Inflation, Deflation and Disinflation

Inflation refers to a sustained rise in prices. Two key terms matter here: sustained and general. A one-time price jump isn’t inflation. If just one good gets more expensive, that’s a relative price change, not inflation.

We measure inflation using a consumer price index. This index tracks a weighted basket of goods over time. The weights reflect typical household spending. But there are known biases. It’s slow to capture substitution (people switch to cheaper goods), struggles with quality change (a phone that costs the same but does more means a real price drop), and the average household it describes may not match anyone at all. Different spending habits mean people face different inflation rates.

There are two main causes. First, Demand-pull: when aggregate demand (AD) rises while capacity is limited, prices go up. It’s like “too much money chasing too few goods.” Second, Cost-push: when input costs rise, short-run aggregate supply (SRAS) shifts left. Prices rise while output falls. Understanding the difference is crucial because the policy response varies. Cost-push is trickier, with no easy fix.

Deflation is a sustained drop in prices. It might sound good, but it’s usually worse. Falling prices encourage buyers to wait before they purchase. This lowers demand, which leads to further price drops. At the same time, the real value of debt rises, making it harder for borrowers when the economy is weak. Japan spent decades trapped in this situation. Remember, disinflation is different: prices are still rising, just at a slower pace.