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Monday, 25 May 2009

The difference between deflation and disinflation

Deflation is a sustained decrease in the general price level resulting in a sustained increase in the real value of the functional currency and other monetary items.

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The functional currency is the currency of the primary economic environment in which an entity operates. It is normally the national or regional measurement currency or monetary unit of account in an economy or monetary union like the Euro in the European Monetary Union.

Deflation only happens below zero percent annual inflation. The functional currency and other monetary items are worth more all the time during deflation as opposed to being worth less all the time during inflation. Deflation is the opposite of inflation. Inflation destroys the real value of the functional currency and other monetary items. Deflation creates more real value in the functional currency and other monetary items.

Disinflation is lower inflation. Prices in an economy are still rising during disinflation, but at a slower rate. The general price level still rises, but, at a slower rate resulting in a continued, but, lower rate of real value destruction in the functional currency and other monetary items.

A lowering of inflation is, by definition, always disinflation. That is the same as a lowering of the rate of increase in the general price level. A lowering of the absolute value of the general price level is deflation.

Deflation means the general price level is not increasing at all, but, actually decreasing continuously and the functional currency and other monetary items are worth more all the time. Deflation causes an increase in the real value of the functional currency and other monetary items.

Inflation destroys the real value of the functional currency. Disinflation destroys the real value of the functional currency at a slower rate. Deflation creates more real value in the functional currency.

Inflation is a sustained increase in the general price level. Disinflation is a slower sustained increase in the general price level. Deflation is a sustained decrease in the general price level.

Disinflation happens, for example, after a period of higher inflation in what are normally considered low inflationary economies and is initially popularly confused with deflation. During disinflation many prominent prices, for example, oil, fuel, property and food prices are falling, but, the general price level is still actually rising, albeit at a much slower rate than during normal low inflation. When the slowing annual inflation rate (slowing increase in general price level) moves lower and lower it eventually gets to a zero percent annual rate for maybe a month or two. There is no increase in the general price level. When the absolute value of the general price level then starts to decrease the economy switches over from inflation to deflation: not just a slower increase in the generally increasing price level as during disinflation but actually a sustained decrease in the absolute value of the general price level below zero percent which causes an increase in the real value of the functional currency and other monetary items: the opposite of inflation.

Countries have little experience of deflation. Deflation is generally regarded as a very serious economic problem that everyone is trying to avoid at all costs especially after what happened during the Great Depression.

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