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Inflation and Deflation

Economics and Currency

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Currency values are also affected by “Inflation” and “Deflation”, which affect the purchasing power of that currency. If a nation’s currency is “inflating” it is losing purchasing power. Each individual unit of currency can purchase less. The currency loses value compared to other currencies with less inflation, or “weakens”. Currency traders will not desire to hold this currency long and will short the currency. “Disinflation” is the decrease in the inflation rate. If an inflation rate rose to 3%, then fell to 2%, a disinflation (fall in inflation) of 1% occurred.

Deflation

If a nation’s currency is “deflating” it is gaining purchasing power, each unit of currency can purchase more. The currency gains value compared to other currencies with less deflation or currencies with inflation, also known as “strengthening”. Currency traders will generally desire to hold this currency long.

Central Bank Preference

Central Banks prefer a modest annual increase in inflation, ranging around 2%. Deflation usually only occurs when an economy is contracting. Inflation typically occurs when an economy is expanding. High inflation is deadly for an economy since an average citizen’s ability to earn enough money to survive is hindered as inflation rises.

Deflationary Spirals

Why is deflation so dangerous? A deflationary spiral can train-wreck an economy if it continues indefinitely. Deflation occurs when the prices found in an economy fall, usually due to a depression or recession, when unemployment is rising and cash is hard to come by. Due to their perceived economic insecurity, consumers stop spending and demand decreases. Businesses, without a source of revenue income, are forced to lay off employees. These employees exacerbate the insecurity in the market, since they now have less money to spend. Without income, they default on their mortgages, car payments, consumer loans, and student related debts. Businesses, desperate for customers, lower their prices further. If this fall in prices doesn’t convince people to spend in uncertain times then demand stays low. More employees are laid off, and more consumers default on debts and fiscal obligations. Investors, banks, and financial institutions who loaned them money and own these obligations are forced to take losses. Banks may eventually owe more to depositors than they have in assets. Eventually, banks and financial institutions are forced to declare mass bankruptcies from owing depositors more than they have on hand. This can lead to an implosion of the financial system.

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