Deflation Causes and Effects in Economics

Table of Contents

What is deflation in economics?

Deflation refers to a general decrease in the prices of goods and services which typically has to do with a decrease in the supply of money and credit in the economy. In essence, deflation occurs when the prices of goods and services begin to decline in the economy over a given period of time. A currency’s purchasing power rises overtime during deflation. One of the reasons why prices fall is increased productivity and technological improvements. In essence, the nominal cost of capital, labor, goods, and services fall as a result of deflation although their relative prices may remain constant. This economic situation has raised serious concern among economists over the decades.

Deflation can be of benefit to consumers because their purchasing power increases. That means they have the ability to buy more goods and services with the same nominal income over time. In other words, it can boost disposable income and increase demand in the short run. However, not everyone derives benefit from lower prices and this raises concerns in the hearts of economists with regard to the falling prices in different sectors of the economy, especially when it comes to financial matters. In the long run, consumers start to push their purchasing decisions back, hoping that they will get the product at a cheaper rate if they begin to expect deflation each year.

Particularly, deflation can be harmful to borrowers. This is because they are bound to repay their debts in money whose worth is more than the money they borrowed. This also applies to any participant in the financial market who invests or carries out speculations on the prospect of rising prices.

In the course of the deflationary crash, the debts within the nation begin to decline. The economy outgrows the growth of the amount of money in the economy. When it becomes persistent, it has a tendency of creating a drag on the economy as consumers would keep pushing back their spending as goods will become cheaper each year.

For governments, businesses, and consumers, deflation can be less economical when it comes to the issue of debt financing. However, it brings about an increase in the economic power of savings on the basis of equity financing. From the viewpoint of an investor, companies that accumulate large cash reserves or have debts that are relatively relative are more attractive under deflation. The reverse is the case for businesses that are highly indebted with little cash holdings. This economic situation also encourages rising yields and brings about an increase in the necessary risk premiums on securities.

Types of deflation

There are two major types of deflation namely;

  • Strategic deflation
  • Circulation deflation

Strategic deflation

Strategic deflation occurs when the government establishes monetary policy which has to do with the control of consumption symptoms that tends to be excessive in the economy or community. When excessive consumption occurs, there can be a suppression in the increase of the price of products in the market. In essence, this type of deflation comes about when the government and the central bank implement policies to reduce the interest rates. It will then become easier for consumers to obtain loans from the bank. Also, producers will keep their money in the bank so as to generate a large amount of interest. In turn, this will bring about a decrease in the circulation of money as well as a decrease in the prices of goods.

Circulation deflation

Circulation deflation results from unstable economic conditions in a country. this occurs when there is a slump in the transition period of a stable economy. Such situations will certainly raise worries in the hearts of the public. Circulation deflation begins when the people’s needs for economic goods decrease significantly. Also, there are situations whereby the production of similar goods in similar quantities becomes excessive in amount. In later times, this will bring about a dramatic decrease in prices.

What causes deflation?

A number of factors bring about deflation. However, it is important to note that these factors alone may not necessarily bring about deflation. For instance, then the demand for goods falls, businesses will be forced to reduce prices so as to stimulate demand. This will therefore cause an economy to expect deflation. If then, the central bank prints billions in currency, this deflationary pressure could give way as the currency circulates in the economy thereby bringing about an inflationary effect.

Factors that can contribute to the rise of deflation exist when we look at them individually. However, in reality, these factors come together to bring about deflationary pressures in their own right.

Now, what are these causes?

  • Fall in consumer demand
  • Aggressive competitive markets
  • Increased productivity
  • Technological advancements
  • Supply shocks
  • Decrease in money supply
  • Consumer expectations
  • Policy implementation by the government or the Central bank

Fall in consumer demand

When consumers’ demand for a product or service falls, then it passes a signal across to the producer that at a definite price, they will no longer want to buy. It is possible for this to happen so rapidly and in this case, a business will experience a sudden fall in the demand for their product as each year passes. When this happens, producers have the option of either reducing the amount of staff they have or reducing prices. So, some will get rid of staff while others will reduce prices. However, the employee or staff of one business is the consumer of another business. By implication, when a business gets rid of an employee, the demand for products will further fall. This, in turn, turns into a vicious cycle.

Businesses cut down jobs and this reduces demand and this further gives them the incentive to further cut down jobs. As unemployment increases, businesses will experience further falls in demand and this gives them no other choice than to reduce prices. It can also be that the business fails to implement accurate calculation of the production amount (output). He produces in a very large quantity. To solve this problem, the producer can organize output to equate the demand from consumers.

Aggressive competitive markets

There are situations whereby markets can become extremely competitive. The industry is probably aging as well as struggling to attract new customers, this makes existing players cut prices. On the other hand, the industry is new, and firms that exist in the industry cut prices in order to attract customers in the growing market. Price wars existing between firms in the industry have proven to be deflationary in the aspect of prices.

Increased productivity

The increase in productivity implies that fewer inputs are required to produce the same number of outputs. In another context, it takes not much time, effort, or money to produce the same number of goods. Businesses as well do not need to spend so much amount to deliver goods to their customers. Prices begin to decline as businesses compete for customers and this can bring about a deflationary environment. However, this may be a short-term adjustment to reflect new gains in productivity.

If a firm purchases a new machine that produces twice as many goods, it may have higher chances of reducing prices by probably half. There may be a permanent reduction in prices but this will not continue until there are further productivity gains. Companies usually will increase the production of similar goods to reach out to many customers while competing with one another. In the long run, there will be various strategies to keep prices as low as possible.

Technological advancement

Technological advancement is another factor that contributes to the emergence of deflation. When a new product enters the market, it tends to lose value in subsequent years as more powerful products emerge. What is visible due to gradual deflation in the price of the original product is that the technology becomes obsolete. For fixed assets, this can be termed as depreciation. By implication, when a new asset emerges, it tends to reduce the value of what it surpasses. In turn, this causes the older models of the assets to deflate in prices.

Supply shocks 

This occurs when there is an unexpected event that brings about sudden changes in the supply of a commodity which results in an unforeseen change in price. This can bring about deflation on a short-term basis mostly when the event amounts to an increase in the level of supply of commodities. As stated above, an increase in supply brings about a fall in the prices of commodities. New innovation can drive prices down thereby playing a crucial role in suppressing the overall rate of inflation.

Decrease in money supply

When the supply of money does not increase in the same proportion as the supply of economic output, there will be significant levels of deflation. If the opposite occurs, it will bring about hyperinflation which is harmful to an economy. A decrease in money supply usually comes about as a result of high-interest rates from banks. This offer, therefore, causes many people to keep some money in the bank.

Consumer expectations

Consumers are bound to push purchasing decisions backward when they are not certain about their income in the future as well as the overall economy. This implies that they will begin to save more and consume in the later period. An overall uncertainty with regard to job security can bring about this. This, in turn, will cause businesses to face fewer demands for their products which will further force them to start reducing prices so as to attract customers. If deflation kicks before the expectation of consumers changes, it can prove to be a vicious cycle. ideally, deflation starts when businesses/firms reduce prices while consumers keep pushing back purchasing decisions as they expect prices to further fall.

Policy implementation by the government or the Central bank 

The government or central bank can implement policies that will eventually amount to a deflationary crash. Here, if the central bank decides to implement policies that relate to high-interest rates, the masses will decide to keep some of their funds in the bank. In turn, this will bring about a decrease in the money circulation in the economy or community.

Effects of deflation

Deflation has several effects on an economy such as;

  • Declining demand
  • Unemployment and lower wages
  • Growth in the debt burden
  • Decrease in investment
  • Strengthening currency
  • Further delay in consumer purchases
  • Higher real interest rates
  • Deflationary cycle

Declining demand

A fall in the prices of goods across an economy is a deflationary signal to consumers. This may look good for the economy in the long run as consumers notice a decline in price and decide to buy more of the products. It is, as well, bound to stimulate further business investment and production. The wider economy can derive benefits from temporary deflation because it can induce demand. However, if the money fails to increase proportionately as the economic output, deflation is bound to become permanent. In other words, if deflation induces greater production while the amount of money supply remains constant, then it means that more goods are being produced but not enough money to maintain their value.

In this case, there is a tendency of deflation becoming permanent and self-fulfilling even when there is a massive circulation of money in the economy. This is because of the fact that consumers begin to expect falling prices and decide to push their purchasing decisions backward.

Unemployment and lower wages

As businesses experience lower levels of demand, they also experience lower profits and a decrease in the need for workers to produce goods. This simply means that they no longer need many workers because they are not selling as much as before. The consequence of this is that businesses begin to get rid of excess staff/employees they no longer need. Another alternative is that some businesses will look towards lowering wages as it can be extremely expensive to lay off workers in some economies. While some businesses cut down prices but they also cut down the wages of workers and make some potentially dismissed. In other words, real wage unemployment results because as prices keep falling, firms will not be able to afford workers. If workers resist nominal wage cuts, then the will be an issue of real wage unemployment.

This will further have an effect on the unemployed or dismissed as there are higher chances for them to default on their debt or fail to pay it off. Also, there is a tendency for banks to lose their money during such periods. So, they may decide to reduce their risk exposure by increasing the amount of cash in hand and also the number of loans they issue.

Growth in the debt burden 

Prices and incomes decline as deflation takes hold of an economy. While businesses are taking in less money, employees are also taking in less. So if for instance, any of the parties decide to take out a loan, they will have to repay that amount unfailingly, but yet, their incomes are declining which means that it takes them a longer period to take it back. In other words, real value debt grows while prices and wages fall. This in turn poses difficulties in paying off debts and meeting debt repayments.

Decrease in investment

Both consumer goods and capital equipment decline in prices as prices decline. This implies that businesses that look towards investing face similar choices as consumers do, such as paying more now or waiting till next year to pay a lower price. This results in the fact that both businesses and consumers invest and spend less. Simultaneously, businesses also face a rising debt burden because deflation is forcing them to reduce prices and profits. This does not change the amount of debt owing. The outcome is usually that businesses will have to make use of more of their profits to pay off their debt. Businesses, therefore, have to pay more for their debts thereby discouraging them from taking out further loans in the future.

Strengthening currency

The fact that deflation pushes prices down means that international firms can pay less to buy more. In other words, foreign importers need less currency in order to buy the same amount of goods. This implies an increase in the value of the currency.

Further delay in consumer purchases

As seen above, as prices of commodities fall, consumers expect prices to further decline in the future. This causes them to put off the purchase of goods.

Higher real interest rates

It is not possible for interest rates to fall below zero. Because of this, there will be a rise in the effective real interest rates if deflation is present. Therefore, even in the face of economic depression, real interest rates remain high. In turn, this discourages borrowing and encourages saving.

Deflationary cycle

What the deflationary cycle implies is that lower demands bring about a reduction in prices, and a decrease in prices brings about a reduction in prices. This, therefore, forms a vicious circle.

In a deflationary cycle, lower demand leads to lower prices, and falling prices cause lower demand, it is a vicious circle.

Why is deflation bad?

Although deflation has so many negative effects, it is not always bad. This is because it can bring about an increase in economic growth if consumers are not expecting prices to further fall. In other words, consumers will increase their demands for commodities as well as purchases or spending as soon as they notice a fall in prices. On the other hand, if they expect prices to fall in the future, deflation can be bad as there will be a delay in consumption, lower economic growth, greater debt burdens, and a decrease in investment. These negative effects usually manifest in the long run, when deflation persists.

How to deal with the deflation

Some of the tools effective in dealing with deflation include;

  • Lowering of interest rates
  • The implementation of monetary policy
  • The implementation of fiscal policy
  • Non-monetary policy implementation
  • Debt repayments
  • Preparation of an emergency fund

Lowering of interest rates

Most people tend to keep their money in the bank when interest rates are high. Certainly, this will bring about deflationary pressures to an economy because of the fact that there is a decrease in the circulation of money. This makes it necessary for banks to reduce interest rates in order to facilitate an increase in money circulation.

The implementation of monetary policy

Usually, central banks implement monetary policy to increase the circulation of money in the economy. Alongside this, there will be a discount rate policy. When the central bank takes this step of reducing interest rates, people will withdraw their money from the banks.

The implementation of fiscal policy 

The government has a major role in determining the fiscal policy that is suitable for the maintenance of a country’s economic conditions in a better way. This is possible by the renewal of existing expenses.

Non-monetary policy implementation

Another suitable way of increasing the money supply/circulation in an economy is the implementation of non-monetary policy.

Debt repayments

Individuals and businesses need to pay off their debts immediately they notice a deflationary sign. This is because of the fact that interest rates increase in the occurrence of deflation.

Preparation of an emergency fund

The occurrence of deflation in a country will certainly have an impact on the bankruptcy of a business or company to job losses. It is of great importance to prepare an emergency fund for expenses incurred of six to seven months. An emergency fund gives an assurance that one will not face economic difficulties in the occurrence of deflation in an economy.

Deflation vs inflation

There is an interrelationship between deflation and inflation but there are major differences. The differences are as follows;

Deflation refers to an economic situation of a continuous decrease in the prices of goods and services over a specific period of time. On the other hand, inflation is an economic situation where there is a persistent increase in prices of goods and services thereby bringing about a decrease in the value of a currency.

The two terms also differ in their causes. While deflation results from a decrease in money circulation, inflation occurs as a result of an increase in money circulation. This also implies that in deflation, too many commodities pursue a little amount of money while during inflation, too much money pursue few commodities.

Deflation and inflation differ in their impacts on the economy. The occurrence of deflation will trigger an increase in the unemployment rate while inflation brings about a decrease in the purchasing power of a currency.

In essence, deflation is directly the opposite of inflation. As the value of money tends to increase in deflationary periods, the reverse is the case for inflation.

Frequently asked questions

Is deflation good or bad?

Deflation is good in the short run although most experiences in different economies have turned out to be detrimental. Deflation has a lot to do with a decline in the rate of economic growth and a higher unemployment rate. Also, a company’s revenue tends to decrease as a result, and debt burdens on individuals and businesses increase as well. However, it is possible for an economy to experience good deflation. This is usually in the short run as stated in the beginning. Deflation can strengthen the value of a currency and help the public to know more about the importance of saving. It is clear that savings provide convenience for individuals and businesses as they can meet their needs in the future. At some point, businesses have the incentives to increase their productivity.

Is deflation worse than inflation?

Although both deflation and inflation have their strengths and weaknesses, deflation can be worse than inflation at some point because interests rates can not decrease below zero. Once interest rates arrive at or hit zero, then central banks must make use of other tools. But as long as businesses and individuals feel as though they are less wealthy, they spend less and further reduce demand for commodities. We can conclude that short-term deflation is not worse than inflation since ir provides some benefits to the economy