Inflation and Deflation: Meaning
Inflation is the consistent rise in the prices of goods and services in an economy. This rise should be over some time in an economy. Also, the price rise is not only consistent but is substantial enough too to be termed as inflation. Also, the price rise is over some time, and not just a few days. Deflation is the exact opposite of inflation. It is a fall in the prices of goods and services over some time in an economy. This fall in prices should be again consistent and substantial and should stretch over some time.
Let us look at the similarities and differences between inflation and deflation.
Change in purchasing power of money
A critical difference between inflation and deflation is the change in the purchasing power of money. Inflation results in a fall in the purchasing power of money in real terms. It means that if there is an inflationary trend in the economy, a person will be able to buy a lesser quantity of goods with the same amount of money.
For example, if a product was priced at US$5 a few years ago, a person could buy 20 units of the product with US$100. Now, if the price of the same product has increased to US$10 due to inflation, we can only buy ten units of the product with US$100. Therefore, there is a fall in the purchasing power of money. Or the capital has lost value over some time due to inflation.
On the other hand, deflation causes an increase in the purchasing power of money. A person can buy a larger quantity of goods with the same amount of money if there is a deflationary trend in the economy. For example, let us suppose that the price of a product was US$15 a few years ago. A person can buy ten units of the product with US$150. The cost of the product has fallen to US$10 due to deflation over the years. Now we can buy 15 units of the product with the same amount of money. Therefore, the value of money has risen over the years, and the purchasing power of money has gone up.
Inflation and Deflation: Difference in causes
Money supply in the economy
The government can change the money supply in the economy through a change in the monetary policy of the Central Bank of the country. In the case of inflation, the banks reduce interest rates. It results in an increase in the overall supply of money in the economy. More money in the hands of people means more spending, more demand, and thus, an increase in the prices.
On the other hand, deflation causes when the monetary policy brings in tightness. It is by increasing the interest rates to reduce the money supply in the economy. A lower money supply leads to a fall in demand for goods and services in the marketplace. It results in a decrease in prices.
Change in demand
At times of rising prices, people may believe that rates will increase further. They will buy more at current prices, leading to an overall increase in demand in the economy. It will result in a further rise in prices and inflation.
On the other hand, demand for goods and services may fall even in times of falling prices. People may be anticipating a further fall in prices; hence the demand keeps falling. It will result in a fall in prices and deflation.
Technology and innovation
Lack of innovation and technology in production processes may result in over-dependence on manual labor. An increase in prices results in the worker asking for higher wages to sustain their living. Higher wages increase the cost of goods and services, and prices rise. The labor further demand higher salaries to accommodate the price rise. It results in a wage-price spiral and causes inflation.
On the other hand, implementing technology and innovation in the production process may result in increased efficiency. A decrease in input costs may be passed on to the consumers by reducing the prices. Also, the increase in supply may lead to a reduction in rates. It will cause deflationary trends in the economy.
Inflation and Deflation: Difference in effects
A little bit of inflation is healthy for any economy. Since inflation decreases the value of money, it acts as a non-deterrent to hoard cash. It encourages businesses to invest rather than save more, which in turn promotes economic activities.
Asset owners like properties find inflation useful as it increases the value of their assets. They will fetch a higher price in the market at the time of their sale. The situation is the opposite for buyers since they will now have to spend more money to purchase that asset.
Temporary deflation, too, is desirable in an economy from an individual’s point of view. People would want more fall in prices at the time of purchase. But deflation over the long term is extremely harmful to an economy. It leads to a fall in prices, a fall in overall demand, unemployment, failures and bankruptcies, loan defaults, and an overall fall in economic activities. Prolonged deflation leads to a recession.
Inflation is controlled by a contraction in the money supply in the economy through changes in monetary policy. Interest rates are increased to control lending. Treasury securities are sold through open market operations to take away surplus money from them. Rates of taxation are also increased.
It curtails spending in the economy. The government also controls its spending on infrastructure and development. All these lead to a fall in demand and liquidity in the market. It further leads to a fall in prices and inflationary trends.
The government and the Central Bank adopt a similar approach in the case of deflation, with the core idea of generating more liquidity and disposable income in the hands of the public. Expansionary monetary policy comes into play. Interest rates go down to encourage borrowing. Open market operations further12 inject money into the economy.
Taxation rates are also cut to boost demand. The government increases its spending rather than reducing it, as in the case of inflation. These measures lead to an increase in need in the economy, resulting in an increase in prices and hence, curtailing deflation.
For both inflation and deflation, the best measure is the Consumer Price Index (CPI). The index measures the percentage change in prices of a basket of goods and services over some time. These goods and services are selected based on the typical purchasing pattern of an average consumer.
The calculation formula is:
(Price Index of base year – Price index of current year/ Price index of the base year) x 100
Temporary inflation and deflation at moderate levels are suitable for any economy. But prolonged and high rates of the two can be very harmful and devastating. Both situations can lead to failures and bankruptcies of businesses, unemployment, and uncertainty in the economy.
But of the two, deflation is more harmful. One way of controlling inflation is by increasing the rate of interest. However, in deflation, there is a limit to which reduction in interest can happen in an economy. The rates cannot go lower than zero. Inflation with rising prices is preferred to boost public consumption and investor sentiments, as opposed to a deflationary phase with falling prices.
Quiz on Inflation and Deflation
This quiz will help you to take a quick test of what you have read here.