Inflation and Deflation the Concepts

Inflation and Deflation

The concepts of inflation and deflation are fairly straightforward to understand. There are many underlying causes of changes to aggregate supply and demand that may lead to either inflation or deflation. Unacceptable levels of inflation or deflation have serious consequences that may completely disrupt economic stability. However, the Federal Reserve and the Government are armed with a variety of monetary and fiscal policies to keep the potential situation under control. For the most part, these available mechanisms typically meet their objectives. Nevertheless, monetary and fiscal polices aren't entirely foolproof as this paper will reveal. The result ranges from depressions, to mild or sharp recessions.

Inflation is defined as a sustained increase in the general level of prices for goods and services. It is measured as an annual percentage increase. As inflation rises, every dollar owned buys a smaller percentage of a good or service. Deflation, the opposite of inflation, is when the general level of prices is falling. Figure 1 shows how continual increases in aggregate demand and continual increases in aggregate supply of the same magnitude decrease the price level without changing real GDP, resulting in deflation. Figure 2, on the other hand, illustrates how increases in aggregate demand that exceed increases in short run aggregate supply and long run aggregate supply increase the price level and real GDP, resulting in inflation.

Figure 1: Deflation

Figure 2: Inflation

There are three causes of inflation, demand-pull inflation, cost-push inflation and built-in inflation. Demand-pull inflation is characterized by an increase in aggregate demand and economic expansion. Demand-pull inflation usually occurs during times of economic growth when too much money is chasing too few goods. This typically happens because the supply of money is increasing more rapidly than the demand for money. Cost-push inflation happens when costs such as wages, taxes or the costs of imports increase and companies respond by increasing prices to maintain their profit margins. Cost-push inflation involves a decrease in the short-run aggregation supply and economic contraction. Built-in inflation is attributable to a continuous price/wage spiral where workers seek higher wages to keep up with prices and then employers pass their higher costs back to consumers and the process continues.

Deflation may be caused by a number of monetary-related factors such as a reduction in the supply of money or credit or a decrease in government, personal or investment spending. In the short-term, shocks to either aggregate supply or aggregate demand can also result in deflation. For example, a positive shock to supply such as an increase in labor productivity may lower prices.

This happens because nominal wages are slow to adjust to unexpected changes in productivity. With productivity rising faster than wages, firms are able to reduce their product prices. A negative shock to aggregate demand such a decline in consumer confidence can reduce aggregate spending and, thus, spark deflation. Resulting higher unemployment and lower capacity utilization will then cause inflation to decrease gradually over time, until the economy returns to full employment.

Both inflation and deflation are troublesome for maintaining economic stability. Inflation reduces the purchasing power of the cash balances held by the private sector. This is often referred to as an "inflation tax" and serves as a drag on the economy because it induces people and businesses to hold lower cash balances, making it more difficult to participate in the money economy. Increasing uncertainty may discourage investment and saving. Inflation redistribues income from those on fixed incomes to those who draw varibale income and from those who lend a fixed amount of money to those who borrow. When domestic inflation is higher than that aborad, a fixed exchange rate will be undermined through a weakening balance of trade. And, hyperflation can grossly interfere with the economy, hurting its ability to supply goods and services in the market.

Deflation can cause even more severe negative consequences than inflation. The real value of nominal debt rises during deflationary periods, which can lead to bankruptcies for those in debt and a fall in asset prices. The negative impact on a banks balance sheet of these events may lead to insolvency and financial instability. Because deflation means an increase in real wages, unemployment may rise. Then, a vicious cycle ensues. As unemployment increases, aggregate demand falls even further leading to more increases in deflation, a further increase in the real interest rate. This deflationary spiral is difficult to stop.

The government uses monetary and fiscal policies to combat inflation and deflation. On the monetary policy side, the Federal can affect the growth of the money supply by engaging in open market operations, the buying and selling of government securities. When the Fed buys securities, it injects money into the system to fight deflation; conversely, when it sells securities, it pulls money out to fight inflation. The Federal Reserve can also affect the ability of banks to create money. Banks take in deposits, from which they make loans. Banks are required to keep a fraction of deposits as reserves. The Federal Reserve can alter the reserve ratio, or it can alter the rate of interest that it charges itself to lend money to banks. To counter inflation, the Federal Reserve would increase the reserve ration and the rate of interest and to counter deflation it would do exactly the opposite Government fiscal policy uses either taxation or government spending to control inflation or deflation. For example, the government could either increase taxes or reduce spending during inflationary times and cut taxes or increase spending during deflationary periods.

The Federal Reserve may encounter many challenges when implementing policies to control inflation or deflation. When dealing with inflation there is frequently a lag or gap between recognizing the need to ease inflation and the easing actually taking affect in the economy. Thus, there is the potential to overshoot desired targets and possibly trigger a recession or at least a decline in economic growth. Further, long-term rates are heavily influenced by foreign capital inflows which may keep long-term credit conditions looser than the Federal Reserve desires. Energy-price shocks challenge monetary policymakers because there may have to be a trade off between economic growth and price stability when setting interest rates..