Inflation and Deflation

Inflation describes a sustained increase in the general price level of commonly bought goods and services. Inflation is calculated as a rate or percentage change of a price index from one time period to another. A price index is a measure that examines the weighted average of prices of a basket of goods and services. The Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of goods and services bought by consumers. It can be used to calculate the inflation rate. When the difference in the price index is positive, prices are rising, and inflation is expected. This is the most commonly used measure of inflation in the United States.

The Producer Price Index (PPI) is a measure that examines the weighted average of prices at the producer level. It can also be used to find the inflation rate. The PPI is an indicator of the CPI. However, the PPI looks at changes in prices from the producer's standpoint, while the CPI focuses on changes in prices from the consumer's standpoint.

The GDP deflator is also used to calculate inflation. This value represents the change in GDP when compared to a base year. It is used as a tool to compare current prices to historical prices.

One type of inflation is called cost-push inflation, a type of inflation that occurs when the price of the inputs of production increases. Companies want to earn profits, the financial gains earned when revenues are greater than costs. If company costs increase, then profits decrease. To maintain profits, companies may choose to increase the prices of their goods and services, which can then increase company revenues. However, increasing prices contributes to inflation.

Another type of inflation is demand-pull inflation, a type of inflation that occurs when demand outstrips the supply of goods. As real gross domestic product (total output of the economy adjusted for inflation) rises and unemployment falls, more money is available for consumers to spend on goods. This increases aggregate demand, but capacity constraints mean that the price of goods rises faster than output of goods.

Deflation describes a sustained decrease in the general price level of commonly bought goods and services. This condition leads to a situation where the same quantity of money can buy greater quantities of goods and services. In modern economics, deflation is generally viewed as a serious problem, or an indicator of serious problems, in an economy. Falling prices can cause a deflationary spiral, which is a situation wherein deflation triggers circumstances that cause further deflation: as prices fall, consumers hold off on making purchases as they wait for prices to drop further. This causes production to stall. Furthermore, deflation can have a negative effect on debtors because the real value of debts, that is, the value adjusted for inflation, increases. Wealth transfers from poorer debtors to wealthier creditors, which can lead to a variety of economic and social crises.

Deflation can have many causes. To monetarists, deflation results from either a decrease in the velocity of money in an economy or a decrease in the supply of money available to people. The velocity of money describes the speed with which money circulates throughout an economy, from one holder to the next. Monetarists propose that the velocity of money in an economy is stable unless an event or external factor, such as a change in the money supply, causes the velocity to change. For instance, a rising supply of money should lead to rising prices because there is more money available to be spent on the same quantity of goods and services. It follows that the opposite would be true and deflation would be caused by a reduction in the money supply. This view has been criticized on the grounds that money velocity is unstable in normal circumstances, which is supported by empirical data.

Throughout most of the 20th century, the United States experienced inflation, but there were some years when prices fell, such as 1921–22, 1927–28, 1930–33, and 1938–39. Since 1939, deflation has been much less common, though there was a dramatic but brief recurrence of deflation during the Great Recession of 2008, a period of economic downturn. Until the 1930s, it was generally believed by economists that deflation was a problem that would resolve itself without intervention. Low prices would lead to rising demand, stimulating economic recovery. This view was challenged by John Maynard Keynes and his followers. Keynes was a British economist who developed a model that described the behavior of the economy. He observed that the economy was not self-correcting in this manner during the Great Depression, the period of severe economic decline in the United States from 1929 to 1939. He proposed that intervention was necessary to counter deflation, by increasing spending or reducing the tax burden. More recently, actions taken by the government to partially or fully abolish a debt, called debt relief, have emerged as another necessary tool for combating deflation and its impact.