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Imagine walking into a store today and finding that your favourite chocolate bar now costs 10% more than it did last year. That’s inflation for you. Now, imagine returning to the same store a year later to find that the same chocolate bar now costs 10% less. That’s deflation.
These aren’t just random numbers. The average inflation rate globally is projected at 5.8% for 2024, while periods of deflation are rarer but can have devastating effects, like during the Great Depression when prices fell by over 10%.
So what is the difference between inflation and deflation, let’s find out!
Understanding inflation
A general increase in consumer prices over an extended period of time is known as inflation. It is commonly represented as a percentage, indicating that the purchasing power of a unit of currency has decreased compared to previous periods.
Causes
Demand-pull inflation: The supply of goods and services is insufficient to meet the demand, leading to price increases.
Cost-push inflation: This kind of inflation occurs when the costs of production, like wages or raw material costs, go up and get transferred to consumers through higher prices.
Increased money supply: If the money supply expands at a rate exceeding the economy’s capacity to generate goods and services, it may result in inflation.
External factors: Factors such as an increase in global market prices or adjustments in tax policies can also lead to inflation.
To illustrate, back in 2002, the price of milk stood at ₹15 per litre. However, fast forward to 2023, and the average retail price of milk in India has surged to ₹57.15 per litre.
Understanding deflation
Deflation refers to a widespread decrease in prices for goods and services, resulting in increased purchasing power over time. Although this may appear to be the perfect scenario for any economy, the underlying reality is less hopeful.
Causes
Fall in aggregate demand: When the overall demand for goods and services decreases, it can result in a drop in prices, which in turn leads to deflation.
Increase in aggregate supply: When production costs decrease, companies can produce more goods without raising prices. This increase in supply can lead to excess supply over demand, intensifying competition and potentially reducing prices.
Tight monetary policy: Central banks may opt for a more stringent monetary policy, such as raising interest rates, which could result in a decrease in the money supply and consequently trigger deflation.
Decline in confidence: In a recession, negative events can cause a drop in aggregate demand as people, fearing economic instability, save more and spend less.
Differences
Inflation vs deflation
Inflation and deflation are two sides of the same economic coin, reflecting the fluctuations in the general price level of goods and services. Inflation, which is typically accompanied by increased prices and diminished purchasing power, is frequently indicative of a flourishing economy.
However, deflation, characterised by declining prices and a boost in purchasing power, may indicate an economy in a downturn. Although both can have positive impacts, such as stimulating spending or boosting the value of money, they can also result in negative consequences like decreased economic activity or higher real debt value.
Inflation vs deflation vs disinflation
In a disinflationary economy, price increases continue but at a more moderate rate.
A well-managed economy, striking a balance between growth and stability, might be characterised by disinflation, in contrast to the common perceptions of inflation as a sign of economic expansion and deflation as a sign of economic contraction.
Inflation vs deflation vs stagflation
Inflation represents a general increase in prices, deflation signifies a decrease, while stagflation combines high inflation with slow economic growth and high unemployment, presenting unique challenges for policymakers.
While inflation and deflation are more common, stagflation is rare and often arises from complex economic factors, making it particularly difficult to address effectively.
The balance between inflation and deflation
Central banks manage inflation and deflation by adjusting monetary policies, such as interest rates and open market operations, to control money supply and influence borrowing and lending costs.
One of the measures used by central banks to understand inflation in the economy is the GDP deflator.
When comparing GDP deflator vs. inflation, GDP deflator is a more thorough measure of inflation since it takes into account the prices of all new, domestically produced, final products and services in an economy.
In order to determine the GDP deflator, the formula is
GDP deflator=Nominal GDPReal GDP100
It differs from other inflation measures like the Consumer Price Index (CPI).
An indicator of general price increases for products and services purchased by consumers is the Consumer Price Index (CPI). It’s used as a key indicator to assess inflation and guide economic policy.
Bottomline
Inflation and deflation are fundamental economic phenomena with contrasting effects on prices and purchasing power. While inflation signifies a general increase in prices, deflation indicates a decline, with both carrying significant implications for economic health and stability.
Thus, by understanding these forces, you can better prepare for the currents of economic change and steer towards a prosperous future!
FAQs
Inflation and depression are two distinct economic phenomena. Inflation is characterised by a sustained increase in the general price level of goods and services, leading to a decrease in the purchasing power of money. On the other hand, depression is a severe and prolonged downturn in economic activity, often characterised by a significant fall in GDP, high unemployment, and deflation.
Deflation, a decrease in the general price level of goods and services, can initially seem beneficial as it increases the purchasing power of money. However, sustained deflation can signal economic weakness. It may lead to reduced consumer spending, as people anticipate further price drops, and can result in higher unemployment and increased real value of debt. Thus, while deflation has some advantages, it can also have significant economic drawbacks.
The Japanese yen’s weakness can be attributed to several factors. Primarily, it’s due to the wide gap in interest rates between Japan and the US. Even after a historic rate hike, Japan’s policy rate remains the lowest in the developed world. This makes investments in the US, and therefore the dollar, more attractive. Additionally, Japan’s economic stagnation and high national debt also contribute to the yen’s weakness.
The Phillips Curve is an economic concept that illustrates a historical inverse relationship between rates of unemployment and corresponding rates of inflation within an economy. It suggests that with economic growth comes inflation, which should lead to more jobs and less unemployment. However, this theory was challenged during the 1970s stagflation period, when high levels of both inflation and unemployment were observed.
The Keynesian theory, developed by British economist John Maynard Keynes during the 1930s, is a macroeconomic theory that emphasises the importance of total spending in the economy. It advocates for increased government expenditures and lower taxes to stimulate demand and pull the global economy out of economic downturns. The theory also asserts that government intervention can stabilise the economy.