Inflation

What causes the overall level of prices in an economy to rise... or fall?

y y y y y y y y

What Is Inflation? Should We Adjust Prices For Inflation? Cost-Push Inflation vs. Demand-Pull Inflation The Quantity Theory of Money Why Not Just Print More Money? Purchasing Power Parity: Link Between Exchange Rates and Inflation What Is Deflation and how can it be prevented? Why Don't Prices Decline During A Recession?

What Is Inflation?
To understand inflation, we first must understand what the word means. The Economics Glossary defines Inflation as: Inflation is an increase in the price of a basket of goods and services that is representative of the economy as a whole. A similar definition of inflation can be found in Economics by Parkin and Bade: Inflation is an upward movement in the average level of prices. Its opposite is deflation, a downward movement in the average level of prices. The boundary between inflation and deflation is price stability. The Link between Inflation and Money Because inflation is a rise in the general level of prices, it is intrinsically linked to money, as captured by the often heard refrain "Inflation is too many dollars chasing too few goods". To understand how this works, imagine a world that only has two commodities: Oranges picked from orange trees, and paper money printed by the government. In a year where there is a drought and oranges are scarce, we'd expect to see the price of oranges rise, as there will be quite a few dollars chasing very few oranges. Conversely, if there's a record crop or oranges, we'd expect to see the price of oranges fall, as orange sellers will need to reduce their prices in order to clear their inventory. These scenarios are inflation and deflation, respectively, though in the real world inflation and deflation are changes in the average price of all goods and services, not just one. Inflation and the Money Supply We can also have inflation and deflation by changing the amount of money in the system. If the government decides to print a lot of money, then dollars will become plentiful relative to oranges, just as in our drought situation. Thus inflation is caused by the amount of dollars rising relative to the amount of oranges (goods and services), and deflation is caused by the amount of dollars falling relative to the amount of oranges. Thus, as shown by the article "Why Does Money Have Value?", inflation is caused by a combination of four factors: 1. The supply of money goes up. 2. The supply of other goods goes down.

3. Demand for money goes down. 4. Demand for other goods goes up.

Should We Adjust Prices For Inflation? (Does Inflation Adjusting Make Sense?)
We often see statements like this made by economists: "Gas prices reached a new 2008 low of $1.61 per gallon, which is the lowest inflation-adjusted price since..."(Emphasis mine) But what do economists mean by inflation-adjusted? A typical definition of inflation is: Inflation is an increase in the price of a basket of goods and services that is representative of the economy as a whole. Measuring Inflation When we adjust for inflation, our unit of measure tends to be something like "1982 dollars". But the entire concept of 1982 dollars is a rather meaningless one. A basket of goods and services in 2008 (or 2009) is fundamentally different than those in 1982. Without access to a time-machine, I cannot go back in time to 1982 so I can buy a brand new Colecovision at Woolco. I can't even do that in 2008. 1982 dollars is not a unit of measure that is relevant to my life today. Inflation and Attempts to Account for Product Changes Naturally the Bureau of Labor Statistics attempts to account for the fact that a representative basket of goods in 1982 is vastly different than one from 2008 by making hedonic adjustments. The Bureau of Labor Statistics has a report on the methods they use, which is available as a PDF file. There is a great deal of debate on whether the BLS's measure understates or overstates the "true" value of inflation. The website Shadow Government Statistics argues that the BLS systemically underestimates inflation. But all such arguments assume that there is a 'true' objective level of inflation and the job of economists is to figure out the best way to estimate it. However, there cannot be an objective inflation because the comparison between two baskets of goods available at two different points in time is subjective in nature. Inflation and Comparing Products In order to measure inflation we must make judgment calls between the quality of goods available in two different time periods. Consider a brand new Colecovision game system (available for purchase in 1982) and a brand new PlayStation 3 (PS3) video game system (available for purchase in 2009). How can we compare these two items? Is the PS3 equally as good as the Colecovision? Twice as good? Two hundred times as good? How do we know? How can we compare the two? If both goods were available for sale at the same time, you could make the argument that two goods are comparable. If the local store sells bananas for 25 cents and oranges for 50 cents, we could say that oranges are twice as good as bananas. But we cannot make this argument for the PS3 vs. Colecovision debate, since new PS3 systems were not available in 1982 and in 2009 we can obtain PS3 systems but new Colecovision systems are not available for retail sale (outside of collectables stores).

The BLS does the best it can under such circumstances, but we have given them an impossible task. There is simply no objective way to measure qualitative differences in products available for sale at different times. The Verdict on Inflation Economists and the media use inflation estimates to adjust the prices of goods sold in two periods of time. During times when the make-up of a typical basket of goods is not changing a great deal, there is some merit to this approach. In times of rapid technological change, however, it is simply impossible to objectively compare baskets of goods that are decades apart.

Cost-Push Inflation vs. Demand-Pull Inflation

The terms cost-push inflation and demand-pull inflation are associated with Keynesian Economics. Without going into a primer on Keynesian Economics (a good one can be found at Econlib) we can still understand the difference between two terms. In articles such as "Why Does Money Have Value?", "The Demand for Money", and "Prices and Recessions" we've seen that inflation is caused by a combination of four factors. Those factors are:
y y y y

The supply of money goes up. The supply of goods goes down. Demand for money goes down. Demand for goods goes up.

Let's look at the definition of cost-push and demand-pull inflation and see if we can understand them using our four factors. Definition of Cost-Push Inflation The text "Economics" (2nd Edition) by Parkin and Bade gives the following explanation for cost-push inflation: "Inflation can result from a decrease in aggregate supply. The two main sources of decrease in aggregate supply are
y y

An increase in wage rates An increase in the prices of raw materials

These sources of a decrease in aggregate supply operate by increasing costs, and the resulting inflation is called cost-push inflation. Other things remaining the same, the higher the cost of production, the smaller is the amount produced. At a given price level, rising wage rates or rising prices of raw materials such as oil lead firms to decrease the quantity of labor employed and to cut production." (pg. 865) Aggregate supply is the "the total value of the goods and services produced in a country" or simply factor 2, "The supply of goods". The supply of goods can be influenced by factors other than an increase in the price of inputs (say a natural disaster), so not all factor 2 inflation is cost-push inflation.

Of course, the next question would be "What caused the price of inputs to rise?". Any combinations of the four factors could cause that, but the two most likely are factor 2 (Raw materials such as oil have become more scarce), or factor 4 (The demand for raw materials and labor have risen). Definition of Demand-Pull Inflation Parkin and Bade give the following explanation for demand-pull inflation: "The inflation resulting from an increase in aggregate demand is called demand-pull inflation. Such inflation may arise from any individual factor that increases aggregate demand, but the main ones that generate ongoing increases in aggregate demand are 1. Increases in the money supply 2. Increases in government purchases 3. Increases in the price level in the rest of the world Inflation caused by an increase in aggregate demand, is inflation caused by factor 4 (An increase in the demand for goods). The three most likely causes of an increase in aggregate demand will also tend to increase inflation: 1. Increases in the money supply: This is simply factor 1 inflation. 2. Increases in government purchases: The increased demand for goods by the government causes factor 4 inflation. 3. Increases in the price level in the rest of the world: Suppose you are living in the United States. If the price of gum rises in Canada, we should expect to see less Americans buy gum from Canadians and more Canadians purchase the cheaper gum from American sources. From the American perspective the demand for gum has risen causing a price rise in gum; a factor 4 inflation. Inflation in Summary Cost-push inflation and demand-pull inflation can be explained using our four inflation factors. Cost-push inflation is inflation caused by rising prices of inputs that causes factor 2 (The supply of goods goes down) inflation. Demand-pull inflation is factor 4 inflation (The demand for goods goes up) which can have many causes.

The Quantity Theory of Money

Simply put, the quantity theory of money is the idea that the supply of money in an economy determines the level of prices and changes in the money supply result in proportional changes in prices. In other words, the quantity theory of money states that a given percentage change in the money supply results in an equivalent level of inflation or deflation. This concept is usually introduced via an equation relating money and prices to other economic variables, as shown by the following setup:

In the above equation,

y y y y

M represents the amount of money available in an economy (i.e. the money supply) V is the velocity of money, which is how many times within a given period, on average, a unit of currency gets exchanged for goods and services P is the overall price level in an economy Y is the level of real output in an economy (usually referred to as real GDP)

The right side of the equation represents the total dollar (or other currency) value of output in an economy. Since this output is purchased using money, it stands to reason that the dollar value of output has to equal the amount of currency available times how often that currency changes hands. This is exactly what this quantity equation states. This form of of the quantity equation is referred to as the levels form since it relates the level of money supply to the level of prices and other variables.

Let's consider a very simple economy where 600 units of output are produced and each unit of output sells for $30. This economy generates 600 x $30 = $18,000 of output, as shows in the right-hand side of the equation. Now suppose that this economy has a money supply of $9,000. If it is using $9,000 of currency to purchase $18,000 of output, then each dollar has to change hands twice on average. This is what the left-hand side of the equation represents. In general, it's possible to solve for any one of the variables in the equation as long as the other three quantities are given, it just takes a bit of algebra. Growth Rates Form

The quantity equation can also be written in growth rates form, as shown above. Not surprisingly, the growth rates form of the quantity equation relates changes in the amount of money available in an economy and changes in the velocity of money to changes in the price level and changes in output. This equation follows directly from the levels form of the quantity equation using some basic math. If two quantities are always equal, as in the levels form of the equation, then the growth rates of the quantities must be equal. In addition, the percentage growth rate of the product of two quantities is equal to the sum of the percentage growth rates of the individual quantities.

The quantity theory of money holds if the growth rate of the money supply is the same as the growth rate in prices, which will be true if there is no change in the velocity of money or in real output when the money supply changes. Historical evidence shows that the velocity of money is pretty constant over time, so it's reasonable to believe that changes in the velocity of money are in fact equal to zero. The effect of money on real output, however, is a bit less clear. Most economists agree that, in the long run, the level of goods and services produced in an economy depends primarily on the factors of production (labor, capital, etc.) available and the level of technology present rather than the amount of currency circulating, which implies that the money supply cannot affect the real level of output in the long run. When considering the short-run effects of a change in the money supply, economists are a bit more divided on the issue- some think that changes in the money supply are reflected solely in price changes rather quickly, and others believe that an economy will temporarily change real output in response to a change in the money supply. (This is because economists either believe that the velocity of money is not constant in the short run or that prices are sticky or don't immediately adjust to changes in the money supply.) Based on this discussion, it seems reasonable to take the quantity theory of money, where a change in the money supply simply leads to a corresponding change in prices with no effect on other quantities, as a view of how the economy works in the long run, but it doesn't rule out the possibility that monetary policy can have real effects on an economy in the short run.

Why Not Just Print More Money?

Wouldnt We All Be Wealthier If We Printed More Money? If we print more money, prices will rise such that were no better off than we were before. To see why, well suppose this isnt true, and that prices will not increase much when we drastically increase the money supply. Consider the case of the United States. Lets suppose the United States decides to increase the money supply by mailing every man, woman, and child an envelope full of money. What would people do with that money? Some of that money will be saved, some might go toward paying off debt like mortgages and credit cards, but most of it will be spent. I know the first thing Id do is going down to Walmart and buy an Xbox or PlayStation 2. Im not going to be the only one who runs out to buy an Xbox. This presents a problem for Walmart. Do they keep their prices the same and not have enough Xboxes to sell to everyone who wants one, or do they raise their prices? The obvious decision would be to raise their prices. If Walmart (along with everyone else) decides to raise their prices right away, we would have massive inflation, and our money is now devalued. Since were trying to argue this wont happen, well suppose that Walmart and the other retailers dont increase the price of Xboxes. For the price of Xboxes to hold steady, the supply of Xboxes will have to meet this added

demand. If there are shortages, certainly the price will rise, as consumers who are denied an Xbox will offer to pay a price well in excess of what Walmart was formerly charging. For the retail price of the Xbox not to rise, we will need the producer of the Xbox, Microsoft, to increase production to satisfy this increased demand. Certainly this will not be technically possible in some industries, as there are capacity constraints (machinery, factory space) that limit how much production can be increased in a short period of time. We also need Microsoft not to charge retailers more per system, as this would cause Walmart to increase the price they charged to consumers, as were trying to create a scenario where the price of the Xbox wont rise. By this logic we also need the per-unit costs of producing the Xbox not to rise. This is going to be difficult as the companies that Microsoft buys parts from are going to have the same pressures and incentives to raise prices that Walmart and Microsoft do. If Microsoft is going to produce more Xboxes, theyre going to need more man hours of labor and obtaining these hours cannot add too much (if anything) to their per-unit costs, or else they will be forced to raise the price they charge retailers. Wages are essentially prices; an hourly wage is the price a person charges for an hour of labor. It will be impossible for hourly wages to stay at their current levels. Some of the added labor may come through employees working overtime. This clearly has added costs, and workers are not likely to be as productive (per hour) if theyre working 12 hours a day as if theyre working 8. Many companies will need to hire extra labor. This demand for extra labor will cause wages to rise, as companies bid up wage rates in order to induce workers to work for their company. Theyll also have to induce their current workers not to retire. If you were given an envelope full of cash, do you think youd put in more hours at work, or less? Labor market pressures require wages to increase, so product costs must increase as well. In short prices will go up after a drastic increase in the money supply because: 1. If people have more money, theyll divert some of that money to spending. Retailers will be forced to raise prices, or run out of product. 2. Retailers who run out of product will try to replenish it. Producers face the same dilemma of retailers that they will either have to raise prices, or face shortages because they do not have the capacity to create extra product and they cannot find labor at rates which are low enough to justify the extra production. We know that inflation is caused by a combination of four factors. Weve seen why an increase in the supply of money causes prices to rise. If the supply of goods increased enough, factor 1 and 2 could balance each other out and we could avoid inflation. Suppliers would produce more goods if wage rates and the price of their inputs wouldnt increase. However, weve seen they will increase. In fact, its likely that theyll increase to such a level where it will be optimal for the firm to produce the amount they would have if the money supply had not increased. This gets us to why drastically increasing the money supply on the surface seems like a good idea. When we say wed like more money, what were really saying is wed like more wealth. The problem is if we all have more money, collectively were not going to be any wealthier. Increasing the amount of money does nothing to increasing the amount of wealth or more plainly the amount of stuff in the world. Since the same number of people are chasing the same amount of stuff, we cannot on average be wealthier than we were before.

Purchasing Power Parity: Link between Exchange Rates and Inflation

The Dictionary of Economics which defines Purchasing Power Parity as: A theory which states that the exchange rate between one currency and another is in equilibrium when their domestic purchasing powers at that rate of exchange are equivalent. Using this definition, we can show the link between inflation and exchange rates. To illustrate the link, we'll take two fictional countries: Mikeland and Coffeeville. Suppose that on January 1st, 2004, the prices for every good in each country is identical. Thus a football that costs 20 Mikeland Dollars in Mikeland costs 20 Coffeeville Pesos in Coffeeville. If Purchasing Power Parity holds then 1 Mikeland Dollar must be worth 1 Coffeville Peso, otherwise we could make a risk free profit buying footballs in one market and selling in the other. So here PPP requires a 1 for 1 exchange rate. Now let's suppose Coffeville has a 50% inflation rate whereas Mikeland has no inflation whatsoever. If the inflation in Coffeeville impacts every good equally, then the price of footballs in Coffeeville will be 30 Coffeville Pesos on January 1, 2005. Since there is zero inflation in Mikeland, the price of footballs will still be 20 Mikeland Dollars on Jan 1 2005. If purchasing power parity holds and we cannot make money from buying footballs in one country and selling them in the other, then 30 Coffeeville Pesos must now be worth 20 Mikeland Dollars. If 30 Pesos = 20 Dollars, then 1.5 Pesos must equal 1 Dollar. Thus our Pesoto-Dollar exchange rate is 1.5, meaning that it costs 1.5 Coffeville Pesos to purchase 1 Mikeland Dollar on foreign exchange markets. If two countries have differing rates of inflation, then the relative prices of goods in the two countries, such as footballs, will change. The relative price of goods is linked to the exchange rate through the theory of Purchasing Power Parity. As we have seen, PPP tells us that if a country has a relatively high inflation rate we should see the value of its currency decline.

What Is Deflation and How can it Be Prevented?

Q: I think the problems that deflation would entail. Also when the government prints money it causes inflation. It seems to me, given these two "facts", the government would only have to print money to avoid deflation. (Pretty simple minded approach!) Is the problem that there is more to printing money than printing money? Is in fact the way printed money gets into circulation, that the fed buys bonds, and thus gets money into the economy? What is the logical rabbit trail that leads to inflation from printing money? Would solving deflation this way work with low interest rates? Why or why not? A: Deflation has been a hot topic since about 2001 and the fear of deflation does not look like it will subside anytime soon. What is deflation? The Glossary of Economics Terms defines deflation as occurring "when prices are declining over time. This is the opposite of inflation; when the inflation rate (by some measure) is negative, the economy is in a deflationary period." Inflation occurs when money becomes relatively less valuable than goods. Then deflation is simply the opposite that over time money is becoming relatively more valuable than the

other goods in the economy. Following the logic of that article, deflation can occur because of a combination of four factors: 1. 2. 3. 4. The supply of money goes down. The supply of other goods goes up. Demand for money goes up. Demand for other goods goes down.

Deflation generally occurs when the supply of goods rises faster than the supply of money, which is consistent with these four factors. These factors explain why the price of some goods increases over time while others decline. Personal computers have sharply dropped in price over the last fifteen years. This is because technological improvements have allowed the supply of computers to increase at a much faster rate than demand or the supply of money. During the 1980's there was a sharp increase in the price of 1950's baseball cards, due to a huge increase in demand and a basically fixed amount of supply of both cards and money. So your suggestion to increase the money supply if we're worried about deflation is a good one, as it follows the four factors above. Before we decide that the Fed should increase the money supply, we have to determine how much of a problem deflation really is and how the Fed can influence the money supply. First we'll look at the problems caused by deflation. Most economists agree that deflation is both a disease and a symptom of other problems in the economy. In Deflation: The Good, The Bad and the Ugly Don Luskin at Capitalism Magazine examines James Paulsen's differentiation of "good deflation" and "bad deflation". Paulsen's definitions are clearly looking at deflation as a symptom of other changes in the economy. He describes "good deflation" as occurring when businesses are "able to constantly produce goods at lower and lower prices due to cost-cutting initiatives and efficiency gains". This is simply factor 2 "The supply of other goods goes up" on our list of the four factors which cause deflation. Paulsen refers to this as "good deflation" since it allows "GDP growth to remain strong, profit growth to surge and unemployment to fall without inflationary consequence." "Bad deflation" is a more difficult concept to define. Paulsen simply states that "bad deflation has emerged because even though selling price inflation is still trending lower, corporations can no longer keep up with cost reductions and/or efficiency gains." Both Luskin and I have difficulty with that answer, as it seems like half an explanation. Luskin concludes that bad deflation is actually caused by "the revaluation of a country's monetary unit of account by that country's central bank". In essence this is really factor 1 "The supply of money goes down" from our list. So "bad deflation" is caused by a relative decline in the money supply and "good deflation" is caused by a relative increase in the supply of goods. These definitions are inherently flawed because deflation is caused by relative changes. If the supply of goods in a year increases by 10% and the supply of money in that year increases by 3% causing deflation, is this "good deflation" or "bad deflation"? Since the supply of goods has increased, we have "good deflation", but since the central bank hasn't increased the money supply fast enough we should also have "bad deflation". Asking whether "goods" or "money" caused deflation is like asking "When you clap your hands, is the left hand or the right hand responsible for the sound?". Saying that "goods grew too fast" or "money grew

too slowly" is inherently saying the same thing since we're comparing goods to money, so "good deflation" and "bad deflation" are terms that probably should be retired. Looking at deflation as a disease tends to get more agreement among economists. Luskin says that the true problem with deflation is that it causes problems in business relationships: "If you are a borrower, you are contractually committed to making loan payments that represent more and more purchasing power -- while at the same time the asset you bought with the loan to begin with is declining in nominal price. If you are a lender, chances are that your borrower will default on your loan to him under such conditions." Colin Asher, an economist at Nomura Securities, told Radio Free Europe that the problem with deflation is that "in deflation [there's] a declining spiral. Businesses make less profit so they cut back [on] employment. People feel less like spending money. Businesses then don't make any profits and everything works itself into a declining spiral." Deflation also has a psychological element as it "becomes rooted in peoples' psychologies and becomes selfperpetuating. Consumers are discouraged from buying expensive items like automobiles or homes because they know those things will be cheaper in the future." Mark Gongloff at CNN Money agrees with these opinions. Gongloff explains that "when prices fall simply because people have no desire to buy -- leading to a vicious cycle of consumers postponing spending because they believe prices will fall further -- then businesses can't make a profit or pay off their debts, leading them to cut production and workers, leading to lower demand for goods, which leads to even lower prices." While I haven't polled every economist who has written an article on deflation this should give you a good idea of what the general consensus on the subject. A psychological factor that has been overlooked is how many workers look at their wages in nominal terms. The problem with deflation is that the forces causing prices in general to drop should cause wages to drop as well. Wages, however, tend to be rather "sticky" in the downward direction. If prices rise 3% and you give your employees a 3% raise, they're roughly as well off as they were before. This is equivalent to the situation where prices drop 2% and you cut the pay of your employees by 2%. However, if employees are looking at their wages in nominal terms, they'll be much happier with a 3% raise than a 2% pay cut. A low level of inflation makes it easier to adjust wages in an industry whereas deflation causes rigidities in the labor market. These rigidities lead to an inefficient level of labor usage and slower economic growth. Now we've seen some of the reasons why deflation is undesirable, we must ask ourselves: "What can be done about deflation?" Of the four factors listed, the easiest one to control is number 1 "The supply of money". By increasing the money supply, we can cause the inflation rate to rise, so we can avoid deflation. In order to understand how this works, we first need a definition of the money supply. The money supply is more than just the dollar bills in your wallet and the coins in your pocket. Economist Anna J. Schwartz defines the money supply as follows: "The U.S. money supply comprises currency -- dollar bills and coins issues by the Federal Reserve System and the Treasury -- and various kinds of deposits held by the public at commercial banks and other depository institutions such as savings and loans and credit unions."

There are three broad measures economists use when looking at the money supply: "M1, a narrow measure of money's function as a medium of exchange; M2, a broader measure that also reflects money's function as a store of value; and M3, a still broader measure that covers items that many regard as close substitutes of money." The Federal Reserve has several options at its disposal in order to influence the money supply and thereby raise or lower the inflation rate. The most common way the Federal Reserve changes the inflation rate is by changing the interest rate. The Fed influences interest rates causes the supply of money to change. Suppose the Fed wishes to lower the interest rate. It can do this by buying government securities in exchange for money. By buying up securities on the market, the supply of those securities goes down. This causes the price of those securities to go up and the interest rate to decline. The relationship between the price of a security and interest rates is explained on the third page of my article The Dividend Tax Cut and Interest Rates. When the Fed wants to lower interest rates, it buys a security, and by doing so it injects money into the system because it gives the holder of the bond money in exchange for that security. So the Federal Reserve can increase the money supply by lowering interest rates through buying securities and decrease the money supply by raising the interest rates by selling securities. Influencing interest rates is a commonly used method of reducing inflation or avoiding deflation. Gongloff at CNN Money sites a Federal Reserve study that says "Japan's deflation could have been dodged, for example, if the Bank of Japan (BOJ) had only cut interest rates by 2 more percentage points between 1991 and 1995." Colin Asher points out that sometimes that if interest rates are too low, this method of controlling deflation is no longer an option, as currently in Japan where interest rates are practically zero. Changing interest rates in some circumstances is an effective way of controlling deflation through controlling the money supply. We finally get to the original question: "Is the problem that there is more to printing money than printing money? Is in fact the way printed money gets into circulation, that the fed buys bonds, and thus gets money into the economy?". That's precisely what happens. The money the Fed gets to buy government securities has to come from somewhere. Generally it is just created in order for the Fed to carry out its open market operations. So in most instances, when economists talk about "printing more money" and "the Fed lowering interest rates" they're talking about the same thing. If interest rates are already zero, as in Japan, there is little room to lower them further, so using this policy to fight deflation will not work well. Fortunately interest rates in the U.S. have not yet reached the lows of those in Japan.

Why Don't Prices Decline During A Recession?

[Q:] When there is an economic expansion, demand seems to outpace supply, particularly for goods and services that take time and major capital to increase supply. As a result, prices generally rise (or there is at least price pressure) and particularly for goods and services that cannot rapidly meet the increased demand such as housing in urban centers (relatively fixed supply), advanced education (takes time to expand/build new schools), but not cars because automotive plants can gear up pretty quickly.

First, do you agree with this and if not, how do you see it? Second, when there is an economic contraction, supply initially outpaces demand. However prices for most goods and services don't go down and neither do wages. [A:] A change in the level of prices (inflation) was due to a combination of the four factors as described earlier. In a boom, we would expect that the demand for goods to rise faster than the supply. All else being equal, we would expect factor 4 to outweigh factor 2 and the level of prices to rise. Since deflation is the opposite of inflation, deflation is due to a combination of the four factors as described earlier. We would expect the demand for goods to decline faster than the supply, so factor 4 should outweigh factor 2, so all else being equal we should expect the level of prices to fall. From my article titled A Beginner's Guide to Economic Indicators we saw that measures of inflation such as the Implicit Price Deflator for GDP are procyclical coincident economic indicators, so the inflation rate is high during booms and low during recessions. The information above shows that the inflation rate should be higher in booms than in busts, but why is the inflation rate still positive in recessions? The answer is that all else is not equal. The money supply is constantly expanding, so the economy has a consistent inflationary pressure given by factor 1. The Federal Reserve has a table listing the M1, M2, and M3 money supply. From Recession? Depression? we saw that during the worst recession America has experienced since World War II, from November 1973 to March 1975, real GDP fell by 4.9 percent. This would have caused deflation, except that the money supply rose rapidly during this period, with the seasonally adjusted M2 rising 16.5% and the seasonally adjusted M3 rising 24.4%. Data from Economagic shows that the Consumer Price Index rose 14.68% during this severe recession. A recessionary period with a high inflation rate is known as stagflation, a concept made famous by Milton Friedman. While inflation rates are generally lower during recessions, we can still experience high levels of inflation through the growth of the money supply. So the key point here is that while the inflation rate rises during a boom and falls during a recession, it generally does not go below zero due to a consistently increasing money supply.