Inflation And Deflation Notes Flashcards

As we are apt to say about stock and bond prices, markets process all of the available information to set prices accordingly. Thanks to the US Treasury, we also have the ability to evaluate inflation expectations this way. Yes, the money supply has increased tremendously going back to the Great Financial Crisis and accelerated in recent months. But, this doesn’t tell the whole story about the potential for inflation. In recent years, consumers have been trained to “wait for the sale” – to avoid buying a good because it’ll surely be cheaper later. In a deflationary environment, goods do in fact go down in price over time.

The theory behind a deflationary spiral is that as prices fall for goods and services, there is less profit. This in turn leads to even lower prices for goods and services, which forms a negative loop that can be immensely difficult to recover from. The rate of return that investors demand in exchange for lending money to the government is just as important to the present value of future surpluses as is the amount of future surpluses that investors expect. And since so much debt is short term, a fall in the real value of the debt must push the price level up. According to the natural rate model, if government attempts to maintain an unemployment rate below the natural rate of unemployment, inflation will increase and continuously rise until unemployment returns to its natural rate. As a result, growth will be more volatile than if policymakers had attempted to maintain the unemployment rate at the natural rate of unemployment. As higher levels of inflation tend to hurt economic growth, expansionary economic policy can actually end up limiting economic growth in the long run by causing accelerating inflation.

Globalization And The Global Output Gap

History shows the impact on stocks of higher inflation tends to be felt more within the higher-valuation segments of the market. As I alluded to earlier, the pervasiveness of choice and transparency across most consumer categories signals lower inflation as opposed to higher. Have you seen all the options for mattresses ordered online and shipped directly to your home? As is usually the case, this is a prediction and forecast-free zone. But there are some economic fundamentals that can inform us of what the inflationary environment in the future might look like. And, to what degree we should be concerned about all the “money printing”. This has nothing to do with them not being important components of households’ budgets. Food and energy are highly volatile compared to other components and their movements tend to also be incorporated into other components over time. The above chart often leads people to conclude that we have seen high inflation in things we need, but low inflation in things we want. A more apt conclusion might be that components with more competition have seen less inflation while those with less competition have seen higher inflation.

Figure 1 shows a measure of pure inflation – the change in prices that is a proportional across all goods and services, independent of changes in relative prices – for the US and Eurozone using an estimator developed by Reis and Watson . In the wake of the biggest recession since the Great Depression, it is surprising how stable pure inflation has been. For many years it was hard to bring under control, but in the last decade has been low and stable. The latest Geneva Report on the World Economy studies the latest bout of stubbornness, asking why inflation has remained in such a narrow range. It shows that a large number of diverse shocks have hit developed economies during the last decade, which have more or less cancelled each other out. One of these ‘shocks’ has been monetary policy, which was skilfully used in response to wider macroeconomic events. Central banks, in other words, combined good policies and good luck.

Inflation Definition

In the United States, the Federal Reserve releases money into the general economy and sets baseline interest rates. When interest rates are low, the economy is said to have a surplus of money flowing through the system. This lowers the value of a dollar as a result, which in turn makes goods more expensive. Consumer confidence typically dips opposite of inflation during inflationary periods, which makes the average person less willing to spend money. In the United States, the official calculation of deflation is done by the U.S. The BLS surveys the prices of goods throughout the U.S. and compares the data it collects. If the price index is lower now than it was previously, it is considered deflation.

If markets interpreted the CBO’s projections as a forecast, not a warning, a run would have already happened. And our debt and deficit problems are relatively easy to solve as a matter of economics . Before the financial crisis, Bear Stearns and Lehman Brothers rolled over debt every day in order to invest in mortgage-backed securities and other long-term illiquid assets. Each day, they had to borrow new money to pay back the old money. When the market lost faith in the long-term value of their investments, the market refused to roll over the loans, and the two companies failed instantly. In a sense, this confirms the Keynesians’ view that expectations matter, but not their view of what the sources of those expectations are. A fiscal inflation would happen today because people expect inflation in the future. A “loss of anchoring,” to use a Keynesian term, would thus likely to lead to stagflation rather than to a boomlet of growth. The key reason is that our government is now funded mostly by rolling over relatively short-term debt, not by selling long-term bonds that will come due in some future time of projected budget surpluses. Half of all currently outstanding debt will mature in less than two and a half years, and a third will mature in under a year.

Deflation: The Opposite Of Inflation

At its worst, deflation can turn into a deflationary spiral that can eventually lead to the collapse of a country’s currency. Both economic responses are very difficult to combat once entrenched because people’s expectations worsen price trends. This bubble can be burst by central banks raising interest rates. When the central bank has lowered nominal interest rates to zero, it can no longer further stimulate demand by lowering interest rates. When deflation takes hold, it requires “special arrangements” to lend money at a zero nominal rate of interest in order opposite of inflation to artificially increase the money supply. A deflationary spiral is a situation where decreases in the price level lead to lower production, which in turn leads to lower wages and demand, which leads to further decreases in the price level. Since reductions in general price level are called deflation, a deflationary spiral occurs when reductions in price lead to a vicious circle, where a problem exacerbates its own cause. In science, this effect is also known as a positive feedback loop. Another economic example of this situation in economics is the bank run.

Other countries also offer similar inflation-indexed bonds, such as the United Kingdom’s index-linked gilt, Mexican Udibonos, or German Bund index. In the U.S., the Department of Labor is responsible for calculating inflation from year to year. Usually, a basket of goods and services on the market are put together and the costs associated with them are compared at various periods. These figures are then averaged and weighted using various formulas and the end result in the U.S. is a number called the Consumer Price Index . Demand-Pull inflation—This sort of inflation happens when demand becomes higher than an economy’s ability to produce. Because there are not enough goods and services going around for everyone, higher amounts of currency are more readily exchanged for them.

Disinflation

The former treasury secretary, he said, is simply not as sanguine about the central bank’s ability to gently change the course of inflation once prices start rising. The relationship between inflation and unemployment is known as the Phillips Curve, but it has not been a reliable predictor of inflation over the past decade. Even though unemployment has dropped from ten percent to about four percent since 2009, inflation has not risen. In the U.S., there are financial instruments called TIPS, or Treasury Inflation-Protected Securities. Treasury that specifically provide protection against inflation. Because the principal of a TIPS is proportional to inflation, as measured by indices such as the CPI, TIPS act as a relatively effective hedge against periods of high inflation. They usually only make up very small portions of people’s portfolios, but anyone seeking extra protection can choose to allocate more room in their portfolio toward TIPS. Because they are largely unrelated to stocks, which are usually the bulk of portfolios, they are also great for diversification purposes. The maturation of TIPS can also be extended to earn term premiums, without risk of inflation, unlike other bonds.

A small amount of inflation is considered a positive because it rewards individuals for saving and investing. Their investments go up in value at a faster rate than the dollar decreasing in value. It also incentivizes people to buy as opposed to save and incentivizes people to invest as opposed to put money under the mattress. First, they determine the current value of the basket by calculating how much the basket would cost at today’s prices (multiplying each item’s quantity by its price today and summing up). Next, they determine the value of the basket by calculating how much the basket would cost in a base period (multiplying each item’s quantity by its base period price). The price index is then calculated as the ratio of the value of the basket at today’s prices to the value at the base period prices. There is an equivalent but sometimes more convenient formulation to construct a price index that assigns relative weights to the prices of items in the basket. In the case of a price index for consumers, statistical agencies derive the relative weights from consumers’ expenditure patterns using information from consumer surveys and business surveys. We provide more details on how a price index is constructed and discuss the two primary measures of consumer prices—the consumer price index and the personal consumption expenditures price index—in the Consumer Price Data section.

This line of academic theory is making its way into policy analysis. This view also helps to explain the Fed’s growing commitment to communicating its intentions. For example, the Fed’s major “stimulative” action over the summer was its announcement that interest rates would stay low for a long time in the future; it did not make any concrete policy move. And serious inflation often comes when events overwhelm ideas — when factors that economists and policymakers do not understand or have forgotten about suddenly emerge.

When purchases are delayed, productive capacity is idled and investment falls, leading to further reductions in aggregate demand. The way to reverse this quickly would be to introduce an economic stimulus. The government could increase productive spending on things like infrastructure or the central bank could start expanding the money supply. Since most societies regard stable inflation as a goal, it is tempting to describe this solid anchoring of inflation as a great achievement of monetary policy. Facing a series of shocks, central banks reacted with an arsenal of policy measures, generating their own shocks to ensure that the sum was close to zero. If inflation had stayed negative for a more significant period, perhaps we could have entered a downward deflationary spiral turning a bad recession into a deep depression. If the relationship between inflation and the unemployment rate has indeed weakened, it would have important implications for economic policy. Economists reasoned that this relationship existed due to simple supply and demand within the labor market. As the unemployment rate decreases, the supply of unemployed workers decreases, thus employers must offer higher wages to attract additional employees from other firms.
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The third was after the Civil War, sometimes called The Great Deflation. It was possibly spurred by return to a gold standard, retiring paper money printed during the Civil War. Debt deflation is a complicated phenomenon associated with the end of long-term credit cycles. It was proposed as a theory by Irving Fisher to explain the deflation of the Great Depression. She has 20+ years of experience covering personal finance, wealth management, and business news.

Finally, another shorter-term inflation tailwind could soon lose some force. With those “stimmy” checks now in the rear-view mirror, this inflation tailwind is set to lose some force. The vagaries of the OER component of the CPI is but one short-term influence on inflation readings. Some measures of wages show upward pressure—especially among small businesses. The share of small businesses—via the National Federation of Independent Business —with positions they’re not able to fill has spiked to a record high, as you can see in the chart below. In contrast, some pandemic “winner” categories either had more subdued gains or a deceleration in gains . We also believe that the impact of government debt on inflation is often misunderstood, and we recently penned a report on that topic.
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Over the previous several decades, the U.S. economy has become more integrated with the global economy as trade has become a larger portion of economic activity. Economists have suggested that as economies increase their openness to the global economy, global economic forces will begin to play a larger role in domestic inflation dynamics. This suggests that inflation may be determined by labor market slack and the output gap on a global level rather than a domestic level. Since the 1980s, trade has expanded significantly in the United States, increasing from less than 20% of GDP to more than 30% of GDP between 2011 and 2013. Economic events that impact the supply of goods or services within the economy, known as supply shocks, can also impact the rate of inflation. The classic example of a supply shock is a reduction in the supply of available oil. As the supply of oil decreases, the price of oil, and any good that uses oil in its production process, increases.