Inflation & Deflation: What You Need to Know

Deflation and inflation are crucial because the economy must maintain a balance, causing it to quickly shift from one to the other. As a consequence of these two factors, deflation and inflation determine the pricing of goods throughout the economy.

India’s Reserve Bank manages deflation and inflation through monetary policy, such as setting interest rates. It’s these two factors that determine the price of goods during periods of inflation or deflation.

Inflation

As a quantitative measure of the rate at which prices in an economy rise, inflation is the rate at which prices go up. There is inflation when commodities and services are in high demand, resulting in a decrease in supply.

Generally, inflation refers to an increase in the price of everyday goods and services, such as housing, food, clothing, recreation, transportation, and consumer staples. In India, inflation is calculated by the Ministry of Statistics and Program Implementation.

For example, if a kg of oranges costs $80 in 2019 and $90 in 2020, the price would rise by 10%. Also, various items and services whose prices have increased over time are grouped, and a base year is used to calculate the percentage. An inflation rate is the percentage increase in the price of a collection of goods.

Inflationary Factors

Inflation has several causes; here are a few:

A measure of the money supply

It is common for an economy to have an excess of currency supply as one of the fundamental causes of inflation. In this scenario, the money supply or circulation of a country expands faster than economic growth, which results in the value of the currency falling.

Debt and the National Debt

The national debt is influenced by a variety of factors, including borrowing and spending. Whenever a country’s debt grows, it has two options:

  • Taxes can be levied internally.
  • In order to repay the debt, more money must be produced.

‘Push-Pull Effect’

Individuals in a developing economy have more money to spend on goods and services as wages rise, according to the demand-pull effect. Due to an increase in demand for products and services, corporations will raise prices that customers will endure.

A Cost-Pushing Effect

In this scenario, corporations will be able to maintain profitability by passing on rising production costs to consumers via higher prices when faced with rising input costs.

An overview of exchange rates

A global economy is largely based on the dollar. As a global trading economy, exchange rates play an important role in determining inflation rates.

The effects of inflation

When a country experiences inflation, its citizens’ purchasing power declines as commodity and service prices rise. In the country, the value of the currency unit falls, lowering the cost of living. Inflation leads to higher costs of living, which slows economic growth. A healthy inflation rate (2-3%), on the other hand, is considered to be favorable, as it increases salaries, profits, and capital movement.

Deflation

Deflation occurs when the rate of inflation drops below 0%. When an economy’s money supply is constrained, deflation will occur organically. Inflation is typically associated with high unemployment and low production levels. It is common to use the terms “deflation” and “disinflation” interchangeably. Deflation occurs when prices of goods fall, and disinflation occurs when inflation slows.

As with out-of-control hyperinflation, uncontrolled price decreases can lead to a dangerous deflationary cycle. The circumstances described above are common during periods of economic crisis, such as a recession or depression, when economic activity slows and investment and consumption decrease. As a result, asset values may fall as manufacturers dispose of stockpiles that buyers no longer want. In order to protect themselves from future financial loss, consumers and companies alike accumulate liquid cash reserves.

As more money is saved, fewer dollars are spent, reducing aggregate demand even further. In addition, people’s expectations for future inflation are lower at this point, so they begin to hoard money. When consumers expect that their money will have more purchasing power tomorrow, they are less motivated to spend money today.

Deflationary Causes

There are a number of reasons for deflation, including:

Changing structure of the capital market

In order to gain an advantage over competitors, companies cut prices when providing identical goods or services.

Productivity has increased

Through innovation and technology, production efficiency is increased, resulting in cheaper goods and services. Inventions can affect the productivity of specific industries and the economy as a whole.

Currency supply has decreased

By reducing money availability, goods and services will become more affordable for individuals.

Deflationary Effects

The following economic effects can be caused by deflation:

Reduced Business Revenues

In a deflationary environment, businesses must lower their prices. When prices are reduced, revenues decline.

Wage cuts and layoffs

In order to reach targets, firms must reduce expenditures when sales decline. It is possible to reduce salaries and lay off workers as one method. As a result, less money will be available for spending by consumers.

Conclusion

Inflation is typically aimed at 2%-3% per year by most central banks around the world. As a result of higher inflation rates, goods prices can grow too rapidly, sometimes exceeding wage increases, threatening an economy. As a result of deflation, individuals hoard cash instead of investing or spending, hoping that prices will soon fall even further.

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