What do you mean by inflation and Deflation?

Discuss the
cause and consequence of inflation and Deflation? Suggest
measuring control of inflation? Can monetary policy along
control inflation?
Inflation is the rate at which the prices for goods and services
increase. Inflation often affects the buying capacity of consumers.
• Inflation refers to the increase in the prices of the goods and
services of daily use, such as food, housing, clothing, transport,
recreation, consumer staples, etc.
• Inflation is measured by taking into consideration the average
price change in a basket of commodities and services over a
period of time.
• A simple example would be, suppose a kg of
apple cost Tk.200 in 2020 and it cost Tk.220 in
2021, then there would be a 10% increase in the
cost of a kg of apple.
• In the same way, many commodities and services
whose prices have raised over time are put in a
group and the percentage is calculated by
keeping a year as the base year.
• The percentage of increase in prices of the group
of commodities is the rate of inflation.
• Causes of Inflation
• Inflation is caused by multiple factors, here are a few:
• Money Supply
• Excess currency (money) supply in an economy is one of
the primary cause of inflation. This happens when the
money supply/circulation in a nation grows above the
economic growth, therefore reducing the value of the
currency.
• National Debt
• There are a number of factors that influence national
debt, which include the nations borrowing and spending.
In a situation where a country’s debt increases, the
respective country is left with two options:
• Taxes can be raised internally.
• Demand-Pull Effect
• The demand-pull effect states that in a growing
economy as wages increase within an economy, people
will have more money to spend on goods and services.
• The increase in demand for goods and services will
result in companies raising prices that the consumers
will bear in order to balance supply and demand.
• Cost-Push Effect
• This theory states that when companies face increased
input cost on raw materials and wages for
manufacturing consumer goods, they will preserve their
profitability by passing the increased production cost to
the end consumer in the form of increased prices.
• Exchange Rates
• An economy with exposure to foreign markets mostly
functions on the basis of the dollar value. In a trading global
economy, exchange rates play an important factor in
determining the rate of inflation.
• Effects of Inflation
• When there is inflation in the country, the purchasing power
of the people decreases as the prices of commodities and
services are high. The value of currency unit decreases
which impacts the cost of living in the country. When the
rate of inflation is high, the cost of living also increases,
which leads to a deceleration in economic growth.
• However, a healthy inflation rate (2-3%) is considered
positive because it directly results in increasing wages and
corporate profitability and maintains capital flowing in a
• Deflation
• Deflation is generally the decline in the prices for goods
and services that occur when the rate of inflation falls
below 0%.
• 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 goods and
services.
• The term “Deflation” is often mistaken with
“disinflation.” While deflation refers to a decrease in the
prices of goods and services in an economy, disinflation
• Causes of Deflation
• 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 the supply of currency
• The decrease in the supply of currency will decrease the
prices of goods and services to make them 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 reductions 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
Controlling measure of inflation
• Fiscal policy:
• Controlling aggregate demand is important if inflation is
to be controlled.
• If the government believes that AD is too high, it may
choose to ‘tighten fiscal policy’ by reducing its own
spending on public and merit goods or welfare payments
Monetary policy:
• One popular method of controlling inflation is through a
contractionary monetary policy. The goal of a
contractionary policy is to reduce the money supply
within an economy by decreasing bond prices and
increasing interest rates. ... So spending drops, prices
drop and inflation slows.
• Cash Reserve Ratio (CRR) : To control inflation, the
central bank raises the CRR which reduces the
lending capacity of the commercial banks.
Consequently, flow of money from commercial
banks to public decreases. In the process, it halts
the rise in prices to the extent it is caused by banks
credits to the public.
Direct controls - a government might choose to
introduce direct controls on some prices and wages
– Public sector pay awards – the annual increase in
government sector pay might be tightly controlled or
even froze (this means a real wage decrease).
– The prices of some utilities such as water bills are
subject to regulatory control – if the price capping
regime changes, this can have a short-term effect on the
rate
• To control deflation, the central bank can increase
the reserves of commercial banks through a cheap
money policy.
• They can do so by buying securities and reducing
the interest rate.
• As a result, their ability to extend credit facilities to
borrowers increases.