What is the Difference between Inflation and Deflation?

Inflation refers to an economic phenomenon where prices of majority of goods and services decrease whereas in deflation, prices of majority of goods and services decrease.

While learning about the economy, it is important to know about the difference between inflation and deflation. Since every economy undergoes turbulence, it either undergoes inflation or it undergoes deflation.

Table of Contents

• Difference between Inflation and Deflation
• What is inflation?
• What causes inflation?
• Negative impacts of inflation
• Is inflation always bad?
• Types of Inflation 
• Relationship between Inflation and Deflation
• Understanding deflation
• Reasons behind the phenomenon of deflation
• How can deflation impact our economy?
• When does deflation become useful?

Difference between Inflation and Deflation

Aspect	Inflation	Deflation
Definition	Increase in the general price level of goods and services over time.	Decrease in the general price level of goods and services over time.
Effect on Prices	Prices rise.	Prices fall.
Purchasing Power	Decreases: Money buys less.	Increases: Money buys more.
Economic Impact	Can encourage spending and economic growth.	Can lead to reduced consumer spending and
Central Bank Response	May raise interest rates to control inflation.	May lower interest rates to encourage
Debt Impact	Reduces the real burden of debt.	Increases the real burden of debt.
Investment Behavior	May encourage investment in assets that	May discourage investment due to fears of
Expectations	Expectations of future inflation can lead to increased current spending.	Expectations of deflation might lead to delayed spending.
Impact on Borrowing	Reduces the real cost of borrowing.	Increases the real cost of borrowing.
Macroeconomic Stability	High inflation can destabilize an economy.	Prolonged deflation can lead to economic
Causes	Demand-pull, cost-push, structural, fiscal	Decreased demand, technological advancements

What is inflation?

Let us imagine you have just turned 18 and you’ve been given a monthly allowance to spend on whatever you like. Last year, with your allowance, you can buy 10 of your favourite books. 

But during this year, with the same amount of money, you can only buy 8 books. 

This is because of the phenomenon of inflation. 

The prices of things go up over time, so the same amount of money buys you less. It reduces the purchasing power of money. It’s like going to a store with a full wallet but coming out with a lighter shopping bag than you expected. 

Technically, inflation occurs when prices of goods and services increase too much. It is an economic situation that impacts the buying capacity of consumers. While inflation sounds like a terrifying situation, it is necessary for running any economy. It is a quantitative measure of the increase in the prices of goods in an economy. 

Causes: How does inflation occur?

This economic phenomenon arises due to the following conditions:

1. Demand-Pull Inflation: When demand for goods and services is high but the supply is low. Due to this disbalance in demand and supply, prices of the in-demand goods also increase. This is also known as a demand-pull situation. 
2. Built-in inflation: This type of inflation arises when workers demand higher wages. To pay higher wages to workers, companies compensate for this by increasing the prices of the goods that they sell.
3. Cost-push inflation: This is caused by a decrease in the aggregate supply of goods and services due to increased cost of production. The increased cost of raw materials or wages leads to increased production costs. When a company undergoes higher costs, it is compensated by charging more prices to customers.

Negative Impacts of Inflation

Inflation can have the following impact:

• Reduces the purchasing power of money.
• Increases the cost of borrowing.
• Leads to ‘menu costs’ or costs of changing prices.
• Can impact import and export.

Benefits of Inflation: Is it always bad?

• Debt reduction: Inflation can have a positive impact in the case of debts. A moderate level of inflation means that you will have to effectively repay less than the amount you borrowed. 
• Stimulate spending: Inflation can boost economic growth as people expect prices to further go up. This leads to an increase in spending.
• Increase in investment: When inflation increases, consumers are more enthusiastic about saving and investing money.n

Types of Inflation

Inflation has the following four stages:

Type	Characteristics	Range (annually)
Creeping inflation	Mild and slowly rising.	2-3%
Walking inflation	Harmful in the long run.	3-10%
Galloping inflation	Loss of confidence in the currency.	10-300%
Hyperinflation	Extremely high inflation. Collapse in the supply of base value of money.	>300%

Relationship between Inflation and Deflation 

The relationship between inflation and deflation is defined by their opposing effects on the general price level within an economy. 

1. Price Movement:

• Inflation: Inflation refers to a sustained increase in the overall price level of goods and services over time. This means that, on average, things become more expensive, and the purchasing power of money decreases.
• Deflation: Deflation is characterized by a prolonged decrease in the general price level. In this scenario, prices tend to fall, and the purchasing power of money increases.

2. Economic Behavior:

• Inflation: During inflation, consumers may feel the need to spend more now rather than later, fearing that prices will continue to rise. This can lead to increased consumer spending and economic activity.
• Deflation: In a deflationary environment, consumers might delay spending, expecting prices to drop further. This can lead to reduced consumer demand, impacting economic growth.

3. Central Bank Response:

• Inflation: Central banks may raise interest rates during periods of high inflation to control spending and reduce price increases.
• Deflation: Central banks often lower interest rates during deflation to encourage borrowing, spending, and investment to counter falling prices.

4. Debt Impact:

• Inflation: Debtors benefit from inflation, as the real value of their debt decreases over time, making it easier to repay.
• Deflation: Debtors can face challenges during deflation, as the real value of their debt increases, potentially leading to difficulties in repaying loans.

5. Economic Stability:

• Inflation: While moderate inflation can be a sign of a healthy economy, high or hyperinflation can destabilize an economy, erode savings, and disrupt business planning.
• Deflation: Mild deflation might seem favorable, but prolonged deflation can lead to reduced consumer spending, business contraction, and economic stagnation.

6. Expectations and Behavior:

• Inflation: Expectations of future inflation can lead to increased current spending, stimulating economic activity.
• Deflation: Expectations of deflation might lead to delayed spending, creating a cycle of falling demand and economic slowdown.

7. Impact on Investment:

• Inflation: Inflation can encourage investment in assets that appreciate with rising prices, like real estate or stocks.
• Deflation: Deflation can discourage investment as businesses fear falling prices and reduced profitability.

8. Trade Dynamics:

• Inflation: High inflation in one country can lead to higher export prices, potentially impacting trade relationships with other nations.
• Deflation: Deflation can lead to lower export prices, potentially affecting global trade dynamics.

What is deflation?

Deflation is an economic phenomenon that occurs when there is enough supply but there is no money in the market. Due to this economic phenomenon, the prices of goods and services decrease.

Imagine, you can buy a product at 100$ last year but this year it only costs 90$. That decrease in price is deflation.

Causes: How does deflation occur?

This economic phenomenon arises due to the following conditions:

• Decreased demand: Deflation can occur when the demand decreases. This compels the sellers to bring down the prices of the products. This helps them in attracting customers even if the demand has gone down. 
• Overproduction: If a business produces more goods than what consumers are willing to buy. This means that inventory goes into excess and the demand is less. Due to this oversupply, businesses can bring down the prices of the goods.
• Reduced production cost: When the production cost of goods goes down significantly, it may force businesses to lower the prices to remain competitive. 
• Changes in monetary policy: When the central bank changes monetary policies which may lead to a rise in interest rates. This leads to a decrease in the availability of money in the market. It, in turn, contributes to deflation.

Negative Impact of Deflation

• Increases of the real value of debt making it difficult for borrowers to repay loans.
• Forces businesses to perform cost-cutting which may even impact the wages of the workers.
• Causes a delay in purchases as consumers expect prices to go down.

Benefits of Deflation: When is it useful?

• More savings: During the period of deflation, the price level of goods and services fall. This helps consumers to buy goods and services at a lower prices. In turn, people are able to save more money. 
• Adjustment period: After high inflation, there is an adjustment period where a short time period of mild deflation helps in price adjustments to realistic level. This helps in maintaining a balance between the economy and prevent negative consequence related to hyperinflation.
• Increased purchasing power: As companies start setting lower prices, the purchasing power of the products increases. This helps people in buying more things at lower prices.