Friday, October 3, 2008

The Difference Between Inflation, Deflation, and Disinflation

The Difference Between Inflation, Deflation, and Disinflation

Inflation is a general increase in the price level. The price level represents the prices of most products in an economy. Thus, the prices of most products are increasing during periods of inflation. The forces of supply and demand still determine prices in individual markets. Yet, inflation creates a tendency for prices to rise throughout the economy.

The inflation rate measures how quickly the price level changes. It is usually reported on an annual basis. In October 2003, for example, the inflation rate was 2.04%. This means that if prices rose at this same rate for an entire year, then they would be 2.04% higher on October 1, 2004 than they were on October 1, 2003. (The price index was actually 0.17% higher on October 31, 2003 than it was on October 1, 2003. Twelve months multiplied by 0.17% yields an annual rate of 2.04% per year.)

Deflation is a general decrease in the price level. During periods of deflation, the prices of most products are decreasing. Deflation is undesirable because it usually causes a significant decrease in overall spending (i.e., aggregate demand) in an economy and is most likely to occur when the economy is already stagnant. For example, deflation occurred in the United States during the Great Depression. Deflation occurs when the inflation rate is negative.

Disinflation occurs when the inflation rate decreases, but remains positive. For example, if the inflation rate changes from 6% in January to 5.5% in February to 5.2% in March, economists would say there is disinflation in the economy during the first quarter of the year (i.e., during January, February and March).

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