Deflation vs. Disinflation: An Overview
Although they may sound the same, deflation should not be confused with disinflation. Deflation occurs when the inflation rate falls below zero, and prices generally decline throughout an economy. Disinflation is what happens when the inflation rate falls but remains positive. In disinflation, prices continue to increase but at a slower rate.
- Deflation is a general drop in price levels in an economy.
- Disinflation occurs when prices continue to grow but at a slower rate than before.
- Deflation is harmful to an economy because it can cause a spiral of reduced economic activity.
- Central banks will fight deflation by expanding the monetary base and lowering interest rates.
- Disinflation can be caused by a recession or when a central bank tightens its monetary policy.
Deflation is the economic term used to describe the drop in prices for goods and services. Deflation slows down economic growth. It normally takes place during times of economic uncertainty when the demand for goods and services is lower, along with higher levels of unemployment. When prices fall, the inflation rate drops below 0%.
Deflation (and inflation) rates can be calculated using the consumer price index (CPI). This index measures the changes in the price levels of a basket of goods and services. They can also be measured using the gross domestic product (GDP) deflator, which measures the price inflation.
There are several different factors that can cause deflation, including a drop in the money supply, government spending, consumer spending, and investment by corporations.
Business productivity can also lead to a drop in prices. When a company uses more advanced technology in its production process, it may become more efficient, thereby reducing its costs. These cost savings may then be passed on to the consumer resulting in lower prices.
Disinflation occurs when prices continue to increase but at a slower rate than before. In mathematical terms, the inflation rate is positive but lower than a previous high.
This term is commonly used by the U.S. Federal Reserve when it wants to describe a period of slowing inflation. Unlike deflation, this is not harmful to the economy because the inflation rate is reduced marginally over a short-term period. The Federal Reserve normally targets an inflation rate of 2-3% and will employ monetary policy to encourage disinflation when prices are increasing too fast.
Unlike inflation and deflation, disinflation is the change in the rate of inflation. Prices do not drop during periods of disinflation and it does not signal an economic slowdown. While a negative growth rate—such as -2%—indicates deflation, disinflation is demonstrated by a change in the inflation rate from one year to the next. So disinflation would be measured as a change of 4% from one year to 2.5% in the next.
The target inflation rate for the Federal Reserve. When inflation is high, the Federal Reserve may reduce interest rates or sell securities to reduce the money supply.
Example of Deflation
Consider the case of mobile phones. Cellphone prices have dropped significantly since the 1980s due to technological advances. This has allowed supply to increase at a faster rate than the money supply or demand for cell phones.
But bonds can perform well during times of deflation. More investors end up flocking to quality assets that promise a safer investment vehicle. By contrast, it can have a negative effect on the stock market. A drop in prices—and, therefore, supply and demand—will hurt the profitability of companies, leading to the erosion of share value.
In order to deal with deflation, a central bank will typically employ an expansionary monetary policy. It lowers interest rates and increases the money supply within the economy. This, in turn, boosts demand for goods and services. Lower interest rates mean an increase in the spending power of consumers. More spending means price inflation and, therefore, higher demand for goods and services. Higher prices lead to higher profits for businesses.
Disinflation is caused by several different factors. A recession or a contraction in the business cycle may result in disinflation. It may also be caused by the tightening of monetary policy by a central bank. When this happens, the government may also begin to sell some of its securities, and reduce its money supply.
Why Is Deflation Bad?
Deflation can cause a spiral of decreasing economic activity. When prices are falling in an economy, consumers will postpone their spending, resulting in even less economic activity. For example, if you are planning to buy a car, you might delay your purchase if you believe that the price of cars will drop. That means less money for the car dealership, and ultimately less money circulating in the economy.
How Is Unemployment Related to Inflation?
Unemployment levels are tied to inflation through the Laffer curve. To put it simply, high levels of unemployment correlate with low inflation, and vice versa. When the unemployment rate is low, workers are able to bargain for higher wages and spend more money, causing the price of consumer goods (and the cost of producing them) to increase. These price increases result in inflation. Conversely, when there is high unemployment, consumers have less spending power, resulting in slower price growth.
How Does the Federal Reserve Adjust the Inflation Rate?
Central banks like the Federal Reserve use monetary policy to adjust the levels of spending and economic activity. One of the most commonly-used tools is to buy and sell government securities. When the Fed buys Treasurys, it injects money into the economy which can spur economic activity. When the Fed sells Treasurys, it removes money from the economy, causing a decrease in activity. The central bank can also adjust activity by lending money to banks at different interest rates, or changing the reserve requirements for commercial banks.
The Bottom Line
Deflation and disinflation are both economic terms that relate to the health of an economy. Disinflation occurs when price growth slows down after a period of high inflation, while deflation occurs when prices tend to decrease. Unlike disinflation, deflation can be damaging to the health of an economy.