Inflation and Deflation

I

Introduction

Inflation and Deflation, in economics, 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.

II

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 realize that loans will be repaid with money that has potentially less purchasing power.

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A greater concern is the growing pattern of chronic inflation characterized 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.

III

History

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 stabilized 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.

IV

Causes

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 labor 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.