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Inflation & Deflation – Definition, Causes, Effects, Basics

Updated on:  

08 min read

Inflation happens when the price of goods and services increase, while deflation takes place when the price of the goods and services decrease in the country. Inflation and deflation are the opposite sides of the same coin.

Maintaining the balance between these two economic conditions, i.e. inflation and deflation is essential as the economy can quickly swing from one condition to the other as a result of these two conditions. The Reserve Bank of India keeps an eye on the levels of price changes and controls deflation or inflation by conducting monetary policy, such as setting interest rates in India.

Inflation

Inflation is the rate at which the prices for goods and services increase. Inflation often affects the buying capacity of consumers. Most Central banks try to limit inflation in order to keep their respective economies functioning efficiently. There are certain advantages as well as disadvantages to inflation.

Inflation refers to the increase in the prices of the goods and services of daily use, such as food, housing, clothing, transport, recreation, consumer staples, etc. Inflation is measured by taking into consideration the average price change in a basket of commodities and services over a period of time.
Inflation is calculated in India by the Ministry of Statistics and Programme Implementation.

A simple example would be, suppose a kg of apple cost Rs.100 in 2019 and it cost Rs.110 in 2020, then there would be a 10% increase in the cost of a kg of apple. In the same way, many commodities and services whose prices have raised over time are put in a group and the percentage is calculated by keeping a year as the base year. The percentage of increase in prices of the group of commodities is the rate of inflation.

Causes of Inflation

Inflation is caused by multiple factors, here are a few:

Money Supply

Excess currency (money) supply in an economy is one of the primary cause of inflation. This happens when the money supply/circulation in a nation grows above the economic growth, therefore reducing the value of the currency.

In the modern era, countries have shifted from the traditional methods of valuing money with the amount of gold they possessed. Modern methods of money valuation are determined by the amount of currency that is in circulation which is then followed by the public’s perception of the value of that currency.

National Debt

There are a number of factors that influence national debt, which include the nations borrowing and spending. In a situation where a country’s debt increases, the respective country is left with two options:

  • Taxes can be raised internally.
  • Additional money can be printed to pay off the debt.

Demand-Pull Effect

The demand-pull effect states that in a growing economy as wages increase within an economy, people will have more money to spend on goods and services. The increase in demand for goods and services will result in companies raising prices that the consumers will bear in order to balance supply and demand.

Cost-Push Effect

This theory states that when companies face increased input cost on raw materials and wages for manufacturing consumer goods, they will preserve their profitability by passing the increased production cost to the end consumer in the form of increased prices.

Exchange Rates

An economy with exposure to foreign markets mostly functions on the basis of the dollar value. In a trading global economy, exchange rates play an important factor in determining the rate of inflation.

Effects of Inflation

When there is inflation in the country, the purchasing power of the people decreases as the prices of commodities and services are high. The value of currency unit decreases which impacts the cost of living in the country. When the rate of inflation is high, the cost of living also increases, which leads to a deceleration in economic growth.

However, a healthy inflation rate (2-3%) is considered positive because it directly results in increasing wages and corporate profitability and maintains capital flowing in a growing economy.

Steps to offset Inflation and its effects on Your Retirement

Factoring for inflation is an essential process for financial planning. The question is how much will you actually need when you retire? Here are a few ways you can retire financially sound keeping inflation in mind.

Invest in long-term investments.

When it comes to long-term investments, spending money now for investments can allow you to benefit from inflation in the future.

Save More

Retirement requires more money than one might imagine. The two ways to meet retirement goals are to save more or invest aggressively.

Make balanced investments

Though investing in bonds alone feel safer, invest in multiple portfolios. Do not put all your eggs in one basket to outpace inflation.

Deflation

Deflation is generally the decline in the prices for goods and services that occur when the rate of inflation falls below 0%. Deflation will take place naturally, if and when the money supply of an economy is limited. Deflation in an economy indicates deteriorating conditions.

Deflation is normally linked with significant unemployment and low productivity levels of goods and services. The term “Deflation” is often mistaken with “disinflation.” While deflation refers to a decrease in the prices of goods and services in an economy, disinflation is when inflation increases at a slower rate.

Causes of Deflation

Deflation can be caused by multiple factors:

Structural changes in capital markets

When different companies selling similar goods or services compete, there is a tendency to lower prices to have an edge over the competition.

Increased productivity

Innovation and technology enable increased production efficiency which leads to lower prices of goods and services. Some innovations affect the productivity of certain industries and impact the entire economy.

Decrease in the supply of currency

The decrease in the supply of currency will decrease the prices of goods and services to make them affordable to people.

Effects of Deflation

Deflation may have the following impacts on an economy:

Reduction in Business Revenues

In an economy faced with deflation, businesses must drastically reduce the prices of their products or services to stay profitable. As reductions in prices take place, revenues begin to drop.

Lowered Wages and Layoffs

When revenues begin to drop, businesses need to find means to reduce their expenses to meet objectives. One way is by reducing wages and cutting jobs. This adversely affects the economy as consumers would now have less to spend.

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