Inflation is the increase in the prices of goods and services. Deflation or negative inflations is the opposite, the decrease in prices of goods and services. Inflation and deflation have their causes, effects, and control measure for an economy.
Central banks and government institutes strive to achieve a delicate balance between inflation and deflation. Both concepts are important for a smooth economy in any country. Both can be bad for an economy, depending on the root causes and their rates.
Inflation and deflation are not always bad for an economy too. That’s the reason central banks look to achieve a balance between the two opposing forces.
Let us understand the definitions and key differences between inflation and deflation.
What is Inflation?
Inflation is the measure of an increase in the prices of goods and services in an economy. It can also be defined as the quantitative measure of the decreasing purchasing power in an economy.
When the prices of goods and services increase, the purchasing power decreases. In economic terms, it is also the measure of a decrease in the value of the local currency. In simpler terms, a person will have to spend more to buy the same goods or services in inflation than without it.
There are different methods to measure inflation. Most commonly, the consumer price index (CPI) is used to measure the inflation rate. It comprises a hypothetical basket of goods and services, including medical costs, transportation, and essential items. Inflation is measured by identifying the purchasing power of this theoretical basket.
In a simple scenario, we can understand the concept of inflation with the increasing prices of products. For instance, if you can buy a coffee cup for $ 5 today, you may need to spend $ 7 to buy the same coffee cup two years later. Your purchasing power decreased due to an increase in the price of the coffee cup. In other words, the dollar lost value in monetary terms.
Causes of Inflation
Inflation is an economic phenomenon. Hence there are several causes of inflation. From government monetary policies to domestic production, several factors contribute to inflation rates.
Let us briefly discuss a few key causes of inflation in an economy.
It is the most common cause of inflation in an economy. When an economy cannot meet the excessive demand for goods or services, there is a supply shortage. It means the demand increases against the falling supplies. It results in increased prices of goods and services.
It is closely related to the demand-supply factor. When there is excessive money (cash) available, it increases the purchasing power. It, in turn, increases the demand for goods and services in an economy. Thus, it eventually pulls the prices up and causes increased inflation rates.
The purchasing power of the public can fall due to the increased cost of production of goods or services. For example, if raw materials are imported, and the prices increase in the foreign country, it will increase the production cost in the importing country’s local economy. Hence, it will contribute to the increased inflation rates.
These are built-in effects in an economy. People assume that inflation rates will go up. Hence, they demand higher wages and salaries. It increases the costs of goods and services being produced. Eventually, the inflation rates start increasing again.
Effects of Inflation
Inflation can cause a severe economic crisis for several reasons. When inflation occurs, the currency loses value. In turn, the purchasing power of the masses decreases. It further affects the economy as businesses witness declining sales. Thus, a high inflation rate affects an economy and causes further currency devaluation.
Contrary to the common notion, inflation is not always bad for an economy. In fact, a controlled inflation rate is necessary to keep an economy running. If the prices of goods and services remain too low, it will cause an excess in supply. Thus, it will again slow down economic activities.
What is Deflation?
Deflation refers to the falling prices of goods and services in an economy. It is also called negative inflation. It means the purchasing power of a currency increases.
In simple terms, you can buy more in deflation with the same dollar amount than in inflation or a normal economic environment. Apparently, deflation seems good for the consumers. However, falling prices are not always good for an economy overall.
In many cases, deflation proves more harmful to an economy than inflation. It is because interest rates can only be lowered to zero. It means people get less for their investments in banks and other income securities. They spend less that causes lower production. Eventually, the economy slows down and can lead to an economic recession.
Causes of Deflation
Several factors cause negative inflation or deflation.
In theory, deflation only happens due to a decrease in the supply of money. Decreased flow of money and credit results in falling prices of goods and services. It makes products and services more affordable to people.
Excessive supply of goods due to increased production or efficient economy is another key factor causing deflation. Technological advancement and bulk production lead to lower production costs of goods that cause deflation.
Price decrease and deflation through increased production can be non-uniform as well. In some industries, deflation can be significant due to increased production and lower cost of production.
Effects of Deflation
The biggest impact of deflation can be the economic slump. When prices fall too low and production increases excessively, it slows down the economic activities. It can result in an economic recession eventually.
Deflation can also lower interest rates. Hence, return on investments through debt instruments decrease. It also decreases the income of people depending on fixed-income securities.
Continuous deflation leads to a slowing economy. That results in unemployment, reduced income, and excessive supplies. These factors can combine to cause an economic recession or depression in any economy.
Key Differences Between Inflation and Deflation
As we have discussed above, inflation and deflation have some key differences concerning causes and effects.
- Demand-supply is the most common cause of inflation.
- Excessive Money
- Built-In are other key causes of inflation.
- The decreased supply of money (cash) is a common cause of deflation.
- Increased supply and lower demand are also common deflation causes.
- Increased production due to efficient technology is another common deflation cause.
- Increased prices, the lower purchasing power of the currency, and declining business activities are the main effects of inflation.
- Controlled inflation can lead to positive economic activities as well.
- Falling prices of goods and services also lead to lower economic activities.
- Deflation causes lower interest rates that can lead to economic recession and depression eventually.
- Central banks start taking corrective measures such as adjusting interest rates.
- Central banks also issue new securities to control the excessive cash supply.
- Economies also recover when they increase the production of goods and control factors such as demand supply and production costs.
- Government increases spending to control the demand-supply deficit.
- Central banks also take corrective measures to adjust interest rates.
- An economy also recovers when the excessive supply of products is slowed down and the purchasing power of currency is restored.