Relationship between inflation and deflation of economy

Inflation & Deflation - : Definition, Causes, Effects, Basics

relationship between inflation and deflation of economy

When taken to their extremes, both are bad for economic growth, but for different How to Tell the Difference Between Inflation and Deflation. Inflation and deflation, theoretical understanding of basics, merits, demerits try to limit inflation in order to keep their respective economies. Inflation and deflation arise from changes in either the demand side or supply . A rise in the savings ratio indicates a decline in consumer confidence, whereas a fall Deflation tends to occur when the economy's capacity, as indicated by the.

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Do not put all your eggs in one basket to outpace inflation. Deflation will take place naturally, if and when the money supply of an economy is limited. Deflation in an economy indicates deteriorating conditions.

Deflation is normally linked with significant unemployment and low productivity levels of good and services. Deflation can be caused by multiple factors: Structural changes in capital markets When different companies selling similar goods or services compete, there is a tendency to lower prices to have an edge over the competition.

Increased productivity Innovation and technology enable increased production efficiency which leads to lower prices of goods and services. Some innovations affect the productivity of certain industries and impact the entire economy. Decrease in supply of currency The decrease in the supply of currency will decrease the prices of goods and services to make it affordable to people. Effects of Deflation Deflation may have the following impacts on an economy: Reduction in Business Revenues In an economy faced with deflation, businesses must drastically reduce the prices of their products or services to stay profitable.

As reducing in prices take place, revenues begin to drop. Lowered Wages and Layoffs When revenues begin to drop, businesses need to find means to reduce their expenses to meet objectives.

One way is by reducing wages and cutting jobs. This adversely affects the economy as consumers would now have less to spend. The decision is made all that more difficult by the simple fact that few senior managers have ever had to deal with either high inflation or deflation in their careers.

Except for those who spent some time in Brazil or Argentina in the s or Japan in the s, disinflation has been the reality. The future may be very different. For the first time in its nearly year history, the Federal Reserve is on record as favoring higher inflation. Even more to the point, they are in a position to do something about it.

relationship between inflation and deflation of economy

As this is being written in the fall ofthe Fed is engaged in a process of quantitative easing in which they print money and use it to buy U. The transmission effect of quantitative easing The path for quantitative easing to work runs through the currency and commodity markets. In the s, the U. In the fall ofthe U.

relationship between inflation and deflation of economy

The result was a sharp drop in the value of the U. A rising price of gold and other commodities reversed the deflationary spiral of the previous eight years and gave a sharp boost to the economy that lasted until the recession of Commodity Research Bureau Figure 1: Spot market price index: Copper, industrial commodities and grains have all experienced sharp gains, with the still rapid pace of growth in commodity poor countries like China and India adding to global demand for commodities.

The rise in commodity prices gives a lift to commodity related businesses and also gives a boost to inflation. In the early s, a rise in commodity prices preceded a broader rise in consumer prices for the next ten years.

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Rising commodity prices coupled with a falling dollar are again signaling inflation. Record government deficits Monetary policy is not the only economic mechanism driving inflation. Record government deficits are also playing a role. Over the course of the past three years, U. Forecasts by the Congressional Budget Office project massive increases in government deficits well into the future. In the last three years government debt as a share of GDP has risen from Monetary policy is not the only economic mechanism driving inflation.

Government debt creates inflationary pressures in at least three ways. First, rising government deficits represent an increase in aggregate demand over supply. While small increases in the deficit have little impact on price levels, large increases in deficits can have a big impact.

Second, by shifting resources from the more productive private sector to the public sector, government spending can reduce productivity and increase the bias in the economy towards inflation. And lastly, the greater the debt as a share of GDP, the greater the temptation a government has to inflate its way out of that debt.

Regulatory drag New regulations, regardless of their target or intent, impose additional costs on business. Those costs eventually get passed along to consumers in the form of higher prices. In the late s, the political push for deregulation was one of the key policy changes that contributed to the disinflationary environment of the next 20 years. Over the past two years we have seen a reversal of that policy transformation. InCongress passed and President Obama signed two massive pieces of legislation that will significantly alter the regulatory landscape for every industry, every business and every individual.

Inflation and Deflation

The plus-page Patient Protection and Affordable Care Act creates more than new federal programs and bureaucracies. The full impact of the bill will not be known until the hundreds of new regulations associated with the bill are written, in some cases litigated and then enforced. By expanding coverage, eliminating lifetime caps on policies and prohibiting price discrimination or refusal of coverage based on pre-existing conditions, the cost of health care insurance is likely to go much higher.

New regulations will cover consumer credit, the trading of derivatives and capital standards, among other things. These changes may increase costs for financial service providers. These costs will likely have to be passed on to the final consumers of credit in the form of higher prices. From a monetary, fiscal and regulatory perspective there is a strong case to be made that the U. Europe, too, is facing regulatory changes — though the focus is different.

As in other industrialized nations, empty state coffers owing to the past recession are accelerating the pace at which governments try to push the costs of healthcare and pension systems toward the private sector. In Germany, health insurance contribution of companies and individuals—which was lowered during the crisis to ease the burden—is being raised back to precrisis levels.

relationship between inflation and deflation of economy

On the other hand, there are likely to be major regulatory reforms related to securing the stability of the monetary union in Europe. The crisis has highlighted the risks of having independent fiscal policy setting in the framework of a single currency area. Control and adjustment mechanisms are likely to be much tighter in the future.

In the context of the discussion of inflation versus deflation, however, the effort of governments in Europe to bring finances back into line with Maastricht criteria is seen more as a deflationary danger. Planning for inflation Inflation plays out on both the balance sheet and the income statement of all businesses and households.

Anticipating the future effects of inflation can work to the advantage of the savvy financial executive.

relationship between inflation and deflation of economy

The fundamental principle to be followed in inflationary times is that cash is guaranteed to lose value over time while the physical assets will gain in value. Incorporating this principle into all financial transactions becomes critical for success.

The balance sheet Since inflation erodes the value of cash, firms should reduce their working capital and shift assets toward inventory or longer-term fixed assets. The obvious first step is to become more efficient in the use of cash, reducing cash and other financial assets.

This will require a major shift in current financial management sentiment. Over the past 20 years, cash and financial assets as a share of total assets have soared: Chief financial officers have viewed cash as a safe haven against uncertainty. Cash in an inflationary environment, in contrast, is a depreciating asset and should be economized as much as possible as was the case during the period of rising inflation between and Inflation will encourage all businesses to reduce accounts receivable and increase accounts payable.

Difference Between Inflation and Deflation

Federal Reserve Board Figure 2: Liquidity as a share of total assets Nonfinancial corporations The role of inventories must also change. Billions of investment in just-in-time inventory management over the past two decades has enabled more and more businesses to operate with less and less inventory.

Inventory-to-sales ratios for the broad economy have steadily declined. In an inflationary environment, inventories are an appreciating asset. Accumulating strategic inventories will become a major shift in inventory management. Capital investment will become more challenging. While the nominal cost of capital will rise in an inflationary environment, so too will the future inflated income stream from capital investment. Capital intensive businesses will want to buy tangible assets today with fewer dollars, rather than waiting to buy them in the future with more dollars.

Inflation will help bail out poor investments and will make good investments even more lucrative. Financial management will take on a large role in an inflationary environment.

relationship between inflation and deflation of economy

On the liability side of the balance sheet, debt becomes more attractive in an inflationary environment. Businesses should increase their leverage and consider issuing longer-term fixed-rate debt whose real interest rate will decrease as inflation increases.

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For multinational firms, borrowing in depreciating currencies while holding their financial assets in appreciating currencies will be a way to further leverage the balance sheet in an inflationary environment. Geographic location of assets will also become more important. For businesses producing for global demand, having assets in countries with depreciating currencies and higher inflation will be advantageous.

The income statement From an income statement perspective, accounting for inventory using the FIFO method will be most beneficial, reducing the tax liability that can come from inflationary gains. Hedging future inventory price increases will become a common practice for a wide variety of different resources.

Hedging will be done for both price as well as currency risk. The airline industry provides a prominent example, with some players having become adept at hedging their fuel risk. With the dollar declining in an inflationary environment, every business that depends on commodities or imported resources will need to hedge their price and currency risk. Pricing becomes a significant challenge in an inflationary environment.

Increasing prices can always be challenging, but in an inflationary environment it will become a requirement for success. Changing product size and packaging as a way of drawing attention away from price changes will become a common practice. Firms may also consider lengthening contracts with vendors to create some degree of certainty. Of course, maintaining the ability to increase prices to customers on a more frequent basis is a critical component of a go-to-market strategy.

Managing wage and salary costs also will become a more complicated task. With the dollar declining in value, the benefits of outsourcing will be diminished. Labor unions and even nonunionized workers will seek out cost of living protections, which will institutionalize cost increases. At the end of the day, an inflationary environment requires a more nuanced understanding of the time value of money.

Effective financial management becomes the key to operational success even at the expense of operational efficiency. The case for deflation "Thus Inflation is unjust and Deflation is inexpedient.

Of the two perhaps deflation is The lesson from Japan in the s was that credit destruction was the key driver in both reducing the supply of money while at the same time increasing its demand.