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Inflation vs Deflation

Comments Off on Inflation vs Deflation 30 April 2011

In the most common sense, inflation is an increase in the average price of goods over a period of time. The rate that prices increase is known as the inflation rate. Inflation happens either when costs go up or when it takes more money to purchase the same items.

CPI is not the same as inflation. Inflation is the change in CPI over a period of time. It can be calculated as [CP1 Year 1 – CPI Year 2]/CPI Year 2, where Year 1 is greater than Year 2. Using the example above the inflation rate from 1984 to 2009 would be 95%. That’s (195-100)/100.

Using CPI is not necessarily an indicator of the specific inflation rate for any given consumer since the goods and services you buy might not be included in the basket. Instead, CPI and the inflation rate is an approximate cost for the country as a whole.

Monetary inflation takes place when the amount of cash in circulation increases quicker than the quantity of products in circulation. The government is the only entity who is allowed to do this. Back in the day, they would just print more money. Today, the government purchases securities from banks, thereby increasing the money supply.

Inflation could eventually lead to deflation. In theory, people would spend less money when costs are going up, but that isn’t always the case. In practice, people spend the money now because they believe the prices will be higher in the future. If they do not have the money for desired purchases, then they borrow it.

Another disadvantage to inflation is that it puts some goods and services out of reach for consumers. Rarely do wages increase the same rate as inflation, so consumers have less cash to spend. As the gap between income and costs closes, so does spending. That situation could eventually lead to deflation.

Typically, deflation is when the average price of goods falls. When the inflation rate drops below zero, indicating negative inflation, we know that there has been deflation. Remember that the inflation rate is calculated based on the change in the Consumer Price Index, or CPI.

Inflation and deflation are both parts of a normal functioning economy. They typically happen in cycles and can correct themselves without any government intervention. However, in extreme situations, like the Great Depression, the economy does need a helping hand from the Feds.

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