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Brazil: Economic Growth, Potential Output and Inflation

The Phillips Curve was presented in the mid-fifties by the Australian economist A. W. Phillips:

a trade-off between inflation and unemployment, that is, a negative correlation between inflation and unemployment. Ten years later, in the mid-sixties, the American economist Arthur Okun developed the so-called Okun’s Law: a positive relation between unemployment and the “output gap” concept, which was defined as the distance between potential GDP and actual GDP measured in percentage terms.

When we consider these two famous macroeconomic relationships together, this indicates of course a negative correlation between inflation and the output gap.

In the late sixties and early seventies, Nobel Prize winning economists Milton Friedman and Edmund Phelps corrected (or improved) these theories of inflation and unemployment, by developing the “accelerationist” concept, that is, a negative correlation between the acceleration of inflation and unemployment (or between the acceleration of inflation and the output gap).

Forty years later, such theories continue to produce a certain degree of confusion and a lot of discussion when one tries to analyze the relationship between inflation and economic growth.

As a matter of fact, the Philips Curve and Okun’s Law by themselves have nothing to say about such correlation. It all depends on the previously existing level of unemployment, which means the previously existing level of the so-called “output gap” in the country to be analyzed.

The present situation of the Brazilian economy in 2010 – low inflation, low acceleration of inflation, and very high GDP growth – is perfectly compatible with Phillips Curve theories and Okun’s Law. As a matter of fact, it seems that Brazil is beginning to repeat the period 1968-1973 (six years), which was then classified as the “Brazilian Miracle” – but there was no miracle…

High rates of economic growth are perfectly compatible with low inflation and low acceleration of inflation when the economy is finally beginning to get rid of a period of great output gaps. This was the case in 1962-1967 in Brazil (including negative GDP growth) and again this was the case in Brazil in the last 15 years due to a succession of years of very low economic growth rates.

The output gap between potential GDP and actual GDP grows whenever the rate of economic growth is lower than the long-term potential growth rate. When both rates are equal, unemployment stays constant and the output gap stays also constant.

It is certainly true that growth of 8 or 9% in the Brazilian economy in 2010 will reduce unemployment and reduce the output gap. But this does not necessarily mean inflationary pressures. In other words, after more than a decade of high unemployment and very low rates of GDP growth, the level of unemployment – as well as the level of the output gap – will certainly diminish but will continue to stay very high.

Let us assume that the potential growth rate of the Brazilian economy in the 21st century is estimated at 5% per year, a number that has been suggested by many economists in many recent studies. This compares with 6/7% in the previous century, but in per capita terms it is basically the same due to a lower rate of population growth nowadays.

Looking at the GDP growth rates of the past 15 years, Brazil has probably generated an output gap in the beginning of 2010 greater than 15%. Even if the Brazilian economy this year grows by 9%, the output gap and unemployment will remain at high levels. And what matters for the Phillips Curve or accelerationist theories of inflation is the level of the output gap (and unemployment), rather than the rate of GDP growth.

Some economic analysts are repeating now in 2010 the same mistakes made in the late sixties and early seventies. There was no economic miracle then and there is no economic miracle now. Brazil is finally returning to a macroeconomic situation similar to 1960-1980 as far as economic growth is concerned.

Even better: in contrast to the last century, it seems that Brazil is coming back to 5% long-term economic growth, but now with much lower inflation rates. The era of two-digit (or three-digit) annual inflation rates is over, but fortunately the era of good economic growth – which characterized Brazil’s last century – seems to be back with full speed.

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