The health of an economy is often gauged by its level of price stability. This involves maintaining a balance between inflation and deflation, ensuring neither spirals out of control. Both phenomena have their causes and consequences, which we shall explore in detail below.
Image courtesy of statista
Inflation vs Deflation
Inflation
Inflation is a term many are familiar with, signifying a rise in the general level of prices for goods and services in an economy over a specified period. When inflation occurs, each unit of currency buys fewer products and services, causing a decrease in its purchasing power.
Causes of Inflation:
- Demand-Pull Inflation:
- Description: Triggered when demand for goods and services outstrips supply.
- Factors Leading to it: These can range from increased consumer confidence, reduced interest rates promoting borrowing, governmental fiscal policies that boost overall demand, or even external events like increased demand from abroad due to strong global economic growth.
A graph illustrating demand-pull inflation.
Image courtesy of learn-economics
- Cost-Push Inflation:
- Description: This emerges when it becomes more expensive to produce goods and services.
- Catalysts: These might include a rise in the prices of raw materials due to geopolitical instability, increased labour costs because of wage hikes, or even supply chain disruptions causing bottlenecks in production.
A graph illustrating cost-push inflation.
Image courtesy of learn-economics
- Built-In Inflation:
- Description: This is the cyclical nature of workers demanding higher wages, and if they obtain them, companies subsequently raising their prices to account for higher wage costs.
- Cycle Process: Wage demands → Wage Increases → Higher Prices → Wage demands.
- Monetary Inflation:
- Description: It originates from an excessive money supply.
- Reasons for Oversupply: Central banks might print more money as a policy decision or in response to national debts. When this newly created money surpasses the economy's growth rate, prices can rise.
It's important to understand the limitations of monetary policy in curbing inflation effectively and the types of monetary policy central banks can employ.
Costs of Inflation:
- Decreased Purchasing Power: As prices rise, each monetary unit's value diminishes, curbing the quantity of goods and services it can purchase.
- Economic Uncertainty: Volatile and unpredictable inflation can sow doubt, stalling business investments and long-term contractual agreements due to ambiguity about future prices.
- Menu Costs: These are not about pricey restaurants but the actual costs firms bear when they have to adjust prices frequently.
- Shoe Leather Costs: It might sound like footwear expenses, but it actually refers to the metaphorical 'wear and tear' consumers and businesses experience when managing their cash and resources during inflationary times.
- Bracket Creep: Inflationary wage hikes can push individuals into higher income tax brackets, causing them to pay more taxes even if their real income hasn't seen substantial growth.
Deflation
Deflation stands opposite to inflation, marking a decrease in the general price level for goods and services. This scenario might seem beneficial to consumers, but prolonged deflation can stifle economic growth.
Causes of Deflation:
- Reduction in Aggregate Demand:
- Description: A widespread drop in demand.
- Reasons: This can be due to a loss of consumer confidence, stricter lending conditions by banks, or even significant demographic changes like an ageing population less inclined to spend.
- Increased Productivity:
- Description: Technological advancements can lead to more efficient production methods, resulting in a drop in prices.
- Examples: Automation in manufacturing, advancements in software, and more efficient supply chains.
- Banking and Financial Crises:
- Description: A collapse or significant strain in the banking system can reduce lending and credit availability, which contracts demand.
- Historical Precedents: The Great Depression of the 1930s was a stark illustration.
- Tight Monetary Policy:
- Description: Intentional actions by central banks.
- Actions: Reducing the money supply or hiking up interest rates can both lead to decreased spending and investment, pulling prices down.
Fiscal policy also plays a crucial role in managing price stability, where understanding the limitations of fiscal policy and different types of fiscal policy is essential.
Costs of Deflation:
- Increased Real Debt Burden: While it might seem counter-intuitive, deflation can make debts more burdensome. The value of debt, in real terms, increases, putting strain on borrowers.
- Consumption Delays: Consumers, expecting prices to drop further, might delay purchases, which can exacerbate economic slowdowns.
- Business Profit Squeezing: Falling prices can erode profit margins, making it tough for businesses to remain solvent, leading to potential closures or layoffs.
- Wage Rigidity and Unemployment: Workers often resist cuts to their pay. However, in a deflationary environment, businesses might struggle to pay wages, leading to increased unemployment.
- Banking Strain: Borrower defaults become more frequent due to the increasing real burden of debt, putting immense pressure on banks.
Reflection
Grasping the intricacies of inflation and deflation is pivotal for anyone keen on understanding macroeconomic stability. Policymakers walk a tightrope, balancing between these phenomena, as both pose unique challenges to sustainable economic growth. The importance of balance of payments stability in maintaining price stability further underscores the interconnectedness of global economic policies and domestic economic conditions.
Image courtesy of wallstreetmojo
FAQ
Inflation and interest rates often share a closely intertwined relationship, governed largely by central bank policies. Typically, central banks raise interest rates when they want to curb rising inflation. The logic behind this is that higher interest rates can make borrowing more expensive and saving more attractive, which can dampen consumer spending and reduce demand-driven inflationary pressures. Conversely, in periods of low inflation or deflation, central banks might lower interest rates to encourage borrowing and investment, hoping to stimulate the economy and push inflation towards the target.
Stagflation is a rare economic phenomenon characterised by stagnant growth (or recession), high unemployment, and high inflation simultaneously. It's particularly challenging because the usual policy tools to combat inflation (like raising interest rates or reducing government spending) can exacerbate unemployment and slow growth, while measures to stimulate growth (like lowering interest rates or boosting government spending) can intensify inflation. Stagflation can be caused by a combination of factors, often starting with a supply shock, like a sharp rise in oil prices, which increases production costs and prices while also reducing economic growth and employment. Concurrent demand-side factors can also contribute, such as a large fiscal expansion or rapid money supply growth.
The velocity of money refers to the rate at which money changes hands in an economy within a given period. It's a measure of how active and efficiently money is being used. If the velocity of money increases (meaning money is circulating more quickly), even without an increase in the money supply, it can lead to inflation. The reason is that more transactions are occurring with the same amount of money, pushing up demand and potentially prices. Conversely, if the velocity of money decreases, even with an expanding money supply, inflation might not occur since the money isn't being actively used. Inflation can be viewed as a result of both the money supply and its velocity.
Hyperinflation is an extreme and accelerated form of inflation where prices rise at exceedingly high rates, often exceeding 50% per month. It's damaging to an economy for several reasons. First, it erodes the purchasing power of money, making the currency nearly worthless. This can wipe out personal savings and deter future saving. Second, it introduces significant uncertainty, making businesses hesitant to invest and produce, and consumers unsure about when or what to purchase. Third, the rapidly changing prices disrupt normal business operations and can lead to supply chain breaks. Finally, hyperinflation can cause a loss of confidence in the government and its monetary institutions, potentially leading to social unrest or political instability.
Inflation targeting and price level targeting are both monetary policy strategies used by central banks. Inflation targeting focuses on maintaining the rate of inflation (usually measured by the Consumer Price Index) within a specified range or at a particular target. Central banks adjust their monetary policy instruments, such as interest rates, to ensure inflation remains within this target. The Bank of England, for example, has an inflation target of 2%.
On the other hand, price level targeting involves aiming for a specific level on the price index rather than a rate of change. If prices rise above the target level, the central bank would aim to reduce inflation below the target for some time, and if prices fall below the target level, it would aim to increase inflation above the target. This approach seeks to offset periods of below-target inflation with periods of above-target inflation, ensuring that the overall price level over longer periods stays close to the target.
Practice Questions
Demand-pull inflation arises when there's a surge in the demand for goods and services beyond the economy's capacity to produce. It's like having more money chasing fewer goods. Key factors contributing to demand-pull inflation might include heightened consumer confidence, reduced interest rates encouraging borrowing and spending, robust global economic growth boosting demand for domestic products, and expansive fiscal policies from the government.
On the other hand, cost-push inflation occurs when the costs to produce goods and services increase, leading producers to raise prices to maintain profit margins. Such inflation can stem from various sources, including a spike in raw material prices (perhaps due to geopolitical events), wage hikes pushing up labour costs, and supply chain disruptions that create production bottlenecks.
Prolonged deflation can pose several threats to an economy. As the general price level for goods and services drops, consumers might delay purchases, anticipating further price decreases. This can stall consumer spending, a significant component of economic activity. Businesses, faced with diminishing prices, can see their profit margins squeezed, making them more vulnerable to insolvency. They might also reduce wage offers or even lay off employees, leading to rising unemployment. In a deflationary spiral, the real value of debt can increase, placing further financial strain on borrowers. This can result in higher default rates, exerting pressure on the banking sector and potentially culminating in a financial crisis.
