Inflation and Deflation

Inflation is a sustained rise in the general price level, in very simple terms if inflation is 5% and you bought a Good for £100, next year it will cost £105.

 

Deflation is a sustained fall in the general price level, 5% deflation means a Good valued at £100 today will be worth £95 next year.

 

All very simple stuff, we hear a lot about inflation but not much about deflation. The only time it is mentioned when sages in the central bank tell us they have to cut interest rates or print more money to prevent deflationary spiral.

 

So what is the issue with deflation? The argument goes that in a deflationary system no one would buy anything, why pay £100 when you can pay £95 next year. As people buy less then business makes less profit meaning it cuts down on investment, wages and stops hiring/starts firing people. This in turn means that there is less money being put directly via investment into the economy and lower wages/higher unemployment means less consumer spending, leading to further falls in profits and prices etc.

 

Frankly put this is nonsense. If interest rates are higher than inflation then we have a situation comparable to deflation. Imagine inflation of 3% but interest rates of 8%. If I leave my £100 in the bank I get £108 next year. The £100 good will only be £103 so I am £5 better off. Exactly the same as if the good had fallen by £5 in price and I had kept my £100.

 

Secondly, apart from when people purchase very big things such as houses, the price of the good in a years time factors very little. I don’t look at a Mars Bar and think if I buy this in a years time I will save 5p, I think do I get more value out of consuming this than the money I pay for it?

 

In a deflationary situation individuals look at products and say, will I get more value out of buying this today than I will do out of buying it in a years time slightly cheaper, that is to say does the value I will get from it in the next year outweigh the money I would save.

 

As I said before this is exactly the same as being in a system where interest rates are higher than inflation and saying will the value I get out of buying it today exceed the value I will get out of putting my money in the bank, buying this product next year, and having some money left over.

 

So why is deflation portrayed as such an evil? The answer, as in most problems, is the Government.

 

Almost all Governments are in a lot of debt, more debt than they can ever pay off. There is one however one hope for them: inflation. If I owe you £100 and pay you after a year of inflation you get your £100 but it is worth a lot less than when you lent it to me. After a year of 5% interest you can buy less stuff with your £100 now than you could when you lent it to me.

 

Inflation is effectively a tax, to allow Government to keep borrowing it ensures that there is adequate inflation to stop its debts spiralling out of control. Deflation would mean that Government owes even more than it did when it first borrowed the money so it is portrayed as evil, whereas inflation which helps the Government is treated as necessary.

 

The truth is that inflation hurts the poor and the middle class, something Ron Paul has highlighted in America. By inflating away the value of a Pound or Dollar, Government and Central Banks reduce the purchasing power of the poorest in society to benefit themselves. It is simply put a myth that we need inflation.

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