When the price of goods and services rises, inflation occurs. Similarly, when the price of goods and services falls, deflation occurs. The delicate balance between these two economic conditions, which are opposite sides of the same coin, is difficult to maintain, and an economy can quickly shift from one to the other.
Central banks keep a close eye on price changes and use monetary policy tools like interest rate setting to combat deflation or inflation.
What is Inflation?
Inflation is a measurement of how quickly the price of goods in a given economy rises. Inflation occurs when goods and services are in high demand, resulting in a decrease in supply. Supplies can be depleted for a variety of reasons: a natural disaster can destroy a food crop, a housing boom can deplete building materials, and so on. Consumers are willing to pay more for the items they want for whatever reason, causing manufacturers and service providers to raise their prices.
The rate of increase in the consumer price index is the most common measure of inflation (CPI). The Consumer Price Index (CPI) is a hypothetical basket of goods that includes consumer goods and services, medical care, and transportation costs. The government keeps track of the prices of the goods and services in the basket to determine the dollar’s purchasing power.
Inflation is often viewed as a major threat, particularly by those who grew up in the late 1970s, when inflation was rampant. When monthly prices rise by more than 50% in a given period of time, this is referred to as hyperinflation. Rapid price increases are frequently accompanied by a breakdown in the underlying real economy, as well as an increase in the money supply.
While hyperinflations are frightening, they are historically uncommon. In reality, depending on the causes and level of inflation, inflation can be either good or bad. In fact, as we will see below with deflation, a complete lack of inflation can be detrimental to the economy. A small amount of inflation can actually encourage spending and investing, as it erodes the purchasing power of cash over time, making it cheaper to buy that $1,000 appliance today than it will be in a year.
What is Deflation?
When there are too many goods available or not enough money circulating to purchase those goods, deflation occurs. As a result, goods and services become less expensive.
For example, if a certain type of car becomes extremely popular, other manufacturers will begin to produce a vehicle that is similar in order to compete. Car companies will soon have more of that vehicle style than they can sell, forcing them to lower the price in order to sell the cars. When a company has too much inventory, it must cut costs, which frequently results in layoffs.
Unemployed people do not have enough money to buy things, so prices are reduced to entice them to buy, which perpetuates the trend. (Deflation should not be confused with disinflation, which is a decrease in the positive rate of inflation from one period to the next.)
When credit providers notice a drop in prices, they frequently reduce the amount of credit available. This causes a credit crunch, as consumers are unable to obtain loans to purchase large-ticket items, leaving businesses with excess inventory and further deflation.
Deflationary periods can stifle economic growth and raise unemployment. The “Lost Decade” in Japan is a recent example of deflation’s negative effects.
Uncontrolled price declines, like out-of-control hyperinflation, can lead to a damaging deflationary spiral. When economic output slows and demand for investment and consumption dries up during a period of economic crisis, such as a recession or depression, this situation arises. As producers are forced to liquidate inventories that people no longer want to buy, this could lead to a general decline in asset prices.
Consumers and businesses alike begin to hoard liquid cash reserves in order to protect themselves from further financial loss. As more money is saved, less money is spent, lowering aggregate demand even further.
People’s expectations for future inflation are also lowered at this point, and they begin to hoard money. When consumers can reasonably expect their money to have more purchasing power tomorrow, they have less incentive to spend money today.