INFLATION AND DEFLATION. If we define inflation as an abnormal increase in the quantity of purchasing power, and deflation as an abnormal decrease in the quantity of purchasing power, the first issue which arises is : under what technical con ditions are inflation and deflation respectively possible? This question cannot be answered without taking into account the circumstances which lead to inflation and deflation. Inflation is necessarily accompanied by a fall in the value of money per unit: deflation is accompanied by a rise in the value of money per unit, and these changes in the value of the monetary unit in themselves mainly depend upon the degree of inflation and de flation and on the psychological reactions thereby set up.
The object of inflation is not the increase in the volume of purchasing power for its own sake. Purchasing power is in creased for the purpose of increasing the consuming power of a given social group. In the modern world the two groups of most importance in this connection are Governments and business men (including both producers and traders). Governments require consuming power at all times, but particularly in periods of war, and in this case require it on an unlimited scale. For psychologi cal reasons that is, "to keep up the war spirit" heavy taxation is unpopular. Borrowing in a form which diminishes spending power by the lenders has equally its limits. Governments resort to in flation, to an increase in the volume of money, and, since they can alter legislation if that stands in the way, they proceed to do so. The fundamental condition is that if inflation is to be practised the currency must no longer be fixed in amount. This implies in practice that the currency, if linked directly or indi rectly with a metallic standard, must be released from such de pendence. It must be made inconvertible into gold or foreign exchange, and must be freed from any legislative limit restrict ing its amount. Business men desire to borrow more whenever they believe that trade prospects are improving. If the currency is linked to gold or some other metal, their borrowing has the effect of imperilling the gold or foreign exchange reserves of the banking system. The consequence is that the banks in their own interests are driven to restrict inflation to the degree con sistent with the maintenance of the standard. Government re lieves, or can relieve the banks of any such limit, and, having freed the banks, can bring powerful pressure to bear to exploit the freedom conf erred.
Deflation to be possible to an unlimited extent also requires a currency system not linked to any metallic standard. But, in contradistinction to inflation, it is not likely to be carried to any considerable extent, even if the technical conditions permit of it. Deflation involves a rise in the value of money and therefore increases the value of debts. Even if, in the interests of prestige or of social justice, a Government desires to deflate, it will hesi tate to do so if the amount of deflation required is considerable: it would prefer to devaluate the currency, that is, to give it a fixed value in terms of gold lower than the value before inflation. In practice, since inflationary legislation does not repeal the right to obtain currency for gold or foreign exchange but only the right to obtain gold or foreign exchange for currency, the limit to deflation comes when the local currency threatens to become more valuable than gold: gold is then presented in exchange for local currency and the fall of prices is checked. When deflation is enforced by banks in order to restore their reserves of gold or foreign exchange after they have been threatened by a busi ness boom the amount of deflation involved is relatively small because the previous degree of inflation has been small also.
The pursuit of an inflationary policy by Government neces sarily involves an "unbalanced budget," that is, a budget which can only be balanced if the surplus of expenditure over revenue is met by means of inflation, so long as the Government inflates by means of its own notes. If the inflation takes the form of loans by a bank to those who only borrow for re-lending to Gov ernment, there will be concealed inflation. When a Government proposes to deflate, that is, to reduce its own note circulation, it must necessarily have a surplus : that surplus of income over expenditure it applies to wiping out the excess notes. When it has itself borrowed from a bank, it must use the surplus to can cel indebtedness to the bank and the bank must use the proceeds to cancel notes. The same is true when the Government has borrowed from third parties, who have themselves borrowed from a bank. The surplus revenue flows from the Government to its creditors, from these to the lending bank or banks, and is by them utilised to cancel purchasing power. If the banks were to re-lend the money repaid to them, there would be no deflation. In the case of inflation and deflation originating in connection with the movements of trade and production, there is of course no difficulty in understanding how the purchasing power is issued and withdrawn : inflation swells the commercial loans and the liabilities of the banks to their customers : deflation involves repayment of loans, a reduction of the assets in the shape of dis counts and overdrafts and a cancellation of deposits and of currency.
The unwillingness to accept a currency the value of which is constantly falling is part of the very complex economic conse quences which flow from inflation, consequences which have been illustrated on a tragic scale in Europe, in particular in the period 1919 to 1925, because the degree of inflation was then far in excess of anything previously known.
Inflation, in so far as it is relatively moderate, will not much affect the willingness to hold money, and operates simply to in crease the proportion of the total income (real and nominal) falling to the beneficiaries of inflation. But rising prices act as a stimulus to producers and to this extent invigorate forces tend ing to mitigate the rise in the price level, whilst at the same time unemployment falls, since real wages lag a little behind prices and the real cost of labour to the employer therefore falls. But if inflation reaches such a stage that the fall in the value of money becomes obvious everyone will try to protect himself against the further fall which is then expected. Goods are bought so far as they are available : everyone will hold real things, if possible, rather than money. The liquid capital, that is, money stocks of employers, diminishes in value : they try to protect their profits by expanding their fixed plant. Traders holding stocks of goods will be reluctant to sell since prices may go up still more. The workers push up money wages and, the time-lag being wiped out, a particular source of profit to employers disappears. The "flight from the currency" withdraws part of the funds available abroad, so that the supply of raw materials, etc., falls off. The constantly rising price level produces "paper profits" and stimulates extrava gance. The result of all these factors is that there is a mal distribution of capital between fixed and liquid forms : that the aggregate of all savings declines and that the national income falls off in total amount. In the end no one has benefited from inflation ; everyone would have gained from its cessation at an earlier stage.
The direct effects of deflation on the relative position of differ ent social classes are the opposite of those of inflation. Deflation involves falling prices ; it therefore reduces the money yield of taxation, reduces the profits of business men and of traders, and adds to the real income of all classes of the population whose money incomes are fixed, whilst prices are falling. It has there fore the effect of increasing the weight of all fixed debts; a par ticularly important matter after a great war when the National Debt stands at a large figure. Since deflation involves falling prices, it increases the volume of unemployment and diminishes the inducement to hold stocks of goods, since these are falling in value. On the other hand, since prices are falling deflation makes saving easier, and since it involves, owing to industrial de pression, a slackening in the demand for fresh industrial capital, it is accompanied by falling interest rates, which facilitate con version operations and thus mitigate the burden of fixed charges. The falling yield of taxation is thus offset in part, by the fall in expenditure on current goods and services, in part by the fall in interest rates.
For reasons already set forth, the practical limits of deflation are reached sooner than the practical limits of inflation. Severe though the sufferings imposed by deflation may be (particularly when represented by widespread unemployment) it is not doubt ful that the sufferings actually covered by inflation have in Europe been much greater than those imposed by deflation ; for the degree to which the value of money has been raised by defla tion has never been equal to the degree to which inflation has in special cases reduced it. (See further, QUANTITY THEORY OF MONEY ; MONEY ; CURRENCY.) (T. E. G.)