This article will take you through all the differences and aspects of inflation and deflation in an economy.
Inflation is defined as ‘the rise in the general price level of goods and services in an economy’. During inflation, the purchasing power of money decreases, i.e., the real value of money decreases. A person buys ‘lesser’ quantity of goods than before with the same amount of money.
In contrast to the definition of inflation, deflation can be defined as ‘the fall in the general price level of good and services in an economy’. The purchasing power of money increases, i.e., the real value of money increases and an individual can buy more quantity of goods than before with the same amount of money.
Measuring Inflation and Deflation
Inflation rate and the deflation rate, are both derived by measuring the changes in the general price index. There are three price indexes used to measure inflation. First is the ‘consumer price index’ (CPI), which measures the cost of buying a fixed basket of goods and services representative of the purchases of the urban consumers (Macroeconomics-Rudiger, Fisher, Startz). Second is the ‘GDP Deflator’, which measures the prices of a wider group of goods and services than the Consumer price index. Third is the ‘Producer Price Index’ (PPI). Even it measures the cost of a given basket of goods, but it includes goods like raw material, semi-finished goods, etc.
Now, let’s compare inflation and deflation based on their causes, effects and ponder over the measures required to bring the condition under control in case of each situation.
|Causes of Inflation||Causes of Deflation|
The central bank with the consent of the government prints new banknotes and coins to monetize their debts. When this happens, the supply of money increases, and the current stock of money gets devalued. Because of the excessive supply of money, people will buy more goods and services and would outdo the supply of goods and services. This will lead to increase in the price of the goods to balance out the demand; which eventually leads to inflation.
Increase in Aggregate Demand
Increase in Government and Private Spending
Decrease in Rate of Interest
|Change in Demand and Supply
Any change in demand or supply will have an effect on the general price level. If there is a drop in the aggregate demand; the quantity supplied will exceed the quantity demanded. This will lead to a fall in the price of the goods and therefore the general price level will fall. For example, this can happen during the period of recession, when the economic activities are slowing down and people because of speculation, spend less money to make a reserve for the future expenses.
Decrease in the Money Supply
Fall in Prices of Goods and Services
High Rate of Interest
Scarcity of Official Money
|Factors||Effects of Inflation||Effects of Deflation|
|Hoarding||People tend to hoard goods when they think that their prices will rise in the near future. This can lead to scarcity of goods. Also the seller can hoard goods, to sell it later and obtain higher profits.||In case of deflation, people tend to hoard money as the rate of return on investments are really low and they speculate further devaluation of money.|
|Purchasing Power Parity||The purchasing power of the individual decreases, as he now buys a lesser quantity with the same money.||The purchasing power increases as people are able to buy more goods with the same amount of money.|
|Investments||In case of inflation, people tend to invest less as the surplus money is less.||People want to save more as they have more surplus money.|
|Demand and Supply of Goods and Services||In case of inflation, the demand for the goods decreases because of the high prices and the supply increases as the seller wants to maximize his profit by selling the goods at a higher price.||In case of deflation, the demand will increase because of the decrease in the price of goods and the sellers will supply less goods as selling it at a lower price will not break even his cost.|
|Taxes||In case of inflation, the investors can be imposed to ‘hidden taxes’; because the increased earnings can push them to the higher taxpayers bracket.||In case of deflation, government will have to enforce tax cuts to boost the demand.|
|Debtors and Creditors||In case of fixed rate investments, the debtors will have to pay a lower rate of interest than the market rate and the creditors will get less returns compared to the current market rate.||In case of deflation, the debtors are at a loss as they are paying a higher rate of interest than the market rate and the creditor is receiving a higher rate of interest than the market rate.|
|Import and Export||Exports become expensive.||Exports become cheap and unfavorable and the imports become expensive.|
|Reallocation of Resources||During inflation, people have less purchasing power, so now they carefully allocate their money in necessities and risk free investments.||People’s purchasing power increases, but the demand is falling down, therefore people may choose to save more money.|
|Liquidity Trap||In the situation of a liquidity trap, slight inflation proves to be beneficial in times of recession, so that the interest rates can stay sufficiently above the nominal interest rate.||Deflation can lead to a liquidity trap. This is because when the return on investments results into zero returns, people start to hoard money and even after reducing the rate of interest to zero it can no longer stimulate the demand.|
|Rate of Interest||High rate of interest is charged by the central bank to reduce the money supply.||During deflation, even the interest of zero does not increase the money supply.|
|Government Spending||In case of inflation the government will have to reduce its spending.||The government will have to increase its expenditure to boost the demand.|
|Taxes||Government will increases the taxes to control the increasing demand.||Government will cut taxes to boost the aggregate demand.|
|Printing Currency||The central bank will not print more bank notes.||The central bank will have to print more banknotes to increase the money supply.|
|Borrow Money||Government will not borrow more money.||The government will have to borrow money and inject it in the economy to stimulate the demand.|
|Buying and Selling of Fixed Assets||Government will sell fixed assets to the bank to reduce their liquidity.||The government will buy fixed assets from banks to increase their liquidity.|
Inflation and deflation are a part and of the business cycles. Though the effect of deflation is considered to be more severe than the effect of inflation, because it takes the economy to a state of stagnation. This can be seen by going back to the history of deflation, when economies were crashed in deflation.