Inflation and Deflation for Dummies

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What is an example of a difference between inflation and deflation?

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They are opposites of one another, describing the same phenomenon in different directions.

  • Inflation = prices of things go up.
  • Deflation = prices of things go down.
  • Inflation and Deflation generally refer to prices generally. Computers getting cheaper doesn’t mean you have deflation. Food, housing, electronics, etc. all going down means you have deflation.

There are other ways to talk about this (I’ll go into it in a moment), but the above is the very simple “what are these terms.”

Now, we can imagine this not as an issue of prices but of money supply.
If the price of everything goes up by exac.

Inflation & Deflation: Causes and Effects

Inflation is frequently talked about, particularly in time of crisis and recession. Some people think it aids economic growth, others believe it’s an institutionalized robbery. We’ve made it our goal to get to the bottom of the subject and figure out ways to safeguard your money.

What is Inflation

Inflation is a process when a currency’s purchasing power weakens as the monetary supply exceeds the demand. In other words, people have more money on their hands, yet they aren’t buying as much as they’re expected to.

Inflation is conventionally divided into official and actual. The difference between the two types will determine your income. To get a better understanding, let’s take a look at the way each one is calculated.

How inflation is measured

Official inflation is based upon the consumer price index (CPI), i.e. by the changes to the price level of market basket of consumer goods and services purchased by households. CPI and the associated inflation are calculated in two steps:

  1. Establishing the contents of the market basket. It’s approximately comprised of 500 items, ranging from a sack of potatoes to a basic blood workup.
  2. Gathering data on the prices of items in the basket throughout the country. The percentage difference between last year’s figures and the current ones will represent the official inflation rate.

For the sake of an example, let’s say the market basket last year came down to $1000. This year, however, it’s worth $1100. That means the price has risen by 10%. The annual inflation rate is — you guessed it — 10%.

The difference between actual and official inflation

The government approach to calculating the inflation rate is pretty straightforward and reflects the general situation for the population as a whole. However, that in itself creates a problem as «average» consumer spendings may differ from your personal ones by a whole lot.

The reality is your personal market basket may go up in price twofold compared to the average one. Meanwhile, your salary would only be increased according to the official inflation rate. There are two ways you could go about this: you have to either increase your income or lower the expenses. We’ll talk more about it later in the article.

Causes for inflation

We have established that inflation emerges as a result of disproportion between public supply and demand. Now let’s look at the origins of this disproportion.

  • Refinancing Rate. Central Banks lend money to the credit institutions under a certain interest. That interest is known as the refinancing rate. The lower the rate — the more affordable the loans will be to the public. Loans and mortgages are a source of additional money circulating the market.
  • Market monopolies. The weak anti-monopoly legislation does nothing to prevent monopolies from dictating their price levels, affecting the price of the market basket and in turn — shaping inflation. To put things into perspective: monopolies drive the prices, the market basket gets more expensive, the inflation rate rises.
  • State budget deficit. Whenever the expenses exceed the revenue, the state starts printing additional money or issuing loan securities to the banks and individuals. That leads to an increase in monetary supply, while the trade volume remains the same.
    Military and emergency expenses. Additional spendings for defense or emergency purposes eat into the national income. Once again, the monetary supply begins to exceed the circulation of goods.
  • Devaluation of the national currency. If a currency depreciates against the other ones, the cost of imported goods rises. Export volumes grow, while internal supply diminishes. As a result, internal prices rise and the market basket gets more expensive.
  • Projected inflation. In an environment where the prices are rising the people start stocking up on goods in fear of further price spikes. Aggregate demand increases rapidly, which further marks up the prices for the market basket.

How to counteract inflation

Set up a savings account. It’s the easiest way to counteract inflation and increase your savings by up to 8% annually.

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Purchase bonds. A bond is a security issued either by the state or a business whenever it loans money from a private individual. Holding one can earn you up to 12% annually.

Investing in stocks. While bonds are confirmation of a loan, stocks are storages of value on their own merit. By purchasing a company’s stock, you’re becoming an investor and can make money off of that company’s revenue growth. The returns on such investments may vary, but the risks are always quite high.

Request fiduciary management. You may want to confide your money to the experts, the people who know how to multiply it. That service, obviously, comes at a price: you’ll have to pay the fiduciary a portion of your profit.

What is «deflation»?

Deflation is the opposite of inflation. The purchasing power of a currency is growing, while the prices are going down. Deflation is usually evident from CPI calculation for a particular month or a quarter, but the year overall normally ends with inflation.

At a first glance it may seem like deflation is a good thing — you can afford more for the same amount of money. In practice, however, it’s more harmful to the economy than inflation is

The dangers of deflation

  • Deflation makes demand go down. People are in no rush to buy expensive goods fearing those could only get more expensive. This causes businesses to slow down their growth and the economy as a whole stall as a result.
  • Businesses shut down. Production volumes plummet and the goods that have already been produced remain on their shelves.
  • Household incomes decline. Lower demand hurts businesses and forces them to lower salaries and lay people off.
  • Purchasing ability goes down. Deflation does make goods and services cheaper. However, household incomes decrease faster than the prices do.
  • The economy slows down. Banks cut back on the number of credit lines, both to private individuals and businesses. Taking out a loan becomes more difficult and ends up costing more in interest money.

Counteracting deflation

Central Banks can lower the refinancing rate to rejuvenate the economy through lending to businesses. In turn, money becomes more accessible to individuals, which boosts public demand. Another thing that can be done at the state level is easing up on the taxes and issuing more state bonds.

As a result, prices will stabilize and the people will have more disposable income, which will benefit businesses. Everybody wins!

Let’s recap

Actual inflation can be different from the official one and that will make a difference in your income.

Inflation can have many causes, most of which you’ll have no power over. That’s why it’s advisable to pay particular focus to your personal finances at that time.

There are several ways to safeguard your income during the times of higher inflation: savings accounts, stocks and other securities, fiduciary money management, cashback and controlling your spending.

Deflation is more dangerous than inflation, but thankfully it doesn’t happen too often.

Inflation and deflation

Inflation and deflation

Inflation and deflation arise from changes in either the demand side or supply side of the macro-economy.

Demand pull inflation

Demand pull inflation usually occurs when there is an increase in aggregate monetary demand caused by an increase in one or more of the components of aggregate demand (AD), but where aggregate supply (AS) is slow to adjust.

The commonest causes are demand shocks, such as:

  1. Earnings rising above factor productivity.
  2. Cheaper credit, following a reduction in interest rates.
  3. Excessive public sector borrowing.
  4. A housing boom creating equity withdrawal and a positive wealth effect.
  5. Changes in the savings ratio.

T he savings ratio

The savings ratio indicates the percentage of disposable income which is saved, rather than spent. Sudden changes in the savings ratio are an indicator of future changes in spending and AD, and can be a prelude to inflation or deflation.

A rise in the savings ratio indicates a decline in consumer confidence, whereas a fall in the savings ratio indicates a rise in confidence and spending, which can trigger an increase in the price level.

Cost-push inflation

Cost-push inflation occurs when an economy experiences a negative cost shock.

An increase in costs causes the aggregate supply curve to shift upward and to the left, resulting in a rise in the price level, and a contraction of aggregate demand.

The commonest causes are:

  1. Oil price shocks, caused by wars or decisions by OPEC to restrict output.
  2. Increases in farm prices or general food prices, following a series of poor harvests.
  3. Rapidly rising wage costs.
  4. A fall in the exchange rate, which increases the price of all imports.
  5. Imported cost push inflation as a result of inflation in other parts of the world.

A fall in the exchange rate

A reduction in the exchange rate will mean that more Sterling is required to purchase a given quantity of imports; in other words, the price of imports will rise. After a time-lag, this will feed its way into retail prices. For example, a motor vehicle imported from Germany for €50,000 would cost £25,000 at an exchange rate of £1 – €2. If Sterling falls in value, to £1 = €1.90, then the Sterling price would rise to £26,316.

Given that approximately 35% of the CPI basket of consumer goods and services are imports, the effect of a fall in the exchange rate is to raise the CPI. In addition, imported raw materials are also more expensive so costs of production will rise for those firms that source their inputs from abroad. Therefore, while a low exchange rate may be beneficial for exports, it has as a potentially inflationary effect on costs and prices.

Research by the Bank of England has identified two phases through which a change in the exchange rate ‘passes through’ the economy.

  1. In phase one, a change in the exchange rate affects import prices fairy quickly.
  2. In phase two, changes in import prices work their way into retail prices. Phase two may take much longer, even up to 3 years to complete.

Causes of deflation

Deflation tends to occur when the economy’s capacity, as indicated by the position of the AS curve, grows at a faster rate than AD. Firms have to cut prices in order to stimulate sales and get rid of stocks.

Deflation can be triggered by an increase in supply. As business and consumer confidence in the economy declines, AD falls, resulting in recession.

Inflation and deflation: two sides of the same coin

What is inflation? Depreciation of money? Types of inflation and the possibility of earning on it. Deflation as the opposite of inflation.

A modern economy cannot exist without inflationary and deflationary processes, which are two different poles of the same financial mechanism. How do they differ and what danger are they?

Inflation – The Depreciation of Money

When prices for goods and services rise, then money loses its price and enters the scene inflation. The occurrence of inflation has several reasons. This may be a shortage of a product or service associated with an increased demand for them and, accordingly, a rising price. Or an administrative reason. Having a deficit of tax revenues, the government, in order to have funds for payments, often pursues a policy of external loans or simply launches a printing press and prints the missing money. Naturally, printing money is the easiest way. The result of this approach is an oversupply of the money supply, which is not backed by any assets. Accordingly, such money depreciates, which leads to inflation.

Types of inflation

  • Administrative inflation – arises from administrative (managed) pricing.
  • Galloping inflation – as the name implies, is characterized by a high rate of price growth.
  • Credit inflation – based on excessive expansion of bank lending.
  • Hyperinflation – galloping inflation, characterized by an annual rate of price increase of more than 100%.
  • Cost inflation – characterized by rising prices for resources and production components.
  • Creeping inflation – characterized by a slower rate of price growth.
  • Imported inflation – the cause of the occurrence, as a rule, is an increase in prices for imported goods or an excessive influx of foreign currency.
  • Induced inflation – due to one of the purely economic inflationary factors.
  • Social inflation – associated with rising costs caused by increased requirements for any social sphere.
  • Premature inflation – characterized by occurrence until full employment is achieved.
  • Stagflation – combines the signs of stagnation and inflation.

In the context of growing globalization, inflation ceases to be a problem for one country, as the result of economic relations is the export of inflation.

Deflation is the antipode of inflation

Deflation is an economic process characterized by lower prices. Perhaps, on the contrary, this may seem useful to some, but deflation is no less dangerous than inflation.

When deflation occurs, investors are in no hurry to invest in production, since they expect further price reductions. In production, there is a shortage of cash, which leads to lower wages, a reduction in social programs, a decrease in production volumes and, as a result, falling profits. In this regard, the employer is forced to reduce workers, thereby increasing unemployment.

Deflation is due to insufficient cash supply. Money does not become anymore, their value is overstated, for one monetary unit accounts for more and more of the providing asset.

Methods of struggle and personal gain

Inflation and deflation have negative social and economic consequencesTherefore, states are actively struggling with these processes.

To combat inflation, the “expensive money” method is used. Monetary authorities direct their efforts to reduce the money supply. Against inflation, an increase in taxes, a reduction in lending, a decrease in government spending, and an increase in sales of government securities are applied.

Inverse measures are used to combat deflation.

How can one benefit from inflation and deflation?

Inflation is better if:

  • you have outstanding loans or other significant debts – they will depreciate.
  • You need a loan – if state loans are available to banks, they will also be more affordable, interest rates on such loans will fall in relation to price increases.

Deflation is better if:

  • You do not have debts on loans or other unpaid loans – during deflation, your salary will also decrease, but payments to the bank will remain at the same level.
  • you have savings in national currency – their real value is growing.
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