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Investors must understand inflation and gross domestic product, or GDP, well enough to make decisions without becoming buried in data.

Inflation is an increase in price levels or the money supply. GDP represents an economy’s total aggregate output.

Annual GDP growth is vital because companies are unable to increase profits or stock values in a declining or flat economy. But too much GDP usually leads to inflation, which erodes stock gains and corporate profit values.

Studies show annual GDP growth above 2.5 percent causes unemployment to fall. But when an economy operates near full employment, aggregate demand for goods and services increases faster than supply, causing prices to rise. Companies then must raise wages, which passes the increase to consumers through higher prices.

Explosive GDP growth can cause hyperinflation. The idea here is that people spend more when inflation increases because they know their money will be less valuable in the future. This causes further GDP and price increases.

Some insist zero percent inflation is ideal, but a little inflation is good. For example, workers want their wages to rise.

Inflation is important to fixed-income investors because it can affect their future income streams. It spurs stock market investing by promising a high real rate of return.

For more information, see The Importance of Inflation and GDP.

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