Defining inflation and deflation
Inflation is a sustained rise in the general price level, which means the value of money falls: each unit of currency buys less than before. Deflation is a sustained fall in the general price level. A slowdown in the rate of inflation is called disinflation and is not the same as deflation, because prices are still rising, just more slowly.
Key idea
Inflation is measured using a Consumer Price Index (CPI). A basket of typical goods and services is priced each period; items are weighted by how much households spend on them, and the change in the basket's cost is the inflation rate.
Causes
Demand-pull inflation happens when total demand grows faster than the economy can supply, pulling prices up. Cost-push inflation happens when firms' costs rise, for example higher wages or imported raw material prices, and firms pass these on. A rapid rise in the money supply can also drive inflation.
Example
A sharp rise in the price of imported oil raises transport and production costs across many firms. They raise prices to protect profit, causing cost-push inflation.
Consequences
High inflation reduces the real value of savings and fixed incomes, creates uncertainty that discourages investment, and can make exports less competitive. Deflation sounds attractive but is harmful too: consumers delay purchases expecting lower prices, demand falls, firms cut output and jobs, and debts become harder to repay.
Remember
- Inflation = value of money falls.
- Demand-pull comes from too much demand; cost-push from rising costs.
- Deflation can trigger falling demand and unemployment.