Understanding Economics: Inflation and Deflation

by Sean Ross

2 min read

Inflation and deflation are two economic concepts that affect business operations. As such, it is important for small business owners to understand what these things are, how they are caused and controlled, and what can be done to protect against them.

What are Inflation and Deflation?

In economics, inflation and deflation are two terms used to describe the changes in the price of goods and services over time.

Inflation is a consistent increase in the prices of goods and services over time. During periods of inflation, a dollar loses some of its purchasing power and it takes more currency to buy the same amount of the goods or services in question. For example, if at the beginning of this year one widget is worth $1.00, but inflation is 5% over the year, it will take $1.05 to buy one widget one year later. Inflation lowers the value of a currency over time.

Deflation is the opposite of inflation. It is a consistent decrease in the prices of goods and services over time. During deflationary periods, a dollar actually gains purchasing power and it takes less currency to buy the same amount of goods or services than it did before. For example, if at the beginning of this year one widget is worth $1.00, but deflation is 10% over the year, it will take only $0.90 to buy one widget one year later. Deflation increases the value of a currency over time.

How Inflation and Deflation are Controlled

Inflation and deflation are caused by market forces, but can be controlled to a degree by government entities. Inflation-targeting is a monetary policy where a country’s central bank has an explicit target inflation rate for a certain time period. This is done for long-term price stability. Canada was one of the first countries in the world to have an explicit inflation target, and the Bank of Canada currently targets a 2% inflation rate.

Inflation can be controlled by:

*Interest rates — if the economy expands too quickly, a central bank can increase interest rates to control the money supply. If the economy is lagging, interest rates can be lowered to encourage borrowing and increase the money supply.

*Open market operations — a central bank can engage in the buying and selling of certain securities to reinforce the target. The bank of Canada uses open market Sale and Repurchase Agreements (SRAs) and Special Purchase and Resale Agreements (SPRAs) specifically.

*Reserve requirements — a central bank may also use reserve requirements, which is a minimum reserve amount that commercial banks must have. Canada abolished its reserve requirement in 1992.

What Can Small Businesses Do?

Inflation and deflation are very macroeconomic concepts. From a daily operational view, there isn’t much a company can do to protect against either. However, with a long-term perspective, there are some things that can be implemented.

To help hedge against inflation, a business can invest excess capital into inflation-linked bonds, which provide at least in tandem with inflation so purchasing power is kept. To hedge against deflation, the best idea is to hoard cash, as its purchasing power is increasing.

References & Resources

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