Deflation: Causes, Advantages and Disadvantages

A lot is said of the dire effects of inflation on price commodities etcetera, but little is said on the commensurate irreversible consequences of a sharp plummet in the price of these commodities. First of all, deflation is an indicator of economic failure, and is historically associated with economic catastrophes such as the Great Depression of 1930’s and the 2008 Financial Crisis. But first let’s define deflation.

Deflation Definition

An antithesis of inflation, deflation is a gradual fall in the price of basic commodities across the economy. Deflation and inflation are indicated by the value of consumer price index (CPI), calculated as the average change in price of commodity baskets. A fall in price of one commodity may be due to a specific factor like demand/supply, government intervention, or international trade theatrics. However, deflation is when prices fall across different sectors in the entire economy, as a result of factors such as monetary policy and low confidence in the economy.

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Causes of Deflation

These include monetary policies to cut money circulation, an unfavorable course of the economy, or increased production.

1. Monetary Policies

These are government directives implemented by the central bank to reduce the amount of money in circulation. These policies include quantitative easing upon a looming crisis whereby the central bank sells government securities to repossess money, increased interest rates on bank loans, and a tighter regulation in the cash reserve requirements held by banks, as required by the central bank. Reduced government spending, though a fiscal policy, may also result in deflation as it cuts the amount of money in circulation. When monetary supplies are lower, the demand of goods and services suffers the same fate. Money is the only way people pay for goods and services, and its supply is directly proportional to demand and the price of commodities.

2. Pessimism and Panic

This one is associated with financial disasters, whereby the public lacks confidence in the trajectory of the economy, holding back their spending and saving more. Deflation is a direct course of demand, and when people do not wish to spend, the prices will dramatically fall. A point in case is during the Stock Market Crash of 2008. Employees were losing their jobs in droves and on a daily basis, spreading financial panic across the population. Seeing that, even the employed held back their spending to save and shield themselves from the effects of a possible retrenchment. 

During the crisis too, people stopped borrowing from banks, fearing that they could fail to repay the loans due to the prevailing financial shocks. Also, customers withdrew deposits from banks in fear of the banks’ collapse. This cut the liquidity of these banks, draining the money in circulation. Lack of confidence in the economy is mostly unsubstantiated, and only based on anticipatory prospects. Sometimes the expected doom fails to come, and deflation happens for no good reason, just imaginations and hot air.

Increased Production

Positive events too can cause deflation. Increased production aggravates market supplies, leading to a fall in price of goods sold. These are just demand/supply dynamics which change so often and may not have lasting impacts on the economy. However, when the deflation transforms into a spiral one, whereby people hold back spending anticipating for further fall in prices, the deflation may never end. This happened with Japan in the 1990’s, whereby a mild fall in demand translated to a case of permanent deflation which has not been resolved to date. 

Increased production is always as a result of technology, or natural phenomenon such as rain. Technology increases productivity and reduces the cost of production, reducing the overall cost of goods at the market. In context, the cost of computer services has fell constantly over time, due to the advances in the technology. Phenomenon like rain have always reduced the price of agricultural commodities after a bumper harvest. This, moreover, can significantly lead to overall deflation in economies that are heavily reliant on agriculture.

Now let’s look at the impact deflation has on the economy.

Effects of Deflation

The effects of deflation are both positive and negative; prices of goods fall but unemployment is warranted in the same breath.

1. Discourages Spending (Spiral Deflation)

Deflation gives consumers even more hope to keep their money and wait for further fall in price of goods. In this case, the economy stagnates wildly as there is no production and at the same time there is no demand for commodities. Spiral deflation is a dangerous course of the economy due to this false hope. 

2. Increases Unemployment

Deflation is not a delight for producers. The demand of goods will result in low production, reducing the demand for labor in return. The low profit margins will force producers to lay off part of their staff in order to remain afloat. In real sense, therefore, consumers are advised to consume more during deflation so as to protect their jobs otherwise they’ll lose them.

3. Increased Cost of Debt

Deflation has huge implications on the real interest rate or in other terms the value for money in the future. Consistent deflation means the value of money today is less than tomorrow, the day after and so on. In literal terms, the amount of goods buyable tomorrow by a set amount of money is more than the goods buyable today by the same money. Therefore, saving is prioritized while debt is more expensive as you’ll pay more tomorrow than today.

4. Boosted Currency Strength

Deflation is an implication of lower monetary supply, and thus a reduced demand for the dominion’s currency. This is because of an increase in the purchasing power of a currency within the country. However, deflation is not a stand-alone factor in exchange rates, as there are more impactful causes like foreign trade and currency demand.

Combating Deflation

At the end of the day deflation is bad news for the economy. The recommended economic condition is a 1-3% inflation rate per annum. This is the ideal condition as it creates jobs, and keeps the economy moving. While governments actively seek to reduce unemployment, the real antagonist under confrontation is deflation. That is why governments are on the constant spending spree, implementing subsidies and other monetary and fiscal policies to pump money in to the economy.

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