Deflation is an economic phenomenon that occurs when prices of goods and services decline over time, effectively increasing the purchasing power of money. While this might sound beneficial to consumers, deflation can have far-reaching consequences for the economy, often signaling a slowdown in economic activity. It can lead to decreased consumer spending, falling wages, and rising unemployment, ultimately triggering a recession. In this article, we will explore the causes and effects of deflation, how governments attempt to control it, and the evolving perspectives on its impact.
What Is Deflation?
Deflation is a state where over time, consumer and asset prices decrease, thereby increasing purchasing power. In other words, with the same amount of money, you can purchase more goods or services in the future compared to what you can today. This is exactly opposite of inflation, which means the gradual rise of prices in the economy.
While deflation can sometimes offer temporary benefits, it often presages an encroaching recession and economic hard times. If people believe prices will continue to fall, they will delay making purchases in anticipation of better bargains later. This reduction in spending means less revenue for businesses and may translate into unemployment and higher interest rates.
That would build into a negative feedback spiral: less spending leads to higher unemployment, which in turn cuts spending even more and forces prices down still further. Deflationary periods in the United States have almost always accompanied sharp economic downturns.
Causes of Deflation
The famous economist Milton Friedman argued that the nominal interest rate under optimal monetary policy should be zero. This policy calls for a central bank to target a deflation rate equal to the real interest rate on government bonds. Under his hypothesis, one would then expect the price level to fall steadily at the real interest rate. In other words, this is called the Friedman rule-a rule for monetary policy.
Other causes of falling prices are decline in the level of aggregate demand and productivity improvement. When aggregate demand declines, which is usually caused by a decline in government expenditures, stock market crash, increased consumer savings, or tighter monetary policy that involves high interest rates, the prices also drop.
It is natural, of course, for prices to fall when the growth of an economy's output outpaces growth in money and credit, and technological improvements in productivity often provide the catalyst for such events, particularly in those sectors that benefit most directly from such breakthroughs. So, it is with technology helping to achieve an increase in efficiency, enabling companies to cut production costs, and savings are subsequently passed on to consumers by reducing prices.
This is price deflation from increased productivity, not generalized price deflation, which is where the general level of prices falls and money becomes worth more. A few examples include technology, where the normal and average cost of a gigabyte has come down so fast. One gigabyte of data, which cost $437,500 in 1980, had its cost fall to three cents in 2014. This has brought the cost of data down by as much as a factor of three, making the products based on the technology pretty much cheaper.
Effects of Deflation
Deflation often accompanies recessions and is a disinflationary event that has several adverse effects:
Rising Unemployment: With falling prices, businesses may attempt to reduce costs through labor force reductions, which would increase the unemployment rate in the economy.
Increased Real Value of Debt: Deflation is generally associated with increased interest rates, thereby raising the real value of debt. The sudden rise in the debt burden may drive consumers to delay spending.
Deflationary Spiral: A deflationary spiral can be initiated through a prolonged downward movement in prices, such that falling levels of prices would result in lower production, reduced wages, and ultimately lower demand levels and further declines in price. This exacerbates the economic downturn and makes any resulting recession much worse than it otherwise would have been.
Controlling Deflation
The government has few strategies to fight deflation:
Increase the Money Supply: RBI can buy treasury securities, thus giving more money to the economy. With higher money supply, the value of each rupee goes down and that encourages spending, raising prices.
Ease Borrowing Conditions: On the contrary, if the RBI takes such a move that may spur the banks to give more credit or at less expensive rates, people can borrow with ease. In this context, the RBI reduces the reserve requirement, thereby allowing banks to do more lending, which increases spending and gives rise to inflationary pressures.
Fiscal Policy Adjustment: The government might increase its expenditure and reduce taxes to try to enhance aggregate demand and disposable income. The probable impact is that there will be a rise in consumer spending, which may inflate the prices.
Changing Views on Deflation’s Impact
Since the Great Depression, when monetary deflation was associated with high unemployment and increasing defaults, deflation has generally been seen by economists as a 'bad thing'. Most central banks thus switched their monetary policies to ensure a continual rise in the money supply, even at the risk of encouraging chronic price inflation and excessive borrowing by debtors.
John Maynard Keynes viewed deflation as something ominous because such a thing deepens pessimism to worsen economic recessions. It can make asset owners invest less during a recession, causing asset prices to further drop and worse, aggravate the economic scenario.
Irving Fisher developed a theory on economic depressions, the focal point being debt deflation. His argument was that, following an economic shock, debt liquidation could sharply reduce credit supply. A contraction in credit would further lead to deflation and further increase the burden on debtors, maybe spiraling into a full depression.
But these traditional views on deflation are questioned by modern economists. For instance, a 2004 study concluded by Andrew Atkeson and Patrick Kehoe examined data from 17 countries over 180 years. It showed that 65 out of 73 deflationary episodes did not result in recession, and 21 out of 29 depressions did not occur with deflation. This means the correlation of deflation and poor economic performance may not be as simple or straightforward as some would imagine it to be.
Conclusion
While deflation can sometimes be driven by technological advancements and increased productivity, its broader economic effects often pose significant challenges, such as reduced consumer spending, rising debt burdens, and prolonged economic downturns. Policymakers deploy various monetary and fiscal measures to counter deflation and maintain a stable economic environment.
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