4/19/2020 Understanding Inflation vs.

Deflation

ECONOMICS MACROECONOMICS

Inflation vs. Deflation: What's the Difference?

By TROY SEGAL | Updated Mar 25, 2020

TABLE OF CONTENTS
Overview Inflation
Deflation The Bottom Line
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Inflation vs. Deflation: An Overview

Inflation occurs when the prices of goods and services rise, while deflation occurs when those
prices decrease. The balance between these two economic conditions, opposite sides of the
same coin, is delicate and an economy can quickly swing from one condition to the other.
Central banks keep a keen eye on the levels of price changes and act to stem deflation or
inflation by conducting monetary policy, such as setting interest rates.

Understanding Inflation vs. Deflation

KEY TAKEAWAYS
Inflation is an increase in the general prices of goods and services in an economy.
Deflation, conversely, is the general decline in prices for goods and services, indicated
by an inflation rate that falls below zero percent.
Both can be potentially bad for the economy, depending on the underlying reasons
and the rate of price changes.

Inflation
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Inflation is a quantitative measure of how quickly the price of goods in an economy is

increasing. Inflation is caused when goods and services are in high demand, thus creating a
drop-in availability. Supplies can decrease for many reasons; a natural disaster can wipe out a
food crop, a housing boom can exhaust building supplies, etc. Whatever the reason, consumers
are willing to pay more for the items they want, causing manufacturers and service providers to
charge more.

The most common measure of inflation is the consumer price index (CPI). The CPI is a
theoretical basket of goods, including consumer goods and services, medical care and
transportation costs. The government tracks the price of the goods and services in the basket to
get an understanding of the purchasing power of the U.S. dollar. [1]

Inflation is often seen as a big threat, mostly by people who came of age during the late 1970s,
when inflation ran wild. [2] So-called hyperfinflations occur when the increase in monthly prices
exceeds 50% over some period of time. These periods of rapid price increases are often
accompanied by a breakdown in the underlying real economy and may also see a sudden
increase in the money supply.

While hyperinflations can be scary, they are historically rare. In reality, inflation can be either
good or bad, depending on the reasons and level of inflation. In fact, a complete lack of inflation
can be quite bad for the economy, as we will see below with deflation. A modest amount of
inflation can actually encourage spending and investing, as inflation can slowly erode the
buying power of cash—so it is relatively less expensive to buy that $1,000 appliance today than
the same $1,000 in a year.

Deflation
Deflation occurs when too many goods are available or when there is not enough money
circulating to purchase those goods. As a result, the price of goods and services drops. For
instance, if a particular type of car becomes highly popular, other manufacturers start to make a
similar vehicle to compete. Soon, car companies have more of that vehicle style than they can
sell, so they must drop the price to sell the cars. Companies that find themselves stuck with too
much inventory must cut costs, which often leads to layoffs. Unemployed individuals do not
have enough money available to purchase items; to coax them into buying, prices get lowered,
which continues the trend. (Note that deflation is not the same as disinflation, which is a
decline in the positive rate of inflation from period to period).

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Important: Deflation can lead to an economic recession or depression, and the

central banks usually work to stop deflation as soon as it starts.

When credit providers detect a decrease in prices, they often reduce the amount of credit they
offer. This creates a credit crunch where consumers cannot access loans to purchase big-ticket
items, leaving companies with overstocked inventory and causing further deflation.

Prolonged periods of deflation can stunt economic growth and increase unemployment.
Japan's "Lost Decade" is a recent example of the negative effects of deflation. [3]

Just as out of control hyperinflation is bad, uncontrolled price declines can lead to damaging a
deflationary spiral. This situation typically occurs during periods of economic crisis, such as
a recession or depression, as economic output slows and demand for investment and
consumption dries up. This may lead to an overall decline in asset prices as producers are
forced to liquidate inventories that people no longer want to buy.

Consumers and businesses alike begin holding on to liquid money reserves to cushion against
further financial loss. As more money is saved, less money is spent, further decreasing
aggregate demand. At this point, people's expectations regarding future inflation are also
lowered and they begin to hoard money. Consumers have less incentive to spend money today
when they can reasonably expect that their money will have more purchasing power tomorrow.

The Bottom Line

Most of the world's central banks target modest levels of inflation, at around 2%–3% per year.
Higher levels of inflation can be dangerous for an economy as it causes prices of goods to rise to
quickly, sometime in excess of wage increases. By the same token, deflation can also be bad
news for an economy, as people hoard cash instead of spending or investing with the
expectation that prices will soon be even lower.

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Related Terms
Inflation
Inflation is a general increase in the prices of goods and services in an economy over some period of
time. more

Deflationary Spiral
A deflationary spiral is a downward price reaction to an economic crisis leading to lower production,
lower wages, decreased demand, and still lower prices. more

What Causes Hyperinflation

Hyperinflation describes rapid and out-of-control price increases in an economy. In this article, we
explore the causes and impact of hyperinflation. more

Biflation Definition
Biflation describes the simultaneous occurrence of inflation, price rises, and deflation, price falls, in
different parts of the economy. more

The Meaning of the Economic Term Basket of Goods

A basket of goods is defined as a constant set of consumer products and services valued on an annual
basis and used to calculate the consumer price index (CPI). more

Stagflation Definition
Stagflation is the combination of slow economic growth along with high unemployment and high
inflation. more

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