Inflation and Deflation Explained: What They Are and How They Affect You w/ Real Examples 

 Two major concepts in the economy are inflation and deflation. These are directly related to the rise and fall in prices that will assist you in making financial decisions with great ease. This article explains both concepts in very simple terms with examples that a layman can relate to easily. 

What is Inflation? 

Inflation refers to a state where there is a rise in the general price level of goods and services over time. In other words, when it happens, your money doesn't go as far; things become more expensive. To put it another way, your money has reduced purchasing power. 

Real Example of Inflation 

Probably the most familiar example of inflation is increased price on a loaf of bread. For example, say that in 2010, a loaf of bread cost $1.00. A decade later, in 2020, that same loaf of bread might cost you $1.50. This rise in price occurred because of inflation. Over time, the prices increase due to the general price rise of goods and services, which means you have to spend more money on similar products. 

What Causes Inflation? 

 Other factors that could result in inflation include the following: 

 1. Demand-Pull Inflation: This refers to a scenario in which demand for goods and services overtakes the supply. For instance, when everyone wants to own the latest smartphone model but there aren't enough made, it's quite likely the price of the phones will rise. 

2. Cost-Push Inflation: It is said to take place when there is an increase in cost of production, including higher cost to the consumer. For instance, if the price of oil has surged then the prices of many goods go up based on how it affects the transportation and manufacturing costs. 

3. Built-In Inflation: It is known as wage-price inflation and takes place when companies raise prices to make sure that they cover higher wages and, in the end, it raises the cost for the consumers. 

Effects of Inflation 

 Inflation works and affects the economy in these aspects: 

1. Purchase Power: If inflation increases, the money gets devalued and with that same money you will not be able to purchase many things which you could with it some time back. 

2. Savings: Inflation reduces the value of money saved. Example: if the rate of inflation is 3% per annum, and your savings account earns an interest of 1 % per annum then the money is actually reducing. 

3. Interest Rates: A central bank like Federal Reserve can raise interest rates to help control high inflation. An increase in interest rates raises the cost of borrowing, which in general can lower economic growth. 

 What is Deflation? 

 Deflation is the opposite of inflation. It is the decline of the general price level of goods and services over time. This can logically be perceived as a blessing for most consumers, as they will have to pay less for goods and services. However, deflation ideally spells nothing but headaches for the economy. 

 Real Example of Deflation 

 An extraordinary example of deflation took place during the 1930s in the Great Depression period. There was a rapid decrease in the price levels of the various goods and services, and people held back from spending their money because of their reduced purchasing power. This led to large-scale unemployment and other problems in the economy. The shrunk economy and lack of profit raised from selling goods put many businesses out of business. 

What Is Deflation Caused By? 

Deflation can be brought on by many different things: 

 1. Decrease in Demand: This leads to a resultant decrease in demand when consumers and business cut down on their spending; hence, prices consequently fall. This normally comes during periods of recession. 

2. Increased Supply: More availability of goods and resources enables them to cost less as a result of a rise in competition by business of consumers. 

3. Strong Currency: This would make imports cheaper, and the price would fall in the country if its money was strong, hence resulting in deflation. 

Effects of Deflation 

The very drastic effects that deflation can have on the economy are as follows: 

1. Decreased Spending: Lowered prices would make people postpone expenditures in the hope that they will fall even further. This situation decreases aggregate demand and can throw the economy into a recession. 

2. Debt Burden: The real value of a debtor's debt increases in deflation. For example, if for the $1,000 that you owe prices fall by 10%, your $1,000 just got more expensive in real terms. 

3. Unemployment: If businesses make reduced money they may opt to lay off workers to reduce the wage bill, hence increasing the rate of unemployment. 

 How Inflation and Deflation Are Measured 

Here are a few key measures that economists use to compute inflation and deflation: 

1. Consumer Price Index (CPI): An index is a statistic that is employed to measure the change in prices of a representative basket of goods and services an average consumer can be expected to consume in relation to their income. One of the most common indexes for inflation reflects changes in the country's price level change over given intervals of time. 

2. Producer Price Index (PPI): A measure indicative of price changes a producer would be obtaining for his goods and services; it can also be a leading indicator of inflation for consumers. 

3. Gross Domestic Product (GDP) Deflator: This quantifies the changes in prices of all goods and services incorporated in the GDP, and it provides a comprehensive indicator of the inflation or deflation prevailing in the various sectors of an economy. 

 Real- World Illustrations of Inflation and Deflation 

 1. Hyperinflation in Zimbabwe 

One of the most extreme examples of inflation happened in Zimbabwe, late in the 2000s. The country went through hyperinflation where prices would double each 24 hours at its peak. The government could be seen printing too much of the money to pay off the debts which mainly led to the collapse of the currency. People could be seen carrying a wheelbarrow of money to just go out and buy basic stuff. 

2. Japan's Deflationary Spiral 

Japan has been gripped by deflation for the better part of the last two decades. In the 1990s, after its real estate bubble burst, the country spiraled into deflation. Prices fell, people put off spending as long as possible, hoping for an even better future deal on goods and services, with the expectation that prices would continue to fall. This was an economic inertia that fed deflation, now famously referred to as "The Lost Decade." 

3. Inflation in the United States During the 1970s 

In the 1970s, the United States had similarly high inflation, and part of the problem arose from the oil crisis. Oil prices quadrupled; it became more expensive to produce most goods and services in the economy. Stagflation is so challenging because it is not just high inflation but high inflation, slow economic growth, and high unemployment—all at the same time. 

  How Central Banks Fight Inflation and Deflation 

 Central banks, such as the Federal Reserve of the U.S., are crucial to managing inflation and deflation. These are done through the use of monetary policy tools, particularly the adjustment of interest rates, within the economy. 

  Combatting Inflation  

1. Raising Interest Rates: A central bank controls the economy. This is done by using principles founded on monetary policies to regulate the key interest rates within an economy. This is done through raising interest rates in a bid to baseline the inflation pertaining within an economy. This normally applies to a developing economy, where the risks of inflation are notably high. 

2. Reducing Money Supply: The other way through which a central bank can reduce money supply includes selling government bonds whereby money is pulled out of circulation, hence reducing inflation. 

Combating Deflation 

1. Lowering Interest Rates: In this regard, central banks will lower interest in order to lower borrowing costs so that people and businesses increase their spending and investment. 

2. Quantitative Easing: This is where to the worst extent, the central banks use quantitative easing through buying government bonds or any security, to make money available out in the economy. 

  Why Inflation and Deflation Matter to You 

 Inflation and deflation are very important to understand concepts for any person managing his personal financial life. Why? 

 1. Savings and Investments: Because inflation constantly eats up the real value of savings, it aims toward savings through investment opportunities where any rise against inflation is allowed. For instance, buying stocks or investing in real estate. 

2. Wages and Employment: Inflation will lead to higher wages, but when very high, it will as well reduce purchasing power. However, deflation will be perfect with unemployment and wage cuts. 

3. Debt Management: Inflation reduces the real value of debt over time, thereby making it easier to pay off. Deflation would have the opposite effect of escalating the real burden of debt, thus making it difficult to manage debt.