Inflation & Deflation
Terminologies:
Inflation is a rise in the general level of prices of goods and services in an economy over a time period.
When the general price level rises, each unit of currency buys fewer goods and services. Therefore inflation
reduces the purchasing power of money hence increases absolute poverty.
Inflation is all about prices going up, but for healthy economy wages should be rising as well. If inflation is
rising at a quicker pace than the rise in wages, then inflation is problematic.
Creeping Inflation is a low and stable rate of inflation e.g. 2%. Seeing a low and steady rise in prices may
encourage firms to produce more.
Deflation is a fall in the general level of prices of goods and services in an economy over a time period. It is
the opposite of inflation also referred to as negative inflation.
Disinflation is the period of slow rate of inflation. The danger that disinflation presents is when the rate of
inflation falls near to zero.
Hyperinflation is unusual rapid inflation in very short span of time. In extreme cases this can lead to the
breakdown of a nation’s monetary system with complete loss of confidence in the domestic currency.
One of the earlier examples of hyperinflation occurred in Germany in early 1920s after the First World War, when prices
rose 2500 % in one month.
Stagflation is the combination of high unemployment with high inflation.
This happened in industrialized countries during 1970s, when a bad economy was combined with OPEC raising oil prices
led to low growth.
Inflation Rate Price Level
Positive
Lowest in first year and highest in last year
Negative
Lowest in first year and highest in last year
Constant
Lowest in first year and highest in last year
Zero No change in price level
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In which year price level is highest? 2015
In which year rate of inflation is highest? 1975
In which year price level is lowest? 1960
In which year rate of inflation is lowest? 2015
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How to calculate Rate of Inflation
Inflation is measured as a persistent increase in the general price level of goods and services over a certain
time period. CPI (Consumer Price Index) tracks the changes in the price of a large ‘consumer basket’ of the
products sold at retail outlets.
Current %change in P
Expenditure Base year Weighted Price Index
Category Weight (W) year price (P2-P1) / P1 x
$ price (P1) WPI = W x % change in P
(P2) 100
300/1000 =
Food 300 100 150 +50% 0.3 x 50% = +15%
0.3
200/1000 =
Clothing 200 100 200 +100% 0.2 x 100% = +20%
0.2
200/1000 =
Entertainment 200 100 130 +30% 0.2 x 30% = +6%
0.2
300/1000 =
Travel 300 100 50 -50% 0.3 x (-50%) = -15%
0.3
Total: $1000 1 +26%
Hence, the rate of inflation has increased by 26%.
Where ‘weight’ is the proportion of total expenditure spent on one category of product. It is calculated by:
Weight = Amount spent on a category / Consumers total expenditure
Then weighted price index (WPI) of each category is calculated.
All WPIs are added which gives us an answer of +26% where positive sign means rate of inflation has increased
by 26% than last year.
OR
Inflation is measured using a consumer price index (CPI)
The consumer price index is calculated in this way:
A selection of goods and services normally purchased by a typical family or household is identified.
The prices of these ‘basket of goods and services’ will then be monitored at a number of different
retail outlets across the country.
The average price of the basket in the first year or ‘base year’ is given a value of 100.
The average change in price of these goods and services over the year is calculated.
If it rises by an average of 25%, the new index is 125% * 100 = 125%. If in the next year there is a
further average increase of 10%, the price index is 110% * 125 = 137.5%. The average inflation rate
over the two years is thus 137.5 – 100 = 37.5%
Formula to calculate rate of inflation = New CPI – Old CPI x 100
Old CPI
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Causes of Inflation
Demand-pull Inflation: Inflation caused by an increase in aggregate demand (AD) 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 income taxes, lower interest rate,
rapid increase in population, higher net exports** etc. The aggregate demand curve will shift right,
causing an extension in aggregate supply and rise in price.
This is also called ‘Good Inflation’, as
higher AD higher national output lower
unemployment
**Explanation of higher net exports leading to demand-pull inflation: When a country’s currency is devalued (fall
in exchange rate), prices of exports fall and prices of imports rise. Demand for exports increases and demand for
imports falls. As a result shortage of goods may take place in the country leading to higher prices of goods.
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, high cost of capital goods etc. The supply curve will shift left
causing a contraction in demand and a rise in price.
This is also called ‘Bad Inflation’, as
lower AS lower national output lower
demand for labour higher unemployment
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Monetary Inflation: A sustained increase in the money supply of a country, likely to result in
inflation, when people have more money to spend on goods and services. A lot of economists agree
that a sustained rise in money supply in contrast with output is the key reason for inflation. If the
GDP isn’t accelerating as much as the money supply, then there will be a higher demand which could
exceed supply, leading to inflation.
Imported Inflation is a general and sustainable price increase due to an increase in costs of
imported products. Increase in the prices of imported fuels, raw materials, and components used by
domestic producers leads to increase in the domestic producers’ cost of production, and finally leads
to increase in the price of domestically produced goods. Imported inflation comes under cost-push
inflation. Thus Imported inflation leading to domestic inflation.
Consequences/Effects 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 due to domestic inflation the prices of exported
goods are high, its competitiveness in international markets will fall as lower priced foreign goods will
be more in demand. This could lead to a current account deficit. This could have more adverse effect if
exports demand is price elastic leading to greater fall in demand.
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 increase, the cost of production again increases,
causing cost-push inflation.
More Tax: Higher income tax rates on taxpayers. Government incurs high fiscal deficit due to
decreased value of tax collections.
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.
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Policies to Control Inflation
Contractionary Monetary policy will reduce aggregate demand. Contractionary monetary policy is
the most popular policy employed to reduce 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 total 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 required for monetary policy to take effect.
Contractionary Fiscal policy will reduce aggregate demand. Raising taxes will discourage spending
and investing and lower 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.
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Causes of Deflation
Aggregate Supply exceeding Aggregate Demand: When aggregate supply exceeds aggregate demand,
there is an excess of output in the economy not consumed, causing prices to fall.
Aggregate Demand has fallen in the economy: During a recession, a fall in total 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 incomes 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 consumer will spend more now, avoiding a deflation.
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Good Deflation vs. Bad Deflation
Types of Deflation
Deflation is often considered a highly unfavorable phenomenon. Although the idea of falling prices may seem
appealing (at least from a consumer perspective), deflation is mentioned among the worst things that can
happen to an economy.
There are different types of deflation: good deflation and bad deflation.
Good Deflation
Good deflation is generally caused by a rise in aggregate supply (outward/right shift of the total supply curve)
that leads to higher level of production sold at lower prices.
Effects:
This type of deflation can be due to technological progress. New technologies allow companies to
improve their production processes and reduce costs. As a result, the price level falls and money
becomes more valuable.
Also more production may require more labour lower unemployment.
Output increases at lower costs country may gain international competitiveness
Bad Deflation
Bad deflation is caused by a fall in aggregate demand (inward/left shift of the total demand curve) that leads
to lower level of consumption at lower prices. In other words, sellers have to reduce prices, because there is a
lack of demand and they cannot sell their goods at the original price anymore.
Effects: This is problematic in several ways:
When prices fall, people tend to postpone purchase decisions because they expect prices to fall even
more. That can lead to a vicious circle, since postponed purchases result in lower demand which in
turn drives prices further down.
The burden of debts increases, if you were to borrow money today, the amount you would have to pay
back in a year would be worth more. Lenders profit from this situation. However, since they usually
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only spend a portion of the additional income, the economy will experience an additional decrease in
overall spending.
As a result of the lower revenue, companies will have to reduce costs, they will have to let people go,
thus causing an increase in unemployment.
In a Nutshell
Deflation is widely considered a harmful phenomenon for the economy. However, we need to distinguish
between deflation caused by a fall in aggregate and deflation caused by a rise in aggregate supply. Bad
deflation causes a vicious circle, because people postpone purchase decisions, the burden of debt increases,
and unemployment rises due to sticky nominal wages. Good deflation on the other hand is mainly based on
technological progress and can actually be beneficial for both consumers and producers. In conclusion it can be
said that deflation may be bad, but it does not necessarily have to be.
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