Economy

Why is Deflation so Bad for the Economy

ADVERTISEMENT

Deflation refers to a drop in the overall prices in an economic system and an increase in the currency’s purchasing power. You can cause it by increasing productivity, a greater supply of credit, or a decrease of total or aggregate consumer.

 

KEY TAKEAWAYS

  • Inflation refers to a drop in the price of goods and services, rather than rising prices.
  • A decrease in overall consumer demand, an increase in productivity or a reduction in credit volume can cause deflation.
  • Deflation is generally a positive trend in an economy. But it can happen under certain circumstances along with a contraction.
  • Deflation, which is the result of an economy that has been dominated by debt-fueled asset prices bubbles, can cause a temporary financial crises and a period in liquidation of speculative investments.

Understanding Deflation

In economic statistics, changes in consumer prices can easily be seen by comparing the changes in a range of goods and products to an indicator. The Consumer Price Index in the U.S. is the most used index for evaluating inflation rates. The general level of prices is declining when the index is lower than it was in the previous period. This indicates that the economy is experiencing inflation.

ADVERTISEMENT

 

It is good for consumers to have greater purchasing power. Some moderate price drops, like in food or energy, can have an positive effect upon increasing nominal consumer spending. A persistent, general fall in all prices, beyond the basic staples, can not only allow people to consume greater quantities but also promote economic growth, stability, and investment by increasing the role of money as a storehouse of value, and encouraging real saving.

 

Under certain conditions, rapid inflation can cause a contraction in the economy. This happens when an economy has a large amount of debt. It is dependent on constant expansion of credit to inflate asset price by financing speculation investment. Asset prices drop when credit contracts are cancelled and asset prices fall.

Sometimes this is known as deflation. Deflation, however, is usually a positive sign of a healthy, growing economy. It reflects technological progress and increases abundance.

 

Deflation: Causes, Effects

Inflation, according to the popular saying, is caused by too many goods being chased by too little money. Conversely, deflation refers to a growing supply and demand for goods and services that are pursued by a steady or slower-growing amount of money.

 

Deflation can occur either through an increase in goods and services supply or a decrease (or lack thereof) in money and credit supply. If prices can adjust downward, it results in a generally falling price.

 

Technological progress, the discovery or increase in productivity, are often responsible for an increase in the economy’s supply of goods and/or services.

 

The increasing value of their incomes and wages allows consumers to purchase and use more quality goods and services. Consumers’ purchasing power and living standards increase over time. This is a clear positive development for society and the economy.

 

The U.S. government has set a 2% annual inflation rate.

There have been times when economists expressed concerns that falling prices might paradoxically lower consumption by inducing customers to hold off or delay buying in order to pay less in the future. However there is very little evidence to support this during normal periods economic growth that includes falling prices due technology and productivity improvements.

 

The vast majority of consumption, however, is made up goods and services that can’t be easily deferred into the future, regardless of whether consumers wish to.

 

Consumers will not reduce spending beyond their basic needs. However, they may choose to cut back on discretionary and luxury spending if the price drop is greater than their time preference to consume current consumption instead of future.

 

Consumer spending that is routinely financed through large debts will be the most affected by falling prices. The real value of fixed loans will increase as prices fall.

 

Debt, Speculation and Debt Deflation

Deflation can also occur after periods of economic crisis, if it is possible to do so under certain conditions.

 

In an highly financialized economic system, where a central bank or another financial authority is involved in the continuous expansion the supply of money in the economy. The reliance on new credit to finance business operations, consumer expenditure, and financial speculation results in continuing inflation in commodity prices and rents, as well as consumer prices and asset prices.

 

Increasing numbers of investment activity are focusing on speculation on the price appreciation and other assets. This is in contrast to profit and dividend payments on fundamentally solid economic activity.

 

The circulation and turnover credit created by new lenders is more important than savings for ongoing business operations. People also borrow more to finance their purchases than they do from ongoing savings.

 

While gold is generally considered a good hedge to inflation, it can also serve as a hedge against deflation.

To make matters worse, the suppression of market rates often causes inflation. This can lead to decisions being made about the type of investment project and the time horizon. The conditions are right for debt deflation at the first sign signs of trouble.

 

Either a real financial shock or a correction to market interest rates could put pressure on heavily-indebted individuals, businesses, and investors. Some have difficulties revolving, refinancing and making payments on various debt obligations like business loans, loans, student loans and credit cards.

 

Delinquents and defaults can lead to liquidation and writedowns poor debts from lenders. These actions begin to reduce the economy’s credit supply.

 

The bank’s balance sheets are less stable and depositors may want to cash out their money in the event of a bank failure. A bankrun is when banks have taken on excessive loans and are unable to pay their obligations. Financial institutions collapse, taking liquidity from borrowers who are even more indebted.

 

This decrease in credit and money supply then affects consumers’ and businesses’ ability to borrow and increase asset and consumer product prices.

 

Falling prices cause even more pressure on consumers, businesses indebted, and investors. The nominal value of their loans remains fixed, as does the corresponding nominal values of their incomes, revenues, and collateral. This is due to price deflation. The cycle of debt and deflation continues at this point.

 

In the short term, this debt deflation process can cause a wave of personal bankruptcy, business failures, and an increase in unemployment. The economy experiences a depression, and the economy’s output drops as investment and debt-financed consumption drop.

 

What is Deflation?

Deflation occurs when prices for goods and services drop across the entire economy. This can increase the purchasing power. It is the opposite to inflation and can be bad for a country because it can signal a downturn, such as a recession or depression. Positive factors like technological advances can also lead to deflation.

 

Is Deflation More Worse than Inflation

It depends. If there are negative factors that cause deflation, such as lack of demand and a reduction in efficiency on the markets, it can be more severe than inflation. If it’s caused by positive factors like technological advances that make goods and services more affordable, deflation can be less than inflation.

 

How do you make money during Deflation?

Investors have options to purchase consumer-staple stocks and investment-grade bonds or dividend stocks in order to protect against deflation. However, they can also keep their money in cash. A portfolio that is diverse can provide protection against various economic conditions.

 

The Bottom Line

A little bit deflation is an outcome of, and good thing for, economic growth. Rapidly falling prices in the event of a debt bubble that was fueled by central banks and then deflation after the bubble burst, can lead to a financial crisis and recession.

 

It is possible to avoid the recession and debt deflation that follow if you resist temptations to raise money and credit.

 

Overall, it’s not deflation but the period of inflation that leads to debt deflation that can be dangerous for a country’s economy. Maybe this is why central banks have been able to inflate this type of debt bubble over the past century.

 

This means that, even though these policies are continuing to be implemented, deflation will continue in association with the economic harm they cause.

ADVERTISEMENT