Inflation is Not Essentially a Rise in Prices

Deflation Is Always Good for the Economy


by Frank Shostak


For most experts, deflation, which they define as a general decline in prices of goods and services, is bad news since it generates expectations for a further decline in prices.

As a result, they hold, consumers postpone their buying of goods at present since they expect to buy these goods at lower prices in the future. This weakens the overall flow of spending and in turn weakens the economy.

Hence, such commentators hold that policies that counter deflation will also counter the slump.

If deflation leads to an economic slump then policies that reverse deflation should be good for the economy.

Reversing deflation would imply introducing policies that support general increases in the prices of goods, i.e., inflation. This means that inflation could actually be an agent of economic growth.

According to most experts, a little bit of inflation can actually be a good thing.Mainstream thinkers are of the view that inflation of 2% is not harmful to economic growth, but that inflation of 10% could be bad news. (Indeed the Fed’s inflation target is 2%.)

Thus, we can conclude that at a rate of inflation of 10%, it is likely that consumers are going to form rising inflation expectations.

According to popular thinking, in response to a high rate of inflation, consumers will speed up their expenditure on goods at present, which should boost economic growth.

So why then is a rate of inflation of 10% or higher regarded by experts as a bad thing?

Clearly there is a problem with the popular definitions of inflation and deflation.

Inflation is Not Essentially a Rise in Prices

Inflation is not about general increases in prices as such, but about the increase in the money supply. As a rule the increase in money supply sets in motion general increases in prices. This, however, need not always be the case.

The price of a good is the amount of money asked per unit of it. For a constant amount of money and an expanding quantity of goods, prices will actually fall.

Prices will also fall when the rate of increase in the supply of goods exceeds the rate of increase in the money supply. For instance, if the money supply increases by 5% and the quantity of goods increases by 10%, prices will fall by 5%, ceteris paribus.

A fall in prices in this example cannot conceal the fact that we have an inflation of 5% here on account of the increase in the money supply.

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