Deflation Vs Inflation: What You Need to Know

Inflation and Deflation are defined as the the rise and fall of prices for good and services. When prices rise this is called inflation, when prices fall this is called deflation (See: What is Deflation? for more detail). Together they form a delicate balance that is known as economic condition. Here is a quick run down of deflation vs inflation concepts.

Inflation

Inflation stems from low availability of any good or service that is in high demand. This demand increases the value of the product and in doing so decreases money’s buying power. When gold prices rise the value of money falls in the economy this is inflation. This drop in value will result in the average person needing to spend more on purchases.

The poor are impacted by inflation more than the rich. As inflation rises the poor have less and less spending power. This directly impacts productivity as everything cost more personal savings are punished by the drop in their net worth.

Inflation has various positive effects as well on an economy. One of these positive effects is the reduction of debt as spending power increases. Additionally these effects can help to keep interests rates above zero and reduce unemployment.

Deflation

When the value of a good or service is in low demand the price falls and more people can purchase the product. This increases money’s buying power. Deflation is a sign of the downward path of a country’s economy. As money and credit supplies begin to dwindle deflation occurs.

In a country whose economy is in decline prices of products also decline. This increases the purchasing power of a country’s money.

Individuals may be able to purchase more but this is still considered to be bad for the economy (why is deflation bad?). As producers see they are not making profits they will lessen production resulting in unemployment. If this trend continues long enough as slowed economy can slip into depression.

The Great Recession in 2008 started with bursting of the mortgage bubble and the credit suddenly drying out. As a result we saw widespread unemployment in the United States and there were real worries of a deflationary cycle emerging out of this. The Federal Reserve responded by increasing the money supply in the economy significantly (when there is more of anything, for example money, it is worth less, or in other words, inflationary) and cutting the interest rates to close to zero.

In today’s modern world most economists are of the opinion that deflation is a problem in the economy as it increases the value of real debt. As the spending power of money drops it becomes harder and harder to pay of an established debt with the lesser spending power of the existing currency. Inflation on the other hand is a necessary condition for the economy to progress. Deflation vs inflation discussion often centers around the idea that no one likes prices to increase, but every one wants the prices to go down. However, the other part of the economic coin is wages and production, and these are equally important for the economy.

Deflation vs Inflation: Is one Worse Than the Other ?

Of the two deflation is the worse due to the reality that interest rates can only be dropped to zero as a counter. People will spend less money when they do not feel wealthy thus deepening deflation. This directly affects prices and they will continue to drop further in a downward spiral.