inflation and deflation graph

“Deflation” is a word which people seem to hear from everywhere nowadays, and especially in Eurozone.  Simply put, “deflation” is the opposite of the better-known “inflation”.  Generally, people complain when inflation is occurring as it is becoming more expensive to purchase goods and services.  Inflationary spirals normally occur when higher costs of living increases demands for higher wages, thereby creating a wage price spiral.  This further increases production costs, and so costs of living will go up again.  This will then cause workers demand even higher wages, and so on into the vicious circle.

Hyperinflation is when this situation is getting out of control.  Popular examples are Germany in 1920 when a one month inflation in January peaked at 56.9%, and more recently Zimbabwe with yearly inflation of 1,730% in 2006.

Central Banks of most governments are combating inflation and are usually setting a target of some sort.  For example, European Central Bank defines price stability as the situation when a yearly inflation is below and close to 2% level. But why not make it 0%?  Why not have an inflation target of 0% so that workers will be sure in how much purchasing power they have?

Deflation is the reason behind this inflation target, because deflation can be as devastating for an economy as the hyperinflation.  Deflationary spirals occur when lower prices lead to lower production.  Lower production leads to decreased wages and demand, and so prices decrease even further.

The main problem with the deflation is that the real value of debt is increasing.  So to combat this, the European Central Bank announced that it would undertake Quantitative Easing.  This is basically designed to weaken the Euro, and to increase the relative price of imports coming into Europe and price levels should then go up.   We will be watching how this situation spans out over the coming weeks and months!