Inflation vs. Deflation: An Overview

Inflation occurs when the prices of goods and services rise, while deflation occurs when those prices decrease. The balance between the two economic conditions, opposite sides of the same coin, is delicate, and an economy can quickly swing from one condition to the other.

Inflation

Inflation is a quantitative measure of how quickly the price of goods in an economy is increasing. Inflation is caused when goods and services are in high demand, thus creating a drop in availability. Supplies can decrease for many reasons; a natural disaster can wipe out a food crop, a housing boom can exhaust building supplies, etc. Whatever the reason, consumers are willing to pay more for the items they want, causing manufacturers and service providers to charge more.

The most common measure of inflation is the consumer price index (CPI). The CPI is a theoretical basket of goods, including consumer goods and services, medical care, and transportation costs. The government tracks the price of the goods and services in the basket to get an understanding of the purchasing power of the U.S. dollar.

Inflation is often seen as a big threat, mostly by people who came of age during the late 1970s, when inflation ran wild. In reality, inflation can be good or bad, depending on the reasons and level of inflation. In fact, a complete lack of inflation can be quite bad for the economy.

1:09

What's The Difference Between Inflation And Deflation?

Deflation

Deflation occurs when too many goods are available or when there is not enough money circulating to purchase those goods. As a result, the price of goods and services drops. For instance, if a particular type of car becomes highly popular, other manufacturers start to make a similar vehicle to compete. Soon, car companies have more of that vehicle style than they can sell, so they must drop the price to sell the cars. Companies that find themselves stuck with too much inventory must cut costs, which often leads to layoffs. Unemployed individuals do not have enough money available to purchase items; to coax them into buying, prices get lowered, which continues the trend.

When credit providers detect a decrease in prices, they often reduce the amount of credit they offer. This creates a credit crunch where consumers cannot access loans to purchase big-ticket items, leaving companies with overstocked inventory and causing further deflation.

[Important: Deflation can lead to an economic recession or depression, and the central banks usually work to stop deflation as soon as it starts.]

Prolonged periods of deflation can stunt economic growth and increase unemployment. Japan's "Lost Decade" is a recent example of the negative effects of deflation.

Key Takeaways

  • Inflation is a quantitative measure of how quickly the price of goods in an economy is increasing.
  • Deflation is the general decline in prices for goods and services occurring when the inflation rate falls below 0 percent.
  • Both can be good or bad for the economy, depending on the underlying reasons and rate.