00%
-5.00%
-10.00%
-15.00%
1780 1800 1820 1840 1860 1880 1900 1920
I have also divided this graph into three smaller parts, which lets us see it more clearly:

Figure 3: Timeline, 1791-1830

CPI % Change Real GDP % Change
25.00%
20.00%
15.00%
10.00%
5.00%
0.00%
-5.00%
-10.00%
-15.00%
1785 1790 1795 1800 1805 1810 1815 1820 1825 1830 1835

Figure 4: Timeline, 1831-1871

CPI % Change Real GDP % Change
25.00%
20.00%
15.00%
10.00%
5.00%
0.00%
-5.00%
-10.00%
-15.00%
1825 1830 1835 1840 1845 1850 1855 1860 1865 1870 1875

Figure 5: Timeline, 1872-1913

CPI % Change Real GDP % Change
25.00%
20.00%
15.00%
10.00%
5.00%
0.00%
-5.00%
-10.00%
-15.00%
1870 1875 1880 1885 1890 1895 1900 1905 1910 1915
For a quick history lesson, here are some key events which correspond with some of the various peaks and valleys of
these graphs:

1812-1815 - War of 1812

1817 - NYSE founded
1819 - Panic of 1819 (some other panics can be seen here)
1861-1865 - American Civil War
1873-1879 (approx.) - Depression of 1873–79, AKA the "long depression"
1893-1897 - Depression of 1893
1907 - The Panic of 1907.
1913 - Creation of the Federal Reserve

There are a lot of ups and downs here, so rather than trying to squint at these graphs, I have made several scatter plots
which allow us to analyze the data more easily.

For each of these plots, I am also going to give the Pearson Coefficient (to 2 decimal places). This is a way of measuring
the degree of correlation between two variables using a scale of -1 to +1. Basically, a value of zero is randomness/no
relationship. A value of +1 is a perfect 45-degree line: "/", and a value of -1 is a 45-degree line going the other direction:
"\".

Figure 6: CPI % Change vs Real GDP % Change, 1791-1913

Pearson = 0.18

15.00%
Real GDP % Change

10.00%
5.00%
0.00% 1791-1913
-5.00%
-10.00%
-15.00%
-20.00 -10.00 0.00% 10.00 20.00 30.00
% % % % %
CPI % Change
We can contrast this with the more modern era:

Figure 7: CPI % Change vs Real GDP % Change, 1914-2009

Pearson = 0.18

20.00%
Real GDP % Change

15.00%
10.00%
5.00%
0.00%
1914-2009
-5.00%
-10.00%
-15.00%
-20.00 -10.00 0.00% 10.00% 20.00% 30.00%
% %
CPI % Change

It's interesting that the correlation came out exactly the same for both time periods. It's not the strongest correlation in the
world, but what it means is that there tends to be greater real GDP growth in years with larger CPI increases.

Next, I split up the data from Figure 6 into three parts: inflationary years, deflationary years, and neutral years (believe it
or not there were 18 years where the CPI stayed exactly the same).

Figure 8: Inflationary Years, 1791-1913

Pearson = 0.13

20.00%
Real GDP % Change

15.00%
10.00%
5.00%
0.00% 1791-1913
-5.00%
-10.00%
-15.00%
0.00% 10.00% 20.00% 30.00%
CPI % Change
Figure 9: Deflationary Years, 1791-1913
Pearson = 0.13

20.00%
Real GDP % Change

15.00%
10.00%
5.00%
1791-1913
0.00%
-5.00%
-10.00%
-15.00%
-20.00% -15.00% -10.00% -5.00% 0.00%
CPI % Change

Figure 10: Neutral Years, 1791-1913

Pearson = N/A

15.00%
Real GDP % Change

10.00%

5.00% 1791-1913

0.00%

-5.00%
-10.00% 0.00% 10.00%
CPI % Change

Again we see the exact same degree of correlation in figures 8 and 9, which indicates that these numbers might actually
mean something! More inflation (or, less deflation) generally results in higher GDP growth. Although I should point out
that the correlation value of 0.13 is not very high.
To illustrate a point that I made earlier, I will post one plot that uses nominal GDP growth instead of real GDP growth:

Figure 11: CPI % Change vs Nominal GDP % Change, 1791-1913

Pearson = 0.85
Nominal GDP % Change

30.00%
20.00%
10.00%
1791-1913
0.00%
-10.00%
-20.00%
-20.00 -10.00 0.00% 10.00% 20.00% 30.00%
% %
CPI % Change

This shows us conclusively that price inflation tends to increase the growth rates of both the CPI and the nominal GDP,
resulting in a much larger degree of correlation than what we saw in the real GDP plots.

Averages:
This seems like as good a time as any to throw some numbers at you, so here they are:

Average CPI % change, 1791-1913: 0.23%

Average real GDP % change, 1791-1913: 3.85%
Average real GDP % change, 1791-1913 (during the 50 inflationary years): 4.64%
Average real GDP % change, 1791-1913 (during the 54 deflationary years): 3.39%
Average real GDP % change, 1791-1913 (during the 18 neutral years): 5.50%

Average CPI % change, 1914-2009: 3.41%

Average real GDP % change, 1914-2009: 3.37%
Average real GDP % change, 1914-2009 (during the 82 inflationary years): 4.06%
Average real GDP % change, 1914-2009 (during the 13 deflationary years): -1.18%
Average real GDP % change, 1914-2009 (during the 1 neutral year): 6.05%

Stable prices seem to be the best possible scenario for high real GDP growth. Inflation is the second-best option, and
deflationary years produce the worst results.

Looking Ahead:

Now, I will examine the effect that inflation has on future GDP growth. Fig. 12 shows the CPI % change for the current
year, compared to the real GDP % change for the next year. Fig's 13-15 compare current-year CPI changes to the average
annual GDP growth over the next 3, 5, and 10 years:
Figure 12: Current Year CPI % Change vs Next Year's Real GDP % Change, 1791-1913
Pearson = -0.04
Next Year's Real GDP %

15.00%
10.00%
5.00%
Change

0.00% 1791-1913
-5.00%
-10.00%
-15.00%
-20.00 -10.00 0.00% 10.00 20.00 30.00
% % % % %
CPI % Change

Figure 13: Current Year CPI % Change vs Next 3 Year's Real GDP Average % Change, 1791-1913
Pearson = -0.23
Next 3 Year's Real GDP

15.00%
Average % Change

10.00%
5.00%
0.00% 1791-1913
-5.00%
-10.00%
-15.00%
-20.00 -10.00 0.00% 10.00 20.00 30.00
% % % % %
CPI % Change
Figure 14: Current Year CPI % Change vs Next 5 Year's Real GDP Average % Change, 1791-1913
Pearson = -0.30
Year's Real GDP Average
15.00%
10.00%
% Change

5.00%
Next 5

0.00% 1791-1913
-5.00%
-10.00%
-15.00%
-20.00 -10.00 0.00% 10.00 20.00 30.00
% % % % %
CPI % Change

Figure 15: Current Year CPI % Change vs Next 10 Year's Real GDP Average % Change, 1791-1913
Pearson = -0.23
Year's Real GDP Average

10.00%

5.00%
% Change
Next 10

1791-1913
0.00%

-5.00%
-20.00 -10.00 0.00% 10.00 20.00 30.00
% % % % %
CPI % Change
And I did the same thing for the post-1914 era:

Figure 16: Current Year CPI % Change vs Next Year's Real GDP % Change, 1914-2008
Pearson = -0.03
Next Year's Real GDP %

15.00%
10.00%
5.00%
Change

0.00% 1914-2008
-5.00%
-10.00%
-15.00%
-20.00 -10.00 0.00% 10.00 20.00 30.00
% % % % %
CPI % Change

Figure 17: Current Year CPI % Change vs Next 3 Year's Real GDP Average % Change, 1914-2006
Pearson = -0.12
Next 3 Year's Real GDP

15.00%
Average % Change

10.00%
5.00%
0.00% 1914-2006
-5.00%
-10.00%
-15.00%
-20.00 -10.00 0.00% 10.00 20.00 30.00
% % % % %
CPI % Change
Figure 18: Current Year CPI % Change vs Next 5 Year's Real GDP Average % Change, 1914-2004
Pearson = -0.13
Year's Real GDP Average

15.00%
10.00%
% Change

5.00%
Next 5

0.00% 1914-2004
-5.00%
-10.00%
-15.00%
-20.00 -10.00 0.00% 10.00 20.00 30.00
% % % % %
CPI % Change

Figure 19: Current Year CPI % Change vs Next 10 Year's Real GDP Average % Change, 1914-2004
Pearson = -0.16
Year's Real GDP Average

15.00%

10.00%
% Change
Next 10

5.00% 1914-2004
0.00%

-5.00%
-20.00 -10.00 0.00% 10.00 20.00 30.00
% % % % %
CPI % Change

Figures 12-19 all had negative correlations, which makes perfect sense: a high rate of price inflation in the current year
results in slower GDP growth in subsequent years.
Conclusions:
Comparing the two time periods (1790-1913 and 1914-2009), I have not found many fundamental differences.
Deflation has become much less common since, 1914, but the behavior of the economy seems very similar. In both
periods, higher inflation generally correlates with higher real GDP growth in that year. Periods of high growth and high
price inflation are generally followed by periods of slower growth, or even negative growth.
Bear in mind that these are just correlations, so if you try to draw conclusions, it leads to a lot of chicken-or-the-
egg types of problems. Is GDP influencing the CPI, or is it the other way around? Probably both, and sometimes maybe
neither. Two variables can show a correlation if certain events influence both of those variables in a similar way. But that
doesn't mean that the two variables are necessarily influencing each other.
Even when you look at the correlation between current-year inflation and future GDP growth, that still doesn't
necessarily mean that high inflation is the cause of lower GDP growth in the future. It just illustrates that boom-and-bust
cycles are a real phenomenon; if the economy is growing at a high rate in one year, then it will probably grow at a slower
rate over the next few years (and vice versa). In future blogs I'll try to dig deeper and hopefully gain a better
understanding of causality. That's it for now.