Inflation is a situation in an economy where prices of goods and services increase and the purchasing power of people decreases. Whereas, in deflation, there is a downward movement of the general price level of goods and services.
In this read, let’s understand the meaning of inflation and deflation, causes and effects and the major differences between the two.
What is Inflation?
In simple terms, inflation happens when there is a price rise in goods and services. It is a rate at which these prices increase such as housing, food items, apparels, transportation among others. Generally, inflation rate is calculated as the average price change in a basket of commodities and services at a particular time period.
Let’s understand inflation from a simple example: for instance, one liter of edible oil costs INR 100 per liter in 2020, and it costs 110 in 2020, which means there is a 10% rise in the price of edible oil. Similarly, the prices of other commodities and services that have also risen over time are put in one basket and then inflation rate is calculated by keeping a base year. The percentage of increase in prices of goods is considered as the rate of inflation.
A consumer also tends to buy less as inflation increases over the years. Let’s understand this concept with the help of an example and hypothetical figures:
For instance, retail price of apples in India:
2010 = INR 40/kg
2015 = INR 50/kg
2020 = INR 100/kg
So, if you had INR 200 in your pocket, you would be able to buy:
2010 = 5 kg apple
2015 = 4 kg apple
2020 = 2 kg apple
As you see, with the increment in the level of the prices, the consumer would be able to buy less quantity of apples than they would buy previously. This is what is called inflation.
Inflation Rates Around the World in 2022
Most central banks including the Reserve Bank of India (RBI) keep a target of low and constant inflation rate, so as to maintain a good balance in the economy. Moderate inflation rates are considered beneficial for the overall financial health of an economy.
However, post pandemic and since the end of 2021, inflation rates have been rising around the globe, as seen in many of the world’s regions. Turkey, by far is experiencing the highest inflation rate in the first quarter of 2022 which is standing at 54.8%. After Turkey, Israel is another nation where inflation rate has grown rapidly over the last two years. Similarly, the U.S. inflation rate has increased fourfold over the past two years. Large increases in inflation rate are also recorded in Japan and the UK due to increase in the prices of food and energy in the year 2022.
However, in India the inflation rate has been in double digits for the past 17 consecutive months. India’s wholesale inflation eased to 12.41% in August 2022 compared to 13.93% month on month. To know more on India’s inflation rate, read our story on Inflation rate in India for more such details.
In India, the inflation is measured on the basis of Wholesale Price Index (WPI) and Consumer Price Index (CPI). The former measures the changes in the price of goods and services at the wholesale level, whereas the latter measures the changes in the price of goods and services at the retail level.
Causes of Inflation
Money Supply: This is one of the basic factors which causes prices to increase in an economy and thus causes inflation. More currency or excess money supply reduces the value of the currency. Too much money circulating in an economy becomes higher than the increase in goods and services produced, which causes inflation in an economy.
Increase in Nation’s Debt: When a country’s debt increases, then that nation either has to raise taxes internally or has to print the additional currency to pay off the debt.
Increasing Purchasing Power: With increase in purchasing power in the hands of people, means people now have more money in hand to spend on goods and services. This situation creates more demand for goods and services and then as a result the companies increase the prices causing inflation in an economy.
Interest Rates: The interest rates also contribute to inflation. When the interest rates are low, the supply of money is more and hence the inflation increases. That is why, in order to curb inflation, many countries generally raise the interest rates to control liquidity.
What Is Deflation?
Deflation is a phenomenon, which is exactly the opposite of inflation. When deflation occurs, the prices of goods and services fall which in turn increases the purchasing power of the money. It also means that more goods and services can be bought with the same amount of money.
This situation comes naturally in an economy when the money supply of an economy gets restricted. Deflation is generally regarded as an economic crisis which is linked with unemployment and very low productivity levels of goods and services.
In a deflation kind of situation, businesses and the public at large accumulate less wealth and thus spending becomes very low, which reduces the demand further. With decrease in demand, corporates tend to lower the prices of goods and services to increase the demand.
Causes of Deflation
Decrease in demand: The fall in demand for goods and services triggers a decline in the prices of the goods and services, which causes deflation in an economy.
Increasing Interest Rates: Increase in interest rates means restricted spending power. So, generally people instead of spending money prefer to save it. Increase in rate means more borrowing costs on home loans and car loans, which also discourages people from spending more.
Low Production Costs: A decline in price for production inputs or raw material will decrease the overall production costs. And, with low costs, producers will tend to increase their production output, which causes an oversupply in the economy. And, if the demand remains low or unchanged, the producers have to decrease the prices of goods and services to make people buy the products.
How to Safeguard Yourself From Inflation or Deflation?
Inflation or deflation are the two major phases of an economy which is caused due to a lot of factors. Here are a few ways which can help you to protect your money whether an economy is in inflation or deflation.
- Consider investing in best investment options in India
- Consider investing in real-estate and gold.
- Make balanced fund investments and diversify your portfolio.
- Save more and spend wisely.
- Consider buying insurance products which provide financial protection, for instance, life insurance and health insurance.
Comparison Between Inflation and Deflation
Bottom Line
As the demand and supply in any economy changes, inflation or deflation are bound to occur. There are certain strong measures which have been adopted by the central bank of a country to tackle inflation such as monetary measures, fiscal measures or controlling the money supply.
In fact, having a moderate kind of inflation gives a boost to the economy and proves beneficial for both consumers and producers of an economy. However, deflation is not that easy to tackle, which might also create a depression kind of situation in the country, which can prove dreadful for any economy.
Frequently Asked Questions (FAQs)
Who keeps a check on the inflation or deflation rates in India?
The central bank of India, which is the Reserve Bank of India (RBI) in Indian context, has the responsibility of keeping inflation or deflation in check. Generally, the RBI does this by tweaking the interest rates or by tweaking the money supply. During inflation, the RBI increases the interest rates so as to make borrowing expensive for consumers and the very opposite happens in deflation.
