INFLATION & DEFLATION
Inflation
Inflation is the persistent (continuous) rise in the average price level of a basket of goods
and services in an economy over a period of time, usually for one year.
Inflation does not mean that the price of all the goods have increased. During inflation the
price of some goods may increase, some may decrease and some may remain constant but
the overall Average / general price level increases.
GOODS 1 GOODS 2 GOODS 3 GOODS 4
Old Price : 100 Old Price : 100 Old Price : 100 Old Price : 100
New Price : 100 New Price :200 New Price :150 New Price :50
GOODS 5 GOODS 6 GOODS 7 GOODS 8
Old Price : 100 Old Price : 100 Old Price : 100 Old Price : 100
New Price :300 New Price :200 New Price :100 New Price : 300
GOODS 9 GOODS 10 GOODS 11 GOODS 12
Old Price : 100 Old Price : 100 Old Price : 100 Old Price : 100
New Price :50 New Price :150 New Price :100 New Price : 200
Old cost of Basket : 1200 Old Avg Price: 1200/12 = 100
New Cost of Basket : 1900 New Avg Price: 1900/12=158.33
During inflation when the general price level increases and purchasing power of money
decreases, the value of money decreases. It means during inflation the same money will
buy less amount of goods.
Causes/Types of Inflation
● Demand-pull inflation: inflation caused by an increase in aggregate demand is
called demand-pull inflation. This is also defined as the increase in price due to aggregate
demand exceeding aggregate supply. Demand could rise due to higher incomes, lower
taxes etc. The demand curve will shift right, causing an extension in supply and a rise in
price. When aggregate demand increases and aggregate supply is insufficient(AD>AS) it's
called demand-pull inflation.
Due to an increase in aggregate demand where the AD curve shifts to the right to AD1, the general
price level rises from Pl to Pl1 which is called demand-pull inflation.
● Cost-push inflation: inflation caused by an increase in cost of production in the
economy. The cost of production could rise due to higher wage rate, higher indirect taxes,
higher cost of raw materials, higher interest on capital etc. When the cost of production
increases, the profitability of firms will decrease. The aggregate supply curve will shift left
causing a contraction in demand and a rise in price level, which is called Cost - Push
Inflation.
When the cost of production increases, the profitability of the firm decreases, SRAS curve(short run
aggregate supply) will shift to the left to SRAS1. As a result, the general price level increases from Pl
to Pl1 which is called cost-push inflation.
The consequences of inflation
● Lower purchasing power: When the price level rises, the lesser number of goods
and services you can buy with the same amount of money. This is called a fall in the
purchasing power. When purchasing power falls, consumers will have to make
choices on spending.
● Exports are less internationally competitive: If the prices of exports are high, its
competitiveness in international markets will fall as lower priced foreign goods will
rival it. This could lead to a current account deficit if exports lower (especially if they
are price elastic).
● Inflation causing inflation: During inflation, the cost of living in the economy rises
as you have to pay more for goods and services. This might cause workers to
demand higher wages increasing the cost of production. If the price of raw materials
also increases, the cost of production again increases, causing cost-push inflation.
● Fixed income groups, lenders, and savers lose: A person who has a fixed income
will lose as he cannot press for higher wages during inflation (his/her real wages fall
as purchasing power of his/her wages fall). Lenders who lent money before inflation
and receive the money back during inflation will lose the value on their money. The
same amount of money is now worth less (here, the people who borrowed gain
purchasing power). Savers also lose because the interest they’re earning on savings
in banks does not increase as much as the inflation, and savers will lose the value on
their money.
● Savers: Inflation leads to a rise in the general price level so that money loses its
value. When inflation is high, people may lose confidence in money as the real value
of savings is severely reduced. Savers will lose out if nominal interest rates are lower
than inflation - leading to negative real interest rates.
● Lenders: Inflation lowers the real interest earned on loans, so the money paid back
by borrowers is worth less than the money lent. During inflation, the borrower
returns the same amount of money but with less value so lenders lose out the real
value. On the other hand, if the interest rate is lower than the rate of inflation, then
lenders real earning reduces.
● Exporters: Domestic inflation increases product prices relative to foreign prices
hence their exported products are less attractive to foreign buyers. During inflation
when domestic goods become expensive export decreases and therefore the
exporting firm loses out on sales and revenue.
● Wage demands: Inflation can get out of control because price increase leads to
higher wage demands as people try to maintain their real living standards.
Businesses then increase prices to maintain profits and higher prices then put
further pressure on wages. This process is known as a “wage price spiral”. Rising
inflation leads to a build up of inflation expectations that can worsen the trade-off
between unemployment and inflation.
Policies to control inflation
● Contractionary monetary policy that will reduce demand: contractionary
monetary policy is the most popular policy employed to curtail inflation. Raising
interest rates will discourage spending and investing (as cost of borrowing rises),
and reduce the money supply in the economy, helping cut down on demand. But this
depends a lot on the consumer and business confidence in the economy. Spending
and investing may still continue to rise as confidence remains high. There is also a
considerable time lag for monetary policy to take effect.
● Contractionary fiscal policy that will reduce demand: raising taxes will discourage
spending and investing, and cutting down on government spending will reduce
aggregate demand in the economy, helping bring down the price level. However, this
is an unpopular policy only employed when inflation is severe.
● Supply side policies: supply-side policies such as privatisation and deregulation
hope to make firms competitive and efficient, and thus avoid inflationary pressures.
But this is a long-term policy only helping to keep the long-term inflation rate stable.
Sudden surges in inflation cannot be addressed using supply side measures
● Exchange rate policy: Appreciating the domestic currency can lower import prices
helping reduce cost-push inflation arising from expensive imported raw materials. It
also makes export more expensive, helping lower the export demand in the economy
as well as creating incentives for exporting firms to cut costs to remain competitive.
Deflation
Deflation is the general fall in the price level.
Deflation is also measured using CPI, but instead of showing figures above 100, it will
show an index below 100 denoting a deflation. For example, a drop in the average prices of
the basket of goods in a year is 10%, the deflation will be 100 – (90% * 100 = 90%) = 10%.
Causes of deflation
● Aggregate supply exceeding aggregate demand: when supply exceeds demand,
there is an excess of output in the economy not consumed, causing prices to fall.
● Demand has fallen in the economy: during a recession, a fall in demand in the
economy causes general prices to fall and cause a deflation.
● Labour productivity has risen: higher output will lead to lower average costs,
which could reflect as lower prices for products.
● Technological advance has reduced cost of production, pulling down cost-push
inflation.
Consequences of deflation
● Lower prices will discourage production, resulting in unemployment.
● As demand and prices fall, investors will be discouraged to invest, lowering the
output/GDP.
● Deflation can cause recession as demand and prices continue to fall and firms are
forced to close down as enough profits are not being made.
● Tax revenue of the government will fall as economic activity and income falls.
They might be forced to borrow money to finance public expenditure.
● Borrowers will lose during a deflation because now the value of the debt they owe
is higher than when they borrowed the money.
● Deflation will increase the real debt burden of the government as the value of
debt money increases.
Policies to control deflation
● Expansionary monetary policy to revive demand: cutting interest rates will
encourage more spending and investment in the economy which will stimulate
prices to rise. However, if interest rate is already at a very low point where
decreasing it any further won’t increase spending, because people still prefer to save
some money and pay off debts, and banks are not willing to lend at a very low
interest rate, (this situation is called a liquidity trap), then cutting interest rates will
have no effect on spending.
● Expansionary fiscal policy to revive demand: increasing government spending in
the economy, especially in infrastructure will help raise demand, along with cuts in
direct taxes. The money for this expenditure can be created via quantitative easing
(selling government bonds to the public).
● Devaluation: devaluing the currency through selling domestic currency and/or
increasing the money supply will cause export prices to fall, encouraging production
of exports, resulting in higher demand; and also increase prices of imported
products which will raise costs and prices for products in the economy.
● Change inflation expectations: when a deflation is expected, businesses won’t
increase wages and consumers won’t pay higher prices (because they expect prices
to fall in the future). This will cause the deflation they expected. But if the monetary
authorities indicate that they expect higher inflation, firms will pay their workers
more and consumers will spend more now, avoiding a deflation.
THE END