Deflation is a general sustained reduction in the price level of goods and services. While inflation boasts an increase in prices, deflation states that the cost of living is falling, but it can also have unfavorable economic impacts. Here’s a closer look at deflation, including its causes and how perceptions about its impact have shifted over time.
Deflation Overview
Deflation occurs when an economy experiences a situation where the inflation rate is lower than zero and produces a downward drift in prices in sectors that surround the economy. This can be sectorial or cross-sectorial, and very often it is an indication of weak demand as well as lower spending by the consumers and the business community. Deflation lowers the purchasing power of money; that is, each unit of money can now buy more as prices fall. This may sound better than inflation, but deep and entrenched deflation can create a vicious circle in economic growth.
When a phenomenon of deflation starts to occur, people as well as firms tend to wait for the prices to fall further before spending and investing. As a result, less amount is spent and invested, which decreases the economic activities and consequently, the incomes of businesses drop. This will start causing lower wages, reductions in employment and subsequently lower consumer spending accelerating the problems with the economy.
Causes of Deflation
Deflation has many causes, and in most cases, it results from the compounding of several forces that bring lower prices. The primary causes are as follows:
Reduced Aggregate Demand
One of the commonest reasons for deflation is the fall in aggregate demand that has emerged because of lower consumer confidence, lower disposable incomes, or saving rates. The more consumers and businesses spend less, the fewer demands for goods and services exist, and the lower prices are. This was quite evident in the Great Depression when a fall in consumer spending brought forth all-round deflation.
Increased Productivity and Technological Advancements
Improvements in productivity are usually associated with lower production costs and higher supply, and so with falling prices and deflation. It is possible for firms to pass on some of their savings through increased productivity in the form of lower prices to consumers. That “good” deflation helps consumers buy goods at a cheaper price, yet it still can exert pressure on overall economic growth if it creates excess supply that dwarfs demand.
Debt Reduction and Credit Contraction
Consumers and producers inevitably seek to reduce debt but also to stop increasing or even reduce debt during recessionary times. This process is commonly called deleveraging. As spending declines and the velocity of money in the economy declines, deflation may occur. Furthermore, tight credit conditions directly restrain borrowing and reduce spending and investment.
Money Supply Decrease
Demand-pull deflation also occurs when the money supply shrinks, whereby fewer dollars are circulating in the economy. Fewer dollars might result from a tight money policy, for example, when during the 1930s the US Federal Reserve entered the fray and tightened monetary policy. Fewer dollars mean fewer expenditures and hence lower prices of goods and services.
Heightened Global Competition and Low Import Prices
Increased globalization has seen the cost of many consumer goods decline as companies can buy products and labor more cheaply in other countries. Low-priced goods have also entered the developed world, which keeps prices there low. This is another external cause of deflation, which has been nicknamed “imported deflation.”
Changes in Perceptions over the Impact of Deflation
The knowledge and perceptions about deflation have evolved over time, largely through the experiences of economists and policymakers in the manner in which it affects different economies.
Classical Approach: Deflation as an Evil Economic Phenomenon
Traditionally, deflation was regarded almost solely as an evil economic phenomenon. Economists believed that when deflation would occur, there could be a vicious cycle of reduced spending, lower demand, reduced profits, and increased rates of unemployment. This view was mainly shaped by the Great Depression, when increasing unemployment and an ailing economy experienced a period in which deflation and inflation were closely in line. Most economists assert that this enhances the real value of debt, putting additional pressure on debtors and worse chances on recovery from an economic downturn, now called the “debt-deflation” theory introduced by economist Irving Fisher.
Modern Distinctions: “Good” vs. “Bad” Deflation
During the last few decades, economists have learnt to understand that deflation is not always bad in itself. There is such a thing as “good deflation”. It occurs when positive technological changes and productivity advances lead to a drift downward in prices without hurting the economy, thereby increasing the purchasing power of consumers. The price of computers and smartphones has decreased every year due to the tech industry innovations without causing any negative impact on the economy. Such a supply-side-related deflation leads to an increase in demand since the products become relatively cheaper.
But “bad deflation” is a situation in which lower prices arise from low demand, and with those stems reduced economic activity as well as possible recession. In such a situation, the sequence of decreased demand and lower prices might become a self-reinforcing process of lower demand and lower prices, reverting to economic stagnation and job loss as experienced in Japan’s “Lost Decade,” were persistent deflation limited growth.
The Role of Central Banks and Monetary Policy
Traditionally, central banks have been more worried about avoiding deflation than even slight inflation. This is partly because low prices can reduce the effect of monetary policy if interest rates are already low. In the recent few years, central banks implemented policies or tools that can be regarded as unconventional, as seen with the injection of money into the economy to prevent deflationary spirals.
Conversely, in high-productivity and low-cost import economies, central banks often ignore mild deflation, provided that it is accompanied by economic growth. A few economists argue that the economy will not be really hurt if there is a low level and stable rate of deflation; however, still, they prefer a low, stable rate of inflation, as the general policy target.
Current Views: Persistence Deflation Risks
Even though economists have distinguished between types of deflation, there remains still anxiety regarding the prospective dangers of persistent inflation. As soon as the population expects it, consumers can also defer purchases so that reduced demand can reinforce a spiral of declining prices further. Deflation also increases the real burden of debt for consumers and governments alike as currency appreciates against fixed loan amounts.
Low interest rates also renewed the controversy over the idea of “secular stagnation” – slow economic growth, and growing difficult to get inflation at low interest rates. In this case, persistent deflation may further worsen economic doldrums since it has in Japan, where the country has been able to live with a low-growth economy and deflation for decades.
Conclusion
Deflation is a rather complex and multi-dimensional economic phenomenon. As opposed to traditional views relating mostly to the negative consequences of such an economic phenomenon, the new vision appreciates a fact that at times deflation may originate from the positive trends, such as technical progress and productivity growth. However, at the same time, the persistent inflation fueled by low demand and weak economic activities may still pose critical risks – decreased.