What is Deflation?

Deflation is a general decrease in the price level of goods and services. If the Consumers expect the prices to fall later then they postpone their purchases. Who wouldn’t want to buy goods and services at a lower rate in the future? This reduces the overall spending in the economy and which ultimately has an adverse impact on it(the economy).

Either there is a fall in aggregate demand or a supply shock that leads to deflation. And, when that happens central banks would use monetary policy tools to restore aggregate spending. It would reduce the interest rates. But, there is a limit to that as well. In such an environment, where interest rates are already low. Bringing interest rates to zero just won’t serve the purpose. The cost of borrowing could still be high for individuals and corporations. They find it better to stay in cash and not spend it.

If a business intends to grow then it has to invest in factors of production. If the economic conditions are not favorable then businesses would choose to delay any investment. And, this all happens as price fall. The more they delay the better it is for them. Apart from that, certain businesses may face tougher conditions. Especially the ones that are affected by the vagaries of the business cycle. Not only do they defer any further investment but also consider ways to reduce costs.

The Federal Reserve mandate requires it to pursue maximum employment and price stability. So, it steps in and takes corrective measures.

Under such circumstances, central banks would have to resort to negative interest rates. Among other things, it reduces the profit margins for the lenders. The purpose is the make savings unattractive to both individuals and corporations. Effectively, it would push them to spend more and that turns the wheels of the economy towards prosperity.

What happens when none of the above works the way it should i.e. the deflation continues unabated? It puts severe stress on corporations’ balance sheets, which marks the beginning of a tough time for lenders. And, if the prices continue to fall then corporations try to reduce costs. One of the measures they may resort to is either reducing wages or layoff some of the labor force. If the wages don’t come down then corporations don’t have the option but to reduce the labor force.

But, deflation is not always something to worry about. If there is a fall in aggregate demand while the aggregate supply stays constant or is increased then it is bad news for the economy. On the other hand, if there is an increase in aggregate supply due to technological improvements, productivity increases while the aggregate demand stays constant then it won’t affect the economy at all. But, how this is good for the consumer? 

Understand it with the help of an example. In the 1970s a Television set would have cost you $515. But, with advancements in technology, we can get one for just $148 today. Technological advancements have reduced costs for producers, which in turn has reduced prices. This leads to an increase in sales. While revenue for corporation increase, consumers get products with new features at lower prices. A win-win outcome for everyone involved.

So, deflation is not always bad. It is the underlying cause that should be examined to ascertain its impact on the economy. It can go both ways.

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