Inflation and Deflation

Have you noticed that the prices of products and services are gradually increasing? What product that you could buy for £1 last year costs more this year? This situation is very common, and in economics, it’s called inflationOn the other hand, if prices of goods are decreasing this is called deflation. Let’s talk about inflation and deflation and why they’re so important in economics. 

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Table of contents

    Inflation

    Simply put, inflation is the progressive increase in the prices of goods and services in an economy.

    Inflation is a general rise in the price level in the economy.

    These goods and services include:

    • Essential goods (such as food items, hygiene products, housing supplies, clothing, etc.).
    • Housing and cars.
    • Rental services (car, accommodation, etc.).
    • Luxury goods.

    These are only a few examples, there are a lot more. Try to think about the items you consume daily and occasionally and they should probably be on this list.

    There are two types of inflation:

    • Demand-pull inflation: this is when inflation is caused by excessive aggregate demand. This means that the aggregate demand is rapidly increasing, faster than the long-run aggregate supply of the economy, creating inflation.

    • Cost-push inflation: this is when inflation arises due to issues in the supply-side of the economy. It can occur due to the increased union power in the wage bargaining process, or through an increase in either commodity or energy prices. This usually causes the short-run aggregate supply to shift to the left due to increased costs of production, creating inflation.

    How to calculate inflation?

    There are two methods that the government uses to calculate inflation. These are the Retail price index (RPI) and the Consumer price index (CPI).

    The RPI inflation was used for a number of years in the UK until 2003, but it is not currently used. The main purpose of using RPI was to calculate the inflation in the retail prices by including mortgage interest repayments.

    Currently, the government uses the CPI, which is relatively similar to the RPI but doesn’t include mortgage interest repayments. The key features of CPI are:

    • The government records the expenditures of the ‘national shopping basket’. This usually consists of goods that people consume on a daily basis.

    • The CPI is calculated based on data collected from various supermarkets. The data includes family shopping basket prices.

    • To calculate the index, items that are included in the shopping basket are weighted in regards to their importance. The importance is decided depending on how much the household spends on the item: the more they spend on it, the higher the importance and thus the weight of the item.

    • The CPI can be used to calculate the prices of the shopping baskets of various consumer groups and consumers in different geographical regions. It can also identify the periods of inflation and deflation.

    • The CPI results can be compared annually to calculate the inflation rate throughout the years in regards to consumers' shopping baskets.

    If a household spends £400 a month on food and drink and £100 on footwear, food, and drink will have a higher weight in the shopping basket.

    CPI example

    The table below represents an example of CPI calculation. The items in the example are the essential items consumed by the household. The importance or weighting of each product or service displayed in the example depends on how much the household spends on it. The weighting of all items should usually add up to 1000. The price index of the previous year (2020) is always displayed as 100 and the increase in price is shown in the ‘Price index in 2021’ column.

    ItemWeightingPrice index in 2020Price index in 20212021 Price index X weighting
    Food and drinks50010010653,000
    Transport20010010320,600
    Clothing and footwear30010010932,700
    Total1000--106,300
    1. To calculate the CPI in this example, we need to first, multiply the ‘weighting’ column by the ‘Price index in 2021’ column of each item individually. 2. We then need to add the calculated sum of the ‘price index X weighting’ of each item together. In this example, the sum of all price ‘indexes X weighting’ is 106,300 (see the last column). 3. Next, we need to divide this number by 1000. Here 106,300 / 1000 = 106.3. This gives us the price index of 106.3 in 2021 regarding all items. 4. Finally, to calculate the inflation rate, we need to subtract 100 (which is the previous year’s index) from 106.3. This gives us an inflation rate of 6.3% from 2020 to 2021.

    Deflation

    Deflation is the opposite of inflation. It means that the prices of goods and services in an economy are falling.

    Deflation is a general fall in the price level in the economy.

    Deflation usually occurs due to the following reasons: there may be a fall in aggregate demand, which would cause the general price level to decrease. Alternatively, the short-run aggregate supply could shift to the right due to decreased costs of production, causing the general price levels in the economy to fall.

    What causes inflation?

    The two main types of inflation (demand-pull and cost-push) are caused by different factors that affect the economy.

    Demand-pull inflation

    • The main cause of demand-pull inflation is an increase in aggregate demand. The prices of products and services will increase to stimulate firms to produce more output in response to growing demand.

    • The positive output gap is another cause of demand-pull inflation. It means that the growth rate of the economy is above the trend growth rate, which leads to higher inflation.

    The trend growth rate of the economy is the long-term rate of economic growth which is sustainable in a way that it will keep inflation to a minimum

    Inflation and Deflation Demand pull inflation StudySmarter OriginalsFigure 2. Demand-pull inflation, StudySmarter Originals

    Figure 2 depicts demand-pull inflation. The aggregate demand for goods and services increases from AD1 to AD2 (a rightward shift), causing an increase in the price level from P1 to P2.

    Cost-push inflation

    • This type of inflation is caused by the growing monopoly power of trade unions. As unions become more powerful they demand higher wages, which raises the cost of labour, thereby raising the costs of production for a firm.

    • Additionally, cost-push inflation can be caused by the increased commodity or energy prices, which raises the overall cost of production causing the short-run aggregate supply to shift to the left.

    Inflation and Deflation Cost push Inflation StudySmarter OriginalsFigure 3. Cost-push Inflation, StudySmarter Originals

    Figure 3 depicts cost-push inflation. The short-run aggregate supply curve shifts to the left from SRAS1 to SRAS2 due to increased production costs, causing an increase in the price level from P1 to P2. The real output falls from Y1 to Y2.

    The situation when the price level increases due to a supply-side shock in the economy with a simultaneous fall in real output, coupled with a rise in structural unemployment is a very specific economic situation: stagflation.

    Stagflation is a period of slow economic growth, rising unemployment, and also rising inflation.

    What causes deflation?

    Several factors can cause deflation. They are:

    • shortages or falling of the money supply
    • decrease in the velocity of money circulation
    • fall in aggregate demand
    • increase in productivity.

    Firstly, the monetarist theory describes that it can occur due to the shortages or falling of the money supply in the economy. Additionally, a decrease in the velocity of money circulation could cause a fall in the general price level.

    To learn more about how the money supply affects inflation read our explanation on the Monetarist Theory of Inflation.

    Secondly, deflation could be caused by a fall in aggregate demand. A fall in the aggregate demand causes a fall in consumer confidence and therefore a fall in spending. This causes the general price level to fall. Firms may then react to this by decreasing wages to lower their costs of production. Lower wages will feed into lower households’ income, causing their demand to fall further. This is referred to as a deflation spiral.

    A deflation spiral occurs when deflation affects the circular flow of income in a way that deflation in itself becomes a self-reinforcing loop.

    Additionally, deflation can occur due to an increase in productivity. This can be influenced by improvements in technology, which reduce the costs of production, causing the aggregate supply to shift to the left and lower the overall price level in the economy.

    Consequences of inflation and deflation

    Let's explore the consequences that inflation and deflation have on the overall economy, consumers, and businesses.

    The consequences of inflation

    These are some of the consequences of inflation:

    Consumers and employees

    • Decrease in consumers' purchasing power due to the increased prices of goods and services.

    • Inflation is favourable for consumers that have loans. Despite the increased prices of goods and income levels, the debt repayments stay at the same level, which makes them decrease in value. This makes it easier for consumers to repay their debts.

    • Along with inflation of the prices of goods and services, workers' income also increases. However, if it increases at a lower rate, consumers become less wealthy.

    • Due to inflation, businesses have to pay higher wages to their employees. To reduce the costs of labour, businesses may make cuts in employees by making them redundant.

    • High and unstable inflation affects agents’ expectation formation about future price levels, which in turn affects the economy in an unpredictable way.

    To learn more about how expectation formation affects the price level in the economy take a look at our explanation on Monetarist Theory of Inflation

    Businesses

    Employees may be demanding higher wages due to inflation, which will result in the increase of the business costs of production. This can cause a reduction in exports as they will become relatively more expensive. For example, if there is inflation in the UK, the prices of goods in the UK will increase, therefore exports will become more expensive for foreign countries to import. This will result in lower demand for exports and an overall decrease in business profits from exports.

    The consequences of deflation

    These are some consequences of deflation:

    • In the long run, consumer spending declines. As prices are decreasing, consumers are likely to hold on to their savings, as in the future they believe that the costs of goods will be even lower.

    • Along with the decrease in the prices of goods, consumer salaries will decrease simultaneously.

    • There is a decline in business productivity due to the lower demand for consumer goods. This results in an increase in unemployment as businesses will not need to supply as many goods.

    • As a result of deflation, price mechanisms are disrupted, which makes people confused about the true value of products and services. This also affects their expectation formation about future price levels.

    • Deflation causes an overall slowdown in the economy.

    Examples of inflation and deflation

    Let’s explore some examples of how inflation and deflation affect the UK and the rest of the world.

    Changes in other economies affect inflation and deflation in the UK

    The global increase in prices of goods that the UK imports, such as oil, raw materials, food, and others causes the price of these products to increase when they are imported into the UK.

    For example, the oil prices increased significantly during 2008 and 2011-12, which influenced inflation in the UK. How did that happen? The higher oil prices caused plastic manufacturing costs to increase. Due to this, the plastic production companies passed increased prices of plastic goods onto consumers, and this caused inflation of goods containing plastic.

    On the other hand, the global economy can have an influence on inflation to slow it down and even cause deflation. For example, rising productivity and technology lower the prices of goods in major exporter countries such as China. If the UK increases its imports from China, this will reduce the prices of those goods sold in the UK.¹

    Changes in world commodity prices affect domestic inflation

    Commodity prices usually respond to changes in the exchange rate of the US dollar. If the dollar increases in value the commodities such as oil and gas will increase in prices in the domestic economies.

    Shocks in the economy such as natural disasters increase the export cost of commodities. Therefore, once the commodity gets to the consumer, its price is higher, which results in domestic inflation for that particular commodity.

    Controlling inflation and deflation

    High deflation and inflation rates can be bad for the economy. Deflation slows down economic growth, while inflation causes a decrease in the consumers’ purchasing power. It also disturbs savings because as money loses value, consumers are likely to spend their money instead of saving it. Therefore, the government and central banks implement various techniques and policies to control inflation and deflation rates.

    To control inflation, the government uses different macroeconomic policies. This is aimed to deflate the economy. That is, decreasing the economic activity and aggregate demand to regulate the price levels of goods and services. The main government’s aim is to achieve disinflation.

    Disinflation is the situation when the rate of inflation is decreasing. In other words, the prices are rising at a slower rate. This applies to a positive inflation rate only.

    To control deflation, the government and central banks implement monetary and fiscal policies. The central bank uses monetary policy to lower the reserve limits and generate more loans for various investments and consumption. That way, there is increased demand for borrowing, which stimulates aggregate demand and supply.

    Additionally, the government can use fiscal policy to increase spending and increase the aggregate demand. To achieve this, the government can provide funds and grants to businesses so that they can employ more people. This would mean that households would have more purchasing power due to more employment, which would result in increased consumer spending. This will increase the demand for goods and services and their prices simultaneously.

    High inflation and deflation are bad for the economy, which is why government implements policies to control them. The government’s overall goal is to achieve low and stable inflation, which is very important for a balanced economy.

    Inflation and Deflation - Key takeaways

    • Inflation means that the price levels in an economy are rising.
    • There are two types of inflation: demand pull-inflation and cost-push inflation.
    • Demand-pull inflation is caused by an increase in aggregate demand.
    • Cost-push inflation arises due to issues in the supply-side of the economy.
    • Stagflation is an economic situation that describes a period of slow economic growth, rising unemployment, and rising inflation.
    • Deflation is opposite to inflation and it means that prices of goods and services are decreasing.
    • The consequences of inflation include reduced consumer purchasing power, a decrease in loan repayments, an increase in the level of income, and increased costs of production.
    • The consequences of deflation include a decrease in consumer spending and income, a decrease in business production, and an overall slowdown in the economy.
    • To control inflation, the government uses different policy tools, the main being Monetary Policy.
    • Disinflation is the situation when the rate of inflation is decreasing. In other words, the prices are rising at a slower rate. This applies to a positive inflation rate only.

    • To control deflation, the government and central banks usually use fiscal and monetary policies. The use of these policies involves increasing bank reserves to lend more money to the citizens and giving funds to businesses so they can increase production and employ more workers. These methods are aimed to increase consumers' purchasing power and demand for goods which should improve the situation of deflation.

    Sources

    1. Tejvan Pettinger, Impact of the global economy on UK inflation, 2013.

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    Frequently Asked Questions about Inflation and Deflation

    What causes inflation?

    Different types of inflation are caused by different factors. Demand-pull inflation is mainly caused by an increase in aggregate demand. Cost-push inflation is generally caused by issues in the supply-side of the economy such as increased union power in the wage bargaining process or an increase in either commodity or energy prices.

    Why are inflation and deflation an economic problem?

    Inflation is an economic problem due to a number of reasons such as the reduction in consumers' purchasing power. If income grows slower than the prices of goods and services, it results in people being able to afford less. For business, inflation increases the costs of production which results in reduced demand for exports.

     

    On the other hand, deflation slows down the economy as people are likely to spend less and hold on to their savings as they believe that in the future their money will be worth more. Due to the lower demand for goods, businesses' production decreases, and unemployment increases.

    What are the three effects of inflation?

    1. Decrease in consumer purchasing power as the prices of goods increase.

    2. Loans become easier to repay because of inflation of prices of goods and income levels, but the level of debt repayments stays the same.

    3. Due to inflation, employees may be demanding higher wages which will cause the costs of production to increase.

    What are the differences between inflation and deflation?

    The main difference between inflation and deflation is that inflation causes the prices of goods to increase along with the employees' salaries. On the other hand, deflation means that the prices of goods and services are decreasing along with employees' salaries.

    What causes deflation?

    Several factors can cause deflation. They are:

    • shortages or falling of the money supply
    • decrease in the velocity of money circulation
    • fall in aggregate demand
    • increase in productivity.

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