By Aniket Bose. Edited by Arjun Chandrasekar.
Inflation occurs when the prices of goods and services begin to rise, while deflation occurs when the prices of goods and services begin to decline. The balance between these two economic conditions is very sensitive and can easily change from one condition to the other. The central banks keep an eye on the levels of price changes and act to prevent deflation or inflation by applying monetary policies such as setting interest rates on bank accounts, credit cards, debit cards, etc. Both inflation and deflation can potentially be dangerous for the economy depending on underlying factors and the rate at which price changes.
What is Inflation?
Inflation is a quantitative measure of how rapidly the price of goods and services in any economy increases. Inflation is caused when goods and services are in high demand, which leads to a decrease in their supply. These supplies can be reduced for many reasons such as natural disasters, explosions at factories, etc. No matter the reason, consumers are most likely to pay more for the items they desire, which allows manufacturers and service providers to charge more for their products.
The most common way to measure inflation is known as the consumer price index (CPI). The CPI is a theoretical basket of goods that includes consumer goods and services, medical care, and transportation costs. The government tracks the prices of these goods and services that are in these baskets of goods, attempting to understand the purchasing power of the U.S. dollar. Inflation is often seen as a big threat mostly by people from the late 1970s because inflation ran wild in their economy, this was called hyperinflation. These hyperinflations occur when the increase in monthly prices begins to exceed 50% over time. These periods of rapid price increases are often associated with a breakdown in the underlying real economy and can also see a sudden increase in the money supply. Despite hyperinflations being frightening, they are historically very rare. In reality, inflation can be both good or bad, depending on the reasons and level of inflation. It is also important to understand that even a complete lack of inflation can prove to be bad for the economy, and the same applies to deflation. For example, a small amount of inflation can encourage spending and investing, as inflation is known to slowly erode the buying power of cash.
What is Deflation?
Deflation occurs when there are too many available goods or when there is not enough money circulating to purchase those excess goods. This leads to the price of goods and services dropping because of the high supply and low demand. For example, if a particular model of a car becomes highly popular, other car manufactures will start to make similar cars to compete in the market. Eventually, car companies have more models of that particular car style than they can sell, so they have to drop the selling price of those models to stay in business. Companies that find themselves stuck with more inventory than they can handle must cut their costs, which often leads to first laying off their employees. It is critical to note that deflation is not the same as disinflation, which is a decline in the positive rate of inflation from period to period.
When credit providers (usually banks) detect a decrease in prices, they will often tend to reduce the amount of credit they offer to consumers. This creates a “credit crunch” where the consumers cannot access loans to purchase valuable items, leaving companies with even more deadstock inventory and causing further deflation in the economy. These prolonged periods of deflation can stunt economic growth and increase the rate of unemployment. For example, in Japan, their “Lost Decade” is a recent example of the negative effects deflation has.
Similar to how out-of-control hyperinflation is bad, uncontrolled price declines can also lead to damaging the economy. This situation usually occurs during the time of an economic crisis, such as recessions or depressions. This also occurs when the economic output slows down and the demand for investments and consumption declines. Consumers and businesses start to hold on to their funds and liquid money as a cushion against any other future financial losses. As more money is being saved, there is less money that is being spent, which leads to decreasing the demand for goods and services even more. During this stage, people’s expectations about future inflations are also lowered as they hold on to their money for longer periods. Consumers have less incentive to spend their money today when they know that they can expect that money will hold more purchasing power tomorrow.
The majority of the world’s central banks target modest levels of inflation at around 2 to 3 percent per year. Higher levels of inflation can lead to becoming dangerous for an economy since it causes prices of goods and services to rise very quickly. In the same manner, deflation can also prove to be very bad for the economy, as people tend to hoard their cash and liquid money instead of spending it on goods or even investing in the stock market because they live with the expectation that the prices of these goods and services will eventually drop even lower.