The term inflation is used a lot when talking about economics. We often hear people talking about it on the news, for instance. However, it is rare to hear about the opposite scenario, deflation, in a conversational way.
When it comes to economics, it is important to know the difference and for those who are interested in investing and the economy, knowing which is better for the economy can help to inform your strategy and how you manage your money. So, which is worse for the economy? We’ll explore more below.
What is deflation?
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To understand which is the worst scenario for the economy, you only need a very elementary grasp of deflation and how it varies from inflation.
Basically put, deflation is the opposite of inflation, when instead of gradually increasing over time, the price of goods and services is falling. It can go hand-in-hand with economic recession. This can happen because people don’t have the money to spend on things, meaning that they are not able to pay high prices and the prices have to drop.
Deflation also has an impact on consumers, who may wait to spend money. It makes sense when you think about it – if you are going to buy a computer but it is not an urgent purchase, then you are likely to wait if the prices are dropping. It could be that the product falls to an even lower price in a month or two. This delays or stops spending and can have a huge impact on many markets and the economy. “Consumer confidence” is the term and it is one of the best indicators of future economic patterns.
What is inflation?
Inflation is something that many people are more familiar with, as it is the trend most of us see. In recent years, we have even seen inflation in areas that traditionally haven’t seen this phenomenon as much, such as the used car market.
Inflation is simply used to described the prices rising over time as goods and services increase in price and perceived value. Every unit of the currency in question is therefore not worth as much and buying power drops.
Inflation is very common in many countries and small rates of inflation are manageable. However, we can experience bigger issues when inflation rises and starts to hit levels that are not so easy to control.
When things spiral out of control and we see examples of issues like hyperinflation, then economies can truly go into meltdown mode but usually, authorities are able to control inflation to an extent.
The impact of interest rates
When prices rise during inflation it can create a spending bubble. It is easy for things to get out of control. People may request higher wages and this in turn means that companies may charge higher prices for goods, rent may rise and people may borrow freely to spend money. Also, people spend more easily when they know that things are going to continue to get more expensive, especially if it is happening quickly.
The banks have a way to tackle this, by increasing interest rates. This helps to prevent any sort of “bubble” from being created and has a big impact on the psychology behind the markets. If interest rates are high, it is in a consumer’s interests to save and be more responsible with money. This normally works, too. A lot of people will quickly adjust their habits, borrow less and save more when this happens. This can help to bring interest rates down and stabilize the economy.
This is only a comeback option for the banks and the governments in the scenario of inflation. If we see deflation, then it is not possible for the banks to do so much. For example, there is no such thing as a negative interest rate – it cannot go into the minus rates, of course.
So, which is worse?
While inflation can be a bad thing if it gets too far out of control, it is generally accepted and understood that deflation is worse and can have long-lasting effects. It can cause businesses to struggle or even to close, and with nobody spending money as freely as they otherwise would, the economy has to deal with some severe repercussions. Huge levels of inflation are not great but at least they can be combated more effectively than deflation ever can.