Inflation and Deflation

Posted by PITHOCRATES - December 26th, 2011

Economics 101

When Demand is Greater than Supply there’s Inflation, when Supply is greater there is Deflation

Agriculture advances gave us food surpluses.  Food surpluses gave us a division of labor.  The division of labor gave us trade.  Money made that trade more efficient.  Religion and the Rule of Law allowed great gatherings of people to live and work together in urban settings.  Free trade let us maximize this economic output and elevated our standard of living.  Free labor sustained economic growth by increasing the number of people making economic exchanges.  Prices automated the process of assigning value and allocating scarce resources (that have alternative uses).  And provided incentive and competition.  The free movement of prices in our economy, then, is very important.  So important that we track extremes in these movements and give them special names.  Inflation.  And deflation.

When the economy is good we typically see prices increase.  Because the greater amount of economic activity is competing for the same scarce resources.  So businesses ‘bid’ up the price of these scarce resources.  To make sure they get what they need before someone else beats them to them.  This more intense competition for these resources causes their prices to rise.  We call this inflation.  Telling other suppliers that demand is greater than the current supply.  This encourages suppliers to bring more supplies to market.  And attracts others into the market.  As this happens the available supply of these scarce resources increases.  And approaches the level of demand.  Where prices then stabilize.

This is the free market correcting prices.  Prices were high because demand was greater than supply.  When supply caught up to demand they stopped rising.  And if supply continues to grow and exceeds demand they will start falling.  Because those scarce resources won’t be so scarce anymore.  Which happens when people bring too much supply to market.  Of course they have no way of knowing this.  Until the prices tell them so.  Falling prices, then, are a signal that supply has exceeded demand.  So suppliers scale back on what they bring to market.  We call this fall in prices deflation.  And when supply drops at or below demand the price correction is complete.  And prices stop falling.

When Government Interferes with Market Prices we can get Bubbles where both Prices and Supply are High

This price-correction deflation goes by another name.  Recession.  And we call this inflation/deflation cycle the business cycle.  Often referred to as a boom-bust cycle.  Times are good on the inflation side.  But not so good on the deflation side.  Because recessions aren’t fun.  Unless you like periods of high unemployment.  But it’s a natural and necessary part of the business cycle.  It’s how the free market corrects prices.  Allocates scarce resources that have alternative uses.  And provides incentive and competition.  Everything that makes free market capitalism function.  Providing the highest standard of living man has ever known.

But some in government like to tinker.  They think why not make the inflation part last longer?  And try to end the deflation part?  So they play with the tools at their disposal.  Monetary policy.  Fiscal policy.  And regulatory policy.  To stimulate demand beyond what the market is demanding.  To keep the good times rolling.  Where we live with permanent but ‘manageable’ inflation.  And avoid deflationary periods all together.  And recessions.  Sounds good.  In theory, at least.  But it rarely ends well when the government interferes with market prices.

When they interfere with market prices they give false information to those in the market.  Continued inflation means continued high prices.  Prices go even higher than they would have if left to market forces.  Indicating a high demand when there is none.  So suppliers rush in to meet this false demand.  Greatly increasing supply beyond demand.  Creating what we call a bubble.  Where both prices and supply are high.  An artificial creation.  And one that cannot last.  And when prices do correct they have a lot farther to fall.  As excess supply is sold off at discount prices.  And employers cut back and shed excess capacity.  Creating high levels of unemployment.  And a long and unpleasant recession until prices finally stabilize once again.  When supply once again matches demand.

The More we try to Eliminate the Deflationary Side of the Business Cycle the More Painful the Recession

Interestingly, government interference into the free market was to eliminate the business cycle.  Especially the unpleasant deflationary side of it.  But their actions only made the deflationary side far more painful.  Because it was their actions that created those inflationary bubbles.  Not the market.  Their actions only delayed the inevitable market correction.  It couldn’t stop it.  Nothing can.  The more they tried the bigger the bubbles they created.  And the bigger the bubble the bigger the correction.  And the more painful the recession.

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