Friday, January 5, 2018

What are Inflation and Deflation?

The scope of economy, as both scientific study and everyday conversation, is overwhelmingly broad to the point where people actually think they know more about the origin of universe than the origin of their debts. Even those who appear on TV in nice suits and shiny shoes can rarely agree on what exactly is happening to the current economic situation; either those people only pretend to look smart or the economy is indeed too difficult to understand. Fortunately in many cases of day-to-day economy discussions at a neighbor’s porch or in an in-law’s car you don’t actually have to understand everything there is to know about it. You only need to recognize some of the most common issues such as inflation and deflation; they are the stars of almost all economic shows, just like Tom and Jerry from the Tom and Jerry Show. Even when you have no idea what it is, you are almost certainly considered a fan as soon as you mention those two characters.


Let us start with definitions because they hardly explain anything about everything. Inflation is often defined as an economic condition when prices rise. It sounds very simple, but not convincing enough. Sometimes it takes just a bit more complicated explanation to get your attention, and this is precisely what we’re trying to accomplish here. In a smarter language, inflation is an economic situation resulted from a steady increase in prices of goods and services over a certain period, usually a year. It is also safe to say that inflation measures how much more you have to pay now for a gallon of gasoline compared to last year, and that’s assuming you have a car.

Nobody actually is responsible for measuring inflation, so there is no one to blame if the calculation is wrong. However, the Bureau of Labor Statistics (BLS) is tasked with compiling price indexes as indicators for inflation among other purposes. Main price indexes are:

  • CPI (Consumer Price Index): the measure of price increases from consumers’ perspectives. To measure inflation, BLS has to track price records of all goods and services including the volatile commodities such as food and energy. The bureau publishes CPI monthly, because weekly-report means too much work for the employees.

  • PPI (Producer Price Index): the measure of price changes of goods and services from local producers’ and sellers’ perspectives. Data is also released on monthly basis.

From the two price indexes, CPI is more widely used by the government, businesses, and banks to help determine the exact rate of inflation, probably because it is less confusing. CPI measures the purchase prices of commodities including imported goods charged to end-consumers. On the other hand, PPI also calculates raw materials purchased by companies to manufacture their end-products.

Core Inflation

Economists, whoever they are, do not use inflation rate based on CPI to accurately calculate trend of price increase annually. Instead, they will use something called Core Inflation and here is why: CPI includes the changes in prices of volatile goods such as food and energy. Prices of those commodities are unbearably unstable during any given year because there are just too many factors in play. Prices of energy goods are affected by the fluctuation of oil supply and the increasing demands for electric cars or bicycles; of course if you sell your car to buy a fancy bicycle, fuel price does not affect you anyway. Foods are also volatile commodities affected by weather conditions, overall crop quality, cost of agricultural labor, and collective willingness to go on a diet. Price changes of all commodities excluding food and energy give more accurate review of the trend.

What are Inflation and Deflation
The general rule is that the more absurd the price index chart looks, the more people are convinced

It is worth mentioning that the increasing price of energy goods may affect other commodities too. For example, price increase in oil indirectly affects the price of oil-dependent goods such as automobiles and paraffin-based candles.

Why It Happens

There are two main reasons why inflation happens: Demand-Pull Inflation and Cost-Push Inflation. The former is closely related to the increasing demand of commodities, while the latter is mostly affected by the decreasing supply of goods and services; both lead to price increase. The most basic economic principle is the Law of Supply and Demand. It dictates that there should be a balance between those two factors to keep prices of commodities in check. In other words, the law makes everything within reasonable price level so you can purchase a diet coke without emptying your wallet, unless you have no wallet or it is empty already.

Demand-Pull Inflation happens if the demand for commodities increases to a level where the sellers feel like they have some sort of control over price. Notice that there is no shortage in supply, yet the price goes up anyway because sellers have the luxury to ask for more money without the worry of not making any sale. In an ideal world the increasing demand does not directly lead to price mark-up; however, some sellers and manufacturers are greedy and they take advantage of consumers’ craving as soon as the opportunity is there. Take smartphones for example; people do not really need new smartphones, but they flock to the stores anyway when phone makers release fresh products every week. Although the new products have exactly the same features as the older ones, a lot of folks buy the things regardless. Demand-Pull inflation may happen because:

  • Burst of economic growth indicated by the increasing wage. People have more money to spend and they buy things they don’t need such as new smartphones.

  • Expectation of inflation which encourages people to buy more things now before the price goes up in the future. Such thing happened before to chocolate bars when Willy Wonka announced the Golden Tickets.

  • Over-expansion of nation’s money supply through the lowering of interest rates or printing more money. People think they’re rich because they have more money in their pockets, so the demand increases. However dollar value becomes very low relative to foreign currencies and even domestic commodities. If previously a pile of money can buy a car, now it can only buy half a car.

  • Asset inflation such as when the housing market burst in 2005. Investors thought there were not enough assets to go around, and this drove the demand up.

In fact, asset bubble in 2005 caused subprime mortgage crisis in 2007. When finally homebuilders could no longer meet investors’ needs, housing prices went down. The problem was that investors borrowed money from banks to purchase the properties, and so the price of the assets became almost worthless to repay the debts. Eventually, this led to global financial crisis in 2008, the greatest global recession since the Great Depression.

Cost-Push Inflation is related to the shortage of supply. Prices for goods and services increase because manufacturers cannot produce enough commodities to meet the demands. There is no mistake on consumers’ part because even when the demand remains at the same level, prices still increase simply because the commodities are only available in low number. It can happen because:

  • Higher tax on products often leaves suppliers with no choice but to distribute the burden of tax to end consumers. In other words, buyers need to pay more for commodities to cover the tax.

  • Increased production cost from labor, raw material, or both. Manufacturers have to increase prices of their products to maintain healthy profit margin in response to higher operational cost.

  • Natural disasters that affect production facilities will also reduce supply of commodities and increase prices. Over-exploitation and depletion of natural resources also contribute to higher prices for those particular resources or goods and services dependent to the depleted resources.

When prices of stuffs go up, it is called inflation. It becomes a problem when the price increase keeps on going and your employer does not seem to care about increasing your salary as well. Inflation basically makes the money you have worth less than it was before, regardless of why or how it happens.

How the Government Handles Inflation

Federal Reserve is responsible for controlling inflation and deflation while avoiding recession at the same time. There are several methods to help stop inflation, and it all depends on what started the economic problem in the first place. When demand increase because people have more money than they should, Federal Reserve can also increase interest rate to discourage people from borrowing money and spend it. High interest rate also helps to reduce money supply (less money in circulation). Another method is to raise reserve requirement or the amount of money that banks are required to keep in reserve at the end of the day. This means banks shall not release money or approve loans more than the Federal Reserve allows. Reducing bond prices also encourage people to invest and save money at the same time; the end goal is to keep money out of circulation so level of demands is in check.


The opposite of inflation is deflation, obviously. Deflation is defined as the gradual decrease in prices of goods and services, which directly also suggests the increase in value of money. Judging by the definition alone, deflation sounds like good news because it means you can buy more private jets and bottles of wine with the same amount of money which previously (before the deflation) could only afford a bicycle and a glass of water.

Deflation is also measured through CPI and spotted when inflation falls below 0% or commonly referred to as negative inflation rate. It is more difficult to measure because the decrease in prices does not happen for all items during the same period; when prices decrease anyway, it does not always mean a bad thing either. You could argue that price increase also happens more or less in the same way, but you’d be wrong again as usual.

An increase in prices almost always suggests weakened purchasing power simply because money can afford fewer things than it used to. On the other hand, a decrease in price may actually mean improvement in manufacturing industry for examples better work efficiency, more production capacity, and higher market competition. For example in technology sector, the price of Internet service has gone down to considerable amount compared to several decades ago. According to Statistic Brain, the cost of a hard drive with 26MB data storage capacity in 1980 was around $5,000; now you can purchase one with more than 500GB capacity for $50 or even less if you choose a crappy kind. Simply put, taking your date to a movie was actually much cheaper than downloading a cat video, or any video for that matter, in the ‘80s. No wonder people preferred going outside to browsing the Internet in the old days. This particular type of price deflation happens thanks to innovation and healthier market competition which eventually lead to better living standard. There is nothing to complain here.

Causes of Deflation

Real deflation occurs after long-term decrease in demand. People are reluctant to purchase goods and services and therefore sellers must reduce prices just to stay in business and actually earn money before the breads reach the expiry date. Drop in demand may occur thanks to:

  • Increased exports, especially from countries with lower standards of living. This means the exporters can afford to keep prices low because wages in those countries are low as well. Domestic commodities must compete with exported goods by reducing prices.

  • Low prices due to exports indirectly encourage people to postpone spending. They wait until sellers drop prices even further (they usually do) before making more purchases, hence low demand.
  • While postponing the spending, consumers put their money in the bank. The amount of hard currency in circulation falls; when money is scarce, it becomes overvalued.

  • Low demand can happen when government and domestic private companies cut wages; one possible culprit is the abundance of exported goods. Manufacturers must drop prices on their products, so it is necessary to reduce expenditures to maintain profit margin; workers are not uncommon victims of the adverse circumstance.

  • Employers can keep wages low because of over-population. Workforce is willing to accept lower wages as they know that their employers can easily find new workers in case the existing employees refuse to accept low salary. Workforce saves the money instead of spending it.

In the event those things happen in long-term, deflation hits a vicious spiral where one bad thing leads to another. Decreased demand forces manufacturers to lower prices; companies often anticipate the potential loss of revenue by cutting wages or downsizing operation (laying-off employees); low wages and more unemployment can only worsen the already reduced demand; constant cost-cutting potentially brings companies to end productions altogether; jobs are scarce so the unemployed remain unemployed. With less money, you cut back on demanding things, but unfortunately your kids don’t. It is never a good sign when your kids are crying over toys you cannot afford. And when you try to explain what deflation is, they cry harder.

What are Inflation and Deflation
Either the kid has just heard you explained about deflation or is taking a nap in the street
Dropping the prices is only a good thing when it is caused by lower production cost. When raw materials become more affordable or new innovation allows for better productivity, there is no need for companies to cut wages or have massive layoff to keep the business profitable. In such period, the deflation is benign, or in fact good for the economy.

How Deflation is Stopped

Once again, the Federal Reserve is responsible for taking actions to stop the vicious spiral. This is a prominent example of why people are reluctant to be responsible for anything; when things go wrong, the first question you hear will be, “Who is responsible for this mess?” and the next thing you see is everybody pretending to be busy sharpening their pencils.

While the government or Federal Reserve can claim that they are not directly responsible for the troubles, they are assigned by the people to prevent bad things from happening in the first place. It is customary to blame the government, so go ahead and do it the next time deflation is here.

There are several popular methods to handle deflation such as by lowering interest rates, lowering taxes, or increasing government spending; all of those are designed to bring demand back to its glory. People love low interest rates because they can borrow money from banks and repay it later with just a little bit more amount than they received earlier. It also means people have affordable capital to start businesses which open new job opportunities. When combined with lower income taxes, workers actually have more money in their pockets so they can spend more on things they don’t need such as gym membership, extended warranties, and books. Government can also spend more money on new projects such as infrastructure or defense equipment. Building a wall comes to mind, which theoretically creates more jobs and it does not even increase government spending because a certain foreign country will pay for it.