Information, correlation, application… many words end in "ation," but for now there are only two you need to worry about: inflation and deflation. In 2007 and early 2008, the economy was in an inflationary period (remember $4/gal gas?); however, by late 2008 and early 2009, gas had plunged to $1.84/gal and deflationary fears surfaced. But what do inflation and deflation mean, and how do they affect you?

Inflation and deflation are opposites like good taste and Speedos on a public beach. According to investopedia.com, inflation is the "rate at which the general level of prices for goods and services is rising." Deflation is "a general decline in prices, often caused by a reduction in the supply of money or credit" and/or by "a decrease in government, personal or investment spending."

The important thing to remember is that low and steady inflation can promote economic growth, but deflation can lead to a downward economic spiral. Clear as mud? Here's the breakdown.

Inflation happens when there's an increase in money supply. There are two main theories about what causes inflation: 1) higher demand for goods than supply (demand-pull), or 2) increasing costs that cause companies to raise prices (cost-push). Either way, as prices rise, consumers spend based on the idea that products will cost more in the future and the dollar will purchase less. Demand for products increases and prices rise to match demand, so the purchasing power of the dollar shrinks--inflation. The upshot is that steady, controlled inflation stimulates economic growth. Most countries try to maintain a steady inflation rate of 2%-3% per year--a $6 burger would cost between $6.12 and $6.18 next year.

To manage the inflation rate, the Federal Reserve (the central bank of the United States, known as the Fed) regulates the money supply. They can put new money into circulation by purchasing bonds on the open market, and the money used to purchase the bonds is then distributed, in the form of loans, by the institutions selling the bonds. The money supply increases as this new capital enters the system and prices on goods inflate, or rise, to match the influx. To slow inflation, the Fed can raise the federal funds rate--the target rate at which financial institutions loan money to each other--which restricts the money supply.

Keeping inflation at a steady rate benefits the economy by allowing businesses and consumers to make long-range plans unhindered by the fear of rapid inflation, because they know that their money will maintain a relatively steady value.

In 2008, the U.S. inflation rate (based on the Consumer Price Index) was 0.1%--the lowest rate since 1954. But all the money flowing into the economy from government packages is increasing the supply of money, which will likely raise the inflation rate. This could raise consumer prices--meaning that you'll pay more for products--but will also pour money back into the system. The danger is that it could cause high inflation. But the alternative is worse.

Deflation is like an economic spiral staircase heading downward. Falling prices lead to falling consumer demand for money, because each dollar purchases more. As prices fall, so do businesses' profits. Falling profits lead to job cuts. Job cuts lead to falling income, which leads to loan defaults, debt and restricted spending.

Spending is the lifeblood of capitalism, and as spending dries up the economy shrivels like a raisin. Less spending forces producers and businesses to lower prices to encourage spending. But lack of disposable income, economic uncertainty, or the belief that prices will drop further in the future causes consumers to hold on to their money rather than spend it. This encourages further price cuts and the cycle spirals downward.

When deflation spirals toward its nadir, the chain reaction can be a factor in events like the Great Depression--a period that caused economic chaos on a global scale.

In early 2009, deflation (and increased unemployment) became a big topic and spurred the U.S. government to take steps to revive the economy. These included reintroducing credit-market liquidity; spending on infrastructure, tax breaks, unemployment benefits, health care, and state budget relief; and lowering the federal funds rate to 0%-0.25% to increase the supply of available money. Theoretically the influx of all that money should kick-start inflation and grease the economic gears.

Sources:

investopedia.com; reuters.com; time.com; bankofcanada.ca; xinhuanet.com; telegraph.co.uk; bls.gov; bizjournals.com; businessmirror.com; consumerreports.org; economist.com; bankrate.com; nytimes.com; econlib.org; frbsf.org; businessweek.com; federalreserve.gov; npr.org; foxnews.com; finance.yahoo.com; msnbc.msn.com; iht.com; fool.com