The meaning of inflation, disinflation and deflation

What is inflation?

Inflation is a rise in the general level of prices of goods and services in an economy over a period of time.

 When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects erosion in the purchasing power of money.

inflation and disinflation diagram

What is disinflation?

Disinflation is a decrease in the rate of inflation – a slowdown in the rate of increase of the general price level of goods and services over a period of time.

For example if the annual inflation rate for the month of January is 5% and it is 4% in the month of February, the prices disinflated by 1% but are still increasing at a 4% annual rate.

What is deflation?

Deflation is a decrease in the general price level of goods and services.

Deflation occurs when the inflation rate falls below 0%.

Calculating Inflation

Rate of inflation is measured by calculating the percentage price increase in goods and services over a period of time.

Inflation is measured through a Price Index. The economists monitor the price changes of a collection of goods & services over a period of time.

There are different Price Indices that can be used, the most popular are:

  • Consumer Price Index (CPI) – measure the price of a selection of goods and services for a typical consumer.
  • Producer Price Index (PPI) – measures the prices for all goods and services at the wholesale level. It is like the consumer price index but it is measuring the prices the producers have to pay.

Price index consists of

A basket of goods

It contains goods and services from various sectors of the economy. There prices are monitored over a period of time.

Base year

This is the first year with which the prices of subsequent years are compared. The price of each commodity is given the value of 100. The base year chosen is a typical year in the sense that there is neither very low or very high inflation, nor any extraordinary occurrences like wars.

Weights

Some commodities are more important in the economy as compared to other commodities. To find out the true effect of inflation. Weights are added to different products and services according to their importance in the society. A product which has a more serious affect is given a higher weight. For example food products which form a staple diet of the society are assigned more weightage than luxury products (perfumes). As the pattern of consumers spending changes over time so the Price Index will have to change the weights assigned to different commodities.