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With all the talk of inflation lately—and we’ve all felt the higher prices at this point—it makes sense to take a look at the other players on the economic stage (deflation and recession).
When we have inflation, deflation and recession can follow. How so? As we put out the fire of an overly eager economy, we’ll see a slowdown that fits the description of deflation.
Putting the brakes on the economy isn’t normally a bad thing. But what can follow, if the cooling off isn’t done with caution, is a recession. Keep reading to learn all you need to know about inflation, deflation, and recession.
Predictable Economic Cycles
Economies follow cycles. They always have.
One day, the economy is grooving along with low interest rates, and perhaps stronger incomes—everything looks pretty rosie. That is, until…
People begin to overspend, causing inventories to drop and consumer prices to escalate. When this happens, the buying power of our money goes sharply down.
Those really high prices cause consumers to shy away from leisure spending such as travel and entertainment. Money stops flowing to those businesses and can take a toll on their balance sheets, which can lead to layoffs.
Meanwhile, consumers may begin hoarding essentials, despite high prices, because they fear shortages and even higher prices. This creates a bigger strain on supply and pricing, leading the government to need to take action.
The Federal Reserve Bank (the Fed/central bank) often raises interest rates to limit cash flow in the economy. This move also discourages people from making big purchases and produces a bit of anxiety which leads to more saving.
With less demand and spending, supplies have a chance to play catch-up with the hopes that lower prices will follow.
Logically, you’d think that falling prices would lead to another spending frenzy, but it’s just the opposite. Suddenly, consumers are excited about rock-bottom prices and eagerly hold onto their cash to see if they’ll drop lower.
As consumer spending comes to a standstill, businesses amass high levels of inventory with no one to buy it. This can result in more layoffs and unemployment.
There is now less cash circulating in the economy and the value of money goes up. Lower prices mean that purchasing power is stronger and cash is worth more.
If left unchecked, this phase can cause a major economic slowdown; the Fed will then lower interest rates to replenish money flow and encourage big purchases with the availability of cheaper loans.
That is an economic cycle in a very simplified nutshell.
Whatever cycle we’re currently experiencing eventually morphs into a different phase. None of it lasts forever.
What Is Inflation?
Let’s cover some inflation basics. For a more in-depth look at inflation, check out this article on the effects of inflation.
The inflationary cycle:
- When demand for things seriously outpaces supply, it’s a recipe for inflation.
- Spend-happy consumers encourage companies to raise prices for profit.
- During inflation, your money buys less since prices are higher.
- You’ll notice that your paycheck won’t cover as many of your expenses.
- As demand for things increases, the prices for materials to make them may increase as well.
- With increased buying and shopping, many businesses must hire additional help.
- The extra hired help increases company expenses so they raise prices to compensate.
- Unemployment often goes down (at least for a while) during inflationary periods.
Inflationary Psychology
Interestingly, the more I study inflation, the more I learn what a large role human psychology and consumer reactions play in economic upturns and downturns.
The crazy thing about inflation is how people’s anxiety can make it worse. The psychological effect on high prices is real.
Consider your own spending behavior when prices are rising. Are you more likely to “stock up” on things before prices go even higher?
Or say you’ve been thinking about a big purchase like a car. If you see prices rising quickly, will you follow your original plan to buy a new car in six months, or buy right away to avoid paying more in half a year?
I think you can guess the answers to these questions. Most consumers will run out and buy extras or make that big purchase right away so they won’t have to spend more later.
The unfortunate thing about this buying behavior during a time of inflation is that it drives prices even higher.
If one million people in your city decide to rush out and buy extra toilet paper (and we all know where this is going), there will be no more toilet paper. Supply won’t be able to keep up, and the price will rise.
People flood the market hoping to save a little money and soon there’s a shortage of inventory.
In-demand products with too little supply can make a business or company very wealthy. It’s a no-brainer to charge more when people are buying like crazy.
It’s economics 101. The more consumers rush to buy stuff, the shorter the supply, and the more the prices go up for those products. Extreme shortages equal high prices.
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What Is Deflation?
The simple definition of deflation is falling prices over a period of time. This process often happens slowly when coming out of an inflationary period.
It’s not simply the price of cars or a few services going down, it’s a measure of price deflation over an entire group of consumer goods and services.
The consumer price index (CPI) helps us measure average price changes over certain periods of time for a fixed set of consumer goods people usually spend money on.
When this index shows prices falling too quickly over a long period of time, a cycle of deflation is likely to occur.
Lower prices sounds great, right? Well, it can get out of hand quickly when consumers react with radical changes to their spending.
How Deflation Affects the Economy
Deflating a frenzied economy will rebalance the extremes of pricing and spending. With careful handling of economic policy, a period of deflation can cool things off.
The goal is to do this gradually and to know when to stop the cooldown. Short-term deflation can give consumers a chance to catch their breath and save more of their earnings.
As prices go down, paychecks will cover more monthly expenses.This results in less anxiety, and spending is brought back to healthy levels.
However, if deflation happens at breakneck speed, there are definite consequences.
Rapid deflation can create a vicious cycle:
- After an extended period of high prices, measures are taken to cool things off.
- People get excited about the lower prices and anticipate even lower prices.
- Consumers then hold onto their money to see how low prices will get.
- Less cash is suddenly available in the economy, businesses start to suffer, inventory is too high, and layoffs begin to happen if the cycle lasts too long.
- As companies begin laying off due to consumers not spending money, the unemployment rate rises.
- With stagnant inventories, companies order less from manufacturers who then suffer and also must lay off workers.
- Serious deflation slows down an economy in dangerous ways which affects many people.
Unexpected Benefits of Deflation
The effects of rapid deflation can be unnerving. But there can be some benefits as well.
As consumers stop spending in certain sectors such as entertainment and travel, those markets slow to a crawl and come up with incentives to stay afloat.
This is actually the best time to take an elaborate vacation. People are cutting back, travel companies slash prices, and the purchasing power of your cash is very high.
Besides travel, investing isn’t always a bad thing to do during a deflationary phase. With lower stock prices, you may want to find a few good companies to help you ride out the volatile market ahead.
Types of Deflation
There are a couple of primary types or causes of deflation. One is closely related to government intervention, and the other occurs through consumer behavior.
There’s also what’s called “good deflation” and “bad deflation”. These describe how deflation affects our economy.
Deflation Through Monetary Policy
Deflation through monteary policy is the lowering of our money supply by the Fed when they raise interest rates. Currently, we know that interest rates are rising. This means the central bank has increased the cost of the money it’s willing to lend regular banks.
The increase in interest rates that’s passed down to regular banks will therefore translate into higher interest rates for consumers.
If our banks have to pay more interest to the primary central banks, then we’ll have to pay more interest when we borrow, so they can afford to pay back their loans as well.
“Good” Deflation: Positive Supply Shock
When there’s a boom in productivity due to advancing technology in production for example, there may be excess products for sale.
Combine plenty of products for sale with lower prices, and you’ll get nice spending which helps businesses to profit. They may in turn hire more people and be able to afford higher wages thus infusing more spending money. Not a bad cycle.
“Bad” Deflation: Negative Demand Shock
This is when we worry. If consumer demand falls very suddenly—much quicker than the supply of stuff that’s already out there—there’s nowhere for the extra supplies to go. It’s just sitting there, not selling and not earning the business any money.
This leads to massive profit loss and the business not being able to pay its bills or employees. Once this happens, layoffs are inevitable and some level of unemployment takes hold.
What Is a Recession?
The National Bureau of Economic Research defines recession as “a significant decline in economic activity that is spread across the economy and that lasts more than a few months.”
Traditionally, most economists determine a recession to be in swing when there are two straight quarters of shrinking output by a national economy. This is measured as GDP, or gross domestic product.
When production of goods and services that would ordinarily result in cash sales throughout a country declines, the economic health of that nation could be in jeopardy.
What Happens During a Recession?
Before you have visions of the great depression or the great recession during the housing bubble burst in 2008, be aware that a recession can be very short lived.
Recessions are a predictable part of periodic economic cycles and they’re not permanent. The economy is fluid and changes are inevitable.
Characteristics of a recession:
- There is a sharp decline in consumer demand.
- Sales of products and services stagnate.
- Businesses lose money.
- The stock market crashes due to severe profit losses.
- Wages may decrease either moderately or significantly.
- Large layoffs can result in high unemployment.
One of the primary sectors that’s directly hurt by a recession is the real estate market. As earnings decrease and interest rates rise, housing is a purchase consumers are reluctant to make during a recession.
This leads to an excess of housing on the market, driving prices lower, which negatively affects the value of houses in many areas.
In addition to plummeting sales, housing foreclosures often rise sharply. With these negative real estate consequences come opportunities for investors. Recessions have silver linings if you know where to look.
Tips to Weather a Recession
Rather than panic, why not tap into your inner financial ninja during a recessionary period. We’ll help you put some wise money moves into practice.
- Pay off your credit cards; especially those with high interest rates.
- Increase your emergency fund savings.
- Learn to live simply—beneath your means. A great time to try out that minimalist lifestyle you’ve been curious about.
- Don’t stop investing in your retirement accounts; stock markets and funds will bounce back.
- Don’t panic-sell your funds and stocks.
- If you’ve got extra cash flow, take advantage of the real estate market. You’ll have a wide range to choose from at low prices and interest rates.
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Frequently Asked Questions (FAQs)
What Is the Difference between Inflation and Deflation?
As you can see, inflation is the opposite of deflation.
The hallmark of higher inflation is high prices, increased demand for goods, and often an increase in wages and jobs.
Deflation, on the other hand, brings falling prices, lower demand, and often higher interest rates. Plus, the dollar has increased purchasing power.
Is Deflation Worse Than Inflation?
It’s hard to decide what’s worse—paying too much at the gas station, or the stock market and retirement accounts taking a beating. Inflation and deflation can be seen as two sides of a coin. But one can definitely be worse than the other.
Deflation can generally be more dangerous than inflation if it happens too rapidly or lasts for a long period of time. There’s a fine balance between increasing the quality of life with lower prices and causing an economy to bottom out.
If rising inflation grows beyond the steady 2% benchmark for a prolonged period of time, it may be time to put the brakes on consumer demand.
Deflationary measures that are carefully implemented can be a good tool for calming inflation for sure. There’s nothing wrong with implementing policy to slow down spending so we can all afford our groceries at lower prices.
If deflation persists and the demand for goods plummets, businesses suffer, jobs are lost, and economic depression can result.
The Bottom Line on Inflation, Deflation, and Recession
Even in “regular” times, spending habits often resemble a roller coaster, wages increase and decrease, cost of living fluctuates, and supply and demand fight like rival siblings.
It’s no wonder that inflation cycles into deflation which can settle into a temporary bout of recession. The main thing to remember is all things are temporary.
What comes up, must come down. And vice versa. Take the time to invest in yourself and increase your financial know-how so you’re prepared for the many economic cycles that will happen during your lifetime.