Inflation, deflation and disinflation: what the words actually mean

Overview

Inflation precisely, hyperinflation and what distinguishes it from ordinary high inflation and inflation described as a fall in the value of money.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Define inflation precisely.

   Model answer

   Inflation is a sustained rise in the general level of prices in an economy over a period of time, which is the same thing as a sustained fall in the purchasing power of money. It is normally expressed as the annual percentage change in a price index. Two elements matter in the definition: the rise must be general rather than confined to particular goods, and it must be sustained rather than a one-off jump.

2. 2

   Why does the definition of inflation insist on a rise in the general price level rather than a rise in prices?

   Model answer

   At any moment some prices are rising and others are falling as relative scarcities change, and that reshuffling of relative prices is how a market economy allocates resources. Inflation is a different phenomenon: it is the whole set of prices drifting upwards together, so that money buys less of everything. A rise in the price of one good, however large, is a relative price change, and it only counts towards inflation to the extent of that good's weight in the overall index.

3. 3

   Define deflation and explain why it is not simply inflation with a minus sign in front of it.

   Model answer

   Deflation is a sustained fall in the general price level, recorded as a negative rate of change in a price index. It is not merely the mirror image of inflation because the economy responds asymmetrically. Falling prices give households a reason to postpone purchases, which reduces demand and pushes prices down further, and they raise the real value of debts because the sum owed is fixed in money terms while incomes fall. Interest rates also cannot be cut far below zero, so the main tool for stimulating demand loses its power precisely when it is needed.

4. 4

   What is disinflation, and how does it differ from deflation?

   Model answer

   Disinflation is a fall in the rate of inflation while that rate remains positive, so prices are still rising but more slowly than before. Deflation is a negative rate, meaning prices are actually falling. A move from 8 per cent to 3 per cent is disinflation and the price level is higher than it was; a move from 3 per cent to minus 1 per cent is deflation and the price level is lower than it was.

5. 5

   A price index stands at 100, then 110, then 115.5, then 113.19 in four successive years. Calculate the annual rate of change in each year and describe what is happening in words.

   Model answer

   From 100 to 110 the change is 10 divided by 100, which is 10.0 per cent inflation. From 110 to 115.5 the change is 5.5 divided by 110, which is 5.0 per cent inflation. From 115.5 to 113.19 the change is minus 2.31 divided by 115.5, which is minus 2.0 per cent, so this is deflation. In words: prices rose sharply, then continued rising but at half the previous pace, which is disinflation, and only in the final year did the price level actually fall. Even after that fall the index at 113.19 is still 13.19 per cent above where it stood in the first year.

6. 6

   The inflation rate falls from 6 per cent to 2 per cent. Has the cost of living fallen? Explain your answer.

   Model answer

   No. A positive inflation rate of 2 per cent means the general price level is still rising, just more slowly than when it was rising at 6 per cent. The cost of living is higher than it was a year earlier, not lower. It would only fall if the rate became negative, and even then it would fall from a level that earlier inflation had already raised.

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