Causes and effects of inflation and deflation on price stability

Inflation & Deflation: The Issue of Price Stability

Inflation and Deflation: The Issue of Price Stability

The general and global economic environment, contemporarily called macroeconomics, is currently faced with two major threats: inflation and unemployment. The concept of inflation denotes a complex socio-economic phenomenon with major impacts upon all participants in the social and economic life. Due to the immense complexity of inflation, specialists in macroeconomics argue with regard to a set definition of the phenomenon. However, inflation could be described as a general and long-term imbalance materialized in a discrepancy between the money stock and the overall volume of the products and services on the market. In other words, inflation involves an unequal growth of product and service prices, which combined with monetary devaluation, results in a decrease of the purchasing power.

Deflation, on the other hand, is the opposite process of inflation. It represents "a decrease in the general price level, over a period of time. The term is also used to refer to a decrease in the size of the money supply. During deflation periods, the demand for liquidity goes up, in preference to goods or interest [...] and the purchasing power of money increases."

Therefore, price stability, generalized to economic stability, is directly linked, and sometimes even confounded with inflation and deflation. In the case of inflation, prices go up and the purchasing power goes down, whereas in the case of deflation, the prices go down and the purchasing power goes up.

Both these phenomena can bring about long-term negative effects upon the social and economical environment. In order to prevent the noxious outcomes of inflation and deflation, specialized economists need to thoroughly analyze the causes and potential effects of the two processes and implement policies to prevent the phenomena.

2. Causes for inflation and deflation

As a macroeconomic process, inflation is generated by multiple causes, the most relevant factors being of economic, social and monetary nature. Aside of these factors, inflation is also caused by external elements.

The economic factors that lead to inflation are mostly the economic conjuncture (which evaluates the overall evolution of a country's economy), commodities crisis and an increase in product and service prices.

The financial and monetary factors refer to uncontrolled increase in the quantity of the coins, discrepancy between the retail prices and the actual production costs of the products and services on the market, great debts of the state towards the public or private sector and difficulties in repaying these debts.

The external causes of inflation refer to fiduciary note issue, continuously expanding demands and characteristics of commercial credits, market structure and foreign exchange speculations.

From a monetary perspective deflation is caused by a reduction in the velocity of money and/or the amount of money supply per person. Within the market mechanism, capitalism is generally an engine of deflation: as capital stocks improve, and there are more competitors, the supply of goods goes up, which means prices must fall until they balance demand."

The Online Economic Forum posted on November 14, 2002 an article provided by the Hong Kong Monetary Authority in which the authors present six causes of deflation: dramatic decrease of immobile values; "excess capacity that resulted from the rapid advancement of information technology globally; decline in the price of imports; convergence of product and factor prices; weak economic condition and unwinding of the appreciation of the real effective exchange rate during the boom years"

3. Effects of inflation and deflation damaging economic stability

The two phenomena have great impact upon the production area of the economy, therefore affecting all economic and social agents.

In the case of inflation, the process leads to a severe imbalance in the monetary system. Also, inflation generates numerous "mutations" of the crediting procedures as the demand for credits drops significantly and money lenders refuse to have their money returned in depreciated currency.

Another area significantly disrupted by inflation is the production sector. Inflation generates and maintains numerous distortions in the production area. For example, investors no longer feel encouraged to invest in the production sector, but tend to withhold themselves and their financial resources from the areas affected by inflation and look for investment opportunities in safer regions.

Moreover, inflation blocks all functions of the banking system, decreases public revenues, decreases the country's capability to be a strong economic competitor on the international market and disrupts the macroeconomic information and communication system.

Deflation is publicly perceived as a positive phenomenon for economy and the population as it involves prices going down. However, an uncontrolled deflation can have disastrous effects upon the economic and social sectors. For example, deflation generates "in times of low inflation, companies can raise prices to maintain their profit margin without losing market share. In deflationary times, most companies cannot raise their prices without losing business. If they cannot raise prices, they have to cut their costs. Cutting costs also means cutting jobs and reducing salaries."

In other words, price decreases, low interest rates and low mortgage rates bring about crashing of the stock index, decreasing wages, massive job losses resulting in unemployment, all of these being able to generate economic crisis.

6. Policies of the Federal Reserve in preventing inflation and deflation

The Federal Reserve System is the "central banking system of the United States whose main attributions are to conduct the nations monetary policy, supervise and regulate banking institutions, maintain the economic stability and provide financial services to depository institutions."

In order to prevent the occurring of inflation and deflation in the country's economy, the Federal Reserve needs to insure a fair and relevant distribution of revenues, costs, credits, debts, interest rates and all other financial elements amongst economic and social agents.

The Federal Reserve should be able to control and measure the demand and supply on the market and correlate the two indexes. Also, and probably most importantly, the Reserve should constantly supervise and regulate the monetary system, assuring correspondence between the amount of money in coins and bills on the market and their coverage in gold and in the total quantity of goods and services produced.

The economic practice has concluded that a common and rather successful technique in diminishing the negative effects of inflation is to deliberately induce deflation and vice-versa.

However, applying these techniques into the economic and social system raises several difficulties for the Federal Reserve. These difficulties generally reside in economic and social factors. The economic factor is represented by the continuously changing and evolving production technologies, increasing demands, cost and revenues which are almost impossible to foresee or control. Moreover, the social factor of the Federal Reserve's difficulties implies the mistrust the large public has towards the organization. Along the years, the Reserve was severely criticized for the content and nature of their acts and decisions, and also for the fact that most of their decisions were taken behind closed doors, regardless of the public's opinion and in secrecy.