RebelCapitalist: Financial Information for the Rest of Us

Deflation vs. Inflation

Apr 23, 2009 | By: Mr_Blue | Tags: inflation, deflation

In the news today we are hearing a lot of talk about this two terms: deflation and inflation. Obviously, they are opposite economic conditions. And like everything else “too much” of one these conditions is a bad thing.

Let’s cover deflation first. Deflation is a sustained decrease in the price levels for goods, services and asset values. We are currently experiencing, and are in, a deflationary period. The most common measure for inflation/deflation is the Consumer Price Index (CPI). The CPI is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. The Bureau of Labor Statistics publishes reports on inflation monthly. Here is a graph to show the period of deflation we are experiencing (Click image to enlarge).

Notice that cliff dive in the graph. That is deflation. Other examples of deflation are the drops in stock prices as felt in the huge drop in values of our 401Ks and average home prices.

The concern that economists and policy makers have right now is that our economy goes into what is called a “deflationary spiral” where prices and wages start decreasing at an alarming rate. This “deflationary spiral” scenario is what happened during the Great Depression. Fortunately, we are not to that point and because of the intervention by the Federal Reserve Bank (increase in money supply and targeting lower interest rates) and U.S. government (stimulus spending) we may not reach that point. However, we are not out of the woods yet. Here is a graph on the percent change in Average Hourly Earnings over a five year period (2004-2009) (Click on image to enlarge):

Obviously, the opposite of deflation is inflation. Most of us are much more familiar with the concept of inflation. Inflation is the sustained increase in price of goods and services. To a certain extent we experience inflation every day particularly with grocery prices and gas prices. Both groceries and gas seem to be increasing in price. Inflation obviously makes things we buy more expense.

Increase in demand and/or decrease in supply for goods and services can cause inflation. Inflation can be caused by policies of the Fed Reserve Bank and U.S. Government. The Fed can increase the supply of money (U.S. Dollars) into the economy too quickly or U.S. Government can spend too much money and issue too much debt which can lead to higher interest rates. Higher interest rates increase inflation.

Too much of either of these economic condition is bad. Right now we are experiencing deflation and the Fed Reserve Bank and U.S. Government are trying to increase demand - inflation a little bit. Their actions and policies if not timed properly can risk a jump in the opposite direction of deflation - meaning inflation. It is a very delicate balance that has to struck by policy makers and risks are high.