What are inflation and deflation in an economy?

In the economic dialect, inflation refers to the increase of the price level of commodities due to an increase in the quantity of money supply. During the period of inflation, the growth of money supply is faster than the level of productivity in the economy. On the other hand the term ‘deflation’ is used to describe productivity growing faster than the money supply in the economy.

Inflations are generally categorised as creeping inflation, walking inflation, galloping inflation, and hyperinflation, by their speed. There are other specific types of asset inflation and also wage inflation. To stop inflation, the Central Bank of the country puts on the brakes by implementing contractionary or restrictive monetary policies like raising interest rates and or selling its holdings of Treasuries and other bonds. For example, when interest rates rise, depositors can earn more interest on their savings and therefore they are more likely to delay present consumption for future consumption. On the other hand, it is more expensive to borrow money, which discourages lending. As lending in a banking system creates “new” money, discouraging lending reduces the rate of monetary growth and inflation. Hence, restrictive monetary policy would reduce the money supply, restrict liquidity, and cool economic growth.

During the period of ‘deflation,’ the opposite is true if interest rates are lowered; saving is less attractive, borrowing is cheaper, and spending is likely to increase, etc.

Read the following money supply and inflation-related posts.