Basic concepts of macroeconomics: Inflation and deflation

Basic concepts of macroeconomics: Gross Domestic Product (GDP) Real variables vs nominal variables

Annexe I: Basic concepts of macroeconomics

At the national level

Inflation

‘Inflation’ refers to a sustained rise in the general price level in an economy. According to this definition, the increasing price of a single item does not constitute inflation. The rising prices should be observed in the majority of the goods and services produced in an economy. A short-term change in the price levels is not considered as inflation either. For inflation to occur, rising prices should be sustained (ongoing).

High inflation rate can have devastating effects on the economy in general. Most significantly, the high rate of inflation reduces the purchasing power of money. Purchasing power simply refers to the value of money in terms of its ability to buy goods and services.

In an economy with a high inflation rate (constantly rising prices), people cannot buy the same amount of goods and services using the same amount of money in comparison to an earlier period. For example, let’s say that $1 can buy a loaf of bread this month. Next month, the price of a loaf of bread increases to $2. Now, the same $1 can only buy half of a loaf. In other words, it is due to inflation that the value of the dollar has significantly decreased (eroded) in a month.

Inflation rate is usually measured using Consumer Price Index (CPI). Consumer price index tracks the price changes for a specific set of goods and services commonly purchased by households (such as food items or fuel). Consumer price index gives us an idea about the changing cost of living over time.

Since the late 1970s, the IMF (within the context of liberalisation) has advised governments to keep the inflation rates low and interest rates high to achieve economic growth. According to this model, financial investors would be more willing to invest their money if there was an expectation of a higher return on their investment (guaranteed by high interest rates) and low risk of their money losing value over time (guaranteed by low inflation rates).¹

Furthermore, when governments used monetary policies and increased money base growth, budget deficits were considered to cause high inflation rates. Therefore, governments were advised to keep their deficits low by cutting much needed public expenditures. In other words, combating inflation provided a rationale for implementing austerity policies. These policies have thus led to a deflationary trend in recent years, which may be a bigger threat to the world economy.²

Deflation

The concept of ‘deflation’ tends to be used less often in daily life, compared to terms like ‘inflation’. ‘Deflation’ means a reduction in general price levels. While inflation reduces the value of a currency, deflation increases the currency’s value for a while. Deflation generally occurs as a tool for economic regulation. However, it may have adverse effects on the economy in the long term.

Recently, the impact of the COVID-19 outbreak and the subsequent fall in the demand for goods and services have resulted in deflationary trends. In many sectors (such as restaurants, hotels, and airlines) prices have fallen drastically. Even though lower prices may seem beneficial, deflation can lead to a severe economic recession by causing unemployment and wage drops.³

Basic concepts of macroeconomics: Gross Domestic Product (GDP) Real variables vs nominal variables

Footnotes

1
Çağatay, N. (2003). Gender budgets and Beyond: feminist fiscal policy in the context of globalisation. Gender & Development, 11(1), 15–24.
2
Ibid. pg. 22
3
Davies, G. (26 April 2020). The Deflation Threat from the Virus will be Long Lasting. Financial Times.