We all know one tings never stay the same –prices. When general prices increase in an economy the rate at which they increase is termed as inflation. This rate of inflation pushes down the purchasing power of people. To put it in monetary terms if inflation rate is 9 percent, a shopping basket full of goods that costs Rs. 100 will cost 109 a year onward. A measure that helps identify inflation rate in the country is Consumer Price Index (CPI).
CPI presents a weighted average of prices of a basket of goods which includes goods for domestic use, transportation and medical care. It is the most prevailing used indicator for assessing the cost of living in an economy. Heavy ascent of CPI in short time implies inflation while vice versa signals deflation.
While inflation pushes down purchasing power of citizens deflation does the same. It is a common fallacy to consider whatever that moves opposite of what is bad must be good, though inflation and deflation are forces in opposite direction, both when unleashed can pull the economy in a vicious spiral.
To understand deflation let’s look at the current trends in international oil prices. Oil production which was primarily a Middle East phenomenon has equally gained momentum in the U.S., Latin American nations and elsewhere. This has resulted in massive supply in oil. This has coupled with decreasing demand for oil majorly due to lowering of China’s consumption given its shrinking growth rate. These circumstances have led to lower revenues for oil producing nations with eventual under recovery of oil production costs.
In an economy experiencing deflation or heavy drop in prices, interest rates drop due to low demand for money, there is lower rate of return on investments, investments fall, people start losing their jobs, demand for goods go down, production shrinks, and the overall economy goes into a spiral resulting in massive contraction.