Saturday, April 30, 2011

Inflation and Deflation

Inflation may be defined as a rise in price level of all commodities in general. Effect of inflation on aggregate demand, and consequently on total production and income cannot be underestimated or ignored. A sustained trend of rising prices, or excessive growth of money income which surpasses the growth of real output, is the basic characteristic of inflation. Thus more money is required to buy the same quantity of a particular commodity. Real productivity fails to keep pace with price rise. The value of money keeps on falling.

Deflation is characterized by a falling tend in the general price level. This happens because of a fall in the aggregate demand. Deflation leads to increased unemployment, as there is a fall in investment due to a pessimistic behaviour on the part of investors. They invest less as the prospect of earning revenue is bleak. This causes unemployment and generates less income. Less income causes less demand.

Depression: If deflation comes at a time when there is sufficient unemployment in the economy, it is called Depression. It has a spiraling negative effect on the economy, and it becomes really difficult to boost it up.

Prof. Paul Samuelson has summarized inflation and deflation in the following words:

"By inflation we mean a time of generally rising prices for goods and factors of production - rising prices for bread, cars, haircuts, rising wages, rents, etc. By deflation we mean a time when most prices and costs are falling."

When money income in the hands of consumers increases, they acquire more purchasing power. The output of goods and services fail to keep pace with the purchasing power. More and more money runs after the same quantity of goods. This pushes up the demand, and consequently prices and costs of other factors of production. If production of consumer goods is cut down, then also there will be a situation of purchasing power, money income or effective demand outstripping actual supply. This will also push up the prices.

Once full-employment has been achieved, any increase in aggregate demand will push up the prices, leading to an inflationary situation. In such cases the economic infra-structure needs expansion. Additional production facilities, backed up by adequate investment, public (Govt.) or private, need to be generated to meet the rising demand.

Inflation may be of two basic types.

1. Demand-pull inflation: When effective demand overreaches actual supply, it is a case of demand-pull inflation. More money and fewer goods lead to a rise in prices.

2. Cost-push inflation: When costs of factors of production, like rent, wages and interest start rising spirally, it is a case of cost-push inflation. The cost of producing one unit of a commodity increases. This increases the market price of that commodity, which leads to inflation.

Stagnation: A period of no growth, or excessive slow growth of the economy, in terms of the gross domestic product, is termed as stagnation.

Stagflation: It is a situation where the economy is not growing, or growing at a negligible rate it terms of gross domestic product, but prices are increasing. It is characterized by persistent high inflation combined with high unemployment and stagnant demand.

An economic growth rate of 2%-3% or less is considered to be negligible.

Also read: Demand-Pull Inflation Cost-Push Inflation Effects of inflation

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