Theories Of Inflation Deflation

After World War 2, deflation has been commonly defined as a sustained decrease of the price level (“price deflation”). There are two important elements of this definition which is the decrease of the level of prices (inflation rate < 0) and not individual prices. Either in a deflation or inflation, some prices will change more than others as relative prices change every day. The level could remain steady although relative prices change. Secondly the decrease must be sustained which means a continuing process over an extended period of time and without interruption. Inflation can be defined as a sustained, rapid increase in prices. It is accompanied by a correspondingly decreasing purchasing power of the currency. The modern economic theory

Those people with fixed contracts, or fixed salaries and pensions will loose relatively more than others. The real value of the principal and interest payments will fall very quickly, so long term creditors are worse off. Secondly welfare losses are to be expected. The more volatile inflation is, the more uncertainty will occur in the markets. It will be more difficult to plan long term operations and a higher risk premium will be added to long term contracts. Higher prices are charged to cover potential (unexpected) higher inflation. More uncertainty on exchange rates results in contracts denominated in different, more reliable currencies and insurances are adopted to cover exchange rates fluctuations. So, higher and higher transactions costs occur which have a negative impact on long term economic growth. The International Monetary Fund summarizes the effects of inflation as distorting prices, eroding savings, discouraging investment, stimulating capital flight into foreign assets, precious metals, or unproductive real estate. Inflation inhibits growth, makes economic planning a nightmare, and, in its extreme form evokes social and political unrest. Authorities choose inflation targeting over alternative policy frameworks out of two reasons. First, achieving price stability - a low and steady inflation rate - is thought to be the major contribution that monetary policy can make to economic growth. Second, practical experience has demonstrated that short-term manipulation of monetary policy to achieve other goals like higher employment or enhanced output may conflict with price stability. Central Banks appear to get more criticism for raising interest rates (an anti-inflationary tactic) than for lowering them and they are under constant pressure to stimulate economic activity. Inflation targeting in principle is suppose to help redress this asymmetry by making inflation the primary