Deflation and disinflation are terms in supply and demand. Inflation is a situation in which the prices of goods and services in an economy rise exponentially. The opposite situation is deflation. It is the gradual decline in the prices of goods and services. In contrast, disinflation is the changes in inflation rates. It refers to economic situations that bring down the high rates of inflation, but still keep it positive.
This article explores deflation and disinflation. It also explains the differences between the two.
Deflation vs Disinflation
Deflation is an economic situation characterised by a drastic fall in the prices of goods and services. It negatively affects the entire economy. The inflation rates fall below zero. Deflation occurs due to a decrease in demand or an increase in supply. When there is a decrease in demand, the prices of goods and services fall. When there is an increase in supply, production needs reduce, leading to companies letting go of their workers or reducing their wages. This situation leads to a decrease in people's purchasing power. Thereby, leading to a decrease in demand and turn, a decrease in prices.
Disinflation is the changes in the rates of inflation. No matter how much the inflation rates fall, disinflation remains positive. In disinflation, the inflation rates call fall until it reaches zero, but it does not go below zero. The government is the main initiator of disinflation. During times of inflation, the government takes measures to bring down the high prices. The government decrees laws and regulations to help the economy by bringing down the high prices of goods and services to normal rates. Disinflation is good for a developing economy. The factors affecting disinflation are consumer behaviour, the money supply in the economy, government policies, and the employment of people.
Difference Between Deflation and Disinflation in Tabular Form
|Parameters of Comparison
|A decrease in prices of goods and services in the economy is deflation
|A decrease in the rate of inflation, but inflation remains positive is disinflation
|Decrease in demand or increase in supply
|Effect on prices
|Prices decrease without stopping
|Prices come down to normal levels
|Effect on economy
What is Deflation?
Economies never stay at the same rate always. Sometimes economic growth may increase and sometimes it may decrease. When the price of goods and services drops because of uncertain or negative economic conditions, it is deflation. During deflation, the rate of inflation will be less than zero per cent. Inflation will be in the negative rates.
Causes of Deflation
The major causes of deflation are a decrease in demand for goods and services and an increase in supply.
The decrease in demand may be due to,
- High-interest rates: an increase in interest rates may force people to stop borrowing money. When there is high-interest, people choose to invest or save their money. Therefore, people end up having less money to spend on goods and services. This situation leads to a decrease in demand in the economy.
- Negative economic events: natural disasters, pandemics, or any event that can negatively affect the financial status of individuals can lead to a decrease in demand.
- Lack of money supply: When there is less money in the economy, consumers will reduce their spending. This causes a decrease in demand and an increase in supply. This situation in turn causes prices to reduce, causing deflation.
The increase in supply may be due to,
- Decrease in production cost: when the prices of manufacturing and production drop, producers manufacture more goods. This situation can lead to an increase in supply. However, it may not affect the demand rates. Hence, producers end up reducing the prices of their products. A decrease in the price of products leads to deflation.
Effects of Deflation
- Job loss: A decrease in prices of goods and services means a decrease in company profits. Sometimes it can result in huge losses for the company. To counter this effect, companies lay off their employees.
- Drop in wages: Companies need to counter the effects of deflation. Therefore, they may cut down the wage rates of their employees.
- High credit rates: when an economy is experiencing deflation, the interest rates increase. This increase makes it difficult for people to borrow money. They will have to borrow money at rates higher than the normal amount. If they are not able to pay back the money, they might end up in debt.
- Deflationary spiral: deflationary spiral is a situation where, one negative effect of deflation leads to more situations that are negative. Due to deflation, the prices of goods and services go down and companies reduce their production. With fewer production needs, companies may let off their employees or lower their salaries. When employees have less financial stability, it reduces their buying habits. This situation, in turn, leads to a decrease in demand and an eventual decrease in prices. Hence, once deflation hits, it is difficult to come out of it.
How to Counteract Deflation
There are two main methods to counteract deflation; one is monetary policies and the other is fiscal policies.
Reducing Bank Reserve Limit
People deposit their money in banks for safekeeping. Banks often give out loans to people using these deposits. There is a reserve limit for giving out loans using deposits. That is banks can only give out a certain percentage of the deposited amount as loans. During deflation, banks bring out this reserve limit. This situation allows them to give out more loans. Hence, it is helping people to borrow money.
Open Market Operation
The central bank buys and sells government securities in the open market. This process is an open market operation. It increases the supply of money in the economy.
Bringing Down Interest Rates
The central bank brings out the interest rates on short-term loans. This encourages people to borrow more money and make purchases.
Sometimes, during deflation, the government purchases private securities on the open market. This helps to keep the money flowing in the economy.
Negative Interest Rates
In normal cases, when people make deposits, they receive an interest on that amount, for as long as it remains deposited. In a negative interest rate, the opposite happens. The people making deposits have to pay interest rates on that amount. This situation encourages people to spend more money than to deposit them. Hence, it helps increase the flow of money in the economy.
Increase Government Spending
During deflation, people stop spending money or at least reduce their expenses. This situation reduces demand and increases supply, which could in turn lead to companies firing people. Therefore, the government takes measures to keep firms from firing people. The government, itself, starts purchasing products. This action helps decrease supply and encourages production, thereby making companies keep the workers. When people have jobs, they will have income and will be willing to spend money. Hence, the demand will rise again.
One way for the government to combat deflation is to reduce taxes. When people have less tax to pay, they will have more money to spend on shopping.
To calculate the deflation rates in an economy use the "consumer price index (CPI)". The CPI measures the prices of goods and services over a period. To calculate deflation, first find the price index of the current year and the previous year. Afterwards, subtract the price index of the current year from the previous year. Then divide the amount by the price year of the previous year. Finally, multiply the amount by 100.
The formula for calculating deflation is as follows,
Deflation rate =CPIc-CPIpCPIp×100
“CPIc" stands for the price index of the current year
“CPIp" stands for the price index of the previous year
Advantages of Deflation
- Reduction in prices: During deflation, consumers prefer to save money than spend. This reduces demand for products, which in turn reduces their prices. Deflation helps people to buy products at lower rates.
- Credit: As a means of counteracting deflation, governments tend to lower interest rates. This low rate helps people to borrow money at lower costs.
- Reduces wealth gap: During deflation, the value of assets other than cash, drop. Wealthy people often hold more non-cash assets like stocks or bonds. When the prices of these assets fall, the people suffer great losses. People with less wealth tend to keep more cash than non-cash assets. They benefit during deflation, as the value of cash increases.
Disadvantages of Deflation
- Lower wages: during deflation, people purchase fewer products. This situation leads companies to experience extreme losses. Hence, to counteract the effects, companies reduce the wages of their employees.
- Unemployment: during deflation, there will be a decrease in demand and an increase in supply. When there are too many products available, companies reduce future production. With fewer production needs, they require only fewer workers. Hence, companies start letting go of workers. In addition, newly graduated and legal individuals have difficulty getting jobs. Thus, deflation leads to unemployment.
What is Disinflation?
When the rate of inflation decreases, it is disinflation. Do not confuse disinflation as the opposite of inflation. During disinflation, inflation is still happening, but the rates keep falling. The rate of inflation can fall until it reaches zero. Deflation rates always remain positive, even though the rates are falling. The opposite of disinflation is reflation. Reflation is a situation in which government tries to increase the supply of money in the economy.
Disinflation is a government manoeuvre. The government takes action to bring down the price levels of goods and services from inflated amounts. Disinflation is necessary for the economy.
Causes of Disinflation
- Monetary policies: A nation’s central bank has the power to control the supply of money in the economy. They can decide to bring down the flow of money in the economy, thus leading to deflation.
- Recession: when businesses do not increase the prices of their products, to gain more customers, it can bring down the inflation levels, causing disinflation.
Effects of Disinflation
- Increases individual purchasing power: While there is still inflation in the economy, the prices of goods and services do reduce during disinflation. However, individuals' jobs and salaries are not affected. Hence, it increases their purchasing power.
- Protects savings: During disinflation, the value of money increases. Hence, it protects the savings of individuals.
- Disinflation helps improve demand for domestically produced goods in the international markets.
- During disinflation, the prices of goods and services fall at high rates. The rates usually keep falling till it reaches zero inflation. Hence, the falling rates can encourage customers to purchase more products.
Factors Affecting Disinflation
- Consumer behaviour: When consumers spend more money and purchase goods and services, the demand goes up. This situation increases the prices, thereby increasing inflation. When consumers spend less money on goods and services, the demand reduces. This situation causes a reduction in prices, thereby causing disinflation.
- Money supply: The presence of available money affects the purchasing habits of consumers. To reduce inflation, the government declares policies that will reduce consumer spending.
- Government regulations: the government can control the disinflation in an economy. If they feel the prices have been increasing too much, they can create regulations to bring down the prices.
- Employment: an individual’s employment status can affect their purchasing behaviour. If they are making enough money, they will spend more, thus increasing demand and prices. In contrast, if an individual is experiencing salary reduction, they may spend less money, thereby decreasing demand and inflation. A decrease in inflation causes disinflation.
The same formula for calculating deflation and inflation also calculates disinflation. The formula is as follows,
Disinflation rate =CPIc-CPIpCPIp×100
“CPIc" stands for the price index of the current year
“CPIp" stands for the price index of the previous year
Main Differences between Deflation and Disinflation (in Points)
- A reduction in prices of goods and services in the whole economy is deflation. A decrease in the inflation rates is disinflation.
- Deflation negatively affects the economy. Disinflation is good for a developing economy.
- Deflation causes unemployment. Disinflation does not negatively affect employment.
- Deflation brings inflation rates below zero making it negative. Disinflation never falls below zero. It is always positive.
- A decrease in demand or an increase in supply causes deflation. Government policies cause disinflation. The government takes measures to reduce inflation rates, thereby causing disinflation.
In short, deflation and disinflation are concepts dealing with the flow of money in the economy. During deflation, a decrease in demand causes the prices of goods and services to reduce. It is a negative reduction of inflation rates going below zero. In disinflation, the reduction of prices remains positive.