How Money Shrinks and Grows

Two economic phenomena people are likely to take an interest in are inflation and deflation. Simply put, when inflation occurs, the same amount of money gets you less, while when deflation occurs, the same amount of money gets you more.

The self-interested individual thus abhors inflation, and enjoys deflation. Don't we all enjoy being able to buy something for less than it used to cost?

Most of us can appreciate the negative consequences of inflation. All we have to do is imagine the insanity of pre-World War II Germany, or present day Zimbabwe, where people are forced to barter their goods thanks to annual inflation rates in the thousands.

What we often fail to appreciate are the negative consequences of deflation. After all, it doesn't hurt our pockets immediately or directly.

But reflect on what happens when we anticipate a continuing period of deflation. Take the simple example of electronics, where Moore's Law effectively guarantees that for the near future, the price of electronics will continue to drop.

Many of us decide to defer our purchases, hoping to wait until the item we want is really dirt cheap. This is, of course, not particularly pronounced in a sexy field such as electronics, since a lot of prestige is attached to having the latest items in the field, but you can appreciate the negative effect on consumption in other areas.

When deflation occurs across the economy, in most areas, the result is that many businesses are forced to close or reduce the scale of their operations. In other words, you will have to take a pay cut or lose your job.

This is why in the modern economy, governments aim to avoid deflation. Instead, central banks aim for "price stability" — in reality, this means they target a minimal inflation rate.

The reason is that if we expect the price of goods to go up a little bit, we are likely to spend sooner rather than save, which furthers economic growth.

This "demand-side" inflation does carry its share of negative consequences, but overall it is fine for the typical economy. The inflation we do not want to see is supply-side inflation, which arises because of expensive raw materials. This does not benefit the economy in the aggregate, and is actually a net loss.

At the same time, not all deflation is bad. Returning to the electronics example, the reason we are seeing deflation occur there is because of technological improvements, meaning we can do more with less. This deflation is beneficial to the economy because it frees up resources for other uses.

What is painful is, of course, demand-side deflation, where people refuse to spend. This type of economic trap is painful and dangerous in the long-run for an economy because businesses rely on people to spend — at least, if they expect to meet their payroll obligations.

Economics is not as open-and-shut or dogmatic as it seems to be sometimes. There are a lot of open questions, a lot of room for disagreement. Inflation and deflation are an example of this; it is not a clearcut case, as it may seem to the layman who likes to see prices drop, without appreciating that this implies his salary will drop too.