ACADEMY OF ECONOMIC STUDIES OF MOLDOVA

FACULTY OF INTERNATIONAL ECONOMIC RELATIONS

Macroeconomics Research Paper

To topic: “Inflation and Deflation, Their Causes and Effects”

Elaborated by: Martiniuc Evghenia

EMREI – 181

Chişinău, 2019
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 Brief Contents:

Introduction.............................................................................................................. 3

How to Tell the Difference Between Inflation and

Deflation....................................................................................................................3

Examples....................................................................................................................3

Causes .......................................................................................................................4

How Inflation and Deflation Are Controlled.............................................................4

Why Deflation Is Worse than Inflation.................................................................... 4-5

What Inflation and Deflation Mean to You.................................................................5

How to Protect Yourself...............................................................................................5-6

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Introduction
Inflation is when prices rise, and deflation is when prices fall. You can have both inflation and
deflation at the same time in various asset classes. When taken to their extremes, both are bad for
economic growth, but for different reasons. That's why the Federal Reserve, the nation's central
bank, tries to control them.

How to Tell the Difference Between Inflation and Deflation

There are five types of inflation. The worst is hyperinflation. That's when prices rise more than 50
percent a month. Fortunately, it's rare. It's only caused by massive military spending. On the other
end of the scale is asset inflation, which occurs somewhere almost all the time. For example, each
spring, oil and gas prices spike because commodities traders bid up oil prices. They anticipate rising
demand at the pump thanks to the summer vacation driving season.

The third type, creeping inflation, exists when prices rise 3 percent a year or less. It's somewhat
common. It occurs when the economy is doing well. The last time it happened was in 2007.

The fourth type is walking or pernicious inflation. Prices increase 3-10 percent a year, enough for
people to stock up now to avoid higher prices later. Suppliers and wages can't keep up, which leads
to shortages or prices so high that most people can't afford the basics.

The fifth type, galloping inflation, is when prices rise 10 percent or more a year. It can destabilize
the economy, drive out foreign investors, and topple government leaders. It's a result of exchange
rate fluctuations.

Deflation is when prices fall. It can be difficult to spot because all prices don't fall uniformly. During
overall deflation, you can have inflation in some areas of the economy. In 2014, there was deflation
in oil and gas prices. Meanwhile, prices of housing continued to rise, although slowly. The Federal
Reserve measures the core inflation rate. It takes out the volatile price changes of oil and food.

Examples

The United States had walking inflation in the late 1980s and early 1990s. Inflation reached a peak
of 6.1 percent. Galloping inflation occurred in the 1970s and early 1980s. That was due to President
Richard Nixon's economic policies. First, he instituted wage-price controls, which
created stagflation. To curb that, he took the dollar off the gold standard, which only spurred
inflation even more as the dollar's value declined. A review of U.S. inflation rate history shows
many other examples.

Japan's economy has ongoing deflation. It began in 1989, when the Bank of Japan raised interest
rates. That sent demand for housing downward. As prices fell in other areas, businesses cut back on
expansion, and people stopped spending and started saving more. The population grew older,
without enough young people to replace workers who retired. Older people bought less, since it's the
young who start families, buy new homes, and purchase furniture. The government
tried expansionary fiscal policies.
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That only doubled its debt without restoring confidence. Japan still struggles to escape this liquidity
trap.

Causes

There are three causes of inflation. The first, demand-pull inflation, occurs when demand
outstrips supply. The second is cost-push inflation, which follows when the supply of goods or
services is restricted while demand stays the same. For example, since there is a shortage of highly
skilled software engineers, their wages skyrocket.

The third, overexpansion of the nation's money supply, arises when too much capital chases too few
goods and services. It's caused by too-expansive fiscal or monetary policy, creating too
much liquidity.

Deflation is caused by a drop in demand. Fewer shoppers mean businesses have to lower prices,
which can turn into a bidding war. It's also caused by technology changes, such as more efficient
computer chips. Deflation can also be caused by exchange rates. For example, China keeps its
currency's value low compared to the U.S. dollar. That allows it to underprice U.S. manufacturers,
lowering prices on its exports to the United States.

How Inflation and Deflation Are Controlled

Since oil and food prices can be so volatile, they are omitted from the core inflation rate. In January
2012, the Fed decided to use the core personal consumption expenditures price index as its
measurement of inflation. If the core inflation rate rises above the Fed's 2 percent target inflation
rate, the central bank will launch a contractionary monetary policy. That raises interest rates,
reducing the money supply and slowing demand-pull inflation.

The Fed usually only addresses general inflation. But contractionary monetary policy can attack
asset inflation as well. High interest rates can slow demand for housing if asset inflation poses a
threat. Unfortunately, the Fed didn't raise interest rates during the housing boom in 2005. It thought
that asset inflation would remain confined to housing and not spread to the general economy. True
enough, inflation didn't spread. When the housing bubble burst, it led to the subprime mortgage
crisis and the 2008 financial crisis.

Inflation isn't really a threat because the Fed has become very good at controlling inflation.

Why Deflation Is Worse than Inflation

Deflation is worse because interest rates can only be lowered to zero. As businesses and people feel
less wealthy, they spend less, reducing demand further. Prices drop in response, giving companies
less profit. Once people expect price declines, they delay purchases as long as possible. They know
the longer they wait, the lower the price will be. This further decreases demand, causing businesses
to slash prices even more. It is a vicious, downward spiral.

What Inflation and Deflation Mean to You

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Inflation lowers your standard of living if your income doesn't keep pace with rising prices. Most of
the time, it rarely does. But if inflation is around 2 percent, then people buy things now before prices
go up in the future. That can spur economic growth. Even when it's mild, inflation always impacts
your life.

Deflation could cost you your job. If prices continue to decline, your employer may not be able to
remain profitable. To stay in business, there may be layoffs. If deflation continues long enough,
many people will lose their jobs. As the economy slows, companies go out of business. That’s what
happened during the Great Depression. The Consumer Price Index fell 27 percent between
November 1929 to March 1933, according to the Bureau of Labor Statistics. Falling prices sent
many firms into bankruptcy.

How to Protect Yourself

Both inflation and deflation are under control in the United States. The current inflation rate reveals
where the economy is at in the business cycle. It's also measured by the Personal Consumption
Expenditures price index, which includes more business goods and services than the CPI.

Two bonds offered by the U.S. Treasury provide built-in ways to protect yourself from inflation.
Both the Treasury Inflated Protected Securities and the Series I Bonds automatically rise in value
along with inflation. If you're anxious about inflation, you'll get peace of mind if you own some of
these. On the other hand, the best protection is a well-diversified portfolio that includes stocks. The
stock market historically outperforms inflation. If you're retired or otherwise can't afford a
downturn, then you might want more TIPS or I Bonds than stocks.What about gold? It's used as a
hedge against inflation, but gold prices are affected by a lot of other things as well. Since it's traded
on the commodities market, it's more volatile. As a result, its prices don't rise and fall with other
asset classes. That makes it good for a diversified portfolio. That’s the main reason why you should
invest in gold.