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Understanding Inflation and Deflation, Effects on Your Pocket


What is Inflation and Deflation?

Inflation is a steady increase in the general level of prices of goods and services in an economy. Inflation can be calculated both for the entire economy as a whole, and for individual sectors or specific products. At the same time, some goods may rise in price more strongly, others, on the contrary, become cheaper, and the prices may not change at all.

When they say that inflation is declining, it means that prices are rising more slowly than before. But they still grow. When prices of the products fall, it is called deflation.

When is Inflation Bad?

Consumers traditionally perceive inflation negatively - no one likes that prices are rising. But this is a natural economic process, both for themselves and for entrepreneurs, economists call low inflation below 6% comfortable. For Russia, the optimal level is now 4%. For a long time, the Central Bank has been focusing on this figure. And, for example, the goal of the American authorities is 2%.

Inflation becomes a problem when it rises sharply and strongly. What, in fact, is the world economy facing in 2022.

Inflation is considered a negative phenomenon, but does this make deflation positive?. A modest reduction in the cost of some goods, like food or energy, can indeed have some positive impact on consumer spending. But in many ways, everything depends on the reasons that led to deflation, and the period for which it stretched.

Prices may start to fall due to a decrease in demand for products, an increase in supply, an overproduction of goods, or an increase in the demand for money. Of the positive causes of deflation, they note the situation when prices fall due to improved production technology and a subsequent increase in the volume of goods. For example, as is happening with today's consumer electronics - more complex than ever before, but at the same time relatively more affordable.

After the Second World War, deflation was rarely talked about, experts at the Higher School of Economics noted. The main enemy of the economies was inflation, which did not subside even in the 70’s, due to rising oil costs and gave rise to the term — stagflation. A situation where an economic downturn is combined with rising prices. Deflation has become a topic of academic interest for the experts.

An anomaly against this background was Japan, which faced a halt in economic growth after the bubble in the financial market burst in 1990. The decade after that was called "lost", followed by the second, and the country is still actively fighting inflation. Formally, it managed to reach and exceed the target of 2% in 2014, but now it is again hovering around 1%. Although the rest of the indicators remain quite good — a high standard of living of the population and life expectancy, as well as scientific and technological progress.

Several Reasons to Fear Deflation

Mostly when prices go down, people stop spending money. After all, why would you buy? If you can wait and later buy for the same money, a little more. In case if demand falls, the goods are not produced in the same value as there's no need. Production is reduced, and this leads to a slowdown in economic growth.

And since prices fall in deflation, businesses are obliged to cut costs, followed by reducing the wages of the workers. A vicious circle arises. Because of unemployment, people lose their jobs, which further contributes to unaffordability, leading to decrease in demand.

At the same time, consumers prefer to save rather than take loans. After all, it is not profitable for borrowers to return interest greater than the loan itself.

If things are going well in the economy, then this effect can be offset by lowering the interest rates. Otherwise, even they may not be enough. A problem that is becoming more and more urgent for European states, in which experts also see symptoms of the "Japanese disease". The economy needs "healthy" loans. On one hand, they allow companies to expand production and on the other hand, they support consumer demand, which also helps in business development.

Krugman also drew attention to the deterioration in the situation of borrowers - deflation exacerbates the real burden of their debt. After all, incomes are reduced, and debt remains the same. As a result, the number of defaults increases, and when the financial sector becomes unsustainable, savers begin to withdraw their savings, afraid of losing them. But inflation leads to the erosion of debt over time.

Is Low Inflation better than Deflation?

A high rise in prices will not please anyone either. Money starts to lose its value. The higher the inflation, the less likely the depositors will receive any profit from their investments in the banks. In addition, inflation is unpredictable, it can accelerate at any time, which increases the instability in the financial market and deprives entrepreneurs of incentives to take loans for a long time.

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Economists call low or moderate inflation, which is under control — up to 2 to 3% per year good for the global economy. The regulators also explain why individual consumers often do not feel the effect of lowering of official inflation:

● A personal consumer basket can be very different.

● Prices rise differently in different regions.

● In addition, inflation is a total index, which means that it cannot be used to judge the price of any one product. The cost of certain types of products can vary quite a lot, but their share in the basket is small, which means they have little effect on the indicator.

● Moreover, there remains a personal perception. Consumers always remember a jump in prices more distinctly than a decline.

How does Inflation Affect Your Pocket?

Money loses value with high inflation. As the increase in income does not follow the variations, people lose the so-called purchasing power.

When prices soar, the challenge arises of maintaining the standard of living while earning the same, which is not so easy. Therefore, the tendency is for families to spend less, make cuts in expenses and find it difficult to save.

Imbalance Between Supply and Demand

First, we need to understand the so-called “law of supply and demand”. If demand for a product is more, the price goes up. Oppositely, If demand for a product decreases, its price also declines.

To exemplify: if the economy is doing well and all people want to exchange their refrigerators for a modern one, it is possible that stores and manufacturers cannot keep up with the demand. Therefore, with high demand and few refrigerators in the market, the result is a price increase.

Rapidly rising production costs

This happens when a sector of the economy suffers from increases in the cost of production, wages and taxes, or when debt accumulates. All these costs divide on consumers. In this case, prices rise and, consequently, inflation as well.

A good example involves fuels. Their price is related to the dollar and the international price of a barrel of oil. If the price of a barrel goes up, the price of fuel paid by the consumer goes up as well.

The increase in the price charged there at the stations makes all land transport more expensive, so all companies that depend on this service to distribute their products will charge more to replace the lost profit with the high fuel.

Inflation and the Average Interest Rate: How Does This Relationship Work?

The third reason for the rise in inflation has to do with the basic interest rate of our economy.

It is from this rate that the central banks of any country prevents the circulation of excess money in its economy to control inflation. The government does not have total control, but uses the interest rate to stop the advancement.

When the rate increases, it becomes more difficult (and expensive) to have access to money through loans and financing, so the population tends to spend less. With fewer people consuming, prices tend to decrease.

In the opposite situation, with the low interest rate, consumption grows and inflation tends to increase.

Start investing now and be prepared for high inflation

Being prepared for times of high inflation is necessary. With the price of all products rising, the ideal is to have an invested reserve so that the money does not lose value and you can maintain your purchasing power.

© 2022 Hamza Hussaini

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