With so much government stimulus lately, there has been a lot of talk in the public press about potential inflation. On the other hand, with prices dropping because of the recent pandemic there has also been discussion about deflation. What’s the difference between the two? They are both very important economic forces that have extremely opposite effects on the economy. Inflation is when prices of goods and services go up compared to recent prices. Deflation is the opposite and happens when prices are good and services go down. Like with most things, either of them in moderation isn’t a really bad thing.
What is Inflation?
What typically indicates that one is bad versus the other, is the reason for it and how extreme that reason is. Hyperinflation or high inflation is extremely negative because it indicates prices are rising faster than people’s incomes. Meaning that people are able to buy less than what they are earning or saving. A small amount of inflation is considered a positive because it rewards individuals for saving and investing. Their investments go up in value at a faster rate than the dollar decreasing in value. It also incentivizes people to buy as opposed to save and incentivizes people to invest as opposed to put money under the mattress.
What is Deflation?
Deflation, on the other hand, is when prices drop. This can also be good in moderation. Certain goods have had prices drops due to innovation. One example of this is a computer. One that you bought 20 years ago was likely more expensive than a computer that you would purchase today. This is because innovation in computer electronics causes those prices to drop. This is very positive. However, deflation can also be a bad thing. When prices drop, people are not incentivized to buy and in turn, savings go up. When savings are increased and not invested it further reduces demand. This causes a vicious cycle where people are saving more under the mattress, not investing as much, and not buying as much because the product they want to buy today will most likely cost less tomorrow. Why buy it today if the price will be cheaper later on? This reduces economic activity and reduces the growth rate. A slight innovation caused deflation is a positive and a slight growth caused inflation is a positive. However, an extreme in either scenario is very negative for the economy. This is something we are watching very closely to see if we have persistent deflation or persistent inflation and if that will have huge impacts on individuals, well-being, net worth, and potential growth down the road.
Trey Booth, CFA®, AIF®
Senior Vice President
Email Trey Booth here
Fi Plan Partners is an independent investment firm in Birmingham, AL, serving clients across the nation through financial planning, wealth management and business consulting. Fi Plan Partners creates strategies in the best interest of their clients using both fee based investing and transactional investing.
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