5. Inflation and deflation

Inflation is an increase in the average price level of the entire economy; deflation is a decrease in the average price level of the entire economy. Prices in some markets can fall even in times of inflation, and prices in some mar­kets (e.g., medical care) can rise even in times of deflation. But it is not the change in individual prices, it is the upward or downward movement in the average prices of all goods and services combined that determines the extent of inflation or deflation.

As the price level rises during inflation, a dollar buys fewer goods and services than before. Hence, inflation reduces the dollar's real purchasing power. As the price level falls during deflation, a dollar buys more goods and services than before. Hence, deflation in­creases the dollar's real purchasing power. Because money is used as a unit of account and as a medium of exchange in most economies, changes in the purchasing power of money generally have several ad­verse consequences.

Inflation can produce misleading information in business ac­counting. Since business is conducted in money terms, figures using changing prices can give deceptive signals.

Inflation hurts people living on fixed money incomes and people who have saved fixed amounts of money for specific purposes such as financing their children's education or their own re­tirement.

In general, the adverse effects of infla­tion depend on the extent to which inflation is correctly anticipated and the extent to which it is unanticipated. If inflation is correctly an­ticipated, contracts can be negotiated to include “inflation premi­ums”. Such premiums are designed to protect lenders and other re­cipients of future money payments from declines in the purchasing power of the money to be repaid to them.

Inflation can occur for several reasons, and economists sometimes distinguish between demand-pull inflation and cost-push inflation.

Demand-pull inflation occurs when aggregate demand in the economy increases faster than the economy's productive capacity at full employment. Demand-pull inflation is often described as “too much money chasing too few goods”. Cost-push inflation occurs when higher prices for the factors of production increase costs.

Price expectations and changes in them can also influence the rate of inflation. If consumers think that prices are going to increase, for example, they may rush out to buy before the prices go up.

We have to learn about the process of inflation and about its relation to other macroeconomic problems such as economic growth and unemployment. When conflicts occur, dilem­mas in economic policy arise. Should policy, for example, be aimed at achieving long-run price stability or high employment? Focus on avoiding inflation may mean higher employment. Focus on reducing unemployment may generate increasing in­flation. Such dilemmas are especially hard to deal with because of their political implications: high rates of unemployment or inflation are likely to affect the party in power.

Comprehension:

1. What is inflation and what is deflation?

2. What determines the extent of inflation or deflation?

3. What are adverse consequences of inflation?

4. What do adverse effects of inflation depend on?

5. When does demand-pull inflation occur?

6. What happens in case of cost-push inflation?

7. Can price expectations influence the rate of inflation?

True-false questions: