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Inflation & Deflation - Basics, Types, Causes, & Effects

Inflation is simply referred to as an increment in the prices of goods and services. Deflation is when the costs of goods and services decline over a time period. An imbalance between the demand and the supply of products and supply can cause deflation & inflation.

What is Inflation?

Inflation is the percentage at which the prices of goods and services increase. However, this increment in prices affects the purchasing power of the customers. Whenever the demand for the product is more than the supply then there is a rise to be seen in the prices of products. Inflation can sometimes be beneficial for the economy or vice versa. Inflation occurs when the cost of a product (housing, clothing, food, travelling, and basic edible oils & things) rises from the average point of cost to higher. Inflation is computed by the Ministry of Statistics and Programme Implementation in India. Let’s take an example to understand this - Suppose in your nearer market, the orange was 100 per/kg in 2019 and cost Rs.120 in 2020, then there would be a 20% rise in the cost of a kg of oranges. Same as above, many items/things and services whose costs have increased over time are categorized in a group and the percentage is calculated by marking a year as the base year. The percentage of increment in the costs of the category of items is the rate of inflation.

Three Types of Inflation

There are 3 classes of Inflation demand-Pull, Cost-Push and Built-in inflation. Refer below for the explanation. Demand-Pull inflation - This type of inflation occurs when the demand for the product or service is higher than the supply. This happens due to the shortage of items and results in rising prices. Cost-push inflation - This type of inflation occurs when the cost of creating or producing the product/service is increased. An increment in the cost of production rates causes inflation in the cost of products. Built-in Inflation - Another type of inflation is built-in inflation. This inflation occurs when the cost of living increases, therefore working professionals demands higher wages or when the wages of working professionals increase, then the demand for the cost of living also increases. This is a two-faced type of inflation. And this cycle goes on.

What are the major causes of inflation?

Monetary Policy - Monetary Policy maintains the supply of currency in the country to stem economic fluctuations. However, an excess supply of money can be a cause of inflation and reduce the value of the currency. Demand-Pull Effect - This type of effect shows that in a growing economy if people are earning more money, then the demand for goods and services also arises. Therefore, companies will have to increase the prices that the consumers will pay in order to balance demand and supply. Cost-Push Effect - This effect comes when the cost of production is increased due to the higher demand in the market. Companies increase the prices of their product or service to maintain their profitability, and inflation occurs. Exchange Rates: Dealing with foreign markets are based on the dollar currency and fluctuations in the exchange rate have an influence on the rate of inflation. Fiscal Policy: It helps to monitor the borrowing and spending of the economy. Loftier borrowings (debt), can result in raised taxes and additional currency to repay the debt.

The effects of inflation?

When the inflation rate increases in a country, increased inflation eliminated the purchasing power of the customers due to the higher prices of the products and services. Moreover, the value of the currency also decreases which affects the cost of living in the country. Following are some of the major effects of inflation- Inflation can lead to an increment in costs due to employees’ demand to raise their wages according to inflation. This may end up as unemployment and companies will be bound to lay off workers to keep up with the prices. Increased inflation could also direct economic growth as it can signify increasing demand. Domestic products might become less competitive if inflation is heightened. The currency of the country can be in delicate form. Generally, the inflation rate must be (2%-3%) which is believed beneficial as it can result in increasing paychecks and corporate profitability and maintains a growing economy.

What is Deflation?

Deflation is when the prices of goods and services start decreasing from a higher to a lower slope. There could be possibly two reasons behind the deflation. The first one is “when the availability of the products on shelves is more than needed then the demand gets low. Another is “when there is a shortage of money in the country to buy the things, then the companies have to reduce the prices of the products to make the people buying things. Deflation is interconnected with the unemployment rate. Assume that a person who is unemployed won’t have enough money to purchase commodities right? In this case, companies have to decrease the cost of the product to coax him/her into buying, and prices get lowered. Note - Deflation is not the same as disinflation, deflation simply means a decline in the prices of goods and services. And disinflation means an increase in inflation but in a subtle form.

What are the causes of deflation?

Deflation is a situation that shows the falling rate of employment, output and income. Although, there can be various reasons for deflation. Defining them, one is that the cost of goods and services is influenced by a transition in the supply & demand curve. If the demand is less than the supply or overproduction of the products can also lead to deflation. Likewise, there are numerous as we have expressed below certain natural causes of deflation, read on!! Decrease in the money supply: When a strict monetary policy is deployed in the country, that declines to spend and raises interest rates on goods and services. However, It gradually becomes hard for people to borrow money to make any purchase of goods and services. A drop in consumer demand: When the demand for products and services falls, the prices are declined to attract the customer to buy the things. Companies usually lower the prices to coax people into buying their services and products and it causes deflation. Rising Advancements Production The growing technological advancements bring great efficiency in the production unit and produce more goods at a lower cost which increases deflation. With an increased supply of products on shelves, prices fall as well as demand.

What are the effects of Deflation?

Deflation has both positive and negative effects on economic growth and purchasing power. However, the declining prices of goods and services help people to purchase the same commodity at less cost. Along with there can certain negative effects mount when deflation. Let’s get those below- Higher unemployment/ Low Income - Deflation can either lead to lower income for working professionals or unemployment. If the business (they are working for) is not obtaining enough profit from the selling then normally the wages or income of professionals will be declined. Sometimes, businesses have to lay off their employees, cut the production cost and stem the investment in innovation for the company. Less Purchasing/demand If people are having less income, they would definitely spend on very few essential goods and services. Less spending is proportional to a less strong economy. Another thing is when prices are continuously falling, people may look up to saving money and delay making big purchases to hold out for a lower price tag.

Frequently asked questions

Inflation simply means, when prices for goods and services increase over a period of time instead of decreasing, as with deflation.

The deflation is opposite of inflation. deflation is when the cost of goods and services decreases over a time period rather than increasing.

The inflation rate in India in 2022 is 6.77%

(Initial CPI – Final CPI/ Initial CPI) x 100 = Inflation Rate CPI= Consumer Price Index

Inflation occurs when the prices of goods and services increase and deflation occur when the prices of the products and services decrease over a time period. Balancing both terms is essential to maintain economic growth.

Consumers get the benefit of deflation over a short time period due to the lowered prices of goods and services. Deflation helps costumers to save money and afford items at declined prices.

Inflation is neither good nor bad. Everything performs balanced to an extent. However, anything which occurs in excess is bad likewise too much inflation is can be worse for economic growth. Higher inflation affects the purchasing power of individuals and declines the cash flow.

The CPI or consumer price index is the most popular measure of inflation and deflation. A CPI is extracted from the weightage of the daily used household products in a basket.

Krishna Gopal Varshney

Krishna Gopal Varshney co-founder & CEO of Myitronline is amongst the top emerging startups of Asia and authorized ERI by the Income Tax Department. A dedicated and tireless Expert Service Provider for the clients seeking tax filing assistance and all other essential requirements associated with Business/Professional establishment. Connect to us and let us give the Best Support to make you a Success. ”

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