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Difference Between Inflation and Recession

The main difference between inflation and recession is that inflation refers to the general increase in prices of goods and services, while a recession is a huge decline in business activities in the economy. Therefore, inflation affects households more, and recession affects businesses more.

inflation and recession

During inflation, your money decreases in value because the prices of goods and services increase. In short, the purchasing power declines. For instance, a packet of milk could be costing $20 before inflation. Then, the price increases to $25 due to inflation. It means that the value of the $20 bill has declined because it cannot afford to buy the same packet of milk it used to buy before the inflation.

Inflation makes people spend more money to meet their basic needs. As a result, their net income declines. High inflation levels may drain consumer savings and make others fall into debt. On the contrary, consumers usually have less money to spend during a recession.

A recession leads to reduced retail sales, production, and manufacturing. Consequently, unemployment rates increase because businesses cannot employ more people when making reduced sales. The table below has a simplified explanation of the differences between these two terms.

Key differences between inflation and recession

InflationRecession
General increase in price of goods and servicesGeneral decline in business activities
Causes a decrease in people’s purchasing powersCauses decline in retail sales
People spend more money to meet basic needsPeople have less money to spend
Affects households moreAffects businesses more
Caused by imbalance in supply and demand and supply shocksCaused by decreased production, economic contraction, economic shocks, monetary and fiscal policies
Measured using consumer price indexMeasured by the changes in the gross domestic product.
It is a continuous phenomenonOccurs only when there is a major economic change

Inflation

Inflation is undesirable, especially in less developed economies where the people’s purchasing power is generally low. Even in developed economies, inflation can be harmful if it is too high. Therefore, governments try to contain inflation to single digits. However, this is not always the case because the macroeconomic factors in the global markets significantly influence the local markets.

Many factors combine and push the prices of commodities up. For this reason, it is important to understand these factors and their contribution to inflation. Here is a simplified list of the major contributors to inflation.

Causes of inflation

The three major factors causes of inflation are supply shocks, imbalance in demand and supply, and market speculations.

1. Supply shocks

A market can experience supply shocks when external forces disrupt supply chains. For instance, wars or boundary conflicts disrupt oil and gas supply. In such cases, the price of the available oil in the market rises, causing inflation. You should note that an increase in oil prices is a major trigger of inflation in an economy.

Historically, supply shocks in the oil industry have always led to inflation. A good example is the supply shock caused by the Kuwait War. Iraqi forces invaded Kuwait in 1990 and destroyed major oil production facilities. Consequently, there were supply shocks in the global oil markets because Kuwait was a major supplier. The effect was an increase in prices of oil and petroleum products worldwide.

2. Imbalance in supply and demand patterns

Sometimes, the market forces of demand and supply fluctuate, causing supply or demand deficits. Additionally, a market can experience increased demand against constant or declining supplies. In such cases, the traders and retailers raise the prices of goods and services because they know customers are willing to buy them at higher prices.

3. Market speculations

Market speculations can cause inflation. For instance, when people anticipate that the prices of goods and services will increase, they demand higher wages. In return, employers and businesses increase the price of goods and services to cover the cost of the increased wages. As a result, inflation sets in.

The impact of inflation

1. Disproportionate impact on low-income households

Why are the low income-earners afraid of inflation? The low-income earners are the biggest casualties of inflation. These people have little money to spend on essential goods and services. They also spend a large proportion of their income on essential commodities, which are mainly affected by inflation. Therefore, they suffer the biggest loss due to the decline of their purchasing power.

2. Decline in consumer purchasing powers

All consumers of basic commodities suffer during inflation because they pay more, yet their wages do not increase proportionally. As a result, their purchasing powers decline, pushing them to poverty or lower living standards. The situation becomes worse if inflation persists for a long time.

3. Interest rates increase

Governments have strong incentives to keep inflation under control. In most countries, political leaders are keen to maintain low inflation rates to appeal to their voters. It is a common practice for governments in such countries to raise interest rates to increase borrowing costs. As a result, fewer people apply for credit, thus reducing the amount of money in circulation.

If the government keeps the interest rates at very high levels, the money in circulation declines significantly. Consequently, consumers have less money to spend, causing the prices of basic commodities to decrease. Therefore, increasing interest rates during inflation can help lower inflation rates.

4. Short-term economic growth

Inflation is not always bad for the economy as many people think. In fact, inflation has positive impacts on the economy. For instance, it can lead to economic growth and a decline in unemployment, but it only lasts for a short time. Inflation discourages people from saving because they know the purchasing power of their savings will decline. As a result, consumers spend more, and businesses invest more, leading to slight economic growth.

5. Can cause a recession

High levels of inflation can lead to stagflation. This phenomenon occurs when economic growth remains low, and unemployment rates remain high during inflation. Stagflation can lead to recession, which worsens the situation because the economy can collapse.

A good example is the stagflation that occurred in the US. In the 1970s, the United States economy was experiencing stagflation when it issued an oil embargo and initiated monetary and fiscal policies to control inflation. The economy experienced slow growth amidst high inflation levels. This example demonstrates that a recession is bad for the economy in the long term.

What to do during inflation

When there is inflation, the prices of basic commodities go up steadily. Inflation has been a fact of life for centuries because it is the nature of the global economy. Therefore, no one is immune to inflation.

Now that you are almost sure there will be moderate, low, or high inflation in your country, you better be prepared to handle the situation. Here is a list of tips you can follow to survive inflation.

  • Reduce spending

You need to reassess your spending habits and, if possible, reduce your spending. You may not reduce spending on basic commodities like fuel, eggs, agricultural goods, and gas. However, you can cut your spending on luxuries, vacations, and other unnecessary purchases. The goal is to ensure that you remain afloat during inflation.

  • Have a spending plan

What is a spending plan? It is an informal plan that helps you spend money in an organized manner. The plan includes your expected income and the planned expenses. It helps instill financial discipline because you will follow it when spending. You will avoid spending money on anything not listed in the plan.  

Humans are emotional creatures. Therefore, people may spend depending on emotions. This behavior could lead to unplanned and unwise spending. It is recommended that you should have a plan to avoid falling into the trap of emotional spending.

  • Invest wisely

Inflation should not stop you from investing. There are still profitable areas in which you can invest during inflation. For instance, you can invest in gold or silver, cryptocurrency, and savings bonds. However, you should know that these investment portfolios are also prone to risks during inflation.

  • Be patient

Inflation may decline in the future. Therefore, be patient with your money. Do not be in a hurry to make long-term investments during inflation because you are uncertain of the future. MyFinanceMasters advises clients to avoid making permanent decisions while they are in temporary situations. Remember that inflation keeps fluctuating, and you may find that the value of your investment has declined or appreciated.

Recession

No country wants its economy to fall into recession because it can collapse the economy. Therefore, countries initiate a raft of measures to prevent recession. However, some strong economic factors can overrun the measures set up by the government and push the economy into recession.

Causes of recession

1. Economic shocks

Financial crises can occur when a major event causes the economy to contract. For instance, in 2007-2008, the American economy experienced a shock when the housing market collapsed. The country plunged into recession. Then, the economic shock spread to other countries, leading to a recession in most Western countries.

2. Monetary and fiscal policies

Governments always initiate monetary and fiscal measures to manage the economy. The central bank issues the monetary policies, while the fiscal policies are the general regulations issued by the government. Monetary policies include interest rates, reserves, treasury bills, and bonds. On the other hand, fiscal policies include taxation and government spending.

Sometimes, these fiscal and monetary policies do not yield the intended results. As a result, the economy does not move in the intended direction. For instance, the government may employ contractionary monetary or fiscal measures that reduce business activities. Consequently, the economy will plunge into recession.

3. Inflation                           

Inflation can lead to recession because it can make raw materials and labor costly. As a result, many businesses cannot afford expensive raw materials or high labor costs, making them to scale down production and manufacturing. Ultimately, few business activities take place in the market, and the economy gets into recession over time.

4. Asset bubble burst

A bubble burst is a crash in the market where the value of assets falls quickly after rising rapidly. In short, a bubble burst is a sudden contraction after a rapid expansion of the asset value. The famous housing bubble burst occurred in the US in 2007/08 when housing prices crumbled. The economy went into recession afterward.

The impact of recession

A recession slows down business activities in the economy. Countries that experience recession often struggle to get their economies up and running again because the impact of recession is huge. Here are the major impacts of a recession on the economy.

1. Unemployment

Recession is always associated with an increase in unemployment rates. The logic behind this argument is the decline in production and manufacturing activities during a recession. As a result, businesses fire some employees and stop hiring new employees. Therefore, the number of unemployed people increases significantly.

unemployment

2. Slow economic growth

When the economy is in recession, businesses are generally not growing because they scale down their operations. In such cases, producers are reluctant to invest more money in production because sales are low. Consumers have little money to spend. As a result, little economic activities take place in the economy, leading to slow growth.

3. Slow wealth accumulation

Wealth is accumulated when business is booming, and investors are making profits. However, investors generally make little or no profits during a recession because retail sales are low. Therefore, there is a slow accumulation of wealth from business activities during a recession.  

4. Limited access to credit

During a recession, banks and credit lenders tend to be strict when lending money. They fear borrowers may not repay the loans or the lending cost is high. For this reason, major credit card companies limit the credit limits for their clients during a recession.

Is inflation better than recession?

Inflation is different from a recession, but the two terms describe economic changes. Neither inflation nor recession is good for the economy. However,  inflation is better than recession. The economy may benefit from inflation, but it only lasts for a short time. Governments prefer to keep inflation rates low and prevent the economy from getting into a recession.

The bottom line

Inflation is a common phenomenon in modern economies because each country experiences some level of inflation. On the other hand, a recession occurs only when there is a major economic change. You can rest assured that you will always experience inflation, although it may be moderate or extremely low. However, you may not experience a recession for a long time. It is advisable to ensure you have a plan to deal with inflation or recession to maintain your financial stability.