Michael Bryan, an economist at the Federal Reserve Bank of Cleveland, describes deflation this way: "Consider that the dollar is a metric by which we alter value," he says. "The Fed wants to keep that metric constant-where 12 inches is equal to a foot."
Say you live in a 4,000 square-foot house and want more space. So you order a 6,500-square-foot house today, measured with a 12-inch foot and contract to pay $150 a square foot. That's $975,000.
But in the nine months it takes to build the house, if the foot gets trimmed to just 11 inches, the house will actually measure 7,630 square feet when finished. If you had paid in advance, that $975,000 translates to $128 a foot. But if you pay on completion, you'll still owe $150 a foot for the "larger" house: $1.14 million.
That's inflation, Bryan says.
Deflation is when the measuring stick gets larger and larger-and the square footage gets smaller and smaller. If you arrange the same deal, but the foot grows to 13 inches during construction, your upfront payment amounts to $179 a foot for a 5,460-square-foot home. If, on the other hand, you contracted to pay $150 per square foot upon completion, when you measure the finished home, you'll owe $818,700.
The point? Inflation favors those who spend immediately, while deflation discourages spending.
That's where the Fed comes in. Says Bryan, "It keeps the standard absolutely constant so that only real fluctuations in the economy are seen. You can manage demand by raising and lowering interest rates when things are good or bad."