Let’s stipulate that CB inflation means that the CB inflates the money stock through bank credit creation so that the economy experiences 2 percent price and inflation and that CB deflation means that the CB inflates the money stock through bank credit creation enough to cause 2 percent price deflation. (Implicitly, then, we’re stipulating that economic growth of output is greater than 2 percent.)
Given those stipulated conditions, the effects of either price inflation or price deflation depend on how people adapt to them. To the extent that people correctly anticipate price inflation or price deflation, the effects are diminished. For example, if people correctly anticipate 2 percent price inflation, then entrepreneurs will bid input prices up today 2 percent higher than otherwise and the owners of inputs will accept 2 percent higher prices for their inputs without changing their supply of the inputs. The rate of return, then, would be unaffected. So there would be no wealth transfer between lenders and borrowers. Even if people only anticipate price inflation somewhat accurately, lenders will insist on higher interest rates to compensate for the price inflation they anticipate and borrowers will be willing to pay higher rates according to their anticipations of how much the purchasing power of money in the future will be diminished. Once again, these speculative activities reduce the wealth transfer from lenders to borrowers. Even the holders of money can reduce the erosion of their wealth from money’s falling purchasing power if they can adjust to receive the newly created money earlier in the social process of it coming into existence and then being spent again and again. It is in the micro-economics of the money creation process that the inefficiencies of monetary inflation reside.
A similar analysis could be done for the price deflation case. There, too, the ill-effects of price deflation are mitigated to the extent that people anticipate the price deflation.
In both the price inflation and price deflation cases, the inefficiency from CB monetary inflation and credit expansion comes from the micro-economic distortions in prices, profit, production, and investment. This inefficiency occurs whether or not the monetary inflation and credit expansion generates price inflation or price deflation. CB monetary inflation through bank credit creation pushes the interest rate below its time-preference level and the borrowed money gets spent along particular lines of production, for example housing, which alters the profitability of production processes ancillary to housing. Patterns of production, resource allocation, and investment shift during the boom. The bust inevitably follows in which the malinvestments are liquidated and the capital structure reconfigured to satisfy time preferences.
For more details on how the boom-bust cycle has played out in its current iteration, take a look at Joe Salerno’s article: