Inflation and Deflation, Its effects and control

Inflation(Inflation and Deflation)

Inflation is the increase in the prices of goods and services over time. Inflation increases your cost of living.

Causes of Inflation(Inflation and Deflation)

1. The Money Supply(Inflation and Deflation)

Inflation is primarily caused by an increase in the money supply that improve faster than economic growth.

Ever since industrialized nations moved away from the gold standard during the past century, the value of money is determined by the amount of currency that is in circulation and the public’s perception of the value of that money. When the Federal Reserve decides to put more money into circulation at a rate higher than the economy’s growth rate, the value of money can fall because of the changing public perception of the value of the underlying currency. As a result, this devaluation will force prices to rise due to the fact that each unit of currency is now worth less.

2. The National Debt(Inflation and Deflation)

A rise in taxes will cause businesses to react by raising their prices to offset the increased corporate tax rate. Alternatively, should the government choose the latter option, printing more money will lead directly to an increase in the money supply, which will in turn lead to the devaluation of the currency and increased prices (as discussed above).

3. Demand-Pull Effect(Inflation and Deflation)

The demand-pull effect states that as wages increase within an economic system (often the case in a growing economy with low unemployment), people will have more money to spend on consumer goods. This increase in liquidity and demand for consumer goods results in an increase in demand for products. As a result of the increased demand, companies will raise prices to the level the consumer will bear in order to balance supply and demand.

4. Cost-Push Effect(Inflation and Deflation)

Another factor in driving up prices of consumer goods and services is explained by an economic theory known as the cost-push effect. Essentially, this theory states that when companies are faced with increased input costs like raw goods and materials or wages, they will preserve their profitability by passing this increased cost of production onto the consumer in the form of higher prices.

A simple example would be an increase in milk prices, which would undoubtedly drive up the price of a cappuccino at your local Starbucks since each cup of coffee is now more expensive for Starbucks to make.

5. Exchange Rates(Inflation and Deflation)

Inflation can be made worse by our increasing exposure to foreign marketplaces. In America, we function on a basis of the value of the dollar. On a day-to-day basis, we as consumers may not care what the exchange rates between our foreign trade partners are, but in an increasingly global economy, exchange rates are one of the most important factors in determining our rate of inflation.

Control of inflation(Inflation and Deflation)

Inflation is generally controlled by the Central Bank and/or the government. The main policy tools to control inflation include:

Monetary policy – Setting interest rates. Higher interest rates reduce demand, leading to lower economic growth and lower inflation

Control of money supply – Monetarists argue there is a close link between the money supply and inflation, therefore controlling money supply can control inflation.

Supply-side policies – policies to increase competitiveness and efficiency of the economy, putting downward pressure on long-term costs.

Fiscal policy – a higher rate of income tax could reduce spending and inflationary pressures.Wage controls. Trying to control wages could, in theory, help to reduce inflationary pressures. However, apart from the 1970s, rarely used.

Why Deflation Is Worse than Inflation?(Inflation and Deflation)

The opposite of deflation is inflation. Inflation is when prices rise over time. Both economic responses are very difficult to combat once entrenched because people’s expectations worsen price trends. When prices rise during inflation, they create an asset bubble. This bubble can be burst by central banks raising interest rates.

Former Fed Chairman Paul Volcker proved this in the 1980s. He fought double-digit inflation by raising the fed funds rate to 20 percent. He kept it there even though it caused a recession. He had to take this drastic action to convince everyone that inflation could actually be tamed. Thanks to Volcker, central bankers now know the most important tool in combating inflation or deflation is controlling people’s expectations of price changes.

Deflation is worse than inflation because interest rates can only be lowered to zero. After that, central banks must use other tools. But as long as businesses and people feel less wealthy, they spend less, reducing demand further. They don’t care if interest rates are zero because they aren’t borrowing anyway. There’s too much liquidity, but it does no good. It’s like pushing a string. That deadly situation is called a liquidity trap and is a vicious, downward spiral.

The Rare Times When Deflation Is Good(Inflation and Deflation)

A massive, widespread drop in prices is always bad for the economy. But deflation in certain asset classes can be good. For example, there has been ongoing deflation in consumer goods, especially computers and electronic equipment.

This isn’t because of lower demand, but from innovation. In the case of consumer goods, production has moved to China, where wages are lower. This is an innovation in manufacturing, which results in lower prices for many consumer goods. In the case of computers, manufacturers find ways to make the components smaller and more powerful for the same price. This is technological innovation. It keeps computer manufacturers competitive.

Deflation(Inflation and Deflation)

Deflation is generally the decline in the prices for goods and services that occur when the rate of inflation falls below 0%. Deflation will take place naturally, if and when the money supply of an economy is limited.
Deflation in an economy indicates deteriorating conditions. Deflation is normally linked with significant unemployment and low productivity levels of good and services. The term “Deflation” is often mistaken with “disinflation.” While deflation refers to a decrease in the prices of goods and services in an economy, disinflation is when inflation increases at a slower rate.

Deflation can be caused by multiple factors:(Inflation and Deflation)

1. Structural changes in capital markets(Inflation and Deflation)

When different companies selling similar goods or services compete, there is a tendency to lower prices to have an edge over the competition.

2. Increased productivity(Inflation and Deflation)

Innovation and technology enable increased production efficiency which leads to lower prices of goods and services. Some innovations affect the productivity of certain industries and impact the entire economy.

3. Decrease in supply of currency(Inflation and Deflation)

The decrease in the supply of currency will decrease the prices of goods and services to make it affordable to people.

Effects of Deflation(Inflation and Deflation)

Deflation may have the following impacts on an economy:

1. Reduction in Business Revenues(Inflation and Deflation)

In an economy faced with deflation, businesses must drastically reduce the prices of their products or services to stay profitable. As reducing in prices take place, revenues begin to drop.

2. Lowered Wages and Layoffs(Inflation and Deflation)

When revenues begin to drop, businesses need to find means to reduce their expenses to meet objectives. One way is by reducing wages and cutting jobs. This adversely affects the economy as consumers would now have less to spend.

Control of Deflation (Inflation and Deflation)

Deflation can be controlled by adopting monetary and fiscal measures in just the opposite manner to control inflation.

1.Monetary Policy:(Inflation and Deflation)

To control deflation, the central bank can increase the reserves of commercial banks through a cheap money policy. They can do so by buying securities and reducing the interest rate. As a result, their ability to extend credit facilities to borrowers increases. But the experience of the Great Depression tells us that in a serious depression when there is pessimism among businessmen, the success of such a policy is practically nil.

In such a situation, banks are helpless in bringing about a revival. Since business activity is almost at a standstill, businessmen do not have any inclination to borrow to build up inventories even when the rate of interest is very low. Rather, they want to reduce their inventories by repaying loans already drawn from the banks.

2. Fiscal Policy:(Inflation and Deflation)

Fiscal policy through increase in public expenditure and reduction in taxes tends to raise national income, employment, output, and prices. An increase in public expenditure during deflation increases the aggregate demand for goods and services and leads to a large increase in income via the multiplier process,while a reduction in taxes has the effect of raising disposable income thereby increasing consumption and investment expenditures of the people.

The government should increase its expenditure through deficit budgeting and reduction in taxes. The public expenditure includes expenditure on such public works as roads, canals, dams, parks, schools, hospitals and other buildings, etc. and on such relief measures as unemployment insurance, pensions, etc.

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