Simple concepts, most young people understand at a high level even very early in life. What is it really and what are the effects? This is where things get a little more complex. For instance you hear the doom and gloom about deflation and how it will destroy an economy, and you suffer the results of inflation while buying milk and eggs in the grocery store... but at the heart of this we get back to my previous posting regarding money as a store of value and/or a medium of exchange.
As a store of value, inflation and deflation are an easy concept to understand. It essentially represents the demand of that commodity vs. the supply. Let's go to tried and true biblical reference of fish. A very common industry that several disciples participated in before being called fishers of men. At any given time there are a certain number of fish on the planet, and only so many are being traded in a market place at a time. Fish are created, born or by the miracle of Jesus, and they are destroyed, through death and consumption. What if there was a plague and the fish death rate increases? Well the intrinsic value of fish would rise, this is Deflation. Consumption increases due to a shift in taste or population growth would also increase the intrinsic value of fish causing deflation in the commodity of Fish. Now what if there was a sudden surge in viable fish births, or Jesus performs a miracle and creates fish for the masses? These would decrease the intrinsic value of fish causing inflation. Is this type of inflation or deflation bad? Not at moderate values, it is only when there is a sudden and rapid swing where this is dangerous. So let's pretend we are a fish trader, due to a plague in fish the number of fish being caught have dropped dramatically but the demand has remained constant. We are a pretty smart trader and we know the prices will rise so we hoard our catch hoping to reap the reward of selling fish at a higher cost this also decreases supply temporarily and prices begin to rise very rapidly to the point where the general population can no longer afford fish so to feed their family they shift to eating bread and corn. Now we as the fish trader go to sell our high priced fish and since the demand has subsequently fallen dramatically we can no longer sell them at the going rate of prices. Our stock may then begin to spoil and we have suffered the consequences of deflation in our commodity. In this small example we will have a localized effect, just for fish and just for a reasonable geographic region for a specific time. The effects of commodity deflation will not necessarily equate to a failing economy in general and the effects on perishable goods versus non-perishable goods will vary... if fish never spoiled we could hold on to them indefinitely if we had the means to. Inflation plays a very different role in this example what you saw was what is commonly referred to as hyper-inflation which follows rapid deflation. For standard inflation we would get a very different result, let's change our example a little and see what would happen. Now there is a boom in fish populations resulting from an increased fish birth rate, fishermen's catches are larger and more frequent so our fish stock becomes more abundant. In a market place where demand is constant this decreases the prices because we as the fish trader know that we must sell our stock in competition against other fish traders. This leads to lower fish prices but if demand does not catch up to equalize prices then we as the fish trader know that we have to reduce the supply so we stop buying fish from the fishermen who sell at the highest prices or sell us the lowest quality of fish... essentially they get fired and are less able to contribute to the economy as a whole and this will have a small but rippling effect on the general economy. This problem is limited to a specific period of time and to a geographic region.
As a medium of exchange the concept is the same but the effects are much more complicated. Let's go back to the great depression where government fiat currency saw the most pronounced swings. Fiat currency causes the effects of inflation and deflation to be LESS localized by region and is not confined to a single commodity, it is however limited to a specific time. Let us assume that we use paper IOU's (oh wait that is Fiat Currency) as our medium of exchange, this has no value what-so-ever other than it's liquidity and the markets definition of it's representation to a commodities value. What happens if we make more paper IOU's? Well the liquidity increases and commodity traders demand more of it subsequently for trade, this is inflation. What happens if we decide to burn it? The liquidity of the currency then decreases and the commodity traders demand less of it, this is deflation. Rapid inflation of a medium of exchange can cause significant problems because it devalues an individuals productivity in a society and rapid deflation can cause equally bad problems because it can cause people to start treating the medium of exchange as a store of value which in turn reduces our paper I.O.U's liquidity in the market place. This is why usury was condemned in the bible and most other religions for that matter. By the way, usury is not just limited to interest rates like a bank might charge even if that is what the modern definition has become. Usury at it's basic principle is making money just for the fact that you have money, interest rates are just the easiest offenders to point a finger at.
Why is treating a medium of exchange as a store of value a bad thing? Simply put, it has the potential to hurt people on a wide scale, if a family cannot come by the currency it needs to buy the necessities of life well the result is obvious, poverty will follow if this happens on a wide scale it has the much more devastating effects, this is what happened during the great depression, and this is what is happening currently in the great recession as I have heard some refer to it. What happened to the money supplies during both of these times? The money supply shrank. After the onset of the federal reserve in the U.S. the money supply changed to be based more on debt than on actual physical currency, if you have a dollar in the bank the odds are much stronger that it is NOT original currency and it is more likely to be someone or something's debt to another entity. Ever wonder why the fed lowers interest rates to combat a declining economy? They tell you it is to encourage people to spend and stimulate job growth but in reality this is only part of the equation, the larger part is that the action of buying on credit increases the money supply which increases the liquidity. What were to happen if the liquidity of a currency were to fall is that the trade of goods and services would slow to a halt, this is a significant contributor to the great depression... even though you might be able to buy more with your money if there is not enough to conduct the actual trades then the system crumbles and crumbles rapidly.
In summary deflation of a medium of exchange, is a bad thing as it can encourage consumers to treat it as if it were a store of value. Small and reasonable amounts of inflation are healthy for a medium of exchange. Whereas in a store of value, small and reasonable deflation is healthy as this gives consumers increased value of their goods and services where as rapid inflation is the result of inefficiencies in the production/consumption rate of those goods and services.
For follow up discussion, there are some notable outlying commodities that don't seem to fit the general rule of thumb, in net searching you will often see computing technology as the great example of why a deflation in general is not a bad thing? Any ideas on what may be happening with this and similar commodities?