Inflation and Disinflation 

Inflation-  increase in the average prices of goods and services in the nation.

Deflation – the decrease in the average prices of goods and services

Disinflation-  decrease in the rate of inflation

Measuring inflation and deflation

• The consumer price index (CPI) is the first step in measuring inflation. 

• It is constructed by the government to measure the general price level.

Constructing a price index:

1. Selecting a base year
2. Finding how households spend their money
3. Finding out price changes
4. Constructing a weighted price index

How to calculate inflation?

Inflation is the rate of change of CPI

Causes of inflation

1. Cost-push inflation 

• Inflation caused by an increase in the cost of production is known as cost-push inflation. 
• Possible reason for cost-push inflation:

1. Increase in wage rates
2. Increase in cost of raw materials

2. Demand-pull inflation

• Inflation caused by excess demand is known as demand-pull inflation
• Often takes place when aggregate demand increases
• If a country has spare capacity of resources then supply can extend to match the increase in demand. If not, inflation occurs. 

Beneficial Effects of Inflation

• Inflation is only beneficial if it is demand-pull in nature.
• Inflation encourages firms to expand.
• Inflation reduces the ‘real’ burden of debt that households or firms have built up.
• Firms’ real wage cost will fall thus preventing the firing of people who are willing to accept increments lower than the inflation rate.

Policies to Control Inflation

• Role of Central bank in controlling inflation. Inflation targeting by central banks.
• Government can use supply-side measures such as education, training and privatization if inflation is due to cost-push factors.
  • It may be a costly affair and add to aggregate demand.
  • If rises in a firm’s prices are due to rising imported raw materials then the government can subsidise firms.
• Contractionary fiscal/monetary policy for demand-pill inflation.
  • Will be effective only when households and firms are positively impacted by these policies i.e. they view them positively.
  • This could lead to cost-push inflation if workers demand a pay rise from employers in reaction to increased tax rates.

Causes of Deflation

Good deflation: the price level decreasing due to advances in technology or an increase in productivity.

Bad deflation: decrease in price level due to a decline in aggregate demand. It can lead to a downward spiral of economic activity.

Consequences of deflation

• Good deflation will reduce the current account deficit or increase the current account surplus.
• Good deflation is associated with an increase in growth and employment.
• Bad deflation leads to a rise in unemployment and reduces output.
• Both good and bad deflation increases the purchasing power of those whose incomes remain unchanged.
• It increases the real debt burden of firms and households.

Policies to control deflation

• The government does not concern itself with good deflation.
• Expansionary fiscal/monetary policy is used to control bad deflation.
• It might not work if bad deflation persists for a long time. This is because usually, interest will have been too low to have any impact by lowering further. Also, individuals will have lost confidence to respond well to cuts in income tax.