(I’m American) Inflation is the rising cost of goods and services. Inflation constantly goes up by varying degrees. When economists say “inflation is decreasing”, that just means that the rate of inflation has slowed, not that inflation reversed.
If inflation is causing money to be less valuable over time, why would it be bad to have deflation? Would that not make my money more valuable? I’ve been told it would be very bad, but not in a way that I understand
In: Economics
Deflation means your money is worth more tomorrow than it is today. It would therefore be prudent to put everything you can under a mattress, because you can buy more with it tomorrow. And even more the day after.
People still need food, water, energy and shelter; so you’re still buying those essential things. However all your discretionary spending your incentivized to hold off on. You’ve no incentive to invest your money, safe move is to lock it away because you’ll be able to buy more with that same money later. It doesn’t stop all discretionary spending, but it does slow it down.
If you have a mortgage or other forms of debt, those are getting relatively more expensive every day. With inflation it was getting relatively cheaper every day. With deflation, every payment you make is worth more than the last. This drives defaults. Because money is more valuable, your $500 000 home is now worth less money. And tomorrow it’s going to be worth even less. But you’re still making payments on the $500k. Relative to deflation your home’s value hasn’t changed, but your loan is still your loan.
Now, because people are spending less than they used to, business start failing. The employees lose their jobs, and the owners lose their investments. New companies are not started, because investing is disincentived and the market is no longer there. So these people that are out of work no longer can afford even the essentials.
Now you have a deflationary death spiral. Your economy has seized up, money is literally moving less and less day after day. More people lose their jobs, or if they are lucky, get their wages cut day after day. Businesses close, banks collapse under a mountain of bad debt. Your money is worth more and more, but getting more of it gets harder and harder until you can’t get any more.
Explanations like mine start at the retail level because it’s easier to explain and to imagine, but the spiral starts small with institutional investors who do care about their money appreciating by 1% or 2% year over year that will act accordingly to protect their positions.
This is why countries have central banks, that are in theory isolated from political influence, who’s sole responsibility is to control the money supply to ensure that you never have deflation and only a low level of inflation. 2% is the typical target as a sort of hedge against some economic stormy weather pushing you into deflation. High levels of inflation is also really bad, but relatively speaking easier to fix than deflation. Still painful though.
Only a small percentage of the money a bank loans out is their own. Banks lend money from the central (aka reserve) bank to lend out to their customers. The interest rate on this loan is the the cost the bank has to pay back, and they charge a higher level of interest to make a profit. This mechanism is how money is added to the money supply (“printing money”) and also removed from the money supply. The more expensive the loan, the less money is borrowed. The central bank changes this base interest rate to encourage or discourage spending as required to maintain the target inflation rate. It’s not perfect, but it works.
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