Introduction
Inflation and deflation are two of the most widely discussed economic concepts, but do you know what causes them? In this blog post, we’ll explore the direct and indirect causes of inflation and deflation in a community. Inflation is a sustained increase in the overall price level of goods and services in an economy over time, while deflation is a sustained decrease in the overall price level of goods and services in an economy over time. We’ll look at both the macro-economic factors, such as government policies and economic cycles, as well as the micro-economic factors, such as supply and demand.
Inflation
Inflation is a rise in prices, which can be translated as the decline of purchasing power over time. The rate at which purchasing power drops can be reflected in the average price increase of a basket of selected goods and services over some period of time. The rise in prices, which is often expressed as a percentage, means that a unit of currency effectively buys less than it did in prior periods. Inflation can be contrasted with deflation, which occurs when prices decline and purchasing power increases.
Understanding Inflation
While it is easy to measure the price changes of individual products over time, human needs extend beyond just one or two products. Individuals need a big and diversified set of products as well as a host of services for living a comfortable life. They include commodities like food grains, metal, fuel, utilities like electricity and transportation, and services like health care, entertainment, and labor.
Inflation aims to measure the overall impact of price changes for a diversified set of products and services. It allows for a single value representation of the increase in the price level of goods and services in an economy over a period of time.
Prices rise, which means that one unit of money buys fewer goods and services. This loss of purchasing power impacts the cost of living for the common public which ultimately leads to a deceleration in economic growth. The consensus view among economists is that sustained inflation occurs when a nation’s money supply growth outpaces economic growth.
To combat this, the monetary authority (in most cases, the central bank) takes the necessary steps to manage the money supply and credit to keep inflation within permissible limits and keep the economy running smoothly.
Theoretically, monetarism is a popular theory that explains the relation between inflation and the money supply of an economy. For example, following the Spanish conquest of the Aztec and Inca empires, massive amounts of gold and especially silver flowed into the Spanish and other European economies.2 Since the money supply rapidly increased, the value of money fell, contributing to rapidly rising prices.
Inflation is measured in a variety of ways depending upon the types of goods and services. It is the opposite of deflation, which indicates a general decline in prices when the inflation rate falls below 0%. Keep in mind that deflation shouldn’t be confused with disinflation, which is a related term referring to a slowing down in the (positive) rate of inflation.
What Are the Three Main Types of Inflation?
There are three primary types of inflation:
- Demand-pull inflation
- Cost-push inflation
- Built-in inflation
Right now, the country is dealing with all three major types of inflation, which is rare, according to Christopher Blake, assistant professor of economics at Oxford College of Emory University. “The story is complicated in a way that it hasn’t been in 40-plus years, given that we usually only see one form of inflation or the other,” he says.
Demand-Pull Inflation
Demand-pull inflation describes how demand for goods and services can drive up their prices. If something is in short supply, you can generally get people to pay more for it.
Are you still paying for plane tickets for a vacation despite prices being considerably higher than normal? That’s a good example of demand-pull inflation.
The U.S. is experiencing demand-pull inflation due to wages rising and Americans having a decent amount of money in their savings accounts, Blake explains, although some consumers are starting to empty those accounts.
“Consumer spending has remained high, despite the rising prices we currently see,” Blake says. “This is commonly referred to as demand-pull inflation, as consumer demand pulls prices higher because firms cannot keep up.”
Cost-Push Inflation
Cost-push inflation often kicks in when demand-pull inflation is going strong. When raw materials costs increase for businesses, the businesses in turn must raise their prices, regardless of demand.
“Increases to the prices that producers face put businesses in a tough spot,” Blake says. “They can either accept higher costs and keep their prices the same, or they can respond by trying to keep their profit margins the same.”
When the price of chicken keeps going up, for example, eventually your favorite restaurant will need to charge more for a chicken sandwich.
Built-in Inflation
As demand-pull inflation and cost-push inflation occur, employees may start asking employers for a raise. If employers don’t keep their wages competitive, they could end up with a labor shortage.
If a business raises workers’ wages or salaries and tries to maintain profit margins by raising prices, that’s built-in inflation.
Now, if you learn about your favorite coffeehouse raising prices due to the climbing cost of coffee beans, you’re a victim of cost-push inflation.
And if you’re going to buy that coffee even though the price is uncomfortably high, you’re engaging in demand-pull inflation.
Causes of Inflation
An increase in the supply of money is the root of inflation, though this can play out through different mechanisms in the economy. A country’s money supply can be increased by the monetary authorities by:
- Printing and giving away more money to citizens
- Legally devaluing (reducing the value of) the legal tender currency
- Loaning new money into existence as reserve account credits through the banking system by purchasing government bonds from banks on the secondary market (the most common method)
In all of these cases, the money ends up losing its purchasing power. The mechanisms of how this drives inflation can be classified into three types: demand-pull inflation, cost-push inflation, and built-in inflation.
Controlling Inflation
A country’s financial regulator shoulders the important responsibility of keeping inflation in check. It is done by implementing measures through monetary policy, which refers to the actions of a central bank or other committees that determine the size and rate of growth of the money supply.
In the U.S., the Fed’s monetary policy goals include moderate long-term interest rates, price stability, and maximum employment. Each of these goals is intended to promote a stable financial environment. The Federal Reserve clearly communicates long-term inflation goals in order to keep a steady long-term rate of inflation, which is thought to be beneficial to the economy.
Price stability—or a relatively constant level of inflation—allows businesses to plan for the future since they know what to expect. The Fed believes that this will promote maximum employment, which is determined by non-monetary factors that fluctuate over time and are therefore subject to change. For this reason, the Fed doesn’t set a specific goal for maximum employment, and it is largely determined by employers’ assessments. Maximum employment does not mean zero unemployment, as at any given time there is a certain level of volatility as people vacate and start new jobs.
Monetary authorities also take exceptional measures in extreme conditions of the economy. For instance, following the 2008 financial crisis, the U.S. Fed has kept the interest rates near zero and pursued a bond-buying program called quantitative easing (QE). Some critics of the program alleged it would cause a spike in inflation in the U.S. dollar, but inflation peaked in 2007 and declined steadily over the next eight years. There are many complex reasons why QE didn’t lead to inflation or hyperinflation, though the simplest explanation is that the recession itself was a very prominent deflationary environment, and quantitative easing supported its effects.
Consequently, the U.S. policymakers have attempted to keep inflation steady at around 2% per year. The European Central Bank (ECB) has also pursued aggressive quantitative easing to counter deflation in the eurozone, and some places have experienced negative interest rates. That’s due to fears that deflation could take hold in the eurozone and lead to economic stagnation.
Moreover, countries that are experiencing higher rates of growth can absorb higher rates of inflation. India’s target is around 4% (with an upper tolerance of 6% and a lower tolerance of 2%), while Brazil aims for 3.5% (with an upper tolerance of 5% and a lower tolerance of 2%)
Deflation
Deflation is a general decline in prices for goods and services, typically associated with a contraction in the supply of money and credit in the economy. During deflation, the purchasing power of currency rises over time.
Understanding Deflation
Deflation causes the nominal costs of capital, labor, goods, and services to fall, though their relative prices may be unchanged. Deflation has been a popular concern among economists for decades. On its face, deflation benefits consumers because they can purchase more goods and services with the same nominal income over time.
However, not everyone wins from lower prices and economists are often concerned about the consequences of falling prices on various sectors of the economy, especially in financial matters. In particular, deflation can harm borrowers, who can be bound to pay their debts in money that is worth more than the money they borrowed, as well as any financial market participants who invest or speculate on the prospect of rising prices.
Types of Deflation
There are two types of deflation. There is bad deflation, which is when aggregate demand for a good falls faster than aggregate supply. Then there is good deflation. Deflation is considered “good” when aggregate supply grows faster than aggregate demand.
Bad Deflation
It is easy to associate a decrease in the general price level with a general benefit to society. Who does not want prices to fall so that they can catch a break? Well, it does not sound so nice when we have to include wages in the general price level. Wages are the price of labor so if prices fall, so do wages.
Bad deflation occurs when aggregate demand, or the total quantity of goods and services demanded in an economy, falls faster than aggregate supply. This means that people’s demand for goods and services has fallen and businesses are bringing in less money so they must lower or “deflate” their prices. This is related to a reduction of the money supply which reduces income for businesses and employees who then have less to spend. Now we have a perpetual cycle of downward pressure on prices. Another issue with bad deflation is the resulting unsold inventory that firms produced before they realized that demand was falling and for which they now have to find a place to store or on which they have to accept a major loss. This effect of deflation is the more common one and has the greater impact on the economy.
Good Deflation
So now how can deflation still be good? Deflation can be beneficial in moderation and when it is the result of lower prices due to an increase in aggregate supply rather than a decrease in aggregate demand. If aggregate supply increases and there are more goods available without a change in demand, prices will fall. Aggregate supply might increase due to a technological advancement that makes production or materials cheaper or if production becomes more efficient so more can be manufactured. This makes the real cost of the goods cheaper resulting in deflation but it does not cause a shortage in the money supply since people are still spending the same amount of money. This level of deflation is typically small and balanced out by some of the Federal Reserve’s (The Fed’s) inflation policies.
What are some causes and control of deflation? What causes it and how can it be kept in check? Well, there are several options. Let’s start with the causes of deflation
Causes of Deflation
By definition, monetary deflation can only be caused by a decrease in the supply of money or financial instruments redeemable in money. In modern times, the money supply is most influenced by central banks, such as the Federal Reserve. When the supply of money and credit falls, without a corresponding decrease in economic output, then the prices of all goods tend to fall. Periods of deflation most commonly occur after long periods of artificial monetary expansion. The early 1930s was the last time significant deflation was experienced in the United States. The major contributor to this deflationary period was the fall in the money supply following catastrophic bank failures.
Other nations, such as Japan in the 1990s, have experienced deflation in modern times.
World-renowned economist Milton Friedman argued that under optimal policy, in which the central bank seeks a rate of deflation equal to the real interest rate on government bonds, the nominal rate should be zero, and the price level should fall steadily at the real rate of interest. His theory birthed the Friedman rule, a monetary policy rule.
However, declining prices can be caused by a number of other factors: a decline in aggregate demand (a decrease in the total demand for goods and services) and increased productivity. A decline in aggregate demand typically results in subsequent lower prices. Causes of this shift include reduced government spending, stock market failure, consumer desire to increase savings, and tightening monetary policies (higher interest rates).
Falling prices can also happen naturally when the output of the economy grows faster than the supply of circulating money and credit. This occurs especially when technology advances the productivity of an economy, and is often concentrated in goods and industries which benefit from technological improvements. Companies operate more efficiently as technology advances. These operational improvements lead to lower production costs and cost savings transferred to consumers in the form of lower prices. This is distinct from but similar to general price deflation, which is a general decrease in the price level and increase in the purchasing power of money.
Price deflation through increased productivity is different in specific industries. For example, consider how increased productivity affects the technology sector. In the last few decades, improvements in technology have resulted in significant reductions in the average cost per gigabyte of data. In 1980, the average cost of one gigabyte of data was $437,500; by 2014, the average cost was three cents.3 This reduction caused the prices of manufactured products that use this technology to also fall significantly.
Control of Deflation
- Reduction in Taxation: The government should reduce the amount and burden of various taxes levied on commodities. This will increase the purchasing power of the people. As a result, the demand for goods and services will increase. Moreover, sufficient tax relief should be given to businessmen to encourage investment.
- Redistribution of Income: Marginal propensity to consume can be raised by a redistribution of income and wealth from the rich to the poor. Since the marginal propensity to consume of the poor is high and that of the rich is low, such a measure will help in increasing the aggregate demand in the economy.
- Deficit Financing: In order to have significant expansionary effects, the government’s public works schemes should be financed by the method of deficit financing. The government should adopt a budgetary deficit (excess of government expenditure over its revenue) and cover this deficit through deficit financing. Deficit financing makes sufficient resources for developmental programmes available to the government without adversely affecting investment in the private sector.
- Reduction in Interest Rate: By adopting a cheap money policy, the monetary authority of a country reduces the interest rate which stimulates investment and thereby, expands economic activity.
- Foreign Trade Policy: To control deflation, the government should adopt such a foreign trade policy that, on one hand, increases exports and, on the other hand, reduces imports. This kind of policy will go a long way in solving the problem of overproduction and help in overcoming deflation.
