Disinflation and Deflation - Video Tutorials & Practice Problems

Disinflation (Paul Volcker)

Alright 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 disinflation. There's still inflation during disinflation. We still have positive inflation rate but at a lower rate than usual. Okay so if maybe our our inflation rate was 10% and now it's 8% and then 6% and 4% notice inflation is still positive but at a lower rate that's 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 19 seventies and eighties had a lot of inflation and then the Fed the Federal Reserve Chairman paul Volcker uh had monetary policy that combated the inflation and brought it down. Okay so let's go through this example together during the 19 seventies the USa experienced high inflation rates. Okay so if you look on this graph around here, we've got the 19 seventies 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 noticed what was happening on 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 um during that Paul Volcker period. So in 1979 President Jimmy Carter appointed Paul Volcker as the chairman of the Federal Reserve. Remember the Federal Reserve does monetary policy, right, monetary policy with the money supply and interest rates. So Voelker's strict anti inflation monetary policy brought down inflation from 10% down to 4% so that's disinflation, right? It was 10% and they 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 used to combat inflation, right? We we contract the economy, we bring down the money supply um and it brought down inflation but it increased short run unemployment and that's what we would expect. Um from from our short runs phillips curve, right? We've seen this inverse relationship as as inflation goes down as we combat inflation and bring it down. Well, unemployment is gonna 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 on our phillips curve. So here we've got the inflation rate on the Y axis and then we'll have the unemployment rate right 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 .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 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. Well in the short run we had a lot of extra unemployment because of this uh 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, is that the workers and the firm's lower their expectations of future inflation? Right. And that that is a determinant of our short run phillips curve. So when there's lower expectations of inflation, what shifts are 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 a new equilibrium with a lower uh inflation rate. So what's gonna happen is in the long run we're gonna 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 four inflation and we're back to our natural rate of unemployment. Okay, so that's what paul Volcker did his, 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 uh 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 was um help combat that inflationary period. Now, what you'll see is the 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 one right there happening and then the long run, the expectations came down and there was point to kind of like on our graph over here. So number one 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 uh down the curve and then a new short run phillips curve uh to the left there. Alright, 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 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 um those down. Alright, so let's look at these two subsections of of U. S. 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. Mhm. 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 gonna write that here negative. Now look at the next 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 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. Okay.