Well as some of you might know, the fed was worried about deflation (that is until congress agreed for 1.6 trillion new dollars to be out in the economy).  I am going to be talking about inflation and deflation and why they are such a bad thing.  I will start off with deflation and work my way into inflation (since it is talked about more in today’s world).  I will conclude with what I think no inflation/deflation would do to our economy.

To start off with, Webster defines deflation as “a contraction in the volume of available money or credit that results in a general decline in prices.”  Most of you might be thinking . . . a declining in prices, eh? . . . that doesn’t sound to bad . . . BUT it can be really bad.  Deflation has a few major concerns including: Decrease in spending and future revenue stream / cash flow problems.

Concerns with deflation

Well many people say we spend too much money we don’t have.  Which this might be true, but if there is long term deflation this will cause us to spend even less.  For starters, why buy something today when you can purchase it tomorrow for a cheaper price?  If people keep on waiting for tomorrow to purchase things this can cause further deflation.

The increasing number of people saving their money, waiting till “tomorrow” to purchase their goods, will ultimately cause our money supply to decrease.  This is because banks create money by borrowing it out.  If people are saving their money and not borrowing it to purchase things then the banks aren’t loaning out the money.

With all this said, this can cause a downward spiral which can get out of control pretty quickly.  Next, businesses get loans based off of their current revenue streams.  In deflation, a person that wants to start up a company or a business wants to expand wont be able to get a loan because banks wont want to loan money out for their current revenue streams.  This is because prices are going down and causing revenues to go down, which will increase defaults on existing loans.  Ultimately, businesses will go out of business because of falling prices and unemployment will rise.

Inflation

Second, I was once told that inflation is an invisible phenomenon that is everywhere.  It is the rise in prices.  Moderate inflation is considered to be healthy in a growing economy.  Prices rise from more people having money.  For example, if more people have jobs or are getting raises then the companies have to pay for these things which add to their cost of production.  But ultimately, we all want jobs and we all want our yearly raises, so in exchange for that we get a steady level of inflation.

Inflation out of control is where the problem is.  This is caused by a dramatic increase in the money supply with a short term fixed number of goods.  If everyone now has more money in their wallets people will start to value things at a higher price, but when this gets out of control is when people start to get priced out of purchasing things.

Right now there is a lot of talk about inflation with all the new money coming into our economy.  Which ultimately we will see a raise in inflation, but that wont be until we start seeing the money being loaned out again (remember banks create money by loaning it out).  So one might say the money that the government is putting out there is just to make up for the money that isn’t being made from loans, any more, and is keeping our economy stable.  I don’t necessarily believe that but I have heard people put it out their.

Well with high inflation what ultimately happens is similar to deflation, except that businesses get priced out of the market.  When business costs increase dramatically, businesses owners don’t have enough time to change their market price to influence current costs which can cause their product to be under-priced.  If inflation is getting out of control then it can cause businesses to do what they need to do to stay in the game (cutting costs how ever they can).

No Inflation

In the past, I have read articles that want no inflation.  This might be good and might be bad?  I think an economy can survive without inflation or deflation as long as the people are willing to survive that way.  This would mean that there wouldn’t be any yearly raises because prices would stay the same.

This is almost impossible to do in real life because of the problem of limited resources and supply and demand shocks to prices.  For example, when gas prices increase, it affects most businesses due to rise in transportation costs.  This can cause prices to go up and shock the system.

Conclusion

In conclusion, no inflation / deflation can sound good on paper but is very hard to do in real life.  I would have to agree with the fed that a steady increase in price levels is manageable by people.