Why is Deflation Bad For the Economy?

Deflation is the reduction in the overall prices in an industry and the purchase powerof the currency. It can be caused by an increase in productivity, an increase in the number of goods and services or a decrease in aggregate demand.

 

KEY TAKEAWAYS

  • Deflation refers when the country’s general prices are falling, and not when they rise.
  • Deflation can be caused either by an increase or decrease in productivity or in the amount of credit in the economy.
  • Deflation is a generally positive trend for the economy. However it can under certain conditions also occur with a decrease in the economy.
  • Deflation is an economic phenomenon that occurs when debt-fueled asset price booms lead to temporary financial crises.

Understanding Deflation

The economic statistics of most countries can show changes in consumer price by comparing changes within a basket different goods and products to an Index. The Consumer Price Index, which is used most often to assess inflation rates in the U.S., is the most frequently referenced index. An indicator that an economy is experiencing deflation is when the index in one period is higher than the other.

 

This is because it gives consumers more buying power. Modest drops in the prices of certain products such as energy or food can have a positive influence on nominal consumer spending. A steady, consistent fall in all price levels can help people consume more, as well as promote economic growth and stability. This is because money acts as a store of value while encouraging real saving.

 

But, in certain situations, rapid deflation could be associated with a short-term contraction in economic activity. This is generally caused by an economy that is heavily depleted and dependent upon the constant expansion of credit. Credit contracts finance speculative investment and then asset prices plummet and credit contracts end.

This is also known as Debt Deflation. Deflation is generally a positive characteristic of a healthy, thriving economy. It reflects technological advances, rising abundance, and rising living standards.

 

Deflation: Causes and Effects

According to the old saying, inflation is due to too much money chasing down not enough goods. In contrast, deflation is a growing demand for goods or services, which is chased by either a constant or slower-growing quantity of money.

 

Deflation can also be caused by an increase in supply of goods or services or a decrease in supply of money or credit. If prices can adjust down, it will lead to a general falling price level.

 

A rise in the supply and demand of goods or services in an economy is usually due to technological progress, new resources discovered, or increased productivity.

 

As the value of their earnings and wages rise, consumers’ purchasing power increases and their living standards improve. They can purchase, use, or consume better quality goods, services, and this allows them to increase their purchasing power. This is a very positive thing for society as a whole and the economy.

 

The U.S. government wants an annual inflation rate of 2.2%.

Some economists have expressed concern that falling prices could paradoxically reduce consumption by inducing people to delay or hold off buying in order pay lower prices in future. But, it is not clear that this happens during normal periods when there is economic growth and falling prices as a result of technological advances, productivity, or resource availability.

 

Additionally, the majority of consumption is composed of goods that cannot easily be deferred to the future, even though consumers would like to.

 

Above these essential needs, consumers won’t reduce their current spending except if they believe the rate at which prices fall will outweigh their natural time preference for current consumption over future.

 

Because fixed debt is more valuable than the actual value of goods, falling prices could cause consumer spending to suffer.

 

Debt, Speculation, And Debt Deflation

Deflation can also happen during periods of economic turmoil, provided that certain conditions are met.

 

A highly financialized society is one in which a central banks and another monetary authority or the banking system engage in continuous expansions of the supply money and credit in an economy. This results in continued inflation in commodity, rent, wage, and asset values.

 

More investment activity takes the form of speculation about the price of financial and other asset, and less profit and dividends on fundamentally sound economy.

 

Business activities are also dependent more heavily on the flow and turnover in credit, rather than real savings to fund ongoing operations. Additionally, consumers tend to borrow heavily to finance more of their expenditures than they can self-finance with ongoing savings.

 

The best hedge against inflation is gold, but it can also work well as a hedge against depression.

To compound the problem, inflation usually results in the suppression or the lowering of market interest rates. This leads to decisions that are not only about how they will be financed but also about the type and duration of business investment projects. When there are signs of trouble, the conditions are perfect for debt deflation.

 

The market rate correction or a real shock can place pressure on consumers, investors, and heavily indebted companies. Some people have trouble refinancing, revolving or paying their various debt obligations (e.g., business loans student loans , mortgages )

 

Delinquencies and defaults result in debt liquidationand writedowns of good debts owed to lenders. This eats away at some of the economy’s accumulated credit.

 

Bank balance sheets get more uncertain and depositors may try to withdraw funds as cash in the event that the bank fails. A Bank Run can occur where banks have to repay extended loans or cover liabilities due to insufficient cash reserves. This could lead to the bank unable meet its obligations. Financial institutions may collapse as liquidity is removed from borrowers in need.

 

This reduces the money and credit supply, which then makes it more difficult for consumers, businesses, and speculative investor to borrow. It also means that asset and consumer good prices will rise, so prices could stop rising, or even fall.

 

Falling prices add to the pressure on indebted consumers, investors, and businesses that are already under debt. Their nominal amount of debts is fixed at the same nominal value as their revenues, incomes, collateral, and falls due to price inflation. This is when the cycle of price deflation and debt becomes vicious.

 

This debt deflation process will lead to more business failures, bankruptcies and rising unemployment in the short-term. The economy experiences recession. As investment and consumption fall, economic output decreases.

 

What is Deflation and How Does it Affect an Economy?

Deflation refers to a decrease in the price of goods and/or services across the entire economy. It increases the purchasing power for consumers. This is the opposite effect of inflation and can be harmful for a nation because it could signal a downturn or depression in an economy. Positive factors like technology advancements can also bring about deflation.

 

Is Deflation Worse than Inflation

It depends. It depends. Positive factors can make inflation less severe than deflation, such as technology improvements that lower the prices of goods and/or services.

 

How do you make it through a period of deflation?

Investors can hedge against deflation by purchasing investment-grade bonds and consumer-staple stock, or dividend stocks. Cash is the best option. Diversified portfolios are good for protecting against different economic situations.

 

The Bottom Line

Some deflation can be good for economic growth. In the case of an economic-wide, central-bank-fueled debt boom followed by deflation when that bubble bursts. Rapidly falling prices can also be associated with a financial crises and recession.

 

The period of recession and debt deflation following is temporary. However, it can be avoided completely if the temptation to inflate money and credit can be resist.

 

The danger to a country’s economic health is not debt deflation. It is the inflationary period that then leads into debt deflation. This has been the case for many years, perhaps because central banks have been inflating this type of debt bubble consistently and repeatedly over the last century.

 

This means that although these policies will continue to be pursued, deflation continues to be associated with economic losses.

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