Inflation Against Deflation - Example

Inflation Against Deflation The supply of money determines if either inflation or deflation will occur. Inflation occurs if the there is too much money in the system as compared to the demand of commodities. On the other hand, deflation occurs if there is very little monetary stock as compared to the demand for services and products. While inflation is characterized by an increase in prices of goods and services, deflation is associated with a reduction in commodity prices. While inflation is caused by an increase in aggregate demand, deflation is caused by a drop in the aggregate demand. Inflation causes unrests, hoarding, and higher opportunity cost of holding money among others. Deflation, on the other hand causes increased rates of unemployment. Most people have accepted inflation as a way of life, but deflation is considered as a rare phenomenon. There needs to be a balance in the supply of money in the economy to avoid both inflation and deflation. Introduction The money supply comprises of coins, cash, and balances held in checking, non-institutional money market funds, as well as savings accounts. To that effect, money supply is the total amount of monetary assets that are available in a nation’s economy at a certain time. The supply of money should keep pace with the expansion of the economy along with an increase in the population. If the supply of money was to rise very fast, then it results in inflation. On the other hand, if the increase in the supply of money is not adequate, deflation can occur. As a consequence, it is very crucial to monitor the amount of money in the system. Therefore, drawing on a variety of sources I will discuss the correlation between inflation and deflation. Discussion The global economy is reliant on credit or money. During inflation, the general level of prices of products and services rise rapidly with a subsequent fall in the purchasing power. In economics, Abel and Bernanke (31) assert that inflation is regarded as a sustained increase in the price of services and commodities over a certain time frame. As a result, inflation shows a decrease in the purchasing power per unit of cash. A reduction in the purchasing power of money means that there is a loss in the real value of money. Inflation is measured by calculating the change in consumer price index (CPI). The other measures of inflation include the producer price indices (PPI), commodity price indices, core price indices, and gross domestic product deflator. The PPIs measures the average changes in the prices that are got by the local manufacturers for their output. The commodity price index measures the price of a selected product. The core price indices measure the quick price changes as a result of changes in the demand and supply (Dwivedi 89-104). Various factors cause inflation. Most economists are of the belief that high inflation rates are caused by an excessive supply of money. If the Central Bank prints more money, a rise in inflation is expected. Studies have also found a link between inflation and unemployment. Correspondingly, there are other factors that cause inflation. They include excess aggregate demand or cost push factors. These results in three types of inflation (Hall 123): demand-pull inflation, cost push inflation, and built in inflation. In the first place, the demand-pull inflation is caused by an increase in the aggregate demand as a result of increased state and private spending (Dwivedi 469). This shifts the aggregate demand (AD) to the right. As a result, the GDP increases together with prices. Studies have evidenced that demand-pull inflation promotes economic development due to the fact that the excess demand as well as favorable market conditions will encourage expansion together with investment. Next is cost-push inflation. It is triggered by reduction in the aggregate supply (Hall 68). This can be as a result of increased input prices or natural disasters. As an example, an abrupt reduction of oil supply may lead to increased prices of oil. The producers then pass this cost to the consumers in terms of increased prices. The AS is pushed to the left. Evidences have suggested that the other causes of cost-push inflation include: rising wages, an increase in the import prices, an increase in the price of raw materials, declining productivity that allows the costs to rise, and higher government taxes, such as excise duty and value added tax. Lastly, built-in inflation is usually induced by adaptive expectations. For example, when employees try to keep their wages at par with commodity prices, the producers pass the high costs of labor to the consumers as increased prices. While the Keynesians hypothesize that the supply of money is the major determinant of inflation, the monetarists share the view that money supply results in moderate inflation levels. Inflation influences the economy both positively and negatively. On the positive side, inflation causes the central banks to make adjustments to rates of real interests. The other beneficial impact of inflation is that it encourages investing in the non-financial capital projects (Hall 124). On the other hand, the negative effects of inflation outweigh the benefits. First, inflation causes a rise in the opportunity cost of holding money. The high inflation leads to people holding more cash balances in the accounts, even though the cash is required to carry out transactions. As a consequence, the people incur more for the numerous trips to the bank to go and acquire the cash. Second, it causes reduction in investments and savings due to the uncertainty in the future business environment. The investors are usually uncertain of the economic environment thus avoiding investments. Third, inflation may result in the hoarding of products by people in anticipation of price increase in future. As a result, the economy will experience shortage of goods. Lastly, inflation also causes revolts and unrests (Hall 125-126). For example, the 2010-2011 Tunisian revolution was caused by inflation of a certain food. Due to the adverse effects of inflation, it needs to be controlled. One way of controlling inflation is by means of monetary and fiscal policy (Dwivedi 577). The Reserve Bank may increase the interest rates reducing the supply of money. The next method of controlling inflation is via fixed exchange rates. Fixing the exchange rate implies that the domestic cost that is imposed on an unyielding exchange rate is predominant to other considerations. As a result, the value of the currency is stabilized. Third, inflation can also be controlled through wage and price controls. Though short term, it minimizes the increase of unemployment. The other remedy for inflation is encouraging economic development and growth. Economic growth can only be attained by means increasing investments in various sectors of the economy (Dwivedi 473-475). Lastly, inflation can be controlled by deflation. Deflation is usually caused by a reduction in the money supply (Durden). Deflation increases the real value of money over time, thus correcting the issue of inflation. Literature have demonstrated that deflation usually occur when the rate of inflation drops below 0 percent. In other words, deflation is witnessed if the inflation rate is negative. During deflation, the business profits considerably reduce. An example of deflation is the Great Depression. Deflation is caused by falling aggregate demand can be caused by factors such as a drop in the supply of money, tight monetary policy that leads to higher interest rates, debt deleveraging where after a credit bubble, people may seek to pay off debts in order to minimize their spending, and overvalued exchange rate and high interest rates with an aim to maintain the value of currency (Baig et al., 7). The causes of deflation are a drop in the aggregate demand and a shift to the right of the aggregate supply. The shift may be caused by a reduction of production costs because of using advanced technologies for production (Stapleford 69). As a result, the prices fall. A drop in the AD results in a lower level of price. The AD moves from right to left. The prices are reduced from P1 to P2. This may result in a fall in the rate of inflation. Considering that the prices are falling, the consumers have an incentive to delay consumption and purchases until the prices reduce further. In turn, the overall economic activity is reduced. Since there is minimal production, the levels of investment also falls. This further reduces the aggregate demand. The other factors that contribute to deflation is the change in the capital market structure. If a majority of different firms sell similar commodities or services, they usually reduce their prices in order to gain competitive advantage. However, if these companies find other means of funding their businesses, such as through debt and equity markets there will be an increased supply of products resulting deflation. This is because they will be forced to further scale down the prices (Burdekin and Siklos 30-33). Next, increased productivity also leads to deflation. By using innovative production techniques, this increases efficiency ultimately leading to the reduction of prices by producers. The other cause of deflation is when governments or consumers significantly reduce spending. This practice is commonly known as austerity measure. Deflation can be expensive and difficult to foresee. However, when it occurs; it usually results in unemployment, reduced business revenues, wage reductions, changes in consumer spending, and reduced stakes in investments (Brezina 29-31). With regard to unemployment, when industries get less revenue they usually react by reducing costs including laying off employees. Similarly, deflation promotes short term consumption together with over-stimulation in project investment, which may not be beneficial to the economy. On one hand, most economists share the view that deflation is problematic in the current economies for the reason that it elevates the real value of debt in addition to increasing recession. On the other hand, under the dropping economic growth rates in addition to wage levels, deflation is to some extent of a relief for the consumer, given that prices are reducing. Even though there exists no definite way of tackling deflation, Goodhart and Boris (128) assert that central banks can influence the direction of the deflation by altering the nation’s supply of money. A moderate expansion in the monetary base of the nation may be an effective way of fighting deflation. The other way of addressing deflation is by means of a fiscal authority in order to increase demand as well as borrowing at interest rates that are below those are accessible to the private entities (Brezina 121). This requires special arrangements to borrow money at a zero nominal interest rate. The monetarists share the view that deflation can be addressed by expanding demand by means of reducing the interest rates. In other words, the cost of money is reduced. Conclusion In summary, I did find out that inflation occurs when there is too much money or credit as compared to the demand for goods and services. Contrarily, deflation occurs if there is reduced supply of money in contrast to the demand for goods and services. I also noted that the signs of inflation include increasing commodity prices. On the other hand, deflation is associated with declining commodity prices. While inflation increases the money supply, deflation reduces. To that effect, I did note that deflation can be used as a remedy for increased inflation rate. In my view, both inflation and deflation have detrimental effects on the economy and should be avoided. Works Cited Abel, Andrew, and Bernanke, Ben. Macroeconomics, New York: Pearson, 2005. Print. Baig, Taimur, Decressin, Jörg, Feyzioglu, Tarhan, Kumar, Manmohan, and Faulkner-MacDonagh, Chris Baig. Deflation: Determinants, Risks, and Policy Options. Geneva: International Monetary Fund, 2003. Print. Brezina, Corona. How Deflation Works. New York: Rosen Publishing Group, 2010. Print. Burdekin, Richard and ‎Pierre Siklos. Deflation: Current and Historical Perspectives. Cambridge: Cambridge University Press, 2004. Print. Durden, Tyler. Deflation vs Inflation. http://www.zerohedge.com/news/2014-11-10/deflation-vs-inflation>. Web. October 11, 2014. Accessed April 1, 2015. Dwivedi. Macroeconomics. New Delhi: Tata McGraw-Hill Education, 2010. Print. Hall, Robert. Inflation: Causes and Effects. Chicago: University of Chicago Press, 2009. Stapleford, Thomas. The Cost of Living in America: A Political History of Economic Statistics, 1880-2000. Cambridge: Cambridge University Press, 2009. pp. 69–73. Print. Goodhart, Charles, and Hofmann, Boris. Deflation, credit and asset prices, In: Deflation - Current and Historical Perspectives, eds. Richard C. K. Burdekin & Pierre L. Siklos, Cambridge University Press, Cambridge, 2004. Print. Read More