Disinflation

What is Disinflation?

Disinflation is when the rise in prices across an economy starts to slow down over a period of time. It's not that prices are falling, which is deflation, but the speed at which they're increasing is decelerating. Think of it like a car that's still moving forward but easing off the gas pedal.

Difference between deflation and disinflation

It is easy to confuse disinflation and deflation as there are only a few letters difference between them. But a simple way to tell the two apart is to remember that:

deflation is a decrease in prices while disinflation is to discourage a fast pace of inflation.

Let's take a look at the graph below to get a visual representation of the difference between inflation, deflation, and disinflation.

Figure 1. Inflation, disinflation & deflation contrast illustration, StudySmarter Originals

In Figure 1, inflation is represented by the rising blue line, disinflation is represented by the falling pink line, and deflation is represented by the falling green line. Since the blue line is rising, that means that inflation is equivalent to an increase in the price level. Since the pink line is falling but still above 0, that shows that disinflation is a decrease in the inflation rate. And since the green line is falling but goes below zero, that shows that deflation is negative inflation!

You can see that inflation is an increase, disinflation is a decrease, and deflation pushes the inflation rate into the negatives!

Deflation is also much more dangerous than disinflation. Deflations are usually signals of recessions or depressions. It's a time of high unemployment rates, low demand, and an increase in real debt! But if deflation means a decrease in prices and an increase in purchasing power, why wouldn't people be shopping and stimulating the economy? Unfortunately, that's due to people not having any money due to low income and difficulty finding jobs if they're jobless.

The other issue is since prices keep dropping and the value of money is increasing, people keep putting off their purchases. Since they know deflation is taking place, they are more likely to withhold spending money since they know that everything will probably be even cheaper tomorrow! This causes many issues for businesses and can even create a deflation spiral. The spiral starts with the low demand, which leads to a lower need for production, which leads to higher unemployment, and then that leads to even less demand.

Measuring disinflation

One of the most used methods to measure inflation/disinflation is the Consumer Price Index (CPI). This measures the shifts in prices of goods/services. The change in CPI is used to determine the inflation level.

The way to calculate the CPI would be as follows:

\(\text{Consumer Price Index} = \frac{\text{Consumer Price Index}_{\text{Given year}} - \text{Consumer Price Index}_{\text{Base}}}{\text{Consumer Price Index}_{\text{Base}}} \times 100\)

Main causes of disinflation

Disinflation is caused by a few factors: a decrease in the supply of money or a recession.

Disinflation: A decrease in the supply of money

With inflation being caused by an increase in the supply of money, it stands to reason that disinflation is caused by a decrease in the supply of money. A reduction in the supply of money could be caused by a tighter monetary policy. This is usually the case when inflation begins to go past an acceptable range and the central bank responds with these new policies in order to try to stop/slow the effects of inflation. Their main concern at that point is hyperinflation. If the bank is successful with this plan, then disinflation should occur.

Disinflation: Recession

Sometimes, disinflation may occur due to an economic recession. The reason behind this is that if we are in a recession, a business owner wants to attract as many customers as possible in order to earn money during these difficult times. In order to do that, the business owner might keep their prices the same instead of increasing the prices as a way to attract customers. By doing so, the business owner is causing disinflation.

Effects of disinflation

Disinflation in itself is not a negative occurrence nor does it bring any harm to the economy. It's a common occurrence as far as the cycle of the economy is concerned. But as with anything in the world, there are some effects of disinflation. Some positive, some negative.

Let's say that the inflation rate has gone down from 8% to 4%. This is considered a plus for the economy. This disinflation:

• Increases purchasing power (since prices have gone down but your salary remains the same or is higher)
• Protects savings (since the value of money is higher now than it was when inflation was 8%)
• Improves competitiveness of domestically produced goods (as they become relatively cheaper on an international market)
• Decision-making uncertainty is reduced (since businesses and customers are not worried about rising prices as much anymore, confidence improves)

But on the other hand, disinflation could be problematic as well if:

• It is caused by a drop in demand (negative growth)
• It becomes deflation (including rising debt and falling spending)

It is argued that policymakers can significantly reduce the effects of disinflation if they state their sincere intentions to reduce inflation. It is their belief that the assumption of future inflation can be reduced by effectively communicating a disinflation policy.

Potential issues with disinflation: disinflation example

Disinflation in itself is a good thing for the economy, but it doesn't come cheap. The process of bringing the rate of inflation down is extremely difficult and this difficulty is exactly why policymakers are desperate to stop inflation from ever getting over a particular rate. Once the inflation rate gets too high, one of the only ways to get it back down to a normal rate again is to (for a short period of time) depress the economy. In order to depress the economy, the cost is usually a high rate of unemployment. As you can imagine, it is a serious issue and is not to be taken lightly.

For these reasons, policymakers try to stop inflation from getting past a certain rate in the first place. They are aware of the issues it would pose if inflation were to get too high and they had to throw the economy into a depression in order to fix it. That's why they respond the way that they do to even the hint of a higher inflation rate than is acceptable.