Deflation and Inflation – What’s the Difference?

Deflation and inflation are fairly common terms nowadays. Many of us have read or heard about these in the news. In addition, the use of such representations can be confusing and misleading at times due to their random and vague nature. Basic knowledge of such topics is great, but having complete knowledge helps determine what is best.

Inflation vs Deflation will be explained in detail in this article, including factors that contribute to inflation and deflation.

What is Inflation?

Basically, inflation is a general rise in the price of goods and services in an economy. An increase in price reflects the decline in purchasing power of the currency. Inflation occurs when a large portion of the population cannot afford more than is necessary.

There is a saying that says, “Inflation is taxation without legislation.”

– Milton Friedman, Veteran Economist and Nobel Memorial Prize holder in Economic Sciences

Types of Inflation Description
Creeping Inflation Price increases of less than 3% per year
Chronic Inflation A prolonged period of creeping inflation
Walking Inflation The price rises by more than 3% but not by more than 10%.
Moderate Inflation Price increases of less than 10% per year
Running Inflation A rise in prices of over 10% per year. 
Galloping Inflation Price rise by the double or triple-digit rate
Hyperinflation An annual increase in price over 1000%

Causes of Inflation in India

By 2026, Indian inflation is predicted to reach 4.05% and gradually decline from there. The following are some key reasons for inflation:

Money Supply

Despite its surprising nature, excessive currency supply causes inflation in economies. A different currency allows people to spend more and more, reducing the value of the currency. Furthermore, as a result of the demand & supply cycle balancing, prices increase by default.

National Debt

Indian budgets are mostly deficit-driven, which increases the national debt. Two options exist for neutralizing the national debt:

  • Internal taxes should be raised.
  • Paying off the debt by printing more currency.

After a period of time, both will cause inflation in some form or another.

Demand-Pull Effect

Growing economies have a demand-pull effect, which states that people will have more money to spend on goods and services. As a result of increased demand for goods and services, companies will raise prices, causing inflation.

Cost-Push Effect

Cost-push effects occur when raw materials and wages increase, causing overall prices to rise (inflation). Inflation caused by cost-push can occur when high production costs cause the supply of goods in the economy to decrease.

Exchange Rates

The exchange rate plays a crucial role in determining inflation in an economy that trades globally. In an economy exposed to forex markets, the dollar is the most important currency.

What is Deflation?

The term “deflation” refers to a situation in which goods and services are priced lower than they were previously. As a result of deflation, the prices of consumables typically fall because nominal costs of capital, labor, goods, and services decline.

Consumers are the only ones benefitting from deflation, not investors. A fall in the price level of items leads to an increase in purchasing power of consumers. At the same time, they have the ability to purchase a greater variety of goods and services. Furthermore, deflation can harm borrowers, since they must pay their debts in money worth more than they borrowed. 

Types of Deflation

Deflation Due to Decreasing Demand

As a result of the decline in demand for goods and services, businesses and the economy suffer. There are situations where enterprises lose money, even below break-even. A decline in profitability and a reduction in demand for products result in lower wages, resulting in the layoff of employees. As a result, the public’s purchasing power is reduced and the general price level of items is lowered.

Deflation Caused Increased Productivity

A reduction in production costs and technological advancements are responsible for increasing production. As a result of this type of deflation, consumers see lower prices, higher output, higher productivity, higher profits, and hopefully higher real wages. Real income and purchasing power of consumers increase, so demand remains the same. 

Causes of Deflation

Causes of Deflation by a drop in aggregate demand for goods and services.

Decreased Money Supply

In some countries, the central bank implements tight monetary policies that cause people to invest rather than spend. The government reduces the country’s money supply when it implements policies such as high interest rates.

Negative Economic Situations

During recessions and deflations, people may be reluctant to invest their money because markets are declining. Consumption is inhibited by pessimism.

Low Cost of Production

A falling cost of production, such as capital, labour, goods, and services, makes producers able to manufacture more, which leads to an economy’s oversupply. The demand for produced units remains unchanged, so producers have to lower prices to sell them. As a result, goods and services price levels decline in general.

Technological Advancement

As a result of technological advancements, more goods can now be manufactured at lower costs and in less time. As a result, the price of goods and services generally decreases.

Inflation vs Deflation

Since deflation and inflation are opposite terms, whatever inflation causes will be affected differently by deflation. Deflation and inflation are two different things.

  • A situation of inflation occurs when the price levels of commodities increase, while a situation of deflation occurs when the prices of commodities fall. 
  • Inflation moderately promotes economic growth, while deflation only benefits consumers.
  • Inflation reduces the purchasing power of the public while deflation increases real income. 
  • When inflation occurs, it disturbs the economy, while deflation reduces investments, resulting in more unemployment. 

The Bottom Line

As a result of the fall in prices in India, the demand for goods and services will improve further, which will further accelerate economic growth. Deflation and inflation both contribute to the economy, but in different ways. Although deflation is the worst possible outcome for the economy, inflation between 0% and 2% is considered to be stable.

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What is better, inflation or deflation?

A rate of inflation below 2% is considered healthy for the economy. Even so, if deflation occurs, the interest rate may reach 0%, and if it goes below 0%, the banks may face difficulties making payments to depositors. 

Who benefits from inflation and deflation?

Inflation and deflation benefit borrowers and lenders. Inflation usually benefits lenders, and deflation benefits borrowers, as they can repay at a lower interest rate during deflation. It all depends on the circumstances and the money supply at the time.

What caused inflation in 2021?

Economists have suggested that inflation can be traced to sudden overspending by people after the lockdown, to short labor supply, and to supply chain breakdowns.

Why is inflation better than deflation?

Inflation is considered healthy for the economy when it is moderate. Produced goods are in demand, which means there is a healthy market for them. On the other hand, deflation indicates that there is very little demand for the goods produced. As a result, deflation discourages producers and slows economic growth.

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