Inflation and deflation: the issue of 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.

4. AD, SRAS, LRAS

In order to better understand the inflation and deflation phenomena, one must prove a wide comprehension of the concepts of supply and demand. "Just like with every other commodity, there is a supply of and a demand for "Money." There are three vital notions that help define the concepts of inflation and deflation: aggregate demand, short run aggregate supply and long run aggregate supply.

The aggregate demand represents the total amount of products and services requested by the consuming public in an economy, during a certain period of time. Generally called AD, the aggregate demand depends directly on the total amount of public consumption, investments, governmental funding and net exports.

The aggregate supply, or AS, stands for the overall amount of products and services which the national economy of a country makes available for its large public during a certain period of time. The AS divides itself into two subcategories based on the time period they apply to, namely short run aggregate supply (SRAS) and long run aggregate supply (LRAS).

Any event that changes the aggregate supply and demand will definitely affect the entire economy of the country and is prone to create inflation or deflation shocks. For instance, an inflation shock could be caused by an increase of the AD due to cost decrease, increase of wages or increase of the money supply on the market. This leads to a growth in the quantity of goods and services produced and a retail prices increase.

0Y axis - Gross Domestic Product

0P axis - Price Level

Source: Lipsey, Richard G., Chrystal, Alec K., Positive Economy, Chapter 10: Inflation, page 827, Published by Weidenfeld & Nicolson in September 1989

The overall effects of an inflation shock depend on whether or not the increasing AD was supported by an uncontrolled increase of the money supply. An AD shock moves the SRAS curve to the left from SRAS0 to SRAS1. Short-term balance is reached at E1. If the monetary system is being controlled, the unemployment rate generates price reduction and production growth, pushing the equilibrium point back towards E0. If the monetary system continues to run uncontrolled, the AD curve moves from AD0 to AD1, meaning that equilibrium is reached at E2, with minimal unemployment but higher prices, P2.