Inflation and Deflation- Causes, Ways to Control and all Important Concepts

Inflation and deflation, both are very important concepts that affect everyone in the society. So in this article, we will learn, inflation and deflation meaning, their causes, how they impact the economy, and measures to control them. This knowledge is necessary for all those students who want to understand the financial world better.

What is Inflation?

Inflation refers to increase in the prices of goods and services over time. It means that as inflation rises, the purchasing power of money decreases. In simple words, you will need more money to buy the same goods and services that you could have purchased at a lower price earlier.

Example of Inflation - At the time of COVID-19, supply chains were disrupted, and production was reduced. At the same time, governments put more money into the market, which increased demand, but did not decrease supply. This is the reason we have to see inflation, especially in healthcare products, food items, and electronics.

Inflation

Causes of Inflation 

• Demand and Supply imbalance: This occurs when demand of goods and services is more than supply and this increase prices. Such conditions usually happens in a growing economy where people have more money to spend.

• Cost-Pull inflation: This occurs when the cost of production increases, leading to higher prices for finished goods. For example, if price of raw materials goes then final product's cost also increases.

• Wage-price inflation: It is also known as built-in inflation. It happens when workers demand for higher wages, and businesses increase prices to maintain cost-price margin.

• Monetary Policy: When Central Bank increases money supply in the economy, then it lead to inflation because more money increase the purchasing power of people and cause increase in demand of goods and services, and cause increases in prices.

Ways to control inflation:

Monetary Policy (Role of Central Bank):

• By increasing the interest rates: If the central bank like RBI has increased the interest rates, then people have started avoiding taking loans and reducing the spending. This reduces demand and brings inflation under control.
• Money Supply Reduction: If RBI sells bonds to withdraw money from the market or CRR (Cash Reserve Ratio) increases then banks will have less money to lend. Due to this, there is less money in the market and inflation has come down.

Fiscal Policy (Role of Government):

• Government Spending has reduced: If the government has reduced its expenditure, then money in the market has reduced. Like reducing funding in infrastructure projects or removing subsidies.
• By increasing taxes: If the government increases taxes, then people's disposable income gets reduced. This cause fall in spending and brings inflation under control.

Supply Side Measures:

• Increasing Production: If the government focuses on increasing production, then supply increases and inflation can be controlled. Like giving subsidies to agriculture or increasing production capacity in factories.
• Reducing Import Duties: If the demand for a product is high and its supply is low, then the government reduces import duties so that that product can be imported from abroad. This reduces supply and brings inflation under control.

What is Deflation?

Deflation is the exact opposite of inflation, where the average price of goods and services decreases over time. However, this seems to be good because the prices are falling but it is not so. Deflation is definitely harmful for the economy because it reduces the production, reduces the wages and increase unemployment.

Example of Deflation - After the global financial crisis of 2008, many countries experienced deflation. People reduced spending, demand fell, and prices started coming down. Governments and central banks had to intervene to keep the economy stable.

Deflation 

Causes of Deflation

• Demand falls: When people buy less goods, demand falls. Due to this the prices have started coming down and cause deflation. This happens more in times of recession.

• Excess Supply: When there is excess supply of any item and people are not buying it, then companies reduce the prices so that the stock can be cleared.

• Technological Advances: When new technologies are introduced which allow more production at lower cost, the prices of products fall.

• Tight Monetary Policy: If the central bank withdraws money from the market, or increases interest rates, people spend less money. This can lead to deflation.

Ways to control deflation:

Monetary Policy:

• Reducing Interest Rates: If the Central Bank reduces interest rates, then people take more loans and spending increases. This increases demand and deflation is controlled.
• Money Supply Control: If the Central Bank supplies money to the market (such as by buying bonds), then people have more money to spend. Due to this demand has increased and deflation has come under control.

Fiscal Policy:

• Government Spending Mechanism: If the government spends more (like increasing subsidies in infrastructure projects), then money comes into the market and demand increases. This reduces deflation.
• Reducing Taxes: If the government reduce taxes, then people will have more money, which they spend. This increases demand and controls deflation.

Supply Side Measures:

• Reduce Supply: If Government reduces the excess supply of any product, then prices of that product become stable.
• Technological Investments: Cost-efficiency can be improved by investing in new technologie. When new technologies are used then cost of production reduces and prices falls in the market which control deflation.

Some other important topics

All these concepts hover around inflation and deflation, and they are also very important to understand when you look at the economy from a broader perspective.

Stagflation:

The situation when there is inflation, but economic growth slows down and unemployment also decreases. This means that the prices of goods are increasing, but people are not getting jobs and the economy is slowing down. This situation is very difficult to control, because if we try to control inflation, then growth can become even more slow.

Hyperinflation:

This happens when inflation suddenly goes out of control, when the government starts printing excessive money without any economic backing. Examples of this have been seen in Zimbabwe or Germany (1920s).

Disinflation:

Disinflation is situation when there is a reduce in inflation rate, but inflation is still happening. If earlier there was 5% inflation and now it becomes 3%, then it is called disinflation. This is not deflation, because prices are still increasing, just their speed have reduced.

Phillips Curve:

This is an economic theory which shows that there is an inverse relation between inflation and unemployment. That is, if inflation is decreasing, then unemployment is likely to decrease and vice versa. But this theory does not work in every situation, especially in stagflation.

Core Inflation:

This is inflation which excludes the prices of volatile items like food and fuel. Because commodity prices of such goods remain below average. Core inflation ignores them and tries to give a steady picture.

Quantitative Easing (QE):

When the economy is in recession and there is a risk of deflation, then central banks add money to the market by buying securities (like bonds). This increases liquidity in the market and gives a boost to the economy.

Conclusion

So, finally this interesting topic is completed. In this, we learned about Inflation and Deflation, their causes and ways to control them. Also we came to know about many related terms like Stagflation, Hyperinflation, Disinflation, Phillips Curve, Core Inflation, and Quantitative Easing (QE). I hope you like this article and get help in enhancing your knowledge.