In very simple terms, a price-rise is inflation and a fall of price is deflation. Both co-existing and maintaining a balance is good for economic growth. However, in extreme both are dangerous for the economic growth.
In the economic sense, Inflation is defined as an increase in the prices causing a fall in the purchase value of money. It is the rate at which level of prices of various goods and services rise thus causing a decrease in the purchasing power of currency. For a smooth running economy, it is important to avoid deflation and limit inflation.
Deflation is exact opposite of inflation. It is a reduction of the prices in economy. This leads to shrinkage in the money that is being supplied and circulated. During deflation, the currency purchasing power and wages are much higher than they what they should be otherwise.
How do Inflation & Deflation occur?
As said before when the prices rise, there is inflation and a dip in the price level causes deflation. It is a very fine balance between the two and the economy can quickly swing from one side to the other.
Inflation occurs when the gap between supply and demand widens. For example, recently, milk ws short of supply in Maharashtra since most the dairy went on a statewide strike. Under such circumstances, milk from other states had to be imported. This is resulted in a high demand but limited supply of milk to the state. When there is a high demand but a drop in availability, consumers tend to pay higher for the commodities. This causes suppliers, service providers and manufacturers to charge higher thus setting in inflation.
On the contrary, when there is a surplus of goods but not enough currency under circulation for those particular goods, deflation sets in. For example, cars are very popular. A particular car manufacturer releases a family car which is more economical and fuel efficient. The car becomes very popular. Seeing this, other manufacturers also manufacture similar cars with perhaps better designs, variations, to compete with the original one. Quickly enough, car companies have more vehicles belonging to this popular style than what they can actually sell. In order to sell these, the prices must drop. The problem now is cost cutting. They have too much inventory and cost must be cut somewhere. The most common way to combat this is to lay-off employees. Unemployment sets in- people do not have enough money and so they must cut costs- the cycle continues.
Also Read : What is Repo Rate?
How are Inflation & Deflation controlled?
When the cost cutting trend sets in credit providers detect the decrease in price. They then reduce the amount of credit that they offer creating a credit crunch. In case of credit crunch, consumers are unable to access loans or purchase items resulting in major expenses like cars, going on vacations, etc. This results in over-stocked inventory with the company and deflation sets in further. If not checked in time, it can even lead to economic depression. Central banks are usually working round the clock to ensure that this does not happen. They swing into action as soon as deflation starts to stop it.