Inflation and Deflation

Looking few years back we often realize that for the same amount of money we were able to buy more things. Some people are complaining that even with a higher salary today they are poorer than earlier. Finally talking to our grand parents we can easily realize that when they were young they were living in a completely different price system than we do. These phenomenons can be explained by probably the most popular economic indicator called inflation. Inflation is very often mentioned by different people in various situations but often there is a lot of confusion around this term. Let's look inside the mechanisms affecting the prices we have to pay to buy goods and services we need.

Inflation refers to a persistent increase in the general price level of goods and services in an economy over a period of time. In other words during inflation times for the same amount of money we can buy less goods or we can also say that purchasing power of money reduces. The opposite process called deflation when prices are decreasing and the money's purchasing power increases.

Inflation

Rising inflation is something that people don't usually like to hear about. However in many developed countries today the low inflation is considered as an economic problem. I'm writing these words 2 days before ECB meeting where the president Mario Draghi will certainly try to suggest additional tools to fight "too low" euro zone's inflation. Something is wrong here, isn't it? Indeed inflation is quite complex phenomenon. Unlike deflation, which is almost always bad, inflation can be either bad or good depending on its pace.

As long as inflation refers to the higher prices it means that profits of the corporations increase, so they hire more workers, this sends wages up, so people can afford more goods, so demand increases, and the prices keep going up. This sequence sounds good, isn't it? Indeed inflation around 2%-3% is a characteristic if a healthy growing economy. The key point in the sequence presented above is wages that are supposed to go up a long with prices. If it is not the case inflation can become dangerous and in some extreme cases can cause an economic collapse.

One of types of dangerous inflation is hyperinflation when general price level within an economy increases rapidly as the currency quickly loses real value. Meanwhile, the real value of goods generally stays the same, and remain relatively stable in terms of foreign currencies. In such conditions usually the wages are not following the pace of the price rising and people can afford less and less of goods.

Another a bit less dangerous type of inflation is a stagflation. This is a situation when the inflation rate is high, the economic growth rate slows down, and unemployment remains steadily high. This situation is difficult to deal with as the governments are usually facing a dilemma for economic policy since actions designed to lower inflation may exacerbate unemployment, and vice versa.

Deflation

We are not talking very often about deflation but this is a natural economic process going closely along with progress. Indeed as technology improves we are now able to produce things cheaper and quicker, a lot of jobs were moved to Asia bringing production costs lower etc. So deflation is something constantly happening in the economy. But we don't really see prices falling. Indeed in the most common scenario deflation is offset by inflation. In other words these are parallel mutually compounding processes where inflation usually winning.
Why deflation is dangerous?

It sounds like a good news that things are becoming cheaper. But unfortunately these good news are hiding much worse consequences. As explained earlier, dynamic economy is likely to produce some inflation. If this healthy inflation is unable to offset deflation it means that country's economy is likely to slow down and probably there is a risk of recession. But probably even more dangerous effect of the deflation is an increase of the debt. Indeed in the developed countries both governments and households are heavily indebted and when money becomes more expensive then your net debt increases as well. This scenario is unacceptable for most of governments especially the United States having a huge debt.
Why deflation is unlikely?

As we are not living in the gold standard era, the purchasing power of the currencies can be easily manipulated by central banks and governments. As long as government doesn't want to see its debt rising it will always act whenever a risk of deflation appears. Indeed central banks usually have a monopoly on printing currency and increasing/decreasing money supply. So they are armed enough to fight deflation if needed.