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When financial experts and central banks describe the state of the economy and monetary policy, two words often get tossed around: deflation and inflation.
If you want to understand more about how the economy works, it’s important to understand what inflation and deflation are, how they are different, and how they impact consumers.
With that in mind, let’s take a closer look at the differences between each of these economic principles.
What Is Deflation?
Deflation occurs when the price level of consumer goods and services drops over time across an entire economy. In deflationary economies, the amount of money you have today has more purchasing power tomorrow, thanks to lower prices. It’s the opposite of inflation, where prices increase.
Deflation tends to happen during periods of economic uncertainty when there is lower demand for services.
What causes deflation?
There are a few factors that lead to deflation.
Deflation tends to happen when the supply of money can’t keep up with the growing supply of goods and services. When productivity increases across the board, deflation is likely to follow.
Deflation may also occur when total aggregate demand increases for goods and services — or when there is a decrease in available credit and money.
This is not a common occurrence. Deflation tends to happen during a recession.
Deflation is similar to disinflation, which is a slight drop in inflation. However, disinflation is temporary and much more common than deflation. When disinflation goes too far, it can lead to deflation and have significant consequences.
How deflation impacts consumers
Deflation may seem like a great thing at first, because prices can drop on important items like food and fuel, lowering the cost of living.
However, deflation can be catastrophic to an economy. When prices slip, businesses have to sell products at a loss — making it harder to pay for labor, machinery, and overhead. As a result, their overall value can plummet along with housing prices and other investments.
Layoffs are also common during periods of high deflation. So while it might not result in higher prices, deflation can spread like wildfire, causing widespread damage.
One of the most infamous examples of deflation happened during the Great Depression, when the Consumer Price Index (CPI) dropped by roughly 25%, causing the deflation rate to spike by 10% in 1932. Under normal circumstances, deflation should hover somewhere between 2% to 3%.
What Is Inflation?
Inflation happens when the prices of goods and services steadily increase across an economy, in turn decreasing spending power for consumers.
Types of inflation
There are a few types of inflation, which we’ll briefly examine next.
Demand-pull inflation occurs when there is more demand than supply. This causes prices to rise. And it tends to happen when unemployment rates drop and consumers have more money to spend.
Built-in inflation is when workers demand higher pay to meet the rising cost of goods. As a result, businesses typically raise prices.
Cost-push inflation is when overall prices rise along with the higher cost of wages.
How inflation impacts consumers
Inflation impacts consumers by raising the price of everyday goods and services. In other words, inflation makes it seem like your paycheck is worth less money than before.
That said, inflation isn’t always a bad thing. For example, consumers can benefit by purchasing assets like stocks or houses before prices rise. It’s a good idea to watch for signs of inflation so you can spend before prices on certain items jump.
At the same time, inflation can reduce purchasing power. Buying power can decrease if you don’t keep up with inflation by earning more over time.
It’s important to note that inflation can have different effects on the economy. For example, some prices can rise due to inflation, while other prices drop.
Inflation can also negatively impact retirement planning — unless you account for inflation as you put money away by putting more aside for growth. Putting the same amount away over time without budgeting for inflation could wind up giving you less spending power down the line.
What is hyperinflation?
Hyperinflation occurs when the inflation rate is very high. This typically follows an increase in the money supply of an economy. Hyperinflation typically leads to rapid price increases across an economy, which can lead to a crisis for consumers when it impacts everyday items like food and gas.
Governments typically need to step in and take measures to counter hyperinflation or it can spiral out of control and wreck the economy.
Inflation vs. Deflation: A Quick Summary
As a brief summary, deflation occurs when prices drop across an economy over a prolonged period of time. Conversely, inflation occurs when prices across an economy.
Deflation almost always hurts consumers, especially when it skyrockets above the 2% to 3% range. Yet inflation can be a bit thicker.
On one hand, inflation can reduce purchasing power and cause the price of certain assets to appear more valuable than they actually are. On the other hand, inflation can benefit consumers when it’s timed properly.
In fact, the Fed believes that some level of inflation is good for the economy because it signals economic growth.
Measuring inflation and deflation
Inflation and deflation are tracked using two different methods, including the Consumer Price Index (CPI) and Producer Price Index (PPI).
The CPI monitors the prices of commonly purchased goods and services. When total CPI prices start to decline, this is an indicator that deflation is occurring. The PPI monitors price fluctuations received by domestic producers.
How to Protect Yourself From Inflation
Deflation isn’t something that consumers typically have to worry about. Deflation is usually countered by government intervention, and it lasts for only a short amount of time.
Inflation, on the other hand, requires consumers to take preventative action.
Here are some things that consumers should consider doing to counter inflation.
Interest rates for savings accounts today are so low that they barely cover the cost of inflation. As such, putting all of your money into savings is not a wise long-term move.
It makes much more sense to invest in the stock market and real estate and aim for returns in the 8% to 10% range. Investing is the best way to protect yourself from inflation.
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Buy tangible assets
Another way to potentially profit during inflation is to purchase tangible assets like gold and silver. These precious metals are thought to be a hedge against inflation. Other commodities to consider are soybeans, coffee, and oranges.
It’s a good idea to pay attention to the way the market is trending by following what economists are saying and trying to predict which way the economy is heading.
By paying attention to the stock market, you can potentially make purchases before prices skyrocket on certain items — and sell before they crash. This is particularly important for markets like real estate and commodities.
However, keep in mind that it can be very tricky and risky to try and time the market. If it were easy, we’d all be millionaires.
Maintain a healthy emergency fund
It can be tempting to move all your money out of an emergency fund and invest it during a time of high inflation to protect against falling interest rates. However, this can be a bad move.
You should always keep some of your money into a high-yield savings account (HYSA) to maximize interest during a time of inflation while maintaining liquidity.
What Is Stagflation?
When an economy is going through a period of both inflation and stagnation in economic output, it is said to be in a state of stagflation. Stagflation is also attributed to periods of high unemployment.
Stagflation results when the economy experiences a sudden change in supply — like when prices shoot up for a particular product, such as fuel. When this happens, prices can increase while economic growth decreases, leading to a drop in production.
Stagflation may also occur when the government steps in and begins increasing the money supply while creating policies that limit commerce.
In short, stagflation is harmful because it can make it challenging for people to purchase items and make ends meet. Unfortunately, consumers and businesses are impacted the most by stagflation and often depend on governments to bail them out.
Frequently Asked Questions
Here are the most frequently asked questions about deflation vs. inflation.
What does the Federal Reserve do during inflation?
The Federal Reserve — or the Fed — plays a central role in managing the rate of inflation and stabilizing the U.S. economy.
The Federal Reserve usually increases interest rates to slow down the economy and prevent inflation from climbing to an unmanageable level.
At the same time, the Federal Reserve sometimes lowers interest rates to boost inflation and jumpstart the economy.
Does inflation impact GDP?
Gross domestic product (GDP) can increase due to inflation. When this happens, the country’s economy can overperform. To calculate the true GDP for a particular market, GDP must be divided by the inflation rate.
What is disinflation?
Disinflation is often confused with deflation, but the two are different terms. Disinflation refers to the temporary reduction of price inflation. So when inflation drops in the short term, leading to falling prices, the economy is said to be going through disinflation.
The Bottom Line
If you want to succeed with managing money, it’s critical to have a working knowledge of how the economy works — and inflation and deflation are two fundamental terms to understand.
Inflation is much more common than deflation, and there are things that can be done to protect yourself and even profit from it. At the same time, ignoring inflation could lead to serious problems.
At the end of the day, you need to keep your eye on the economy, make smart investments, and know when to move money as the economy changes. By taking action, you can protect yourself from changing economic conditions.
Here’s to making smart decisions on your path to financial freedom.