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Deflation – What It Is And How It Works

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Deflation is defined as a decline in the general price level of goods and services over time. Deflation occurs when the economy experiences a negative inflation rate, i.e. inflation rate falls below 0%. Deflation increases the purchasing power of money, allowing one to buy more goods and services with the same amount of money. Economists generally contend that deflation is a problem in a modern economy because it creates a vicious spiral of falling profits, shrinking employment and incomes, and increasing defaults on loans by individuals and companies. During the Great Depression of the 1930s, the United States experienced a long period of deflation. More recently, Japan has been in the throes of deflation for more than a decade.

ia-deflation-cycle

 

Causes of deflation:

The following are the major causes of deflation:

  1. Decrease in money supply: If a government adopts contractionary monetary policy, it makes credit more costly by raising the interest rate. In an economy based on credit, customers will choose to spend less, forcing sellers to cut prices.
  1. Increase in productivity: Development of new production processes help increase efficiency, which brings about lower prices, thereby triggering deflation.
  1. Reduction in Government expenditure: Deflation can be the result of decreased governmental spending, which causes national income and employment to drop, and leads to a fall in aggregate demand and investment.
  1. Heavy taxes: A big rise in taxes reduces the disposable income in the hands of the people. This exerts pressure on both consumption and investment expenditure, and results in a deflationary spiral.
  1. Increase in economic inequality: An increase in economic inequality means the rich get richer and the poor get poorer. And, since the marginal propensity to consume of the rich is less than that of the poorer class, increasing inequalities of income and wealth will reduce consumption expenditure and encourage deflationary conditions.
  1. Public borrowing: If the government decides to borrow from the public, it will result in the transfer of money from the public to the government, which should also reduce aggregate demand and cause deflationary situation in the economy.

Effects of deflation:

Deflation may have any of the following effects on an economy:

  1. Reduction in business revenues: Businesses must significantly reduce the prices of their products and services to stay competitive. As a result, their revenues start to drop.
  1. Wage cuts and lay-offs: When business revenues start to drop, companies resort to slashing wages and cutting positions to control their expenses and meet their bottom line.
  1. Decrease in spending: Consumers, who have lost their jobs or taken pay-cuts, also start decreasing their spending to offset the loss of income.
  1. Reduced credit: As lenders realize that financial position of borrowers is more likely to deteriorate as employers start cutting their workforce, they quickly begin to pull the plugs on many of their lending operations.
  1. Fall in investment: In times of deflation, investors are more likely to consider cash as one of their best possible investments. Deflation also discourages private investment, because there is reduced expectation on future profits when prices are set to fall.
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David Waring

David Waring

David Waring was the founder of LearnBonds.com and has been a major contributor to the extensive library of investing news and information available on the site. Until the launch of Learnbonds.com in late 2011 there was no single site on the internet catering exclusively to the individual bond investor. This was true even though more individuals own stocks than bonds. Learn Bonds was launched to fill that gap.

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