Three Aspects of the Economy: Inflation, Disinflation and Deflation - Essay Example

Three Aspects of the Economy: Inflation, Disinflation and Deflation Abstract There are three aspects of the global economy, which are to be discussed in this paper; inflation, disinflation, and deflation. Inflation can be termed as the gradual rise, over a certain periods, of the cost of products in a financial system. In addition, when inflation takes place, it is always found that the value of the currency used in an economy also decreases. This is because the money available in the economy is able to purchase a limited number of products when compared to the previous period. Disinflation is a decrease in the inflation rate, and this is more often than not realized through the slowing down of the rate of price increase in the economy over a certain period. It is usually seen when the prices of products within the economy deep from their current levels to much lower levels over time. Disinflation occurs within the economy only for a short time, and it takes place especially when an economy is undergoing a recession. Deflation is the decrease which takes place in the cost of products, when the rate of inflation goes below zero percent. Its greatest effect is that, over time, it increases the value of the currency being used within the economy. This ensures that one is able to buy more products with the same amount of money which they had when inflation was taking place. These three aspects of the economy are extremely powerful in determining how it is working, whether it is doing well or not. Furthermore, the central banks use the measurements of these aspects in order to determine what their fiscal policies are going to be. Inflation Inflation can be termed as the gradual rise, over a certain period, of the cost of products in a financial system (Hartwig, pg23). In addition, when inflation takes place, it is always found that the value of the currency used in a particular economy also decreases. This is because the money available in the economy is able to purchase a limited number of products when compared to the previous period. All the countries in the world whose economies are connected to money have a way of finding out the inflation rate of their currency. Every year, the percentage of inflation is calculated and the result is often used in the planning of the budget for the forthcoming year (Campilo and Miron, pg 335). Inflation has a massive effect on how the economy works, and this effect is sometimes positive, or negative, depending on the situation. One of the negative effects of inflation is that it becomes extremely risky to hold onto large sums of the currency, which is undergoing inflation, because one does not know whether the inflation will continue, or not. If it does, then there is a high possibility of people ending up with large sums of money, which is worthless (Ciccareli, pg524). Another major effect of inflation is that since there is uncertainty concerning future inflation, many people choose not to invest their money in the economy or to save this money in banks (Atkeson and Ohanian, pg 2). The rapid rise of inflation means that within a short time, goods that were common on shelves will suddenly become scarce, as people start hoarding these goods in anticipation of future increases in prices. Inflation not only has negative aspects, but positive ones as well, and one of these is that it allows banks to be able to change interest rates to suit the economic situation that is current at that time. Furthermore, it allows people to cease concentrating on investment that is monetary in basis and instead choose to invest in those that do not directly involve money as a return (Blanchard and Simon, pg 135). Many of those who have specialized in the field of economics believe that inflation is caused by the fast growth of the supply of money in the economy. However, there is little agreement concerning what causes the inflation rate in an economy and how it can be moderated. Low levels of inflation can be characterized as a feature of low demand for products within the economy. Furthermore, it can be attributed to the changes, which take place when there is a scarcity of products as well as the stabilization of the supply of money in the economy. Inflation that lasts for a long time within the economy is often attributed to the faster growth of the money supply when compared to the growth of the economy. In the current economic situation, the most favored rate of inflation is one that is low and steady, so that in case of a recession, their severity is not too strong that the economy takes too long to recover. It is believed that a steady rate of inflation allows the labor market to swiftly change whenever there is an economic downturn (Stock and Mark, pg 293). It also ensures that government financial policies are able to quickly stabilize the economy, hence its stability. In most economies, the task of ensuring that the inflation rate is stable is given to central banks, which carry out their tasks through the setting of the monetary policies. These monetary policies include the determination of the interest rates, as well as setting the reserve amount, which each bank functioning within the economy, has to maintain (Jerzy, pg 290). From the beginning of economic studies, there has been a concern about what the cause of inflation is, as well as its effect on the economy. Quite a number of theories have been brought about and these theories can be split into two categories, namely, the theories of inflation dealing with quantity, and those dealing with quality. The quality theory is based on the supposition that a seller will accept the money given to him by a buyer with the expectation that he or she will be able to acquire more goods using the money received. The quantity theory, on the other hand, deals with the quantity of money that is related to its supply as well as its value when being used for exchange. In the current world economy, it is widely accepted that the quantity theory is the best suited to explain the causes of inflation. Therefore, it is now the common belief that the level of inflation is reliant on on the growth of the supply of money in the economy as a comparison to the economic growth (Blanchard and Simon, pg 135). It is also believed that immediate causes of inflation may depend on the rates of demand and supply of goods in the market, and this is because of the relative flexibility of wages, the prices of goods, as well as the interest rates set by central banks (Ciccareli, pg 524). There are two schools of thought when it comes to determining whether the short term effects of inflation may last long enough to become a problem to economic stability. One school believes that the prices of products and the wages, which people receive, tend to change fast enough to ensure that they leave no permanent mark on the inflation rate (Campilo and Miron, pg 335). However, another school states that prices and wages in the economy change at different rates and that these changes may last for long enough to affect the inflation rate (Hartwig, pg 23). Disinflation A decrease in the inflation rate is known as disinflation, and this is normally realized through the slowing down of the rate of price increase in the economy over a certain period. It is usually seen when the prices of products within the economy deep from their current levels to much lower levels over time. Disinflation occurs within the economy only for a short time and it takes place especially when an economy is undergoing a recession. In a circumstance where the inflation rates within an economy are quite low and a disinflation occurs, it can lead to swift decreases in the prices of products, and this could harm the economy (Carlson, pg 947). While it is generally agreed that inflation is caused by the increase in the supply of money when compared to the economic growth, disinflation occurs in the dead opposite way. Disinflation is caused when there is fast economic growth when compared to the amount of money within it. It can be caused by the decrease in the availability of funds in a financial system. This situation can also be caused when there is an incredibly high demand for products within the economy, causing a shortage of money needed to purchase such products. Disinflation normally occurs when the government decides to tighten its financial policy in order to control the flow of money in the economy. When the government starts selling its securities, a reduction in the supply of money within the economy occurs, and the purpose for this is to ensure that the demand for money is stabilized. The government often does this in times of economic recession, where businesses increase the prices of their products with the intention of passing the burden on to their customers. Therefore, when the government tightens its financial policy, it is for reducing the demand for products, hence ensuring that businesses also reduce their prices to attract customers (Rogoff, pg 54). In this case, even though there is a decrease in the prices of products, their supply remains constant; as the prices continue to fall over a certain period, disinflation occurs. Disinflation also comes about when the rate of unemployment grows at a much faster rate than the rate of economic growth. This results in the large number of people having little money to spend because they do not have a stable income. The reduction of the supply of money in the economy is indirectly influenced by the rate of unemployment, which means that disinflation has occurred. Deflation Deflation is the decrease that takes place in the cost of products, when the rate of inflation goes below zero percent. Its greatest effect is that, over time, it increases the value of the currency being used within the economy (Humphrey, pg 11). This ensures that one is able to buy more products with the same amount of money, which they had when inflation was taking place. It is believed that deflation has a negative effect on the economy because it could lead to a spiral that could cause economic stagnation. Deflation is not necessarily related to poor growth as seen when it occurred in nineteenth century United States, even though there was extraordinary economic growth because of technological advances (Michael and Andrew, pp 799). There is often a decrease in the entire economy of the willingness to buy as well as the prices of products (Wilem, pg 2). Due to the decrease in the price of goods, consumers tend to delay making acquisitions with the expectation that the prices will decrease further (Mervyn, pg 423). This delay on the part of consumers also has the effect of slowing down the economic activities. Since there is a reduction of economic activity, then the incentive for making investments also decreases, meaning that there is remarkably little going on within the economy. It is during such periods that central banks take the initiative to create policies, which encourage the growth of inflation. This acts as a stimulus to the economy, because not only will the prices of products increase, it will also ensure that there is more interest from investors to put their money in the economy. Recently, there has developed the belief that deflation is related to risk; so that when investors notice a slowing down in the economic activities, they choose to hoard all their money until such a time as they feel that it is less risky to invest. Deflation is always associated with the fear by investors that they will get nothing from their investments if they attempt to invest during such a period (Andrew and Patrick, pg 102). When deflation occurs, there is often the possibility that there will be a reduction of money in the economy. This is because most of the money is in the hands of individuals, who due to their higher purchasing power will spend singularly little of what they have(Wilem, pg 2). Deflation is also characterized by an increase in the number of transactions taking place, because the increased value of the currency enables people to buy more than they normally would. Deflation is an accepted part of economies, which have hard currencies, which have a supply of money, which is less than the population and economic growth (Mervyn, pg 423). When deflation takes place in such economies, the amount of money per person decreases and since the money is in short supply, the purchasing power of the money that is available increases tremendously. The improvements in the efficiency of producing products often ensure that the prices of such product remain low; this can indirectly lead to deflation. Competition between various businesses within the economy to sell more of their products tends to prompt some of them to reduce their prices so that they can have an edge over their competitors. Since consumers end up buying products at lesser prices than the actual price of the product, deflation takes place. This is because the businesses from which they are buying their products have indirectly increased their purchasing power. In more developed economies, deflation can occur if there is an increase in the amount of products in the market while there is a decrease in the money available to purchase these products. Episodes in American history, such as the Great Depression, can be listed as examples of instances where deflation took place in the economy (Andrew and Patrick, pg 102). In this period, the amount of goods in the economy was much higher than the money available to purchase it and this caused the depression (Andrew and Patrick, pg 102). The Federal Reserve contributed even more to this problem when it further decreased the monetary supply, a result of which a further deepening of the deflation within the American economy. Conclusion In summary, deflation refers to an overall fall in price level, which can be sustained. Basically, it is the opposite of the renowned inflation. According to reports, inflation refers to an increase in the price levels over a given period of time. On the contrary, disinflation is used to describe the period when a positive inflation is registered; however, the trend being experienced is declining steady over the period. As can be seen from the above discussion, inflation, deflation and disinflation are activities that represent different perspectives of price level behaviors. Most of the economic studies suggested that price level can be used as a common measure of Consumer Price Index (CPI) and Deflator of Gross Domestic Product (GDP). The broad index of economic deflation is known as GDP Deflator. In addition, consumer price index (CPI) is used as a measure for changes that have occurred in the price levels and are attributed to broader consumer products basket. Referring to the case of United States, there were two brief periods that portrayed a clear deflation, particularly, in the CPI (Consumer Price Index). The first case took place between mid 1949 and mid 1950, followed by the second deflation period recorded between 1954 (fall) and 1955 (summer). In the same note, Consumer Price Index showed a period of inflation, which occurred for a long period of time between 1947 and 1999. On the contrary, there was a period of disinflation registered in the mid 1980 and mid 1982. During this time, the inflation rate was in a declining trend and was reported on monthly basis. Economists argued that deflation period is mainly associated with corresponding downturns in the overall economic performance. The brief deflation periods that was recorded in the United States was equivalent to the recession period, which affected the performance of the global economy. In reality, it is advisable that, the average deflation period to be shorter as opposed to the Great Depression of 1930s, where U.S recorded a long deflation period that could not be easily sustained. Generally, in case the average price fall is steady and is being recorded over a long period of time, it can lead to a serious depression in the economy. Works Cited Andrew, Atkenson and Patrick, Kehoe, J. “Deflation and Depression: Is there an Empirical link? Journal of American Economic Review, 94.2 (2004): 102. Atkeson, A., and Ohanian, L. H. “Are Phillips Curves Useful for Forecasting Inflation?” Federal Reserve Bank of Minneapolis Quarterly Review 25.1(2001):2. Blanchard, O., and Simon, J. “The Long and Large Decline in U.S. Output Volatility.” Brookings Papers on Economic Activity 1(2001):135. Campilo, Marta and Miron, Jeffrey A. “Why does Inflation Differ across Countries.” Journal of Reducing Inflation, Motivation and Strategy 5540(1997):335. Carlson, John A. 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Finance & Development 40.4 (2003): 54. Stock, James H., and Mark, Watson, W. “Forecasting Inflation,” Journal of Monetary Economics, 44.2(1999):293. Wilem, Buiter, H. “Deflation: Prevention and Cure.” National Bureau of Economic Research Technical Working Paper Series 9623.3869(2003):2. Read More