Closely associated with its opposite, namely inflation, here is an explanation of what deflation is, what are its causes, effects and solutions.
Deflation refers to the general decline in the prices of goods and services, that is, when the inflation rate becomes negative and leads to an increase in the purchasing power of money. Deflation occurs naturally when the money supply of an economy is manipulated. It should not be confused with disinflation, a simple slowdown in the inflation rate.
It is a less common economic phenomenon than inflation, but it can have significant consequences on the economy of a country and beyond, as demonstrated by what is happening in Cina. Let’s try to understand the concept of deflation, the differences with inflation, the risks and possible consequences, as well as some historical examples to better understand this process.
What is deflation: meaning and definition
Deflation, as anticipated, occurs when the prices of goods and services decrease in a general and prolonged way.
In other words, the purchasing power of money increases, allowing people to buy more with the same amount of money. This dynamic is the opposite of inflation, in which prices tend to increase over time.
Technically, deflation can be defined as a sustained reduction in the general level of prices in an economy, often accompanied by a reduction in demand for goods and services. It is important to note that deflation does not refer to a temporary decrease in prices in individual sectors, but to a systematic trend on a larger scale, which affects the overall economy of a given area.
Although it may seem like an opportunity to the average consumer, In general it is correct to say that a healthy economy - in the context of balanced and sustainable economic growth - produces slight inflation.
The difference between inflation, deflation and disinflation
The main difference between inflation and deflation concerns the movement of prices:
when there is inflation, the value of money decreases, and you have to spend more to buy goods and services; in the case of deflation, however, the value of money increases and you can buy more with the same amount of money.
These are two sides of the same coin. The cause of these phenomena is linked to the balance between supply and demand of goods and services. Inflation can be caused by an increase in demand or a reduction in supply, while deflation is generally due to a weak demand, which leads to an overabundance of goods and services on the market.
Both are not to be confused with disinflation, which occurs when inflation decreases, but still remains positive. In other words, prices continue to increase, but at a slower pace than before. For example, if inflation goes from 5% to 3%, there is disinflation: prices are still rising, but not as fast as before.
The Causes of Deflation
By definition, monetary deflation can only be caused by a decrease in the supply of money or financial instruments redeemable for money. In modern times, the money supply is influenced by central banks, such as the ECB.
Periods of deflation most commonly occur after long periods of artificial monetary expansion. The last significant deflation in the United States economy occurred in the early 1930s. The main contributor to this deflationary period came from the decline in the money supply following catastrophic bank failures. Other countries, such as Japan in the 1990s, have experienced deflation in modern times.
Deflation is caused by a variety of factors, but it largely occurs as a result of two events:
- a decline in aggregate demand (a leftward shift in the aggregate demand curve);
- an increase in productivity.
A decrease in aggregate demand typically translates into lower prices. Causes of this shift include reduced government spending, stock market failures, consumers’ desire to increase savings, and tighter monetary policies (i.e., higher interest rates).
With respect to productivity, businesses operate more efficiently as technology advances. These operational improvements lead to lower production costs and lower costs that are passed on to consumers in the form of lower prices.
Price deflation through increased productivity differs by specific industry. For example, consider how increased productivity affects the technology industry. In recent decades, technological improvements have led to significant reductions in the average cost per gigabyte of data. In 1980, the average cost of a gigabyte of data was $437,500. In 2010, the average cost was three cents. This reduction also causes the prices of products manufactured using this technology to decrease significantly.
The Effects of Deflation
Deflation is a much more insidious problem than inflation: the general decline in prices may in fact appear to be a good thing, especially after decades of demonizing inflation.
In reality, deflation triggers a vicious circle that feeds on itself and in the long run hurts everyone:
falling prices generate an expectation of further future price drops, this leads individuals to postpone purchases (each thinking "if I wait it will cost less") and the sum of these general expectations leads to a general decrease in consumption. Paradoxically, in a situation where purchases become more convenient, people do not buy!
A drop in consumption then has an impact on companies that see both margins and turnover decrease and are forced at a certain point to lay off workers or even close down: at this point we have new unemployed who will no longer have an income to spend on consumption, thus giving new "fuel" to the process of destruction of the economy.
A second harmful effect of deflation concerns debts: by devaluing the currency, inflation helps debtors to repay their debts by decreasing in real terms the value to be repaid, a sort of "discount" on the interest to be paid.
If inflation is too high, the ones who lose are the creditors who see their money returned that was already devalued, but if inflation is too low or even negative (deflation, precisely) the situation becomes unsustainable for debtors who must repay "heavier" capital in real terms without any "inflation discount" on the interest rate and in a climate of economic depression due to the vicious circle we described above: in the long run, this situation is also dangerous for creditors who risk not recovering their money from debtors reduced to being insolvent.
Following the Great Depression, when monetary deflation coincided with high unemployment and an increase in insolvencies, most economists believed that deflation was an adverse phenomenon. Thus, most central banks adjusted monetary policy by allowing large increases in the money supply, even if they cause chronic price inflation and encourage debtors to borrow too much.
Economists have been busy revising old interpretations of deflation lately, especially after Andrew Atkeson and Patrick Kehoe’s 2004 study. After examining 17 countries over a 180-year period, Atkeson and Kehoe found 65 out of 73 episodes of deflation without an economic crisis, while 21 out of 29 periods of economic depressions did not have deflation.
Today, there is a wide variety of opinions on the usefulness of deflation and price deflation.
Deflation, some historical cases to understand
Some historical cases of deflation - we have already mentioned them - help us better understand the dynamics and risks of this phenomenon. The best-known case is probably that of the United States during the Great Depression of the 1930s. During this period, a combination of falling demand and production led to prolonged deflation, with prices falling by 10% per year between 1930 and 1933. Deflation exacerbated the crisis, making it increasingly difficult for businesses and households to service their debts, triggering large-scale bankruptcies and a deep recession.
Another notable example is Japan in the 1990s, which entered a period of chronic deflation known as the “lost decade.” After the speculative bubble burst in the late 1980s, Japan experienced decades of stagnant economic growth and persistent deflation, despite efforts by the authorities to stimulate the economy. This case demonstrates how difficult it can be to escape from a deflationary trap once it has set in.
Even more recently, during the 2008 global financial crisis, several economies experienced brief periods of deflation, caused by contracting demand and falling commodity prices. Not to mention modern-day China.
Original article published on Money.it. Original title: Il significato della deflazione e gli effetti sull’economia
