Meaning of Deflation

Deflation is defined as a decline in the general price level of commodities and services within a given economy.

Deflation occurs when demand for commodities decrease or supply of commodities increase. Lower demand or higher supply forces businesses to reduce prices. This leads to a negative rate of inflation. Thus, deflation is the opposite of inflation that occurs in an economy.

It is a phenomena that occurs when demand for commodities decrease (may have caused because the purchasing power of people have declined) or supply of commodities increase, leading to a decline in the overall price level. This leads to a negative rate of inflation. Thus, deflation is the opposite of inflation that occurs in an economy.

Understanding Deflation through a practical example

To drive the point further, let’s take an example of three friends Ron, Tina and Natasha. We give each of them 10 candies. Now we ask them if they would be willing to trade 5 of their candies for a toy.

Suppose Ron is ready to pay 4 of his candies. Tina also likes the toy so she is ready to pay 5 candies. Natasha wants the toy more and is ready to pay 6.

Now let us take 5 candies away from each of them. Natasha obviously cannot afford to buy the toy now. Ron likes the toy but he doesn’t want to be left with just one candy. So all of them are now unwilling to pay the amount they were ready to pay earlier due to lower purchasing power.

We also need to consider the impact on the person who is selling the toy. He must now reduce the price of the toy if he wishes to sell it. This leads to deflation.

Not as good as it sounds

At first sight, deflation seems like a favorable economic condition. The reality is the opposite. Deflation is a sign of deterioration of economic conditions. It is often associated with a rise in the level of unemployment within an economy. As demand of commodities declines, firms start producing less. Lower production reduces the demand for factors of production – land, labor, capital and entrepreneurship. This ultimately leads to increase in unemployment.

Decline in production affects business firms even more. Businesses have to deal with lowering profits. They are not able to invest more capital or focus on development of new technologies.

Similarly, business firms are at loss (profits decline due to decline in production and selling of commodities) during deflation, which further hampers the expansion of capital and development of new technologies.

Causes of Deflation

Deflation is often caused due to reduced supply of money. But, it may also result due to a decline in personal, governmental, or investment spending. There are other economic factors that lead to the phenomena of declining prices. Some of the factors contributing to deflation are stated below:

Increased productivity of the firms

Businesses and manufacturing firms become more productive through new and innovative processes of production. As efficiency increases, the stock level of goods and commodities increases. To sell more and reduce stock levels, producers reduce the price level of goods and services. This may have a profound effect on the entire economy, leading to deflation.

For example, after the fall of Soviet Union in 1991, people from the newly formed countries were willing to work at low wages for a living. Companies in the United States outsourced their work at lower wages to those people. Subsequently, their supply increased and so they had to reduce price of the commodities. This led to deflation in the 20th century.

Decrease in money supply

Deflation occurs when money supply is slower than the supply of commodities. Prices decline because there is limited money flow in the economy. So, business firms accept lower prices for goods and services in order to earn as much as they can.

For example, in 1913 the Federal Reserve in the United States contracted the supply of money. This reduced the purchasing power of households and individuals. As a result, demand declined, and producers were forced to sell at lower prices, which caused deflation.

Fall in aggregate demand

Aggregate demand falls when people demand less of the goods and services. This occurs when people hoard money with an expectation of further rise in the value of money. Producers are thus forced to reduce the price of commodities in order to avoid profit decline and piling up of inventories. This results in deflation in the economy.

Deflationary Spiral

People become cautious spenders in an economy going through mild deflation. The economy reaches a situation where it cannot revive from declining prices and aggregate demand levels. This accumulates and it leads to further decline in prices in a vicious circle known as the deflationary spiral.

The diagram below shows how deflationary cycle affects the economy:

Deflationary spiral

Change in structure of capital markets

To compete in a market, producers try to sell their products at a lower price than their competitors. The increase in demand can help them get a return on their investment later, but this needs more investment to begin with.

Changes in capital structure can make it easy for companies to access debt and equity markets. Manufacturing companies can invest in new technologies, reduce costs and improve efficiency.

Firms can then reduce prices of the supplied goods to make a sale in the market. This may result in deflation.

Effects of Deflation

Deflation can damage the economy severely. There have been cases where countries never recovered from this economic condition. Some of the major impacts seen in the economy as a result of deflation are stated below:

Change in customer spending pattern

Falling prices often has an unfavorable impact on the spending pattern of consumers. It encourages people to delay their purchases because of the expectation of further price fall in the future.

Demand for luxury goods such as TV or car reduces because people wait for the commodities to become cheaper. Thus, deflation leads to lower consumer spending.

Cyclical unemployment

Deflation occurs due to fall in aggregate demand in the economy. This leads to business firms reducing their output levels which results in laying off of labors. As consumers delay spending while waiting for the prices of commodities to fall, economic activities decline, and this gives rise to unemployment.

Decline in business revenue

Business firms significantly reduce prices of the produced commodities in order to stay competitive against the falling prices in the economy. Subsequently, revenues earned by these firms start declining.

It is natural for revenues to fall sometimes, even during normal economic conditions. The problem lies in the fact that deflationary cycles are repetitive. Firms cannot recover from business losses during deflationary period.

Decline in supply of credit

Financial institutions and lenders decrease the supply of credit as deflation starts rising in the economy. This is because during deflation, value of assets used as collateral by individuals such as houses decline. So, in case borrowers are not able to pay back the debt, lender would have to recover their investment through property seizures. Since the value of properties are in a declining state, lenders cannot fully recover the value. Thus, creditors become more reluctant in providing credit or loan to borrowers.

Deflationary spiral

The falling of prices of goods and services triggers the deflationary spiral.

As profits decline, businesses are less inclined to make new investments. Firms also lay off workers to cut costs. This reduces household incomes and decreases aggregate demand. The economy falls into a deflationary trap.

Increase in real value of debt

During the period of deflation, debtors face a difficult time in paying off their debts. Business firms as well as individuals have to give up larger portion of their disposable income for debt payment. This is because, during deflation, firms are likely to earn less profit, and individuals face the problem of lower wages rates. Thus, deflation increases the real value of money and the real value of debt.