Causes & Effects of Inflation/Deflation - SS2 Economics Lesson Note

Inflation and deflation are two opposite economic situations that affect the prices of goods and services in an economy. Inflation occurs when the general level of prices for goods and services increases over time, while deflation is the opposite, when the general level of prices decreases.

Causes and effects of inflation

Causes:

Increase in demand: When the demand for goods and services exceeds the supply, prices tend to increase.

Increase in production costs: If the cost of production such as labor, raw materials, or transportation increases, businesses may raise prices to maintain their profit margins.

Expansionary monetary policy: When central banks increase the money supply, it can lead to inflation by increasing demand.

International factors: Changes in exchange rates or global supply and demand can impact prices of imported goods and services.

Effects:

Decrease in purchasing power: Inflation decreases the value of money, meaning that the same amount of money can buy fewer goods and services.

Uncertainty and speculation: Inflation can cause uncertainty, leading to speculation and investments in inflation-hedging assets like gold or real estate.

Increase in interest rates: Central banks may increase interest rates to curb inflation, which can affect borrowing and lending rates.

Redistribution of income and wealth: Inflation can impact people's income and wealth distribution as those with assets like real estate, stocks, or commodities tend to gain while those on fixed incomes tend to lose.

Causes and effects of deflation

Causes:

Decrease in demand: When the demand for goods and services decreases, prices tend to decrease.

Increase in supply: When the supply of goods and services increases, prices tend to decrease.

Tightening monetary policy: When central banks decrease the money supply, it can lead to deflation by decreasing demand.

Technological advancements: As technology improves, it can increase productivity and lower production costs, leading to lower prices.

Effects:

Increase in real value of money: Deflation increases the purchasing power of money, meaning that the same amount of money can buy more goods and services.

Increase in debt burden: Deflation can increase the burden of debt because the value of money increases, making it harder for debtors to repay loans.

Decrease in consumption and investment: Deflation can lead to a decrease in consumer spending and investment, which can negatively impact the economy.

Increase in unemployment: Deflation can lead to lower demand and decreased production, which can result in unemployment.