According to Investopedia.com, “Inflation is defined as a sustained increase in the general level of prices for goods and services.” In other words, the value of the dollar does not stay consistent during times of inflation, and the purchasing power of the dollar declines. Thus, your money will buy less of a product or service. Economists have long debated the causes of inflation. However, most agree that inflation can be both good and bad, depending on the situation.
Anticipated inflation often signals a growing economy. When demand grows faster than supply, prices increase. In order to have demand, you generally must have people willing to spend money. This is a sign that the economy is healthy. Additionally, if inflation is expected and within reason, then the economy follows suit with little negative effect. Companies raise rates of pay, and banks drop interest rates to sustain the good economy.
When prices rise unexpectedly and severely, this is unanticipated inflation. This causes consumers on fixed incomes to stop or slow down spending. Uncertainty may cause corporations to stop hiring and consumers to spend less. Additionally, the economy must absorb the repricing of goods and services, as salaries are not rising at the same rate as prices. Inflation can also hurt domestic products, if the severe inflation happens only in domestic markets.
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Deflation is the opposite of inflation, and is the decrease in prices of goods and services. When prices fall, people tend to put off purchases, hoping that prices fall further. Thus, there is a waiting game that hurts businesses, banks and overall economic growth. This has been a problem with the housing market, as people do not purchase homes in fear of the value falling after the purchase. In general, people are afraid to spend money during times of deflation. Thus, some inflation could be considered a good thing.
When inflation is caused by a false or unsustainable economic growth that causes a boom, then it may be followed by a recession. A recession is when gross domestic product (GDP) growth is negative for two or more consecutive quarters. GDP refers to all of the services and products produced by a nation in a set period. A negative GDP can lead to changes in the stock market, higher unemployment, a drop in wages and lower profits for companies. This type of inflation has negative effects.