Understanding the Differences Between Inflation, Deflation & Stagflation
July Fourth saw big crowds, congested highways and full airplanes as tens of millions of Americans celebrated not only the country’s independence but their own liberation from the pandemic. There were worries that creeping inflation would keep people home as the price of gas, meat and just about everything else ticked up — but the pessimists would not be vindicated. Inflation, after all, isn’t always bad — and it’s far from the only economic phenomenon that involves changes in the cost of stuff and the value of money.
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Inflation: Your Incredible Shrinking Dollars
Economists use indicators like the consumer price index to measure inflation, but for you, all the data you need is right there at the grocery store, the gas pump or the coffee shop. Over time, the cost of goods and services gradually rises as the purchasing power of your dollars falls.
Some inflation is natural and inevitable, but too much can be harmful because when consumers can no longer afford to buy the things they once could, the national standard of living declines, and the economy declines right along with it.
But inflation can also be beneficial because it adds value to people’s assets even though their debt remains fixed. Inflation can also be a sign of a booming economy. During periods of growth, businesses are making money and hiring new workers, who then have more disposable income, which increases demand and sends prices up. When prices get too high, however, consumers cut back on purchases, businesses lose money and lay off workers, and the economy begins to contract.
Once Considered a Myth, the Misery of Stagflation Is Very Real
When prices rise in response to growing demand from cash-flush consumers in a booming economy, inflation can be good. But when rapid inflation coincides with high unemployment and slowing growth, as it did in the 1970s, the result is economy-killing stagflation.
During that time, America was experiencing crushing double-digit inflation, but not because the economy was expanding — quite the opposite. Soaring fuel costs sent the price of everything up just as the economy was contracting and more people were out of work, which most of the era’s economists simply didn’t believe could happen at the same time.
U.S. economic and monetary policy changed forever when the world saw what happened when a stagnant economy suffers runaway inflation (stagflation): back-to-back recessions, soaring prices, millions of people unemployed and a general sense that the country was coming unglued.
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Deflation: Falling Prices Are Great — Until They’re Not
Just as it is with bicycle tires and air mattresses, deflation in economic terms is the opposite of inflation. During times of deflation, the cost of goods and services goes down and your dollars can buy more — sounds great, right?
Not so fast.
Policymakers and central banks fear deflation above all other outcomes because of a domino effect of destruction called deflationary spiral:
- When prices are falling, consumers delay purchases to wait for them to fall some more.
- When consumers stop buying things, production slows as demand falls.
- When production slows and demand falls, prices drop, businesses lose money and lay off workers.
- As unemployment rolls grow, consumers have less money and make even fewer purchases.
- The cycle repeats itself, and the spiral continues until a downturn becomes a recession and a recession becomes a depression.
While Inflation Can Be Bad, Deflation Is Always Terrible
Modest inflation is a natural part of the economic cycle that might be good news, bad news or no news at all — but deflation is always a reason for worry. While it’s true that inflation makes things more expensive, it also lowers the value of debt, so people and businesses don’t stop borrowing money. Plus, you can fight back against inflation by investing your money — when things get more expensive, your assets are no exception and become more valuable.
Deflation, on the other hand, lowers the cost of everything, including the assets of people and businesses. The more assets lose value, the more expensive debt becomes, so people and businesses stop borrowing money, which strangles the economy even further.
In a world where everything is losing value except debt, money has few safe places to hide.
This article is part of GOBankingRates’ ‘Economy Explained’ series to help readers navigate the complexities of our financial system.
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Last updated: July 8, 2021