Why Are Inflation and Deflation Important?

Why Are Inflation and Deflation Important?

As Americans struggle through what we hope is the tail end of the “Great Recession”, we hear the terms “inflation” and “deflation” often.  For many people, these terms mean little beyond the definitions of “a rise in general prices” and “a fall in general prices”, respectively.  In many ways however, inflation and deflation are two of the biggest drivers for your investment decisions. How, then, does inflation and deflation really affect our families and finances?


If you recently noticed retail prices have increased, you can blame inflation.  Our money does not buy the same amounts of goods and services as before.  However, this is not entirely negative, because inflation allows businesses to offer more employment opportunities.  In fact, many economists believe a gradual and stable inflation rate of 2 to 3% per year is a positive factor in maintaining a low unemployment rate, a stable amount of consumer spending, and desirable lending and savings rates.  Right now, for example, the hope in inflating prices is that companies may begin to hire employees and reduce the unemployment rate.  However, this only works if consumers continue to spend and invest. 


On the other hand, prices that decrease can produce deflation, which, when left un-countered, can spiral out of control.  As consumers, we would think deflation would be a good thing because we can buy more with our money.  However, deflation often traps people into cutting off spending until prices reach rock bottom.  A slow-down in spending then causes businesses to slow production and to decrease their own spending, including laying off and/or firing employees.  This cycle continues until the scales are balanced again and consumers have faith in the government and businesses.    

Inflation and Deflation in Today’s Economy

If inflation is desirable and deflation is not, how do we control the level of inflation in America?  The magic number of desired inflation is 2 to 3%, and the United States can control the level of inflation by printing additional money, decreasing prime lending rates, and piping money into the economy. 

Let’s look at the recent housing bust as an example.  To counter the 2007 housing market crash, in 2008 the government tried to stimulate the economy by flooding consumers with extra money. If this sounds dangerous, it can be. The Federal Reserve lowered interest rates to try to get more banks lending and more consumers buying. Unfortunately the results were limited. While we can never know what would have happened had the government not stepped in, most people can agree the results were still very painful.

Inflation and deflation are difficult to control, but as we continue to struggle out of our Great Recession, we aim for a slow, stable increase to our desired 2 to 3% inflation rate. 

Why Do I Care?

The reason you as an investor want to pay attention to these numbers is so that you can make good investments. More than a simple question of how much goods will cost in the future, inflation tells you what kind of returns your investments need just to break even.

If inflation is 3% and my money is tucked away in my mattress, it's losing value -- everything costs 3% more. This is why it's so important to look for investments that return more than inflation; your regular old bank savings account -- unless it's returning more than 3%, the rate of inflation -- may actually be losing you money.

Aim for investments that will return more than the rate of inflation.

Photo Source rubberduckee

Money reasons's picture

Money reasons wrote:

Mon, 11/22/2010 - 17:28 Comment #: 1

No question about it, both inflation and deflation have an impact on investments.

If your rich, deflation can be viewed as a good thing... Unfortunately, I'm not rich!!! :(

Invest It Wisely's picture

Invest It Wisely wrote:

Mon, 11/22/2010 - 18:54 Comment #: 2

Price deflation due to increasing productivity is a great thing. It means that things are getting cheaper and we can buy more of them. This is what we have been seeing in the electronics market for a long time now.

Price deflation due to monetary deflation due to credit collapse is more painful, I agree. We need to ask a very important question though: Why did we allow credit to rise so high in the first place? It's like jumping out of a skyscraper: of course it's going to hurt. Why did you go up there and jump in the first place?

Christa Palm's picture

Christa Palm wrote:

Mon, 11/22/2010 - 19:21 Comment #: 3

Money reasons, I agree -- I wish I was financially rich, too! But I'm rich in family and love, so that counts for so much more :-)

Christa Palm's picture

Christa Palm wrote:

Mon, 11/22/2010 - 19:32 Comment #: 4

Good point, Invest It Wisely -- deflation in the electronics world (and other increased productivity markets) is a good thing. I know the time-saving experiences offered by new technology can help businesses and individuals -- time does equal money.

Your further points are great -- I definitely think greed played a huge part in our nation's current financial downfall, but I'll post more on that thought later.

Financial Ramblings « Intelligent Speculator's picture

Financial Ramblings « Intelligent Speculator wrote:

Sat, 11/27/2010 - 11:01 Comment #: 5

[...] -Think long term when shopping black friday and cyber Monday @ Free From Broke -Why are inflation and deflation important @ Momvesting -6 new volatility ETF’s @ Vix and [...]

Teaching Kids About Inflation | MomVesting's picture

Teaching Kids About Inflation | MomVesting wrote:

Thu, 02/09/2012 - 12:15 Comment #: 6

[...] let's quickly redefine inflation so that we're on the same page. In general, inflation occurs when the cost of goods and services [...]