Inflation and Deflation

Inflation is when a currency decreases in value, and deflation is when a currency increases in value. Although inflation is generally viewed as worse than deflation, if either continue steadily for a long time, or occur drastically very quickly, it can lead to a depression.

Currency can increase in value if the economy that is backed by the currency does well, and it can decrease in value if the economy does poorly. However, that covers only the 'demand' part of 'supply and demand'. The other factor that affects the value of a currency is how much of that currency is in circulation. The more currency there is in circulation, the less the currency is worth. Conversely, the less currency is in circulation, the more the currency is worth. Generally, governments control the amount of money in circulation so that the value of the currency stays steady. But sometimes, when governments need to raise money quickly, they print a lot more money than they should without thinking about the consequences.

In the Civil War, for example, the Confederate government printed huge amount of Confederate dollars to fund the war. Whereas at the beginning one dollar of Confederate money was almost equal to one dollar in gold, as the Confederate government printed more and more money, it soon took ten dollars, then twenty, then fifty dollars of Confederate money to match one dollar in gold. By the time of the last exchange, it took $1200 of Confederate money to match one dollar in gold.

When the value of a currency decreases very, very rapidly, this is called hyper-inflation. One example of hyper-inflation occured in Germany after World War I. Germany's economy was suffering because trade connections had been disrupted as a result of World War I. Marks fell in value more slowly than Confederate money at first, from 8.9 marks to the US dollar in January 1919 to 191.8 to the US dollar in January 1922. Germany also had to pay huge reperations to the Allied Countries because of the Treaty of Versailles. The German government couldn't pay the money because the mark was dropping in value, so they borrowed and printed much more money than they were able to pay off. This started a vicious cycle. The more money the German government printed, the less the money was worth, so the government printed more money , and the money dropped in value again, and so on and so on. Also contributing the mark's drop in value was the consumers' reaction to the inflation. People rushed to buyproducts with their marks, because they knew it wouldn't be long before the mark dropped in value again. So the demand for goods of all kinds was going up. As demand increased, prices rised. Hyper-inflation began in earnest. In June of 1922 the dollar was worth 350 marks, in October it was worth 4,500 marks. By January 1923, the dollar had risen to 18,000 marks per dollar. In November 15, 1923, when the vicious cycle was finally stopped, one dollar was worth 4.2 trillion marks.

Inflation can be stopped by instituting wage and price controls, by decreasing demand for products, or by decreasing the amount of money in circulation.

During inflation, people rush to buy products, but during deflation, people don't buy many products, because they expect the worth of the currency to increase (or because they don't have any money to spend). Consumers saving instead of spending is both a cause and effect of deflation. If people expect bad times ahead, they may begin savingmore money, and this can lead to deflation.

One famous example of deflation was the Great Depression. When the American economy collapsed due to a variety of stresses and failings, a world-wide depression was triggered. Many people in the working and middle classes lost their jobs and stopped buying products. The upper classes also cut back on their consumption of luxury products. As a result, there was less demand for products. Manufacturers cut prices, with the hope that more people would buy their products, and fired people to pay for the drop in prices. As prices dropped, the same amount of currency could buy more products. But this didn't help the people who had lost their jobs. They didn't have any money to spend on goods.

The deflation of the Great Depression was especially hard on people in debt. As the value of the currency increased, so did the value of the debt. Meanwhile, the price of the products the person was producing kept dropping, making it difficult to pay off debt.

Deflation can be stopped by making consumers buy more and save less, which is done by lowering interest rates, lowering taxes, and/or making the currency cheaper.

In review, inflation is a drop in the purchasing power of a currency, and is usually due to an increase in the amount of money in circulation, a decrease in the amount of products in circulation, and/or an increase in demand for products. Deflation is a rise in the purchasing power of a currency, and is usually due to a decrease in the amount of money in circulation, an increase in the amount of products in circulation, and/or a decrease in demand for products.