What’s it: Disinflation is a situation in which the price level increases at a slower rate of growth. In other words, inflation is still positive, but lower than the previous period. For example, suppose the inflation rate slowed from 3% inflation in the second quarter to 2.5% in the second quarter and 2.1% in the third quarter.
If the percentage falls into negative territory, it is deflation. For example, the inflation rate would be -0.1% in the second quarter and -0.2% in the third quarter. In general, deflation is more dangerous than deflation.
What is the difference between deflation and disinflation?
Disinflation is a common phenomenon in an economy. It may happen during a phase of a weak economy where demand starts to slow down.
Conversely, deflation is more dangerous. A fall in the price level usually takes place during an economic recession or depression. At that time, demand was weak because most households were thrifty. High unemployment rates make income prospects worse. As a result, they spend less on some goods and services.
Indeed, during deflation, the purchasing power of money increases. But, that doesn’t encourage people to shop. Why? Because they have no money due to grim income and job prospects.
Also, deflation causes real debt to increase. It hurts the borrower. This phenomenon is referred to as debt inflation.
Like inflation, we measure disinflation using a price index. The most quoted indicator is the consumer price index (CPI). An alternative is the producer price index or GDP deflator.
CPI inflation measures changes in the average price of consumer goods and services. It is one of the most monitored measures of the economy by investors and central banks. The company also monitors it, especially to adjust cost components (such as salaries) and its selling prices.
The percentage change in the CPI over time refers to the inflation rate. We can calculate it with the following formula:
Inflation rate = [(CPIt / CPIt-1) -1] * 100%
I have applied the above formula to calculate the inflation rate. And the results are as follows:
From the table, you can see there was deflation between 2011 and 2012, where the inflation rate fell from 4.0% to 2.0% then to 1.0%.
Furthermore, in 2016-2018, the economy experienced deflation because the inflation rate moved into negative territory.
Causes of disinflation
Disinflation occurs due to several factors.
First, the growth rate of the money supply slows down. That usually happens when the central bank adopts a tighter monetary policy. The central bank sees that the inflation rate has exceeded the target and moves in a harmful direction.
High inflation makes the economy overheat. It can lead to hyperinflation if not prevented. To cool the economy, the central bank adopted stricter policies through:
- Raising the policy rate
- Increasing the reserve requirement ratio
- Open market operations by selling government securities.
If the policy is successful, it should result in disinflation. However, suppose the policy is too aggressive. In that case, it will not slow down inflation, but lead the economy into contraction and deflation.
In general, you can use the formula for the quantity theory of money to see the relationship between the money supply, real output, and the price level. Here is the equation:
M x V = P x Y
- M = money supply
- V = velocity of money, i.e., the number of times the same money changes hands in a year.
- P = Price level
- Y = Real output
Second, real GDP growth slows down as aggregate demand weakens. Producers try to rationalize their production rate to match demand. Also, on average, producers are likely to increase their selling prices at a more moderate level than before.
In some cases, a slowdown in the inflation rate can also occur at the start of an economic recession (contraction). The price level is on downward pressure during this period. It may only slow down the inflation rate rather than deflation. But, if the recession deepens, deflation is more likely to emerge.
Impacts of disinflation
As I said earlier, disinflation doesn’t harm the economy, and it is a common phenomenon in an economic cycle.
Disinflation improves household purchasing power. Let’s take a simple example.
Say, the inflation rate slows down from 5% to 3%. Simultaneously, the percentage increase in your salary is the same as the previous year, which is 4%. Because the inflation rate is lower, your purchasing power increases. In the previous year, your salary’s purchasing power was eroded by 1% (4% -5%) because the inflation rate was higher than the salary increase. But, now, with the lower inflation rate, the purchasing power of your salary has increased.
On average, for firms, the disinflation resulted in lower revenue growth than before, assuming a fixed sales volume. Say, in the previous year, the company increased its selling price by about 3%. However, since demand shows weakening signs, they can only increase the selling price by 1%.