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Inflation and Deflation
Inflation and deflation, in economics, are terms used to describe, respectively, a decline or an increase in the value of money, in relation to the goods and services it will buy.
Inflation is the pervasive and sustained rise in the aggregate level of prices measured by an index of the cost of various goods and services. Repetitive price increases erode the purchasing power of money and other financial assets with fixed values, creating serious economic distortions and uncertainty. Inflation results when actual economic pressures and anticipation of future developments cause the demand for goods and services to exceed the supply available at existing prices or when available output is restricted by faltering productivity and marketplace constraints. Sustained price increases were historically directly linked to wars, poor harvests, political upheavals, or other unique events.
Deflation involves a sustained decline in the aggregate level of prices, such as occurred during the Great Depression of the 1930s; it is usually associated with a prolonged erosion of economic activity and high unemployment. Widespread price declines have become rare, however, and inflation is now the dominant variable affecting public and private economic planning.
Kinds of Inflation
When the upward trend of prices is gradual and irregular, averaging only a few percentage points each year, such creeping inflation is not considered a serious threat to economic and social progress. It may even stimulate economic activity: The illusion of personal income growth beyond actual productivity may encourage consumption; housing investment may increase in anticipation of future price appreciation; business investment in plants and equipment may accelerate as prices rise more rapidly than costs; and personal, business, and government borrowers realise that loans will be repaid with money that has potentially less purchasing power.
A greater concern is the growing pattern of chronic inflation characterised by much higher price increases, at annual rates of 10 to 30 percent in some industrial nations and even 100 percent or more in a few developing countries. Chronic inflation tends to become permanent and ratchets upward to even higher levels as economic distortions and negative expectations accumulate. To accommodate chronic inflation, normal economic activities are disrupted: Consumers buy goods and services to avoid even higher prices; real estate speculation increases; businesses concentrate on short-term investments; incentives to acquire savings, insurance policies, pensions, and long-term bonds are reduced because inflation erodes their future purchasing power; governments rapidly expand spending in anticipation of inflated revenues; and exporting nations suffer competitive trade disadvantages forcing them to turn to protectionism and arbitrary currency controls.
In the most extreme form, chronic price increases become hyperinflation, causing the entire economic system to break down. The hyperinflation that occurred in Germany following World War I, for example, caused the volume of currency in circulation to expand more than 7 billion times and prices to jump 10 billion times during a 16-month period before November 1923. Other hyperinflations occurred in the United States and France in the late 1700s; in the USSR and Austria after World War I; in Hungary, China, and Greece after World War II; and in a few developing nations in recent years. During a hyperinflation the growth of money and credit becomes explosive, destroying any links to real assets and forcing a reliance on complex barter arrangements. As governments try to pay for increased spending programs by rapidly expanding the money supply, the inflationary financing of budget deficits disrupts economic, social, and political stability.
Examples of inflation and deflation have occurred throughout history, but detailed records are not available to measure trends before the Middle Ages. Economic historians have identified the 16th to early 17th centuries in Europe as a period of long-term inflation, although the average annual rate of 1 to 2 percent was modest by modern standards. Major changes occurred during the American Revolution, when prices in the U.S. rose an average of 8.5 percent per month, and during the French Revolution, when prices in France rose at a rate of 10 percent per month. These relatively brief flurries were followed by long periods of alternating international inflations and deflations linked to specific political and economic events.
The U.S. reported average annual price changes as follows: 1790 to 1815, up 3.3 percent; 1815 to 1850, down 2.3 percent; 1850 to 1873, up 5.3 percent; 1873 to 1896, down 1.8 percent; 1896 to 1920, up 4.2 percent; and 1920 to 1934, down 3.9 percent. This extended history indicates a recurring sequence of inflations, linked to wartime periods, followed by long periods of price stability or deflation. Consumer prices accelerated during the World War II era, rising at an annual average rate of 7.0 percent from 1940 to 1948, and then stabilised from 1948 to 1965, when the annual increases averaged only 1.6 percent, including a peak of 5.9 percent in 1951 during the Korean War.
In the mid-1960s a chronic inflationary trend began in most industrial nations. From 1965 to 1978 American consumer prices increased at an average annual rate of 5.7 percent, including a peak of 12.2 percent in 1974. This ominous shift was followed by consumer price gains of 13.3 percent in 1979 and 12.4 percent in 1980. Several other industrial nations suffered a similar acceleration of price increases, but some countries, such as West Germany (now part of the united Federal Republic of Germany), avoided chronic inflation. Given the integrated status of most nations in the world economy, these disparate results reflected the relative effectiveness of national economic policies.
This unfavorable inflationary trend was reversed in most industrial nations during the mid-1980s. Austere government fiscal and monetary policies begun in the early part of the decade combined with sharp declines in world oil and commodity prices to return the average inflation rate to about 4 percent.
Demand-pull inflation occurs when aggregate demand exceeds existing supplies, forcing price increases and pulling up wages, materials, and operating and financing costs. Cost-push inflation occurs when prices rise to cover total expenses and preserve profit margins. A pervasive cost-price spiral eventually develops as groups and institutions respond to each new round of increases. Deflation occurs when the spiral effects are reversed.
To explain why the basic supply and demand elements change, economists have suggested three substantive theories: the available quantity of money; the aggregate level of incomes; and supply-side productivity and cost variables. Monetarists believe that changes in price levels reflect fluctuating volumes of money available, usually defined as currency and demand deposits. They argue that, to create stable prices, the money supply should increase at a stable rate commensurate with the economy's real output capacity. Critics of this theory claim that changes in the money supply are a response to, rather than the cause of, price-level adjustments.
The aggregate level of income theory is based on the work of the British economist John Maynard Keynes, published during the 1930s. According to this approach, changes in the national income determine consumption and investment rates; thus, government fiscal spending and tax policies should be used to maintain full output and employment levels. The money supply, then, should be adjusted to finance the desired level of economic growth while avoiding financial crises and high interest rates that discourage consumption and investment. Government spending and tax policies can be used to offset inflation and deflation by adjusting supply and demand according to this theory. In the U.S., however, the growth of government spending plus "off-budget" outlays (expenditures for a variety of programs not included in the federal budget) and government credit programs have been more rapid than the potential real growth rate since the mid-1960s.
The third theory concentrates on supply-side elements that are related to the significant erosion of productivity. These elements include the long-term pace of capital investment and technological development; changes in the composition and age of the labour force; the shift away from manufacturing activities; the rapid proliferation of government regulations; the diversion of capital investment into nonproductive uses; the growing scarcity of certain raw materials; social and political developments that have reduced work incentives; and various economic shocks such as international monetary and trade problems, large oil price increases, and sporadic worldwide crop disasters. These supply-side issues may be important in developing monetary and fiscal policies.
The specific effects of inflation and deflation are mixed and fluctuate over time. Deflation is typically caused by depressed economic output and unemployment. Lower prices may eventually encourage improvements in consumption, investment, and foreign trade, but only if the fundamental causes of the original deterioration are corrected.
Inflation initially increases business profits, as wages and other costs lag behind price increases, leading to more capital investment and payments of dividends and interest. Personal spending may increase because of "buy now, it will cost more later" attitudes; potential real estate price appreciation may attract buyers. Domestic inflation may temporarily improve the balance of trade if the same volume of exports can be sold at higher prices. Government spending rises because many programs are explicitly, or informally, indexed to inflation rates to preserve the real value of government services and transfers of income. Officials may also anticipate paying larger budgets with tax revenues from inflated incomes.
Despite these temporary gains, however, inflation eventually disrupts normal economic activities, particularly if the pace fluctuates. Interest rates typically include the anticipated pace of inflation that increases business costs, discourages consumer spending, and depresses the value of stocks and bonds. Higher mortgage interest rates and rapidly escalating prices for homes discourage housing construction. Inflation erodes the real purchasing power of current incomes and accumulated financial assets, resulting in reduced consumption, particularly if consumers are unable, or unwilling, to draw on their savings and increase personal debts. Business investment suffers as overall economic activity declines, and profits are restricted as employees demand immediate relief from chronic inflation through automatic cost-of-living escalator clauses. Most raw materials and operating costs respond quickly to inflationary signals. Higher export prices eventually restrict foreign sales, creating deficits in trade and services and international currency-exchange problems. Inflation is a major element in the prevailing pattern of booms and recessions that cause unwanted price and employment distortions and widespread economic uncertainty.
The impact of inflation on individuals depends on many variables. People with relatively fixed incomes, particularly those in low-income groups, suffer during accelerating inflation, while those with flexible bargaining power may keep pace with or even benefit from inflation. Those dependent on assets with fixed nominal values, such as savings accounts, pensions, insurance policies, and long-term debt instruments, suffer erosion of real wealth; other assets with flexible values, such as real estate, art, raw materials, and durable goods, may keep pace with or exceed the average inflation rate. Workers in the private sector strive for cost-of-living adjustments in wage contracts. Borrowers usually benefit while lenders suffer, because mortgage, personal, business, and government loans are paid with money that loses purchasing power over time and interest rates tend to lag behind the average rate of price increases. A pervasive "inflationary psychology" eventually dominates private and public economic decisions.
Any serious antiinflation effort will be difficult, risky, and prolonged because restraint tends to reduce real output and employment before benefits become apparent, whereas fiscal and monetary stimulus typically increases economic activity before prices accelerate. This pattern of economic and political risks and incentives explains the dominance of expansion policies.
Stabilisation efforts try to offset the distorting effects of inflation and deflation by restoring normal economic activity. To be effective, such initiatives must be sustained rather than merely occasional fine-tuning actions that often exaggerate existing cyclical changes. The fundamental requirement is stable expansion of money and credit commensurate with real growth and financial market needs. Over extended periods the Federal Reserve System can influence the availability and cost of money and credit by controlling the financial reserves that are required and by other regulatory procedures. Monetary restraint during cyclical expansions reduces inflation pressures; an accommodative policy during cyclical recessions helps finance recovery. Monetary officials, however, cannot unilaterally create economic stability if private consumption and investment cause inflation or deflation pressures or if other public policies are contradictory. Government spending and tax policies must be consistent with monetary actions so as to achieve stability and prevent exaggerated swings in economic policies.
Since the mid-1960s the rapid growth of federal budget spending plus even greater percentage increases in off-budget outlays and a multitude of federal lending programs have exceeded the tax revenues almost every year, creating large government deficit borrowing requirements. Pressures to provide money and credit required for private consumption and investment and for financing the chronic budget deficits and government loan programs have led to a rapid expansion of the money supply with resulting inflation problems. Effective stabilisation efforts will require a better balance and a more sustained application of both monetary and fiscal policies.
Important supply-side actions are also required to fight inflation and avoid the economic stagnation effects of deflation. Among the initiatives that have been recommended are the reversal of the serious deterioration of national productivity by increasing incentives for savings and investment; enlarged spending for the development and application of technology; improvement of management techniques and labour efficiency through education and training; expanded efforts to conserve valuable raw materials and develop new sources; and reduction of unnecessary government regulation.
Some analysts have recommended the use of various income policies to fight inflation. Such policies range from mandatory government guidelines for wages, prices, rents, and interest rates, through tax incentives and disincentives, to simple voluntary standards suggested by the government. Advocates claim that government intervention would supplement basic monetary and fiscal actions, but critics point to the ineffectiveness of past control programs in the United States and other industrial nations and also question the desirability of increasing government control over private economic decisions. Future stabilisation policy initiatives will likely concentrate on coordinating monetary and fiscal policies and increasing supply-side efforts to restore productivity and develop new technology.
Now try the exercises. Exercise a, Exercise b, Exercise c
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