What is Deflation? Inflation vs Deflation

Economy plays an important role in a country’s progress and development. Macroeconomics is the branch of economy that deals with the study of an entire system. Under macroeconomics, the entire nation or world is treated as the system, and a fiscal study is done on it. 

 

There exists two terms in macroeconomics, i.e., inflation and deflation. Both terms define the different processes and peaks in the economy. One benefits the consumers and other to the producers. 

 

In this blog we will learn how deflation affects the lives of consumers, whether it is good or bad for the economy as well as the difference between the two terms, inflation and deflation.

 

 

What is Deflation in Economics?

 

Deflation is defined as a decline in the economy. The general decline in prices for goods and services is defined as deflation. It is typically associated with a contraction in the supply of money and credit in the economy. Sometimes, the prices decline due to increased productivity and technological improvements. 

 

Duration of a deflation period varies from situation to situation. But during a deflation period, the purchasing power of currency rises over time. The price level, money supply, and the economy are deflating or inflating changes the appeal of different investment options.

 

(Take a look at our blog on - The federal reserve)

 

 

The Process of Deflation

 

Deflation has been an important and popular issue among economists for decades. Deflation is responsible for the decline in the nominal costs of labor, capital, goods and services. 

 

Sometimes, even at deflation time the relative prices remain unchanged. The deflation assists the consumers as it allows them to purchase more goods and services with the same income over the time. 

 

This declination is responsible for different consequences in various sectors. At the same time, deflation is harmful for the borrowers. It facilitates the financial market participants to invest or speculate on the prospect of rising prices.

 

 

Debt Deflation

 

The changes in consumer prices are observed in the nation's economy by comparing changes of a basket of diverse goods and products to an index. The index of analyzing inflation and deflation rates varies from country to country. 

 

In the US, the CPI, or consumer price index is the most preferred factor. Economic experience deflation occurs when the index in one period is lower than in the previous period. The deflation in the economy indicates the decline in the general price. 

 

The decrease in general price is a positive thing because it accesses the customer’s greater purchasing power. A low to moderate drop in certain products have positive and healthy effects. It increases the nominal consumer spending. 

 

Not only it supports the people to consume more, but also promotes economic growth and stability. The decline in general prices enhances the function of money as a store of value. Thus it also encourages real saving.

 

But, in certain conditions rapid deflation can cause a short term contraction of economic activity. Deflation occurs when heavily loaded with debt and dependent on the regular expansion of the supply of credit to inflate asset prices by financing tentative investment. 

 

When the volume of credit contracts, it asset the declination of prices and over-investments are liquidated. This process is known as debt deflation.

 

(Speaking of Credit, take a look at our blog on Credit Rating)

 

 

What are the causes of Deflation in the economy?

 

Monetary deflation is caused by a decrease in the supply of money. The other reason is the decline of financial instruments redeemable in money. Currently, the money supply is controlled by the central banks. 

 

Once the supply of money declines or falls, with altering the decrease in economic output, the prices of all goods tend to fall. Period of deflation occurs mostly after the long periods of artificial monetary expansion. 

 

The fall in money supply and catastrophic bank failures is one of the major reasons for the economic deflation around the 1930s in the United States. According to the Friedman rule or the monetary policy rule the central bank should seek a rate of deflation equal to the real interest rate on the government bonds.

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Causes of Deflation

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A number of factors can be responsible for the declination of the prices. The major reasons for the same are mentioned below:

 

1.     A decline in the total demand for goods and services or aggregate demand.

2.     By increase in productivity.

3.     When the output of the economy grows faster than the supply of circulating money and credit.

4.     When technology advances the productivity of an economy.

5.     High competition in the market is also responsible for deflation. Suppose two companies produce the same goods. Then obviously, one will reduce its prices to increase its annual targets.

 

 

How is technology responsible for the deflation in the economy?

 

Once technology is improved it focuses on the products and industries. Technological improvements assist the companies to operate more efficiently, thus it also leads to lower cost of production. Then cost savings are transferred to consumers in the form of lower prices. Overall, thus technological developments bring the general decrease in the prices.

 

 

Results of price deflation

 

Price deflation is indirectly responsible for high productivity. This high productivity causes different changes in different sectors. The major effects of price deflation are as follows:

 

1.     Reduction of government spending.

 

2.    Failure in stock marketing.

 

3.     Tightening monetary policies and rules.

 

4.     Higher interest rates.

 

5.     Consumer desire to increase savings.

 

6.     Reduction in business revenues.

 

7.     Deduction in per person pay and layoffs.

 

(Suggested blog - Difference between positive and normative economics)

 

 

What is the difference between Inflation and Deflation?

 

Inflation is a contradiction to deflation in the terms of its meaning, causes and process.  The list of differences between the two terms of macroeconomics is given below:

 

Inflation

 

In simple language, inflation is defined as an increase in general prices.

 

Causes

 

1. Excess Money: If the excess of money or currencies are there then this is the major cause of inflation. When the supply of money in the country grows above the economic growth then the value of the currency decreases. 

 

2. Demand Pull: If the demand of the goods increases then the supplier may increase the prices of goods and services.

 

3. Cost push: If the cost of production increases for any company then they can automatically increase the prices of the goods and services. 

 

Effects

 

1. In the case of a person who is getting his wages, if the percentage which is raised is less than the rate of inflation then it does not effectively rise in true sense because it doesn't maintain the purchasing power of your money.

 

2. If the inflation is higher in a country than its trading partner countries, then the cost of the goods and services are higher for that country than the imported goods.

 

Safeguarding

 

One should park their money into long term investment if he/ she wants to protect themselves from inflation. In long term investments the rate of return is higher than the average inflation rate. The average return on the Saving account is less than the average rate of inflation. 

 

(Speaking of investment, take a look at what are investment funds)

 

 

Deflation

 

In simple language, deflation is defined as a decrease in general prices.

 

Causes

 

1. Efficient Production: The various types of technological innovation are there which make the production more efficient, and it leads to decrease in the prices of goods.

 

2. Decrease in supply of currency: if the supply of currency decreases then the prices of goods and services also decrease.

 

Effects

 

1. If the customers postpone their consumption and purchasing of the goods and services then it will affect both the micro and the Macroeconomics factors.

 

2. Due to this the investment get suspended and leads to increase in unemployment rate, recession and depression. 

 

Safeguarding

 

Deflation doesn't last long, but it can affect the economy of a country. The government takes corrective measures very quickly.

 

 

A way forward

 

Both inflation and deflation are essential for studying the branch of macroeconomics. These two phenomena are used all over the world. 

 

Traditional economists used to consider deflation as a bad symbol in economics, but the modern economists have challenged the old interpretation of deflation and are studying more relevant proof considering the usefulness of deflation.