Why do prices rise and fall?

Prices of goods and services in a free market are determined by the forces of demand and supply. Thus you cannot have constant prices unless and until you have a constant demand for these good as and services along with a constant rate of supply
In general it is observed that demand increases faster than the supply which leads to an increases in prices over a period
However in unusal times, when demand falls you may actually see a fall in the general level of prices, which in technical terms is called “Deflation”
An increase in the general level of prices implies a decrease in the purchasing power of the currency.  That is, when the general level of prices rises, each monetary unit buys fewer goods and services.

Is deflation healthy?
Both, a high level of inflation and deflation impact the economy adversely

It is believed that moderate inflation over a period of time is good for the economy because it encourages producers to increase output

However, a high level of inflation or deflation has the opposite effect.

If inflation rises to very high levels then…

It reduces the purchasing power of the money in the hands of the people….

Resulting in a slowing down of demand for the goods and services produced….

Which in turn compels providers of these goods and services to reduce output

On the other hand, a deflationary scenario makes the production of these goods or services less lucrative and so encourages producers to reduce output.

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Type of Inflation

Demand Pull Inflation is caused by the presence of excess money in the system which leads to increase in aggregate demand in the system.  It’s a classic case of “Too much Money chasing Too Few Goods”

This kind of inflation can be controlled by monetary measures such as high interest rates and by asking banks to maintain high case reserves.  These measures act as breaks on money supply.

Cost Push Inflation on the other hand has been caused by supply side constraints.  The high cost of labor or raw materials may force producers to increase the prices of their goods and services.  High crude oil and food prices are examples of supply shocks leading to unexpected increases in prices of their goods and services.

This kind of inflation requires a more careful use of monetary and fiscal measures

Built in inflation is a type of inflation that resulted from past events and persists in the present.  It thus might be called hangover inflation.

Often linked to the “price/wage spiral”, as it involves workers trying to keep their wages up with prices and then employers passing higher costs on to consumer as higher prices as part of a “vicious circle.”

In this case, inflation encourages inflation to persist, which means that the standard methods of fighting inflation using either monetary policy or fiscal policy to induce a recession are extremely expensive, i.e., meaning increase in unemployment and fall in real GDP.  Hence, alternative methods such as wage and price controls may be needed as complementary to recessions in the fight against inflation.

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