Question

What is the economic principle that guides efforts to analyze the costs of inflation and deflation?

Answer 1

Broadly, there are 10 Principles of Economics that guide the functioning of different laws of economics and the rationale behind optimal economic choices by every agent in an economy. Although every principle’s working is somehow interlinked with other principles, the main principle out of the 10 principles of Economics that guides efforts to analyze costs of inflation and deflation is:

“Society faces a short-run trade-off between Inflation and Unemployment”.

This is the very last of the 10 Principles of Economics, but the rationale behind this principle is hinged on the very first of the 10 principles of Economics, namely:

‘People Face Trade-offs’.

The essential idea underlying the first principle is that, since the resources in an economy are limited but wants are unlimited, in order to get an additional unit of one good/service, the economic agent has to give up some other good/service. Thus, the rational agent must face trade-offs or choices and has to choose the optimal combination of goods or services applying the other economic principles.

The last principle is also dependent on the 9^th principle which says that:

Price Rises When The Government Prints Too Much Money.

When a rise in the amount of money in the economy pushes up overall levels of expenditure, the demand for goods and services also rises. While this causes the price of goods and services to rise, it simultaneously causes firms to hire more workers to satisfy the rise in demand. This in turn reduces unemployment.

Coming back to the 10^th principle that guides efforts to analyze the costs of inflation or deflation, a link can thus be established in the form of a short-run trade between inflation and unemployment. This means that over a short period of time, as inflation in the economy rises, unemployment is lowered. This trade-off has a very important role to play in the analysis of the business cycle and policymakers can exploit this short-run trade off using various fiscal and monetary policy tools.

The opposite happens in case of deflation wherein there is a continuous fall in the level of prices in an economy. In this case, overall levels of expenditure and thus the demand for goods and services falls. This causes firms to hire fewer workers and sometimes even lay off workers, to lower their production levels to match them with the fall in demand. This in turn increases unemployment and there is a short-run positive relationship between deflation and unemployment.

Thus, while the costs of inflation can be a sharp rise in the price of goods, its benefits come in the form of reduced unemployment and rise in the standard of living as production increases (This is in fact linked to Principle 8 which says that the standard of living depends on a country’s production.) Similarly, during deflation, when the fall in prices apparently seems like boon, it is actually acting as a bane with its costs amounting to very high levels of unemployment and reduced standard of living in the economy.

It is clear that while this particular question only refers to the last principle, the rationale behind its working cannot be isolated and seen in the light without the simultaneous working of some other principles.