Inflation and Deflation for Dummies

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Inflation vs. Deflation: What’s the Difference?

Inflation vs. Deflation: An Overview

Inflation occurs when the prices of goods and services rise, while deflation occurs when those prices decrease. The balance between these two economic conditions, opposite sides of the same coin, is delicate and an economy can quickly swing from one condition to the other. Central banks keep a keen eye on the levels of price changes and act to stem deflation or inflation by conducting monetary policy, such as setting interest rates.

Key Takeaways

  • Inflation is an increase in the general prices of goods and services in an economy.
  • Deflation, conversely, is the general decline in prices for goods and services, indicated by an inflation rate that falls below zero percent.
  • Both can be potentially bad for the economy, depending on the underlying reasons and the rate of price changes.

What’s The Difference Between Inflation And Deflation?

Inflation

Inflation is a quantitative measure of how quickly the price of goods in an economy is increasing. Inflation is caused when goods and services are in high demand, thus creating a drop-in availability. Supplies can decrease for many reasons; a natural disaster can wipe out a food crop, a housing boom can exhaust building supplies, etc. Whatever the reason, consumers are willing to pay more for the items they want, causing manufacturers and service providers to charge more.

The most common measure of inflation is the consumer price index (CPI). The CPI is a theoretical basket of goods, including consumer goods and services, medical care and transportation costs. The government tracks the price of the goods and services in the basket to get an understanding of the purchasing power of the U.S. dollar. 

Inflation is often seen as a big threat, mostly by people who came of age during the late 1970s, when inflation ran wild.   So-called hyperfinflations occur when the increase in monthly prices exceeds 50% over some period of time. These periods of rapid price increases are often accompanied by a breakdown in the underlying real economy and may also see a sudden increase in the money supply.

While hyperinflations can be scary, they are historically rare. In reality, inflation can be either good or bad, depending on the reasons and level of inflation. In fact, a complete lack of inflation can be quite bad for the economy, as we will see below with deflation. A modest amount of inflation can actually encourage spending and investing, as inflation can slowly erode the buying power of cash – so it is relatively less expensive to buy that $1,000 appliance today than the same $1,000 in a year.

Deflation

Deflation occurs when too many goods are available or when there is not enough money circulating to purchase those goods. As a result, the price of goods and services drops. For instance, if a particular type of car becomes highly popular, other manufacturers start to make a similar vehicle to compete. Soon, car companies have more of that vehicle style than they can sell, so they must drop the price to sell the cars. Companies that find themselves stuck with too much inventory must cut costs, which often leads to layoffs. Unemployed individuals do not have enough money available to purchase items; to coax them into buying, prices get lowered, which continues the trend. (Note that deflation is not the same as disinflation, which is a decline in the positive rate of inflation from period to period).

Deflation can lead to an economic recession or depression, and the central banks usually work to stop deflation as soon as it starts.

When credit providers detect a decrease in prices, they often reduce the amount of credit they offer. This creates a credit crunch where consumers cannot access loans to purchase big-ticket items, leaving companies with overstocked inventory and causing further deflation.

Prolonged periods of deflation can stunt economic growth and increase unemployment. Japan’s “Lost Decade” is a recent example of the negative effects of deflation. 

Just as out of control hyperinflation is bad, uncontrolled price declines can lead to damaging a deflationary spiral. This situation typically occurs during periods of economic crisis, such as a recession or depression, as economic output slows and demand for investment and consumption dries up. This may lead to an overall decline in asset prices as producers are forced to liquidate inventories that people no longer want to buy.

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Consumers and businesses alike begin holding on to liquid money reserves to cushion against further financial loss. As more money is saved, less money is spent, further decreasing aggregate demand. At this point, people’s expectations regarding future inflation are also lowered and they begin to hoard money. Consumers have less incentive to spend money today when they can reasonably expect that their money will have more purchasing power tomorrow.

The Bottom Line

Most of the world’s central banks target modest levels of inflation, at around 2%-3% per year.   Higher levels of inflation can be dangerous for an economy as it causes prices of goods to rise to quickly, sometime in excess of wage increases. By the same token, deflation can also be bad news for an economy, as people hoard cash instead of spending or investing with the expectation that prices will soon be even lower.

What Causes Deflation?

What is Deflation?

Deflation, or negative inflation, happens when prices generally fall in an economy. This can be because the supply of goods is higher than the demand for those goods, but can also have to do with the buying power of money becoming greater.. Buying power can grow due to a reduction in the money supply, as well as a decrease in the supply of credit, which has a negative effect on consumer spending.

Key Takeaways

  • Deflation is the general decline of the price level of goods and services.
  • Deflation is usually associated with a contraction in the supply of money and credit, but prices can also fall due to increased productivity and technological progress.
  • Deflation incentivizes people to hoard cash because they can buy relatively more with a dollar in the future than now – this has negative feedback loops that can lead to economic depression..

Causes of Deflation

Deflation can be caused by a combination of different factors, including having a shortage of money in circulation, which increases the value of that money and, in turn, reduces prices; having more goods produced than there is demand for, which means businesses must decrease their prices to get people to buy those goods; not having enough money in circulation, which causes those with money to hold on to it instead of spending it; and having a decreased demand for goods overall, therefore decreasing spending.

By definition, monetary deflation can only be caused by a decrease in the supply of money or financial instruments redeemable in money. In modern times, the money supply is most influenced by central banks, such as the Federal Reserve. When the supply of money and credit falls, without a corresponding decrease in economic output, then the prices of all goods tend to fall. Periods of deflation most commonly occur after long periods of artificial monetary expansion. The early 1930s was the last time significant deflation was experienced in the United States. The major contributor to this deflationary period was the fall in the money supply following catastrophic bank failures. Other nations, such as Japan in the 1990s, have experienced deflation in modern times.

World-renowned economist Milton Friedman argued that under optimal policy, in which the central bank seeks a rate of deflation equal to the real interest rate on government bonds, the nominal rate should be zero, and the price level should fall steadily at the real rate of interest. His theory birthed the Friedman rule, a monetary policy rule.

However, declining prices can be caused by a number of other factors: a decline in aggregate demand (a decrease in the total demand for goods and services) and increased productivity. A decline in aggregate demand typically results in subsequent lower prices. Causes of this shift include reduced government spending, stock market failure, consumer desire to increase savings, and tightening monetary policies (higher interest rates).

Falling prices can also happen naturally when the output of the economy grows faster than the supply of circulating money and credit. This occurs especially when technology advances the productivity of an economy, and is often concentrated in goods and industries which benefit from technological improvements. Companies operate more efficiently as technology advances. These operational improvements lead to lower production costs and cost savings transferred to consumers in the form of lower prices. This is distinct from but similar to general price deflation, which is a general decrease in the price level and increase in the purchasing power of money.

Price deflation through increased productivity is different in specific industries. For example, consider how increased productivity affects the technology sector. In the last few decades, improvements in technology have resulted in significant reductions in the average cost per gigabyte of data. In 1980, the average cost of one gigabyte of data was $437,500; by 2020, the average cost was three cents. This reduction caused the prices of manufactured products that use this technology to also fall significantly.

Consequences of Deflation

While it may seem like lower prices are good, deflation can ripple through the economy, such as when it causes high unemployment, and can turn a bad situation, such as a recession, into a worse situation, such as a depression.

Deflation can lead to unemployment because when companies make less money, they react by cutting costs in order to survive. This includes closing stores, plants, and warehouses and laying off workers. These workers then have to decrease their own spending, which leads to even less demand and more deflation and causes a deflationary spiral that is hard to break. The only time deflation can work without hurting the rest of the economy is when businesses are able to cut the costs of production in order to lower prices, such as with technology. The cost of technology products has decreased over the years, but it is because the cost of producing that technology has decreased, not because of decreased demand.

A deflationary spiral can occur during periods of economic crisis, such as a recession or depression, as economic output slows and demand for investment and consumption dries up. This may lead to an overall decline in asset prices as producers are forced to liquidate inventories that people no longer want to buy. Consumers and businesses alike begin holding on to liquid money reserves to cushion against further financial loss. As more money is saved, less money is spent, further decreasing aggregate demand. At this point, people’s expectations regarding future inflation are also lowered and they begin to hoard money. Consumers have less incentive to spend money today when they can reasonably expect that their money will have more purchasing power tomorrow.

Inflation and Deflation for Dummies

Inflation and deflation are the two important economic indicators in the world of binary options trading. Inflation is the rise in the price of the asset in the market while deflation occurs when the asset’s price decreases. Inflation happens when there are a lot of demands for a product and it is during this time that the manufacturers and providers will grab the chance to increase the price to make more money. The problem with inflation is that when the price for these products increase and the income of people and unemployment remains the same, they will find it harder to afford these things. So, maintaining a balance in the inflation and deflation is crucial for achieving a good economy.

On the other hand, deflation happens when the manufacturer has produce much more products than the demand in the market. For example, the European Union just recently put a restriction on the import of goods from Russia so the Russian manufacturers are going to have problem clearing their inventory. Because they are not able to clear off these inventory, they have to cut cost by reducing the staff and the consequence is that many people will be unemployed and the economy will enter into recession.

Countries that have lower inflation rates have better currency values. The central bank will take action by increasing the short term interest rate to overcome inflation and balance the economy. The purpose of increasing the short term interest rate is to encourage people to borrow loans. Doing so allow the bank to play a role in influencing the price of consumer products and national currency’s values indirectly. The central bank has a mandate to keep the inflation to below 2% so they have a duty to take action before the money will lose value. Inflation rates here.

In the USA, the inflation rate is determined by a gauge called Consumer Price Index (CPI). The monetary policy of a bank is based on the CPI level. The U.S. Bureau of Labor Statistics will publish the CPI in between the 13 th and 19 th of every month. The prices of several products are taken into account when calculating the CPI including transportation, education, housing, food and beverage. As a binary options trader, you must pay attention to the CPI because the increase or decrease of the inflation rate can affect the demands of the goods. Usually, you can find the CPI for the economies worldwide in the economic calendar including USA, Europe, UK, Australia and Japan.

Other countries will also release their own consumer price index and they will be released at a different price. The way the Consumer Price Index (CPI) is calculated vary across the different countries. For example, the USA CPI is calculated by looking at the core inflation for example inflation on the core resources like oil and energy. Before you start trading, you should study the information in the consumer price index (CPI). The CPI gives a monthly overview of the fluctuation of the prices of the products. It will be best that you study the consumer price index as soon as it is released into the public.

If the inflation is higher than 2-3%, the value of the stocks will decline because the average consumer will not be able to afford the expensive products. When there are lesser people buying the products, the value of the stocks of the companies will also decline. Deflation will likewise reduce the value of the stocks. During a deflation, sellers will reduce the price to make it affordable for people because of the lay off situation and many people don’t have money to buy the expensive goods.

The binary options trading signal you receive will depend on the changes in the inflation rate. You must always monitor the financial news and pay attention to the inflation rate of the asset you are trading. Having a good understanding on the inflation rate of the forex, stocks or indices you are trading on will increase your chances of winning the trades.

In conclusion, it is crucial that every binary trader become familiar with the concepts of inflation and deflation. Understanding how inflation affect the prices of your financial assets can increase your winning rates.

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