Inflation and Deflation
How do we define
inflation?
 “A continuing increase in the general price level”.
But let’s focus on some key words in the definition
Inflation defined….
 Continuing means the increase must be
occurring over a period of time, not just a
one time increase
 Increase refers to the rising price level of
goods and services on average, not every
good and service in the economy
 General price level is an average of prices of
goods and services in the entire economy
How do we define
deflation?
 “A continuing decrease in the general price
level”. (the same descriptions apply here as
in the definition of inflation)
How are inflation and
deflation expressed?
 As a percentage change of the general price
level that has occurred over the course of a
year (although shorter time periods are also
calculated).
 Inflation is much more commonly seen than
deflation
Changes in the price level vs.
changes in rate of inflation
 Consider this: In one year we have an
increase in the general price level of 5%,
followed the next year by an increase in the
general price level of 7%.
 What can we say is happening to the price
level and inflation rate in both years?
Changes in the price level vs.
changes in rate of inflation
 Now assume we have an increase in the
general price level of 10%, followed the next
year by an increase in the general price level
of 7%.
 What can we say is happening to the price
level?
 What can we say about the rate of inflation?
Causes of inflation
 There are three causes of inflation. Can you recall
any or all of these?
Demand-pull inflation
 This type of inflation is caused by increases
in AD which move the economy beyond the
equilibrium level of real GDP and the
equilibrium price level.
 Demand-pull inflation is associated with an
inflationary gap, and the unemployment
rate falls below the natural rate of
unemployment.
Demand-pull inflation
How to deal with demandpull inflation?
 Simple, just reduce AD by enacting
contractionary fiscal policy or “tight-money”
monetary policy.
 This should bring the AD curve back to the
equilibrium level of real GDP and lower the
average price level.
Cost-push inflation
 This type of inflation is caused by increases
in costs of production which move the
economy below the equilibrium level of real
GDP and above the equilibrium price level.
 You can also think of this as the negative
supply-shock phenomenon as input costs
rise and firms supply less output.
Cost-push inflation
How to deal with costpush inflation?
 It depends. If increasing wage rates are the
root of the problem, the supply-side folks
have lots of ideas.
 If the problem is caused by increasing
commodity prices (like oil), efforts to reduce
oil consumption could lead to lower prices,
as demand for oil falls, but this won’t
happen overnight…
More sources of cost-push
inflation
 Monopolies and/or oligopolies may behave
in a manner as to increase prices to raise
profits. Supply-side policies to dismantle
these firms may be in order.
More sources of cost-push
inflation
 A depreciating domestic currency may
increase input costs for firms if they use
foreign goods in production. Efforts to
reduce reliance on imports could solve this
problem.
Excessive growth in the
money supply
 Monetarists argue that changes in the money
supply affect the general price level.
 They use the quantity equation on the next
slide to express their views…
Quantity Equation
M X V = P X Q
Where M = money supply
V= velocity of money (or circulation)
P = price
Q = quantity of output
MXV=PXQ
 M X V = total spending in the economy
 P X Q = nominal value of GDP
 Because total spending and the value of
GDP are equal as we learned when
discussing the three methods of calculating
GDP, the equation is true.
 Now let’s go further…
MXV=PXQ
 Monetarists make two assumptions:
 V is stable over short periods of time
 Q is determined by quantity and quality of
factors of production, not the supply of
money or the price level
 So any change in M will directly affect P
Inflation due to increase in
money supply
Inflation due to increase in
money supply
 Monetarists argue that increasing the money
supply (M) will shift AD to the right as C
and I spending increase.
 In the short-run, output increases and price
level does too, but in the long-run, output
returns to the equilibrium level and all we
have is a higher price level (P)
Monetarists believe:
 The long-run happens quickly, so gains in
output are short-lived
 Demand-side policies can’t increase real
GDP in the long-run
 In benchmarks for increasing money supply
(GDP grows by 3%, increase the money
supply by 3%)
Last word on monetarism
 The monetarist conclusions are subject to
debate. Their conclusions about the
relationship b/w money supply and
inflation holds in the long-run, but not so
much in the short-run
 One thing is clear, if you want
hyperinflation, you must increase the money
supply!
Costs of inflation
 One cost is the loss of purchasing power. If
your income remains constant and the
general price level rises, your purchasing
power has decreased.
 You can no longer buy the same quantity of
goods if the price level is increasing more
rapidly than your real income 
Costs of inflation
 Inflation redistributes income from one
group to another. If you have a fixed income
and the inflation rate begins to rise, you end
up with less money than before.
 Who fits in this category?
Fixed income folks
 Workers with fixed wage contracts
 Pensioners
 Landlords
 Welfare recipients
Other Inflation losers
 Holders of cash
 People who save money
 People who lend money
Inflation Winners
 Borrowers
 Payers of fixed incomes or wages
Other Inflation Problems
 Firms get antsy when it is difficult to predict
what is happening with the general price
level. They may be unwilling to invest in
new capital goods if they fear customers
may lose purchasing power in the future.
 This general level of uncertainty may slow
economic growth.
Other Inflation Problems
 Menu costs suggest that firms will incur
large printing costs as the general price level
fluctuates.
 Sounds silly, but this can still be a real
expense for a firm if they have to constantly
redo their pricing lists.
Other Inflation Problems
 A “money illusion” may fool people into
thinking they are doing better than they
really are.
 If you get a 10% raise at work, but the
inflation rate is 15%, you are obviously
worse off, but if you are not paying close
attention to the general price level, you
might make some foolish spending decisions
Other Inflation Problems
 If a country is experiencing inflation, it’s
exports become more expensive to foreign
nations and imports become cheaper than
domestically produced goods.
 This can severely disrupt a country’s trade
position and balance of payments
Hyperinflation
 Inflation gone wild. If the price level
increases by 50% a month, you have
hyperinflation.
 An inflationary spiral results and a massive
disruption of economic activity occurs. The
barter system may take over and significant
social problems often follow
Causes of deflation
 Deflation is a very rare occurrence for
several reasons:
 Worker’s wages rarely fall, so firms tend to
not lower the price of the goods they sell
 Oligopolies abhor price wars
 Firms try to avoid menu costs
Causes of deflation
 Decreases in AD may eventually lead to a
decrease in the general price level.
Unfortunately, recession often accompanies
this change, as do falling incomes and
output, as well as cyclical unemployment.
 This is what happened during the Great
Depression of the 1930s.
Decreasing AD
How to deal with less AD?
 Obviously expansionary fiscal policy and
“easy” monetary policy would be in order to
shift the AD curve back to the original
position
Increases in AS
 The “good” deflation may occur when the
AS curve shifts to the right, thus lowering
the average price level while output
increases.
 Economic expansion, rising incomes and
output, increasing employment and
economic growth may all occur.
Costs of deflation
 Redistribution of income (opposite as during
inflation)
 Uncertainty for firms may lead to lack of investment
 Menu costs again…..
 A deflationary spiral may result as borrowers are
discouraged from taking loans, and spending slows
by consumers as they expect prices to continue to
fall and AD continues to fall….
Add it all up….
 With deflation, the real value of debt rises,
the economy is in recession, incomes are
falling and bankruptcies result as borrowers
are unable to pay back loans.
 A major financial crisis could easily occur.