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How to Avoid the Deflation and Inflation Scenarios: A One Minute Guide



From Deflationary Shock/Crash to Inflationary Spiral: A One Minute “Deflation to Inflation” Scenario

What is deflation and why is it bad for the economy? Deflation is a general decline in the prices of goods and services, which sounds like a good thing for consumers, but it can have negative consequences for the economy as a whole. Deflation can be caused by a sudden drop in demand, a surge in supply, or a contraction in the money supply. When deflation occurs, consumers and businesses may postpone their spending and investment decisions, expecting that prices will fall further in the future. This can create a vicious cycle of lower demand, lower production, lower income, lower spending, and lower prices, which can lead to a deflationary spiral.

A deflationary spiral is a situation where deflation feeds on itself and becomes self-reinforcing, causing a severe economic downturn. A deflationary spiral can be triggered by a deflationary shock, which is a sudden and large negative shock to the economy that reduces aggregate demand or aggregate supply. For example, a global pandemic, a financial crisis, a natural disaster, or a war can cause a deflationary shock. A deflationary shock can reduce consumer and business confidence, increase uncertainty and risk aversion, and disrupt the normal functioning of markets and institutions. This can result in a sharp decline in economic activity, employment, income, and asset prices, which can further depress demand and prices.

How can a deflationary shock turn into an inflationary spiral? An inflationary spiral is a situation where inflation feeds on itself and becomes self-reinforcing, causing a rapid and persistent increase in the prices of goods and services. An inflationary spiral can be caused by a combination of demand-pull and cost-push factors, which increase the aggregate demand and reduce the aggregate supply in the economy. For example, an expansionary fiscal or monetary policy, a devaluation of the currency, a supply shock, or a wage-price spiral can cause an inflationary spiral. A wage-price spiral is a process where higher wages lead to higher prices, which lead to higher wage demands, which lead to higher prices, and so on.

A deflationary shock can turn into an inflationary spiral if the government or the central bank responds to the deflationary shock by implementing excessively expansionary policies to stimulate the economy and prevent deflation. For example, the government may increase its spending, lower its taxes, or run large budget deficits to boost the aggregate demand. The central bank may lower its interest rate, increase its money supply, or buy government bonds or other assets to lower the borrowing costs and increase the liquidity in the financial system. These policies can be effective in the short run to counteract the deflationary shock, but they can also create inflationary pressures in the long run if they are not reversed or moderated in time.

If the expansionary policies are too large, too prolonged, or too poorly coordinated, they can create an excess of aggregate demand relative to the aggregate supply in the economy. This can result in a demand-pull inflation, where the prices of goods and services rise because the demand exceeds the supply. Moreover, if the expansionary policies cause the currency to depreciate, the prices of imported goods and services can increase, which can raise the production costs and lower the profits of domestic producers. This can result in a cost-push inflation, where the prices of goods and services rise because the supply falls below the demand. Furthermore, if the expansionary policies cause the inflation expectations to rise, the workers and the firms may adjust their wages and prices upward to maintain their real income and purchasing power. This can result in a wage-price spiral, where the prices of goods and services rise because the wages and costs rise.

If the government or the central bank fails to control or contain the inflationary pressures, the inflation rate can accelerate and become unstable, leading to an inflationary spiral. An inflationary spiral can have negative consequences for the economy and the society, such as eroding the value of money and savings, distorting the relative prices and resource allocation, reducing the real income and living standards, increasing the income and wealth inequality, and undermining the economic growth and stability.

Therefore, it is important for the government and the central bank to balance their policy objectives and instruments, and to coordinate their actions, to avoid the extremes of deflation and inflation. They should adopt a flexible and forward-looking approach, and adjust their policies according to the changing economic conditions and expectations. They should also communicate their policy intentions and actions clearly and transparently, to enhance their credibility and effectiveness. By doing so, they can achieve a low and stable inflation rate, which can foster a healthy and sustainable economic development.

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