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Inflation Vs. Deflation

Inflation Vs. Deflation

This article will take you through all the differences and aspects of inflation and deflation in an economy.
Foram Mehta
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
Monetizing Debt
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.

Cost Push
Cost push inflation refers to the fall in the supply of goods and services. This could be because of any reason; a natural calamity or increase in the price of the raw material. The fall in the quantity supplied will lead to a scarcity in the market. The demand outgrows the supply and thus the price of the goods increases; inflating the general price level.

Increase in Aggregate Demand
If there is an increase in the aggregate demand then there would be an increase in the general price level leading to inflation, if the demand exceeds the supply of the goods. The reason for the increase in aggregate demand can be the increase in population, or increase in the per-capita income, etc.

Built in inflation is an automatic way in which the general price level rises because of the 'price spiral effect'. This happens when the wages are increased above the inflation level by the employees through collective bargaining; following which the employer in turn transfers this cost to the consumers, by increasing the price of the product; leading to inflation.

Increase in Government and Private Spending
This is known as the demand pull inflation. When the government and the private sectors increases their spending, it results into a fast economic growth. This is because as spending increases, demand and supply also increase, this leads to increase in the national income and the per capita income. The increase in income will lead to increase in consumption expenditure, which will increase the general price level in an economy.

Decrease in Rate of Interest
A decrease in the rate of interest makes loans cheaper. This will increase the demand for the loans. Increase in the demand for loans will lead to a further increase in the spending expenditure; which in return will increase the general price level leading to inflation.
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
The government and the central bank can decrease the money supply to control the bank failures and the movements in rate of interest. Thus, when the government decreases the money supply, loans become expensive and the expenditure on consumption falls. The fall in the aggregate consumption leads to a fall in the quantity demanded; which in turn will decrease the general price level.

Fall in Prices of Goods and Services
If the prices of the goods and services fall, because of a more cost-efficient way of producing a commodity then, this fall in price of the commodity in turn will increase the value of money. People will spend less and thus reduce the general price level.

Cash Hoarding
When people are skeptical about the economic conditions, they tend to hoard money instead of investing it or consuming it. This results in the money to come 'out of' circulation and earning more profits. It reduces the overall demand, circulation and consumption for money and thus leads to deflation.

High Rate of Interest
When the rate of interest is high, the loans are made expensive and people tend to postpone their consumption or expenditure. This again leads to a decrease in the aggregate consumption, thus reducing the demand and dropping the price of the goods.

Dumping is a situation when an exporter imports goods at a price cheaper than the prevailing one in the domestic market. This can be done to get over the rejected stock or to also create a monopoly by driving out the domestic producers and manufacturers. This will lessen the price of a particular commodity, deflating the prices for the same.

Scarcity of Official Money
Official money is said to be scarce if the total money in circulation is not equal to total reserves held. This makes the government inefficient to control the credit in the market and that can lead to deflation.

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.

Controlling Measures Inflation Deflation
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.