Costs of inflation and deflation
Introduction
This lesson focuses on the costs of both inflation and deflation.
Enquiry question
What are the costs of both high rates of inflation in the economy and deflation?
Lesson time: 70 minutes
Lesson objectives:
Discuss the possible consequences of a high inflation rate, including greater uncertainty, redistributive effects, less saving, and the damage to export competitiveness.
Discuss the possible consequences of a high inflation rate, including greater uncertainty, redistributive effects, less saving, and the damage to export competitiveness.
Discuss the possible consequences of deflation, including high levels of cyclical unemployment and bankruptcies.
Teacher notes:
1. Beginning activity - start with the opening activity, a monetary policy game extracted from the European Central bank (10 minutes)
2. Processes - technical vocabulary - students can learn the content watching the first video, reading the key terms and then completing the first activity, which should take around 10 minutes.
3. Applying the theory - activity 3 focuses on Turkey, a country experiencing high rates of inflation as a result of excessively loose monetary policy.
4. Reinforcement processes - the handout includes 2 reinforcement activities. Allow 20 minutes to complete both.
5. Reflection activity - activity 5 begins the second part of this lesson, on deflation. This reflection exercise is designed to provide a graphic example of why deflation can lead to deferred consumption, one of the costs of falling prices. (5 minutes)
6. Processes - technical vocabulary - students can learn the content completing activity 6. (10 minutes)
7. Applying the theory - activity 7 should take around 15 minutes.
8. Reflection activity - contains an example of a paper one type question, which you can either print off or project onto the whiteboard. Allocate 10 minutes for this activity.
Key terms:
Hyper inflation - very high and typically accelerating inflation, of generally several hundred %. It quickly erodes the real value of the local currency, as the prices of all goods increase.
Real income - a person's income adjusted for the effects of inflation.
Deflation - a fall in average price levels, when the rate of inflation is below zero.
Good deflation - a fall in average prices caused by a fall in production costs, perhaps a reduction in oil or raw material prices, a rise in the value of the currency or a rise in productivity.
Bad deflation - a fall in aggregate demand as a result of a fall in economic activity, when AD falls at a faster rate than AS.
Deflationary spiral - a process by which deflation creates expectations of further price falls, and therefore consumers reduce their spending because they expect goods to become spending in the future. This fall in spending creates further deflationary pressure in the economy.
The activities on this page are available as a PDF file at: 
Costs of inflation / deflation
Activity 1: The costs of inflation
Watch the following short video and then highlight some of the costs of high inflation on an economy.
Sudden inflation shocks cause price confusion, where price signals are more difficult to interpret. It also makes business planning more difficult and can also contribute to money illusion.
High rates of inflation also encourages indebtedness because loans become cheaper in real terms - money is transferred from the lender to the borrower.
Inflation also discourages saving and penalises fixed income earners such as pensioners, who see their real incomes diminished. Demand for assets such as gold or property rises and the level of savings available for investment falls.
If the inflation within an economy is higher than its trading partners then over time the goods and services produced in the country will be more expensive, resulting in a loss of competitiveness.
Activity 2: The inflation cycle
Observe the following table which illustrates the downward spiral of inflation and a weakening currency in Turkey.
| Year | Inflation rate in Turkey | Inflation rate in EU | Value of the TL relative to the Euro |
| 2022 | 74% | 8.3% | 18.75 |
| 2021 | 35% | 2.59% | 10.5 |
| 2020 | 22% | 0.25% | 7.66 |
| 2019 | 21% | 1.21% | 6.55 |
| 2018 | 18.1% | 1.9% | 7.3 |
| 2017 | 10.2% | 1.4% | 3.6 |
| 2016 | 7.78% | 0.24% | 3.5 |
| 2015 | 7.67% | 0.03% | 3.3 |
1. Calculate the total increase in prices for the two regions between 2015 and 2022?
Between 2015 and 2022 average prices in the Turkish economy rose by 424% (1x1.0885) + (1x1.0767) e.t.c.. During the same period, average prices across the Eurozone increased by just 17%.
2. Calculate the % fall in the value of the Turkish lira, relative to the ͼ between 2014 and 2012?
The value of the Turkish lira, relative to the Euro, fell by 468/18% during this period. Calculated by the difference 15.45/ 3.3) x 100.
3. How do the above figures contribute towards the upward spiral of inflation in Turkey?
Between 2015 and 2022 average prices in Turkey rose nearly 5 fold, relative to those in the Eurozone, Turkey's main trading partner. In response, the value of the Turkish lira fell in value by almost the same amount as goods and services produced in the country became less competitive. The declining value of the TL then brought further inflationary pressures, as Turkey was forced to pay higher prices for their oil and other imported raw materials (in TL terms), perpetuating the inflationary spiral.
Activity 3: A focus on Zimbabwe
Watch the following short video, which describes the hyperinflation of the Robert Mugabe era.
(a) Summarise why the nation's hyper inflation problems started?
The problem started when the country started financing its public spending programmes by money printing, in the form of 20.5 Trillion Z$ in order to repay the arrears that they had with the International Monetary Fund.rather than through taxation and / or government borrowing. The new money does not create additional wealth, but instead forces up prices as more notes in circulation chase the same number of products. Consumers quickly realise what is happening and simply get rid of their notes as soon as they access them.
(b) Did the Zimbabwe government not realise that excessive expansionary monetary policy was the cause of the hyper inflation.
Probably, but officially no, the president, Robert Mugabe, rejected the idea and insisted that money printing actually helped reduce inflation. This is a particularly interesting notion given that Robert Mugabe claimed to have a Masters degree in economics from the prestige London School of Economics. A claim later discovered to be false by the institution, though he did graduate with a Bachelor of Arts from South African University, Fort Harare. At some point, however, it would have been too late to change tact given that the notes were already in circulation and could not simply be taken out.
Activity 4: Living under inflation
The following short video features an extract from a news service on the difficulties of life for the middle classes in an inflation hit nation.
(a) How much do the family earn a month?
280 Z $ s a month, which equates to $30 US each. Their budget for groceries is 2 / 3 of this and even this is insufficient to purchase many of the goods and services they need.
(b) Why are workers on fixed incomes particularly vulnerable to high rates of inflation.
Workers on fixed incomes will not see a significant rise in their nominal wage levels when prices rise, meaning a fall in real wage levels.
(c) 10 years ago the nation abandoned its currency. Is this likely to be effective in stabilising the rate of inflation?
It certainly could reduce some of the inflationary pressures in the economy by taking the excess supply of money but will of course cause other challenges for the economy.
For more images illustrating the impact of hyper inflation in Zimbabwe go to the following presentation: 
Zimbabwe inflation
More information about the impact of hyper inflation in Zimbabwe can be found at: 
Zimbabwe inflation
Activity 5: Deflation reflection activity
You are considering purchasing a new smart phone. Apple / Samsung introduce a new version which is very expensive. You know that if you wait, perhaps a couple of months, the price will fall. You do not need the new phone urgently so do you wait until the price falls or purchase the new expensive model immediately?
For those of you who decide to wait until the price falls congratulations, you have behaved just as many others consumers would. You have also described one of the problems associated with deflation - deferred consumption which reduces economic activity in the economy.
Activity 6: The costs of deflation
Watch the following short video which identifies some of the costs of a fall in average prices within the economy. After watching the video summarise the costs of deflation.
The video identifies the following costs of deflation:
Deferred consumption as consumers delay their purchases, leading to falls in production. In turn, this leads to higher unemployment and yet further falls in demand.
Firms are reluctant to invest in products they may not be able to sell.
(b) Explain why deflation discourages borrowing.
Deflation increases the real value of debt. This makes it harder to meet repayments and companies are more at risk of going bankrupt. Because bankruptcies increase, banks become reluctant to lend. This leads to a further fall in spending and investment (deflationary spiral).
(c) Draw a deflationary spiral with falling prices, falling demand and rising unemployment e.t.c.
A focus on Japan
Use the following video to explain why deflation may be as significant a threat to an economy?
Further reading on the Japanese economy 30 years on can be accessed at: 
Japan 30 years on
Activity 7: Government measures to tackle deflation
The diagrams below illustrate an economy in equilibrium.
Cost push deflation
Demand pull deflation
(a) Illustrate cost push and demand pull deflation on the two diagrams.
(b) Describe some of the supply side / demand side policies that a government might employ to tackle deflation in the economy?
Expansionary monetary policy - Increasing the money supply through quantitative easing or lower interest rates.
Expansionary fiscal policy - rises in government spending or lower taxes.
Activity 8: Link to the assessment
An example of a paper one question on deflation:
(a) Explain why deflation can be a significant a threat to an economy. [10 marks]
In answering this question responses should include the following:
A definition of deflation. Responses should also note that deflation is not the same as disinflation. Deflation is a sustained fall in average prices while disinflation is merely a fall in the rate of inflation.
A suitable real life example might include Japan or other nation that has battled with deflation as a sluggish economy maintained the economy in a seemingly permanent deflaitonary gap. This has reduced income levels and forced many Japanese families into negative equity on their homes and other assets and acted as drag on investment and private consumption.
Deflation can be illustrated with two AS / AD diagrams, one illustrating cost push (good) deflation and the other demand pull or bad deflation. The cost push deflation diagram (to the left) is illustrated by a rise in the AS curve leading to lower average prices. The diagram of demand pull deflation (below to the right) is illustrated by a fall (or left shift) in the AD curve, leading to a deflationary gap, represented on diagram 2 by a fall in national income from Y1 to Y2.
A description of some of the problems associated with deflation, e.g. price reductions leading to reduced profit margins and companies then forced to reduce staffing levels, leading to unemployment.
A recognition that a sustained period of deflation is also likely to lead to a fall in consumption levels as many consumers delay certain purchases in the expectation of further price falls - deferred consumption. Debtors, including those with mortgage payments will see their debts increase in relative terms, as the size of the loan grows in relation to the value of the asset secured on it. This in turn leads to falling real wealth and further reductions in consumption and investment. In this situation many creditors will not be repaid leading to further job losses and loss of output.
The impact of deflation on low investment and economic growth, including an explanation of the use of the reverse multiplier.
Candidates should also explain why governments may be powerless to prevent deflation simply by expanding the monetary supply - interest rates cannot fall below zero for example.
Examples of deflation e.g. Japan and the impact that deflation has had on the economy of that nation.
(b) Using real examples, evaluate the view that deflation can be even more harmful for an economy than inflation. [15 marks]
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Command term: Evaluate
Key terms to define: Deflation, inflation
In this example the command term evaluate means weigh up the strengths and weaknesses of the statement and reach a conclusion supported by evidence.
Responses should include the following:
A consideration of whether deflation is the product of cost push (good) inflation or demand pull (bad) deflation. Good deflation should be shown by a right shift in the AS curve, illustrated on diagram 1, leading to lower average prices.
By contrast, demand pull deflation would be illustrated by a fall (or left shift) in the AD curve, leading to an output or deflationary gap. This is illustrated on diagram 2 by the fall in aggregate demand from AD1 to AD2.
Deflation, particularly demand pull deflation, can also be harmful for the wider economy. For instance, deflation will lead to price reductions which reduces profit margins and forces companies to reduce staffing levels, leading to unemployment (in the case of demand pull deflation).
The economy is also likely to see a fall in consumption and investment levels, as many consumers and producers delay the purchases of certain goods and services in the expectation of price falls in the future.
Debts, including mortgage payments will increase in real terms as the value of money increases, thus further reducing consumption and investment levels. This may also apply to national or government debt which is particularly noteworthy in the case of Greece and Japan.
Responses should also consider why governments seem powerless to prevent deflation e.g. the fact that monetary and fiscal policy measures are less effective because interest rates cannot fall below zero and that large budget deficits may prevent governments from greater borrowing to fund a stimulus package.
On the other hand, inflation is also harmful to the economy but for different reasons.
One example is that nations experiencing high rates of inflation are likely to see a reduction in purchasing power, while those on fixed incomes will also experience a fall in real incomes, leading to lower real output in the economy, illustrated on diagram 3 by Y1 to Y2, following a rise in average price from PL1 to PL2.
When inflation is high in the economy saving is also discouraged and instead excessive consumption is encouraged. This is because the interest which savers earn from their savings is diminished. Instead demand for assets such as gold or property rises and the level of savings available for investment falls.
Another consequence might be the impact on global competitiveness. When the inflation within an economy is higher than its trading partners then over time the goods and services produced in the country will be more expensive. This will result in a loss of competitiveness as the level of exports falls and import levels rise.
In times of high inflation banks will also raise the interest rate they charge to borrowers in order to protect their profit margins. Higher interest rates in the economy will cause a further drag on the level of investment.
Uncertainty is a further consequence of high rates of inflation with many entrepreneurs reluctant to invest. High interest rates will also make it more expensive to borrow the funds required for any investment.
An example of a nation that is experiencing problems caused by high rates of inflation include Turkey, a nation with one of the highest rates of inflation in the world, as the government has abandoned any attempt to control average prices and instead prioritise growth policies. Other examples might be Ukraine or Venezuela.
Alternatively a real life example might include Japan which has faced the opposite problem - a deflaitonary spiral within the economy.
A suitable conclusion might be that either excessive rates of inflation or deflation are undesirable for an economy and that an economy works best with a low and stable rate of average prices in the region of 2 - 2.5%.