Deflation is when the prices of goods and services fall, which increases consumers' purchasing power because they can now afford more things than they previously could. Like inflation, deflation is also measured using the consumer price index. Technically speaking, deflation occurs when the inflation rate falls below zero. When the inflation rate decreases but is still positive, it is known as disinflation, not deflation. Deflation only occurs when there is negative inflation in the economy (below zero percent).
1. What Causes Deflation in the Economy?
Several factors may lead to deflation in the economy. Firstly, a fall in the consumer demand for goods and services is perhaps the first factor that must be discussed. When consumers are not spending enough like they were doing so previously, it causes downward pressure on all items' prices. Prices are reduced to encourage people to spend more. This is how deflation occurs. The fall in demand can be attributed to various reasons such as reduced disposable income or uncertain financial futures etc.
Another reason which can decrease the demand for goods and services is the rising interest rates. When people see an increase in interest rates, they withhold more of their money and want to spend less. They start saving more rather than spending, which means that market demand falls. People may also start feeling pessimistic about their future financial security, which can lead to lesser consumption.
Secondly, deflation can also be created by decreasing the money supply or an overall increase in the production of goods and services. When production is increased, the supply of goods increases in comparison to their demand. When supply is greater than demand, it creates a surplus of goods and services. Ultimately, the market forces down the prices of these items to get rid of the surplus. Thus, an increase in supplies can ultimately lead to deflation.
Supply can increase due to several reasons, such as technological advancement or reduced production costs. When producers can make an item at a lower cost, they tend to increase their production, raising the item's supply level in the market. This can push prices to decrease so that more people buy the products. Technological advancements may make production much simpler and quicker, which means more supply and ultimately lower prices.
2. Is Deflation Good or Bad?
There are several ways in which deflation affects the economy. When suppliers are forced to reduce their prices due to low demand, they sometimes may even have to cut down prices that fall below the item's production cost. This means that businesses lose their profits. While deflation may seem right for consumers, persistent deflation can be very harmful to the producer's side. Thus, length deflationary periods are usually bad for any economy. It not only leads to an overall reduction in business revenues but ultimately, wages also reduce, and unemployment is caused as most companies struggle to remain in business and may eventually shut down.
Lower wages, salary cuts, and a rise in unemployment levels also change the pattern of consumer spending. Additionally, deflation also causes a fall in equity prices as more people tend to sell their investments in the slowing economy. The falling prices further discourage more consumer spending as people begin to delay their purchases because they expect future prices to be lower. Especially for luxury goods, consumers try to save their money by waiting to purchase non-essential items as they will become cheaper during deflation. Ultimately, deflationary periods reduce people's spending and slow down economic growth (which creates more deflationary pressure in the economy).
Another significant effect of deflation is that it increases the real value of money as well as debt. It makes it much more difficult for people in debt to pay their debt off. This means that people and businesses tend to spend a larger proportion of their disposable income on fulfilling their debt requirements. The economic effects of deflation depend on the extent of the personal debt of individuals and businesses. People usually take out a mortgage by assuming that their real wage will rise, and positive inflation will occur. But when deflation occurs, it can confuse people and reduce their spending much more than expected to fulfil their debt obligations.
In deflationary periods, firms are getting lower profits, and consumers are getting lower wages. This leaves behind less money for investment or saving. In countries where debt is a huge problem, a period of deflation can be very damaging. It can also make it difficult for governments to reduce their debt to GDP ratios. (They usually start becoming worse in such times).
Deflation also leads to an increase in real interest rates. Since interest rates typically cannot fall below zero, it causes real interest to rise if deflation takes place. This means that people can benefit more from saving their incomes, which means less spending and an unwanted tight monetary policy. Such conditions in the economy can mean lower growth rates and higher unemployment rates, which can be very damaging. It also makes it more difficult for wages and relative prices to adjust like they usually do.
Deflation is very difficult to control, and that is why it is usually considered to be much worse than inflation. In the worst-case scenario, deflation can cause a deflationary spiral that can ultimately cause the country's currency to collapse. To combat deflation, various combinations of various fiscal and monetary policies are implemented. Interest rates and taxes are reduced to stimulate consumption and increase the aggregate demand in the economy. It becomes very difficult to change people's inflation expectations and bring the economy back to normal economic growth.
On the other hand, the right kind of deflation from improved efficiency and low production costs will substantially improve consumers' purchasing power provided that their income remains unaffected. Moreover, if one country is experiencing deflation while the rest have inflation, the country will improve its international competitiveness and increase exports. This can improve their balance of payments in the long term. For example, during the period of Japan's deflation, they were able to strengthen their exports, which offset the lower consumer spending substantially. However, if there is a deflation period in the whole region or world, this competitive advantage may not come in hand.
Deflation may be caused by many positive reasons such as improvement in productivity, advancements in technology, new sources of innovation and resources, etc. This is beneficial for the overall growth of the economy and its industries. The people also become better off as their buying power gets improved and can improve their living standards. But the main problem is how quickly deflation can occur and overturn all the positives into negatives.
3. The Types of Deflation
As previously discussed, deflation can either be good or bad. However, most deflation experiences in western countries were mostly bad. Thus, deflation has been associated with declining economic growth rates and high unemployment levels in major economies. However, it is also possible to have another type of good inflation resulting from a rapid productivity improvement. In such cases, deflation becomes consistent with high economic growth rates.
The "good" type of deflation usually results from lower costs of production. This means that firms can earn higher profits and pay higher real wages to their workers. In this type of deflation, the prices are lower while the output, productivity, and profits rise, which means real wages also rise. If consumers are experiencing lower prices along with an increase in their real wages, this would, in theory, mean that they would start spending more because of the extra disposable income they now have.
An Example of Good Deflation
From 1870 through 1890, the UK and US economies greatly benefited from a global decline in prices resulting from the second industrial revolution. This was due to the major increase in productivity levels due to better and more efficient steam engines, increased steel production, cheaper cost of transport by railway, and improved communication systems. These factors helped these economies to transition from a traditional agrarian economy towards an industrial one. The economy of the United States experienced rapid growth during this time as the new technology significantly lowered their costs of production. However, it is important to note that deflation was there during this period, but the wages remained constant, and in some cases, they even increased. This meant that the people were also well off, and the economy flourished due to this good deflation.
Deflation Due to a Fall in the Aggregate Demand
The second type of inflation is "bad deflation." This means reduced prices are caused by a decline in consumer demand, which in turn means reduced profitability for businesses. In this situation, firms do not increase their wages but rather try to cut down their workers' wages to maintain their profits. Moreover, if businesses cannot cut their employees' wages, there may also be a rise in unemployment. Therefore, bad deflation leads to lower wages and higher rates of unemployment. In this case, the falling prices are not enough to stimulate spending in the economy. People become more risk-averse, and in turn, the economy slows down.
Examples of Bad Deflation
One example of bad deflation occurred in the 1930s when the UK experienced a prolonged deflationary period. The inflation rate was barely rising above zero during this time. This was caused by the high real interest rates that were suppressing aggregate demand. Moreover, the UK's exchange rate was highly overvalued at this time, which caused substantial deflationary pressures. UK exporters became very uncompetitive. Overall, this deflation period resulted in low economic growth in the region, a higher national debt to GDP ratio, and high unemployment rates in the country.
Another example of deflation happened during the recession of 2007-2008. During this time, the inflation rate fell below zero, which may seem like a good thing for consumers. In reality, it was a reflection of the lower aggregate demand, which meant lower profits. Lower profits caused many layoffs, and people suffered from unemployment and salary cuts during this period of deflation.
4. What is a Deflationary Spiral?
A deflationary spiral happens when the fall in prices further causes more deflationary pressures, resulting in even lower prices. When deflation occurs, it creates a general expectation in the economy that prices will further fall. Consumers then start reducing their current spending as they expect the process of goods to fall in the future. This reduced spending causes more deflationary pressure in the economy.
Moreover, deflation also increases the real value of debt, making it much harder to be repaid. Individuals and businesses face the risk of becoming bankrupt, and most of them eventually do. This means there is a further reduction in spending and investment in the economy, which leads to a recession. Once deflation takes hold of the economy, it affects economic behaviours in several different ways, making deflation more probable. This causes the deflationary spiral, which can be very difficult to break, as seen in the Great Depression.
To get out of this vicious cycle, some actions must be taken. For example, increasing the money supply in the economy is a way to stimulate consumer spending. The government also starts to target a higher rate of inflation, which helps raise people's inflationary expectations. An expansionary fiscal policy is useful in combating the deflationary spiral as the government borrowing uses up the surplus savings, which can be spent on different projects such as infrastructure etc. This also ensures that the circular flow of income stabilizes, and the economy is stimulated once again.
5. Is Hyper Deflation a Reality?
When an economy's productivity level starts to increase, goods and services become cheaper and more affordable for people to buy. However, the amount of money that people want to spend largely depends on the interest rates set. Higher interest rates mean more returns on savings and less consumer spending, while lower interest rates mean less return on savings and more consumer spending. These interest rates are usually determined by the amount of money that is printed and how stable the currency of the economy is.
Thus, when more currency is printed, or the market loses its confidence in that currency much more rapidly than the increase in the economy's productive capacity, hyperinflation is experienced. Contrastingly, when a currency is printed much slower than the increase in the economy's productive capacity, or the market starts gaining confidence in the currency, hyper deflation may be seen in that economy from that currency's perspective.
Another way hyper deflation could occur in the economy is if its productive capacity skyrockets to unprecedented levels. There would be no scarcity of resources, and producers could instantaneously create any product in such a situation. There would be no problems with the high costs of production as well. This could create a period where the dollar would be able to buy twice as much every month until a single penny would be enough to afford anything that a person could ever want! In this case of hyper deflation, money would become meaningless and would lose all its value. However, this does not seem like a realistic scenario in the real world where resources are scarce, and technology is advancing, still has its limits.
6. Investing in a Period of Deflation
Making investment decisions during a period of economic deflation can be very challenging as the prices of assets and equity are falling, causing a loss of interest. The value of cash, real estate, gold, and stocks is also reduced, which tends to create losses during deflation. However, some sectors can be good areas for investment during such challenging times. For example, the sectors that fund in areas like health care, staple goods, utilities, and other commodities that people need regardless of the economy's condition are always good ideas. For instance, people will still use electricity, go to the hospital, and brush their teeth every day, even if prices fall and the market crashes.
The demand for such goods and services remains somewhat stable, even during deflation, making them a safer investment option. However, market timing is risky when choosing the right investment during a short period of deflation in the economy. In this case, the best course of action is to build a diversified portfolio that will pay off in every economic environment, whether inflationary or deflationary.