Thursday, February 12, 2015

Inflation - Part III

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If the government tries to increase Inflation rate to stimulate economy, then it will be known as Reflation. It can be done by -
  • Increasing money supply to the market
  • Reducing taxes, etc.
When Reflation is needed?
When the economy is in highly deflated state, i.e., in Deflation, where price level of commodities is too low, or value of money is too high (meaning you can buy a lot of goods with small amount of money!)

It is the opposite of Reflation. Disinflation process will be used by the government, if it tries to decrease the Inflation rate to recover the economy from a high Inflation state. It can be done by -
  • Decreasing money supply to the market
  • Increasing taxes, etc. 
When Disinflation is needed?
When the economy is in highly inflated state, i.e., in Inflation, where price level of commodities is too high, or value of money is too low (meaning you can buy a small amount of goods with a lot of money!)

Note that Reflation and Disinflation are the process of increasing and decreasing the Inflation rate, respectively. But Inflation and Deflation are the state of economy, where the price level of goods are too high and too low, respectively.

For example, suppose Inflation of January is 5 % (Inflation) and February is 4 % (Inflation). Then you can say that the price is disinflated by 5 - 4 = 1 %, but is still in Inflated state (in Inflation) in February.
Now suppose Inflation of January is 1 % (Inflation) and February is -2 % (Deflation). Then you can say that the price is disinflated by 1 - (-2) = 3 %, and is in Deflated state (in Deflation) in February.

There are two extreme cases of Inflation -
  • Hyperinflation - This is an extreme situation of Inflation in an economy, when the country experiences very high price level of goods (which is rapidly accelerating), and the real value of money is very low (which is rapidly depreciating).
    In this situation, people try to hold foreign currencies (e.g., USD), because their local currency has very low value.
  • Stagflation - This is an extreme situation of Inflation, which is associated with high unemployment (stagnant inflation). It raises a dilemma for government, because reducing inflation will rise unemployment, while reducing unemployment will increase inflation.

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