Friday, May 8, 2009

Inflation vs. Deflation

The new issue of The Economist has an interesting article debating the issue of inflation and deflation. This is relevant to the current economy because one of the possible effects of a prolonged recession is that prices begin falling on a broad scale - deflation. Deflation is a problem in a number of ways. Long-term debts have to be repaid with dollars of increasing value. Falling prices act as an incentive to postpone purchases - furthering the incentive to reduce prices. And wages are prices.

We see the other relevant aspect if we borrow a quote from Milton Friedman, "inflation is always and everywhere a monetary phenomenon." Essentially, large and sustained increases in the money supply are ultimately reflected in higher prices. The actions the Fed has taken to provide stability in the financial sector have had the coincident effect of increasing the money supply. The concern is that once the economy turns around (and some say it may be doing so as we write) and begins to gain speed, the increases will have to be withdrawn.

The article in the economist mentions this video (HT to Greg Mankiw which is a satirical debate on the same question.

The chorus of the song asks whether we will become Zimbabwe - the poster child for hyperinflation (see this photo, HT to Mark Perry) - or Japan - which went through a prolonged recession/depression in the 1990s. It would provide an interesting kick-off to a discussion about current economic policy and the longer term effects.

The author of the piece in The Economist seems to think that inflation is a more manageable and less immediate threat. I'm not sure I agree. What are your thoughts?

This post relates to the following Keystone Economic Principles:
1. We all make choices.
2. There ain’t no such thing as a free lunch.
3. All choices have consequences.
4. Economic systems influence choices.
9. Prices are determined by the market forces of supply and demand…and are constantly changing.

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