What's the Difference Between Inflation and Deflation?
Inflation is the expansion of money and credit in an economy.
Deflation is the contraction of money and credit in an economy.
That is the simple difference between inflation and deflation, but there’s a deeper story.
The source of the difference between inflation and deflation lies in the ebb and flow of social mood. In the 1930s, R.N. Elliott discovered that the stock market (and hence the economy) progresses in a series of distinct and repeatable patterns which he called waves. The five-wave advance, three-wave decline fractal structure of growth means that the economy should, indeed, perennially advance as most people believe. However, the fractal nature means that the punctuations in economic growth (i.e., retrenchment, aka recessions or depressions) will, at various times, be deep and long-lasting.
What Elliott had discovered was that economic, and hence societal, progress is patterned and because the economy is driven by the collective mood of society, social mood is therefore patterned according to the Elliott Wave Principle.
When social mood is trending positively, people feel good about their circumstances and are inclined to behave accordingly. They buy stocks because they are optimistic about the future and, among many other manifestations of positive social mood, they also borrow and take on debt. Therefore, a positive social mood is accompanied with an increase in debt (or credit) – that is (one key part of) inflation.
When social mood is trending negatively, on the other hand, people feel bad about their circumstances and are inclined to behave in a negative way. They sell their stocks because they are pessimistic about the future and, also amongst many other manifestations of negative social mood, they do not take on new debt and seek to reduce their existing debt (or credit) – that is (one key part of) deflation.
The chart below is from Robert Prechter’s “Conquer the Crash” and it shows the economic results of major mood trends going back to 1700. Notice how progress is always made (prosperity) despite setbacks (depression).
Inflation of money and credit accompany these periods of prosperity while deflation of money and credit accompanies depressions.
What About Inflation and Deflation Prices?
You will notice that we have not mentioned prices yet. Almost every explanation you will find with regard to the difference between inflation and deflation will be about prices. “Inflation is a rise in the general level of consumer prices and deflation is a fall in the general level of consumer prices,” is the standard statement from almost everyone. They are wrong and correct at the same time.
Price changes, particularly consumer price changes, can occur for many reasons such as wartime shortages or harvest gluts. That is why the true definition of inflation and deflation is the monetary one – inflation is an expansion of money and credit; deflation is a contraction of money and credit.
The quantity of money and credit in an economy can have an effect on consumer prices as well, but the relationship is not symbiotic. Back in the 1970s, famed economist, Milton Friedman, stated that “inflation is always and everywhere a monetary phenomenon,” reinvigorating the Quantity Theory of Money which posits a direct link between the amount of money in an economy and the general level of consumer prices. While there have been cases in history where this is true, such as in Weimar Germany during the 1920s, there have also been periods when the theory has proven to be flawed. The quantity of money in many economies grew very strongly from 2009 but the rate of change in consumer prices remained subdued.
The fact that consumer prices can change for any number of reasons means that defining those changes as deflation or inflation is problematic. At best, we can contextualize it by referring to a positive rate of change in consumer prices as price inflation and a negative rate of change as price deflation.
What is Disinflation?
A term you may hear a lot is disinflation. This refers to a situation whereby inflation is slowing. That is, when the rate of change is still positive, but that rate of change is declining. As an example, suppose the annual rate of change was 3% in year one, 2% in year two and 1% in year three. That declining trend in the rate of change is known as disinflation. Note that the price or cost of the underlying vehicle is question is still rising, just at a slower pace.
Once again, though, be careful as to what disinflation refers to. Most people will refer to it in the context of consumer prices. In the correct, monetary definition of inflation and deflation, though, disinflation refers to the situation whereby the positive rate of change of money and credit in an economy is slowing down. Once that rate of change turns negative, of course, it would be defined as deflation.
Inflation and Deflation Mindset
Thus, there is a plain mathematical difference between inflation and deflation. Inflation is when the rate of change is positive; deflation is when the rate of change is negative.
However, the underlying driver of those outcomes is the mindset of society as a whole, that is, crowd psychology, or, as we prefer, social mood. And the best model to view the ebb and flow of social mood is the Elliott Wave Principle.
When social mood is trending positively, people buy stocks, the economy grows and debt (or credit) inflates. On the other hand, when social mood is trending negatively, people sell stocks, the economy contracts and debt / credit deflates.
So there you have it, the difference between inflation and deflation and some common manifestations of each so you have a better handle on what’s going on!