What Is Deflation?
In economics,
deflation is a decrease in the general price level of goods and services.Deflation occurs when the inflation rate falls below 0% (a negative inflation rate). This should not be confused with disinflation, a slow-down in the inflation rate (i.e., when inflation declines to lower levels).Inflation reduces the real value of money over time; conversely, deflation increases the real value of money – the currency of a national or regional economy. This allows one to buy more goods with the same amount of money over time.
Economists generally believe that deflation is a problem in a modern economy because it increases the real value of debt, and may aggravate recessions and lead to a deflationary spiral. Historically not all episodes of deflation correspond with periods of poor economic growth. Deflation occurred in the U.S. during most of the 19th century (the most important exception was during the Civil War). This deflation was caused by technological progress that created significant economic growth.This deflationary period of considerable economic progress preceded the establishment of the U.S. Federal Reserve and its active management of monetary matters.
What are some effects of Inflation and Deflation(Economic Issue)?
Some effects of Inflation:
1. Hardships for poor people and fixed income salaried households
2. Business Profits tend to go up in times of inflation
3. Demand for pay hikes and wage increases
4. Social tensions
5. Value on money lent out falls in purchasing power - value of money to be repaid falls in terms of purchasing power falls.
6. Interest may rise.
7. Exchange rate may fall
8. Central Bank my try to control money supply growth through hike in
cas reservecration, raising discount rates (lending intrest rate) and
conduct open market sale of securities.
The effects of inflation
Inflation can be very damaging for a number of reasons. First, people
may be left worse off if prices rise faster than their incomes. Second,
inflation can reduce the value of an investment if the returns prove
insufficient to compensate them for inflation. Third, since bouts of
inflation often go hand in hand with an overheated economy, they can
accentuate boom-bust cycles in the economy.
Sustained inflation also has longer-term effects. If money is losing its
value, businesses and investors are less likely to make long-term
contracts. This discourages long-term investment in the nation’s
productive capacity.
The flip-side of inflation is deflation. This occurs when average prices
are falling, and can also result in various economic effects. For
example, people will put off spending if they expect prices to fall.
Sustained deflation can cause a rapid economic slow-down.
Some effects of Deflation
1. Company profits may fall
2. Private domestic capital investment may fall
3. Unemployment may increase.
4. Real value of lans to be repaid may rise,
Deflation is a decrease in the general price level over a period of
time. Deflation is the opposite of inflation. For economists especially,
the term has been and is sometimes used to refer to a decrease in the
size of the money supply (as a proximate cause of the decrease in the
general price level). The latter is now more often referred to as a
'contraction' of the money supply. During deflation the demand for
liquidity goes up, in preference to goods or interest. During deflation
the purchasing power of money increases.
Deflation is considered a problem in a modern economy because of the
potential of a deflationary spiral and its association with the Great
Depression, although not all episodes of deflation correspond to periods
of poor economic growth historically. In economic theory deflation is a
general reduction in the level of prices, or of the prices of an entire
kind of asset or commodity. Deflation should not be confused with
temporarily falling prices; instead, it is a sustained fall in general
prices. In the IS-LM model this is caused by a shift in the supply and
demand curve for goods and interest, particularly a fall in the
aggregate level of demand. That is, there is a fall in how much the
whole economy is willing to buy, and the going price for goods. Since
this idles capacity, investment also falls, leading to further
reductions in aggregate demand. This is the deflationary spiral. The
solution to falling aggregate demand is stimulus either from the central
bank, by expanding the money supply, or by the fiscal authority to
increase demand, and borrow at interest rates which are below those
available to private entities.
In more recent economic thinking, deflation is related to risk, where
the risk adjusted return of assets drops to negative, investors and
buyers will hoard currency rather than invest it, even in the most solid
of securities. This can produce the theoretical condition, much debated
as to its practical possibility, of a liquidity trap. A central bank
cannot, normally, charge negative interest for money, and even charging
zero interest often produces less stimulative effect than slightly
higher rates of interest. In a closed economy, this is because charging
zero interest also means having zero return on government securities, or
even negative return on short maturities. In an open economy it creates
a carry trade and devalues the currency producing higher prices for
imports without necessarily stimulating exports to a like degree. The
experience of Japan during its 1988-2004 depression is thought to
illustrate both of these problems.
In monetarist theory deflation is related to a sustained reduction in
the velocity of money or number of transactions. This is attributed to a
dramatic contraction of the money supply, perhaps in response to a
falling exchange rate, or to adhere to a gold standard or other external
monetary base requirement.
Deflation is generally regarded negatively, as it is a tax on borrowers
and on holders of illiquid assets, which accrues to the benefit of
savers and of holders of liquid assets and currency. In this sense it is
the opposite of inflation (or in the extreme, hyperinflation), which is
a tax on currency holders and lenders (savers) in favor of borrowers
and short term consumption. In modern economies, deflation is caused by a
collapse in demand (usually brought on by high interest rates), and is
associated with recession and (more rarely) long term economic
depressions.
In modern economies, as loan terms have grown in length and financing is
integral to building and general business, the penalties associated
with deflation have grown larger. Since deflation discourages investment
and spending, because there is no reason to risk on future profits when
the expectation of profits may be negative and the expectation of
future prices is lower, it generally leads to, or is associated with a
collapse in aggregate demand. Without the "hidden risk of inflation", it
may become more prudent just to hold onto money, and not to spend or
invest it.
Deflation is, however, the natural condition of hard currency economies
when the rate of increase in the supply of money is not maintained at a
rate commensurate to positive population (and general economic) growth.
When this happens, the available amount of hard currency per person
falls, in effect making money scarcer; and consequently, the purchasing
power of each unit of currency increases. The late 19th century provides
an example of sustained deflation combined with economic development
under these conditions.
Deflation also occurs when improvements in production efficiency lowers
the overall price of goods. Improvements in production efficiency
generally happen because economic producers of goods and services are
motivated by a promise of increased profit margins, resulting from the
production improvements that they make. But despite their profit motive,
competition in the marketplace often prompts those producers to apply
at least some portion of these cost savings into reducing the asking
price for their goods. When this happens, consumers pay less for those
goods; and consequently deflation has occurred, since purchasing power
has increased.
While an increase in the purchasing power of one's money sounds
beneficial, it can actually cause hardship when the majority of one's
net worth is held in illiquid assets such as homes, land, and other
forms of private property. It also amplifies the sting of debt, since--
after some period of significant deflation-- the payments one is making
in the service of a debt represent a larger amount of purchasing power
than they did when the debt was first incurred. Consequently, deflation
can be thought of as a phantom amplification of a loan's interest rate.
(But, conversely, inflation may be thought of as a regressive, across
the board general tax.)
This lesson about protracted deflationary cycles and their attendant
hardships has been felt several times in modern history. During the 19th
century, the Industrial Revolution brought about a huge increase in
production efficiency, that happened to coincide with a relatively flat
money-supply. These two deflationary catalysts led, simultaneously, not
only to tremendous capital development, but also to tremendous
deprivation for millions of people who were ill-equipped to deal with
the dark side of deflation. Business owners-- on average, better
educated in economic theory than their unfortunate cohorts (or just
better able to withstand the economic stresses) -- recognized the
deflation cycle as it unfolded, and positioned themselves to leverage
its beneficial aspects. Hard money advocates argue that if there were no
"rigidities" in an economy, then deflation should be a welcome effect,
as the lowering of prices would allow more of the economy's effort to be
moved to other areas of activity, thus increasing the total output of
the economy. However, while there have been periods of 'beneficial'
deflation (especially in industry segments, such as computers), more
often it has led to the more severe form with negative impact to large
segments of the populace and economy.
Since deflationary periods favor those who hold currency over those who
do not, they are often matched with periods of rising populist
sentiment, as in the late 19th century, when populists in the United
States wanted to move off hard money standards and back to a money
standard based on the more inflationary (because more abundantly
available) metal silver.
Most economists agree that the effects of modest long-term inflation are
less damaging than deflation (which, even at best, is very hard to
control). Deflation raises real wages which are both difficult and
costly for management to lower. This frequently leads to layoffs and
makes employers reluctant to hire new workers, increasing unemployment.
Note:
Actually, deflation itself is neither good nor bad. It depends on the
cause of the deflation whether people will suffer or rejoice. As I said,
if the cause is increasing supply of goods that would be good. Another
example of this is in the late 1800's as the industrial revolution
dramatically increased productivity.
However, if deflation is caused by a decreasing supply of money as in
the great depression, that would be bad. The stock market crash sucked
all the liquidity out of the market place, the economy contracted,
people lost their jobs and then banks stopped loaning money because
people were defaulting. The problem compounded as more people lost
their jobs and money supply fell further causing more people to lose
their jobs, etc. etc.
During the Depression demand for money was high (but no one could afford
it) because supply was low. So deflation can be caused by several
different things and thus can be good or bad depending on the cause.
How To Controlling Deflation?
To fight deflation, attempts must be
made to raise the volume of aggregate effective demand. It will output,
income and employment in the economy, Effective demand can be
increased partly by consumption expenditure and partly by increasing
investment expenditure. Various measures to increase consumption and
investment expenditures in the economy.
1. Reduction in Taxation:
The government should reduce the number
and burden of various taxes levied on commodities. This will increase
the purchasing power of the people. As a result, the demand for goods
and services will increase. Moreover, sufficient tax relief should be given to businessmen to encourage investment.
2. Redistribution of Income:
Marginal propensity to consume can be
raised by a redistribution of income and wealth from the rich to the
poor. Since the marginal propensity to consume of the poor is high and
that of the rich is low, such a measure will help increasing the
aggregate demand in the economy.
3. Repayment of Public Debt:
During deflation period, the government
can repay the old public debts. This will increase the purchasing power
of the people and push up effective demand.
4. Subsidies:
The government should give subsidies to induce the businessmen to increase investment.
5. Public Works Programme:
The government should also directly
undertake public works programme and thus increase expenditure in
public sector. Care should, however, be taken that the public works
policy of the government does not adversely affect investment in the
private sector; it should supplement, and not supplant, private
investment. For this, it is important that only those projects should
be selected for the government's public works policy, which is either
too big or not so profitable to attract private investment.
6. Deficit Financing:
In order to have significant
expansionary effects, the government's public works schemes should be
financed by the method of deficit financing, i.e,, by printing new
money. The government should adopt a budgetary deficit (excess of
government expenditure over its revenue) and cover this deficit through
deficit financing. Deficit financing makes available to the government
sufficient resources for its developmental programmes without adversely
affecting investment in the private sector.
7. Reduction in Interest Rate:
By adopting a cheap money policy, the
monetary authority of a country reduced the interest rate, which
stimulates investment and thereby expands economic activity in the
economy.
8. Credit Expansion:
The central bank and the commercial
banks should adopt a policy of credit expansion to promote business and
industry in the country. Bank credit should be made easily available
to the entrepreneurs for productive purposes.
9. Foreign Trade Policy:
To control deflation, the government
should adopt such a foreign trade policy that, on the one hand,
increases exports, and, on the other hand, reduces imports. This kind
of policy will go a long way in solving the problem of overproduction,
and help overcoming deflation.
10. Regulation of Production:
Production in the economy should be
regulated in such a way that the problem of over-production does not
arise. Attempts should be made to adjust production with the existing
demand to avoid over-production.
In short, fiscal policy alone or
monetary policy alone is not sufficient to check deflation in an
economy. A proper co- ordination of fiscal, monetary and other measures
is essential to effectively deal with the deflationary situation.
is the nominal quantity of money.
is the 
is the general price level;
is an index of the 
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