What is deflation and is it bad?

If potatoes cost Rs.100 per kg in August 2014, and if they cost Rs.110 per kg in August 2015, then inflation in the price of potatoes was 10 per cent.

Published - September 27, 2015 02:46 am IST - NEW DELHI:

With Chief Economic Advisor Arvind Subramanian first cautioning about impending deflation, and then in an interview to The Hindu clarifying that he meant deflation in a limited price-related context, it is a good time to explain the various contours of the rise and fall of prices.

What is inflation?

Inflation is simply a measure of the extent of increase in prices. If potatoes cost Rs.100 per kg in August 2014, and if they cost Rs.110 per kg in August 2015, then inflation in the price of potatoes was 10 per cent.

When this happens across prices of all commodities for a relatively sustained period of time, then one can say the economy is experiencing inflation. Looking at consumer prices, India is still undergoing inflation. That is, prices are still increasing. For example, in August 2015, overall consumer prices were 3.7 per cent higher than they were in August 2014.

So, then what does it mean when the government says inflation is coming down?

All that means is that the rate of increase of prices is slowing. Going back to the example of potatoes, if they were Rs.110 per kg in August, then went to Rs.120 per kg in September, Rs.125 in October and Rs.127 in November, one can see that although the price is still going up, the rate of increase is decelerating.

Is there a technical term for such a phenomenon?

The U.S. Federal Reserve often uses the term ‘disinflation’ to refer to a period where the rate of inflation has been slowing on a sustained basis.

So, looking at the Consumer Price Index, India is currently technically going through a phase of disinflation. The rate of inflation as measured by the CPI was 10.7 per cent in August 2013, which came down to 3.7 per cent over the course of two years.

So, then, what is deflation and why is there so much controversy and confusion around the term?

Deflation is simply the opposite of inflation. That is, prices fall from one period to the next. The confusion comes from the fact that deflation has historically generally been accompanied by significant economic contraction. But that is not the case in India.

Real GDP growth, the final figure that the government presents to you, is calculated by looking at how the value of the total production of the economy has changed compared to the previous year, and then reducing the effect of inflation/deflation from this. If the rate of growth of the economy and prices are both falling, then that is not a good place to be in — as it is usually accompanied by rising unemployment, lower demand, falling corporate earnings, reduced investments, etc.

This gets exacerbated when people begin to expect prolonged deflation. If they expect that prices will be lower in the future, then people and companies both defer their investments and expenditure waiting for those lower prices. This postponement of expenditure hurts the economy. But slowing inflation coupled with about 7 per cent GDP growth and a pickup in domestic demand — as India is experiencing now — is not a bad thing in itself. Following an extended period of double-digit inflation, this cooling off of prices may just be a correction.

Fun fact

There is such a thing as hyperinflation, when the rate of increase of prices is beyond anything seen in normal circumstances. As one website succinctly defines it, “Hyperinflation is a situation where the price increases are so out of control that the concept of inflation is meaningless.”

One famous example of hyperinflation was when French and Belgian troops invaded the industrial regions of the Weimar Republic (of World War I fame) to ensure the payment of war reparations.

The Weimar Republic’s currency, the Mark, was at 320 Marks per dollar in the first half of 1922. By November 1923, the exchange rate was at 4,210,500,000,000 Marks per dollar.

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