What is The Difference Between Inflation And Deflation?
Inflation can occur when there is a high demand of a particular product and/or service – but there is a low supply of that product.
Supplies can decrease for many reasons, but let’s take a focus on our particular application: real estate.
For example, if people are looking to move into a neighborhood that’s really enticing but there is only one house available for sale, then the price for that house is going to be inflated. There is a high demand for the neighborhood, but little supply.
As such, the value of the house skyrockets because people are going to pay more for that house due to the high demand.
Thus, the price is inflated.
Inflation is tracked by the U.S. government using the consumer price index (CPI) to achieve an understanding of the purchasing power of the U.S. dollar.
As we’ve noted, inflation can be both good and bad, depending on the reasons and level of inflation. In fact, a complete lack of inflation can actually be bad for the economy.
Small amounts of inflation actually encourages spending and investing, as inflation can slowly abrade the buying power of cash. Therefore, it can be theoretically less expensive to buy a $400,000 home today than to buy the same $400,000 home in a year from now.
Deflation occurs when there are too many goods available, or when there is not enough money circulating to purchase those goods.
As a result, the price of goods and services drops.
For instance, let’s go back to our neighborhood example from above. If residents of that neighborhood see the demand for their homes, they might decide to sell their home as a response.
The problem is that the more that neighbors decide to put their homes on the market, there will be a larger supply.
That supply might be just enough to satiate the demand, or it might exceed the demand. Either way, the value of their homes will go down because people have more opportunities to enter the neighborhood than before.
Thus, the prices will go down and are thereby deflated.
Deflation can lead to an economic recession or depression, and our financial institutions try very hard to stop it as soon as it begins.
For the most part, credit providers will largely reduce the amount of credit available to the public when they detect a deflation of prices. Obviously, this is a problem because it creates a credit void where consumers cannot obtain loans to purchase big-ticket items like homes or cars. Once that happens, it leaves companies with too much inventory and causes further deflation because they have to reduce the prices in order to rid themselves of the inventory.
The main problem with deflation, however, is how people and businesses both begin to hold cash reserves in order to cushion themselves against any more financial losses.
This is a problem because as more money is saved, less money is spent. If less money is spent, that means there is less of a demand, and the value of homes will begin to plummet because no one is buying them.
In turn, people have less incentive to spend money today when their money could potentially have more purchasing power next year (within reason of course).
At the end of the day, neither inflation or deflation is inherently good or bad for the economy. However, it’s important to understand when one is picking up so that you can protect your real estate portfolio.
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