Changes in value of money (Inflation, Deflation,

Disinflation, Reflation, Devaluation, Depreciation)

What Is Inflation?
Inflation is the decline of purchasing power of a given currency over time. A quantitative
estimate of the rate at which the decline in purchasing power occurs can be reflected in the
increase of an average price level of a basket of selected goods and services in an
economy over some period of time. The rise in the general level of prices, often expressed
as a percentage, means that a unit of currency effectively buys less than it did in prior
periods.

Understanding Inflation
While it is easy to measure the price changes of individual products over time, human
needs extend much beyond one or two such products. Individuals need a big and
diversified set of products as well as a host of services for living a comfortable life. They
include commodities like food grains, metal and fuel, utilities like electricity and
transportation, and services like healthcare, entertainment, and labor. Inflation aims to
measure the overall impact of price changes for a diversified set of products and services,
and allows for a single value representation of the increase in the price level of goods and
services in an economy over a period of time.

As a currency loses value, prices rise and it buys fewer goods and services. This loss of
purchasing power impacts the general cost of living for the common public which ultimately
leads to a deceleration in economic growth. The consensus view among economists is that
sustained inflation occurs when a nation's money supply growth outpaces economic
growth.

To combat this, a country's appropriate monetary authority, like the central bank, then
takes the necessary measures to manage the supply of money and credit to keep inflation
within permissible limits and keep the economy running smoothly.
Theoretically, monetarism is a popular theory that explains the relation between inflation
and money supply of an economy. For example, following the Spanish conquest of the
Aztec and Inca empires, massive amounts of gold and especially silver flowed into the
Spanish and other European economies. Since the money supply had rapidly
increased, the value of money fell, contributing to rapidly rising prices.

Inflation is measured in a variety of ways depending upon the types of goods and services
considered and is the opposite of deflation which indicates a general decline occurring in
prices for goods and services when the inflation rate falls below 0%.

Causes of Inflation
An increase in the supply of money is the root of inflation, though this can play out through
different mechanisms in the economy. Money supply can be increased by the monetary
authorities either by printing and giving away more money to the individuals, by
legally devaluing (reducing the value of) the legal tender currency, more (most commonly)
by loaning new money into existence as reserve account credits through the banking
system by purchasing government bonds from banks on the secondary market. In all such
cases of money supply increase, the money loses its purchasing power. The mechanisms
of how this drives inflation can be classified into three types: Demand-Pull inflation, Cost-
Push inflation, and Built-In inflation.

Demand-Pull Effect
Demand-pull inflation occurs when an increase in the supply of money and credit
stimulates overall demand for goods and services in an economy to increase more rapidly
than the economy's production capacity. This increases demand and leads to price rises.
What Is Deflation ?
Deflation is a general decline in prices for goods and services, typically associated with a
contraction in the supply of money and credit in the economy. During deflation, the
purchasing power of currency rises over time.

• Deflation is the general decline of the price level of goods and services.
• Deflation is usually associated with a contraction in the supply of money and credit,
but prices can also fall due to increased productivity and technological
improvements.
• Whether the economy, price level, and money supply are deflating or inflating
changes the appeal of different investment options.
Understanding Deflation
Deflation causes the nominal costs of capital, labor, goods, and services to fall, though
their relative prices may be unchanged. Deflation has been a popular concern among
economists for decades. On its face, deflation benefits consumers because they can
purchase more goods and services with the same nominal income over time.

However, not everyone wins from lower prices and economists are often concerned about
the consequences of falling prices on various sectors of the economy, especially in
financial matters. In particular, deflation can harm borrowers, who can be bound to pay
their debts in money that is worth more than the money they borrowed, as well as any
financial market participants who invest or speculate on the prospect of rising prices.

Causes of Deflation
By definition, monetary deflation can only be caused by a decrease in the supply of money
or financial instruments redeemable in money. In modern times, the money supply is most
influenced by central banks, such as the Federal Reserve. When the supply of money and
credit falls, without a corresponding decrease in economic output, then the prices of all
goods tend to fall. Periods of deflation most commonly occur after long periods of artificial
monetary expansion. The early 1930s was the last time significant deflation was
experienced in the United States. The major contributor to this deflationary period was the
fall in the money supply following catastrophic bank failures. Other nations, such as Japan
in the 1990s, have experienced deflation in modern times.

World-renowned economist Milton Friedman argued that under optimal policy, in which the
central bank seeks a rate of deflation equal to the real interest rate on government bonds,
the nominal rate should be zero, and the price level should fall steadily at the real rate of
interest. His theory birthed the Friedman rule, a monetary policy rule.

However, declining prices can be caused by a number of other factors: a decline

in aggregate demand (a decrease in the total demand for goods and services) and
increased productivity. A decline in aggregate demand typically results in subsequent
lower prices. Causes of this shift include reduced government spending, stock market
failure, consumer desire to increase savings, and tightening monetary policies (higher
interest rates).

Falling prices can also happen naturally when the output of the economy grows faster than
the supply of circulating money and credit. This occurs especially when technology
advances the productivity of an economy, and is often concentrated in goods and
industries which benefit from technological improvements. Companies operate more
efficiently as technology advances. These operational improvements lead to lower
production costs and cost savings transferred to consumers in the form of lower prices.
This is distinct from but similar to general price deflation, which is a general decrease in
the price level and increase in the purchasing power of money.

Price deflation through increased productivity is different in specific industries. For

example, consider how increased productivity affects the technology sector. In the last few
decades, improvements in technology have resulted in significant reductions in the
average cost per gigabyte of data. In 1980, the average cost of one gigabyte of data was
$437,500; by 2010, the average cost was three cents. This reduction caused the prices of
manufactured products that use this technology to also fall significantly.

By definition, monetary deflation can only be caused by a decrease in the supply of money
or financial instruments redeemable in money. In modern times, the money supply is most
influenced by central banks, such as the Federal Reserve. When the supply of money and
credit falls, without a corresponding decrease in economic output, then the prices of all
goods tend to fall. Periods of deflation most commonly occur after long periods of artificial
monetary expansion. The early 1930s was the last time significant deflation was
experienced in the United States. The major contributor to this deflationary period was the
fall in the money supply following catastrophic bank failures. Other nations, such as Japan
in the 1990s, have experienced deflation in modern times.

World-renowned economist Milton Friedman argued that under optimal policy, in which the
central bank seeks a rate of deflation equal to the real interest rate on government bonds,
the nominal rate should be zero, and the price level should fall steadily at the real rate of
interest. His theory birthed the Friedman rule, a monetary policy rule.

However, declining prices can be caused by a number of other factors: a decline

in aggregate demand (a decrease in the total demand for goods and services) and
increased productivity. A decline in aggregate demand typically results in subsequent
lower prices. Causes of this shift include reduced government spending, stock market
failure, consumer desire to increase savings, and tightening monetary policies (higher
interest rates).

Falling prices can also happen naturally when the output of the economy grows faster than
the supply of circulating money and credit. This occurs especially when technology
advances the productivity of an economy, and is often concentrated in goods and
industries which benefit from technological improvements. Companies operate more
efficiently as technology advances. These operational improvements lead to lower
production costs and cost savings transferred to consumers in the form of lower prices.
This is distinct from but similar to general price deflation, which is a general decrease in
the price level and increase in the purchasing power of money.

Price deflation through increased productivity is different in specific industries. For

example, consider how increased productivity affects the technology sector. In the last few
decades, improvements in technology have resulted in significant reductions in the
average cost per gigabyte of data. In 1980, the average cost of one gigabyte of data was
$437,500; by 2010, the average cost was three cents. This reduction caused the prices of
manufactured products that use this technology to also fall significantly.

Disinflation
What Is Disinflation?
Disinflation is a temporary slowing of the pace of price inflation and is used to describe
instances when the inflation rate has reduced marginally over the short term.
 • Disinflation is a temporary slowing of the pace of price inflation and is used to
describe instances when the inflation rate has reduced marginally over the short
term.
• Unlike inflation and deflation, which refer to the direction of prices, disinflation refers
to the rate of change in the rate of inflation.
• A healthy amount of disinflation is necessary, since it prevents the economy from
overheating.
• The danger that disinflation presents is when the rate of inflation falls near to zero,
as it did in 2015, raising the specter of deflation.

Understanding Disinflation
Disinflation is commonly used by the Federal Reserve (Fed) to describe a period of
slowing inflation and should not be confused with deflation, which can be harmful to the
economy. Unlike inflation and deflation, which refer to the direction of prices, disinflation
refers to the rate of change in the rate of inflation.

Disinflation is not considered problematic because prices do not actually drop, and
disinflation does not usually signal the onset of a slowing economy. Deflation is
represented as a negative growth rate, such as -1%, while disinflation is shown as a
change in the inflation rate, say, from 3% one year to 2% the next. Disinflation is
considered the opposite of reflation, which occurs when a government stimulates an
economy by increasing the money supply.

A healthy amount of disinflation is necessary, since it represents economic contraction and

prevents the economy from overheating. As such, instances of disinflation are not
uncommon and are viewed as normal during healthy economic times. Disinflation benefits
certain segments of a population, such as people who are inclined to save their earnings.

Disinflation Triggers
There are several things that can cause an economy to experience disinflation. If a central
bank decides to impose a tighter monetary policy and the government starts to sell off
some of its securities, it could reduce the supply of money in the economy, causing a
disinflationary effect.

Similarly, a contraction in the business cycle or a recession can also trigger

disinflation. For example, businesses may choose not to increase prices to gain
greater market share, leading to disinflation.

Reflation

What Is Reflation?
Reflation is a fiscal or monetary policy designed to expand output, stimulate spending, and
curb the effects of deflation, which usually occurs after a period of economic uncertainty or
a recession. The term may also be used to describe the first phase of economic
recovery after a period of contraction.

• Reflation is a policy that is enacted after a period of economic slowdown or

contraction.
• The goal is to expand output, stimulate spending and curb the effects of deflation.
 • Policies include tax cuts, infrastructure spending, increasing the money supply, and
lowering interest rates.
Reflation Methods
Reflation policies typically include the following:

• Reducing taxes: Paying lower taxes makes corporations and employees wealthier.
It is hoped that extra earnings will be spent in the economy, lifting demand and
prices for goods.
• Lowering interest rates: Makes it cheaper to borrow money and less rewarding to
stow capital away in savings accounts, encouraging people and businesses to
spend more freely.
• Changing the money supply: When central banks boost the amount
of currency and other liquid instruments in the banking system the cost of money
falls, generating more investment and putting more money in the hands of
consumers.
• Capital Projects: Large investment projects create jobs, boosting employment
figures and the number of people with spending power.

In short, reflationary measures aim to lift demand for goods by giving people and
companies more money and motivation to spend more.

Reflation vs. Inflation

It is important not to confuse reflation with inflation. Firstly, reflation is not bad. It is a period
of price increases when an economy is striving to achieve full employment and growth.

Inflation, on the other hand, is often considered bad as it is characterized by rising prices
during a period of full capacity. G.D.H. Cole once said, "reflation may be defined as
inflation deliberately undertaken to relieve a depression."

Additionally, prices rise gradually during a period of reflation and fast during a period of
inflation. In essence, reflation can be described as controlled inflation.

Devaluation:
Devaluation, reduction in the exchange value of a country’s monetary unit in
terms of gold, silver, or foreign monetary units. Devaluation is employed to
eliminate persistent balance-of-payments deficits. For example, a devaluation
of currency will decrease prices of the home country’s exports that are
purchased in the import country’s currency. While making the exported goods
cheaper for other countries, devaluation also increases the prices of imports
purchased in the home country. If the demand for both exports and imports is
relatively elastic (that is, the quantity purchased is highly responsive to
changes in price), the country’s income from exports will rise, and its
expenditure for imports will fall. Thus, its trade will be more in balance and
its balance of payments improved. Devaluation will not be effective if the
balance-of-payments disequilibrium is a result of basic structural flaws in a
country’s economy.

In contrast to devaluation, revaluation involves an increase in the exchange

value of a country’s monetary unit in terms of gold, silver, or foreign monetary
units. It may be undertaken when a country’s currency has been undervalued
in comparison with others, causing persistent balance-of-payments surpluses.
(See also exchange control.)

Depreciation
What Is Currency Depreciation?
Currency depreciation is a fall in the value of a currency in terms of its exchange rate
versus other currencies. Currency depreciation can occur due to factors such as economic
fundamentals, interest rate differentials, political instability, or risk aversion among
investors.
 • Currency depreciation is a fall in the value of a currency in a floating exchange rate
system.
• Economic fundamentals, interest rate differentials, political instability, or risk
aversion can cause currency depreciation.
• Orderly currency depreciation can increase a country’s export activity as its products
and services become cheaper to buy.
• The Federal Reserve's quantitative easing programs used to stimulate the economy
in the aftermath of the 2007-2008 financial crisis caused U.S. dollar depreciation.
• Currency depreciation in one country can spread to other countries.

Understanding Currency Depreciation

Countries with weak economic fundamentals, such as chronic current account deficits and
high rates of inflation, generally have depreciating currencies. Currency depreciation, if
orderly and gradual, improves a nation’s export competitiveness and may improve its trade
deficit over time. But an abrupt and sizable currency depreciation may scare foreign
investors who fear the currency may fall further, leading them to pull portfolio investments
out of the country. These actions will put further downward pressure on the currency.

Easy monetary policy and high inflation are two of the leading causes of currency
depreciation. When interest rates are low, hundreds of billions of dollars chase the
highest yield. Expected interest rate differentials can trigger a bout of currency
depreciation. Central banks will increase interest rates to combat inflation as too much
inflation can lead to currency depreciation.

Additionally, inflation can lead to higher input costs for exports, which then makes a
nation's exports less competitive in the global markets. This will widen the trade deficit and
cause the currency to depreciate.