Karina meets up with her friends every Sunday at the same cafe, and she always orders the same thing: a small coffee and a glazed donut. She knows to bring $5 with her because a small coffee costs $2.50 and a donut is $2, which leaves a little left over for the tip jar.
However, one Sunday she walks in and sees that the same small coffee now costs $3 and the donut is $2.50. Karina’s $5 is no longer enough to cover her usual order.
The manager of the cafe explains that a recent rise in gas prices has caused their main supplier to start charging more for delivery, so they had no choice but to increase their prices to cover the cost. This is an example of how inflation happens in an economy.
Definition of Inflation and Deflation
Inflation is a general increase in prices and fall in the purchasing power of money. During periods of inflation, the amount of money required to buy goods and services increases, and the amount of goods and services that money can buy decreases. Inflation is represented as a percentage. It measures the rate at which the average price level of a set of goods and services increases over some period of time. Inflation can cause economic uncertainty, lower investment, and lead to a recession.
Deflation is a decrease in the general price level of goods and services. Consequences of deflation include an increased level of real debt, decreased profits, and a rise in cyclical unemployment. Deflation is indicated by an inflation rate that is below zero percent.
How it Works
There are three types of inflation. The most common is Demand-Pull inflation, when the overall demand for goods and services in an industry increases faster than the supply. For example, if a certain toy becomes extremely popular, the toy producer will increase the price in order to reduce the demand for the limited item.
The second type is Cost-Push inflation. This is when the cost of resources in the production line increases, causing a higher cost of the final product. An example of Cost-Push inflation is the increase in price of bread during the French Revolution. Before the revolution, the average French worker spent about half their wages on bread. However, during 1788 and 1789, grain crops failed, causing a decrease in grain supply and a spike in prices. The price of bread inflated to 88 percent of the average worker’s wage during these two years.
The third type, Built-In inflation, is when increasing costs of goods and services prompt workers to demand higher pay. Since wages are included in the cost of production, increased wages result in even higher costs of goods and services. This leads to a cycle of inflation.
In order to curb inflation, the central bank decreases the money supply by increasing interest rates. This encourages saving, reduces the amount of money in circulation, and halts the rate of inflation.
Deflation, meanwhile, occurs when there is a shortage of money in circulation, or the supply of goods is greater than the demand for those goods. The inflation rate falls below zero percent and the value of currency increases. The Great Depression of the 1930s is one of the most famous cases of deflation. The cause was the failure of hundreds of banks, which led to a significant decrease in the money supply and a decrease in prices.
During a period of deflation, consumers expect that prices will continue to drop. This can lead to cash hoarding, where consumers delay investing or purchasing goods and services knowing that prices will continue to drop. Cash hoarding causes further deflation. In order to prevent deflation, the central bank decreases interest rates, making investing more appealing, which in turn increases the circulation and supply of money.
Governments aim to maintain a steady, low inflation rate in order to avoid the negative consequences of both inflation and deflation. Most of the world’s central banks try to keep the inflation rate between two and three percent and prevent deflation as soon as it starts.
Understanding inflation and deflation is necessary to comprehending monetary policy, which impacts consumer spending, employment rates, tax policies, and interest rates. Inflation also has international impacts, as it affects the exchange rate between currencies and demand for foreign goods.
Understanding these concepts is also key to understanding economic information coming from the news, social media, and politicians or government officials. Economic events, like periods of inflation and deflation, are often politicized, particularly when the different sides are trying to blame each other for negative outcomes. The real answer is often complicated, and it’s important to think critically about how and why these are terms being used.