Disinflation and Deflation - Online Tutor, Practice Problems & Exam Prep

Disinflation refers to a significant reduction in the inflation rate while still maintaining positive inflation, as seen in the U.S. during the 1970s under Paul Volcker's contractionary monetary policy, which lowered inflation from 10% to 4% but increased unemployment. In contrast, deflation is characterized by a negative inflation rate, indicating a decline in the price level. Understanding these concepts is crucial for grasping economic dynamics, particularly the relationship between inflation, unemployment, and monetary policy.

Disinflation (Paul Volcker)

All right. Now let's discuss the differences between Disinflation and Deflation. So let's start here with disinflation. Disinflation is a significant reduction in the inflation rate. Okay? So one thing to note about disinflation is that there is still inflation during the disinflation. There's still inflation. We still have a positive inflation rate, but at a lower rate than usual, okay? So if maybe our inflation rate was 10% and now it's 8%, then 6%, and 4%. Notice, inflation is still positive Disinflation. We're bringing down the inflation rate. Okay. So a very common example that you see when we talk about Disinflation is the USA during the 1970s and '80s had a lot of inflation and then the Federal Reserve Chairman Paul Volcker had monetary policy that combated the inflation and brought it down. Okay? So let's go through this example together. During the 1970s, the USA experienced high inflation rates. Okay? So if you look on this graph, around here, we've got the 1970s. And this is the inflation rate on the y-axis. And we've got just years, the time on the x-axis. So in those 1970s, notice what was happening in the graph, right? We've got tons of inflation. We had a big peak and it brought down a little bit and then it peaked again and then you can see it kind of stabilized a little more during that Paul Volcker period. So in 1979, President Jimmy Carter appointed Paul Volcker as the Chairman of the Federal Reserve and remember, the Federal Reserve does monetary policy, right? Monetary policy with the money supply and interest rates. So Volcker's strict anti-inflation monetary policy brought down inflation from 10% down to 4%. So that's disinflation, right? It was 10% and he brought it down to 4%. So how did he do this? He had very strict policy, contractionary monetary policy, right? And contractionary monetary policy is what we use to combat inflation, right? We contract the economy, we bring down the money supply, and it brought down inflation, but it increased short-run unemployment. And that's what we would expect, from our short runs Phillips curve, right? We've seen this inverse relationship as inflation goes down, as we combat inflation and bring it down, well, unemployment is going to go up, right? That's what we saw in the short run. So let's go down to the graph and let's see what this looks like on our Phillips curve. So here, we've got the inflation rate on the y-axis and then we'll have, the unemployment rate on the x-axis. Y-axis inflation, x-axis unemployment there. And notice what happened. We were at this point way up here where we had high inflation, say 10% like in our example. And then his contractionary monetary policy moved us down the short run Phillips Curve to a position down here, right? And this will be let's say, that's point 1 that I mentioned up above is him combating the inflation by bringing it down but it increased our unemployment, right? So he brought down inflation down to 4%, but at the cost of a lot of unemployment. So let's say that our long-run equilibrium, our natural rate of unemployment is say 5% and this is the natural rate, right? Remember, in the long run, we're going to be at our natural rate of unemployment. On the short run, we had a lot of extra unemployment because of this, contractionary monetary policy. Let's say, unemployment got all the way up to 9% in this case. Okay? So we have a lot more unemployment, but we've brought down the inflation rate. Now, what happens in the long run is that the workers and the firms lower their expectations of future inflation, right? And that is a determinant of our Short Run Phillips Curve. So when there are lower expectations of inflation, well, it shifts our Phillips Curve to the left. Okay? And then that's exactly what we're going to see now is that the short-run Phillips curve shifts to the left and we become at a new equilibrium with a lower inflation rate. So what's going to happen is in the long run, we're going to have a new short-run Phillips Curve because of these lowered expectations about inflation and we'll be at this equilibrium right here where we've got 4% inflation and we're back to our natural rate of unemployment. Okay? So that's what Paul Volcker did. His contractionary monetary policy first so this is the second thing that happened over here is it shifted to the left and we got to this new equilibrium right there. Okay? So that was the strict monetary policy got us through basically like that on the graph. Now, one more thing to note is that the fiscal policy so that was the monetary policy, but the fiscal policy did not help combat the inflation. In fact, it was doing the opposite during the time. During the Reagan era, there were increases in the budget deficit, increased spending, higher aggregate demand leading to more inflation, right? So Paul Volcker was not only combating previous inflation, but new inflation from the Reagan era's increased spending as well. Okay? So that's what Paul Volcker did, helped combat that inflationary period. Now, what you'll see on the right here is the actual situation. The actual Phillips Curve here. Obviously, it's not as pretty as our theoretical one on the left, but you can see what happened, right? We started up here in 1979 and it started to shift outwards, right? We saw higher unemployment, so more unemployment, more unemployment. So this was like 1 right there happening. And then the long run, the expectations came down and there was 0.2 like on our graph over here. So, number 1 was the inflation coming down a little bit, but unemployment getting a lot higher. And then the second step was in the long run, it's shifting back to a more natural unemployment rate and a lower inflation rate, right? So it's not as pretty as our straight lines that we have there, but in essence, that is what was happening during this period, okay? So it shifted down the curve and then a new short-run Phillips curve to the left there. All right? So let's pause here and let's talk about deflation in the next video. So this was disinflation. Now, let's go over deflation.

Deflation

So a lot of students get these confused, disinflation and deflation. Disinflation, we still have inflation, but at a lower rate than previous years. Deflation, well, that's a decline in the price level. Disinflation, there's still inflation, at a lower rate. Deflation is a negative inflation rate, okay? During deflation, the inflation rate is negative. So it's very easy to spot deflation because there's a negative inflation rate. The prices are lower than the previous year. Okay? So note the difference between disinflation and deflation. Here, we've got the definitions again, okay? So make sure you've got those down, alright?

So look at these two subsections of US history here and let's look at the Consumer Price Index and the inflation rates during each period. Which one do you think is a period of disinflation and which is a period of deflation? So I'm guessing you guys thought this one is deflation, right? What if I were to tell you that you're absolutely right? This is deflation, right? We're seeing negative inflation rates, right? The price level is decreasing during this period, right? The price level is decreasing. Price level decreasing, inflation rate negative. I'm going to write that here, negative.

Now look at the next five years here. The price level is still increasing, right? Increasing, increasing, increasing, increasing in each of those periods. From one to the next, it's increasing, but look at our inflation rate. Okay. In this first one, it's increasing but look, decreasing, decreasing, decreasing. This is a disinflation. We'll say that these four years right here, this is disinflation. Notice that the price level is still increasing, but at a smaller and smaller rate. So this was the Paul Volcker disinflation right here. Okay? So he was the one in charge of the Fed at that point and he helped that disinflation happen and get us out of those crazy inflation rates at the end of the 1970s. Cool? So make sure you don't confuse those, disinflation and deflation. That's always an easy trick on the test and easy points if you remember it. Cool? Alright, let's pause here and move on to the next video.

Here’s what students ask on this topic:

What is the difference between disinflation and deflation?

Disinflation refers to a significant reduction in the inflation rate while still maintaining positive inflation. For example, if the inflation rate drops from 10% to 4%, it is disinflation. Deflation, on the other hand, is characterized by a negative inflation rate, indicating a decline in the price level. During deflation, prices decrease compared to the previous year. Understanding these concepts is crucial for grasping economic dynamics, particularly the relationship between inflation, unemployment, and monetary policy.

How did Paul Volcker's monetary policy achieve disinflation in the 1970s?

Paul Volcker, appointed as the Chairman of the Federal Reserve in 1979, implemented strict contractionary monetary policies to combat high inflation. By reducing the money supply and increasing interest rates, Volcker's policies brought down the inflation rate from 10% to 4%. However, this also led to a short-term increase in unemployment. Over time, as expectations of future inflation lowered, the short-run Phillips Curve shifted left, stabilizing inflation at a lower rate while returning unemployment to its natural rate.

What are the economic consequences of deflation?

Deflation, characterized by a negative inflation rate, can have several adverse economic consequences. It often leads to decreased consumer spending as people anticipate lower prices in the future, which can reduce overall demand. This can result in lower production, layoffs, and higher unemployment. Additionally, deflation increases the real value of debt, making it more burdensome for borrowers. These factors can contribute to a deflationary spiral, where reduced spending and investment lead to further economic decline.

What role does the Phillips Curve play in understanding disinflation?

The Phillips Curve illustrates the inverse relationship between inflation and unemployment in the short run. During disinflation, as contractionary monetary policies reduce inflation, unemployment tends to rise. This movement along the short-run Phillips Curve shows the trade-off between lower inflation and higher unemployment. Over time, as inflation expectations adjust, the short-run Phillips Curve shifts left, leading to a new equilibrium with lower inflation and a return to the natural rate of unemployment.

Can fiscal policy impact disinflation efforts?

Yes, fiscal policy can impact disinflation efforts. For instance, during the 1980s, while Paul Volcker's contractionary monetary policy aimed to reduce inflation, the fiscal policy under President Reagan increased the budget deficit through higher spending. This increased aggregate demand, counteracting some of the disinflationary effects of Volcker's policies. Effective disinflation often requires coordination between monetary and fiscal policies to ensure that fiscal actions do not undermine monetary efforts to control inflation.